Is Your R&D Spend Healthy?
Updated: Dec 7, 2022
Every company executive eventually poses the question at some point or another to get an understanding of whether their company’s spending is healthy or in line with the norms.
The short answer to this question is that benchmarking with the average R&D spend (*) from revenue by industry is fairly accurate and consistent and makes a good benchmark to peer groups, but it is nevertheless somewhat apples to oranges.
The long answer is that benchmarking should provide a healthy range for guidance only and then should be refined using other variables. However, a company must account for all of the nuances and differences to get their own proprietary value that is adequate for their situation. Some of these variables can have a small impact, but the aggregate can make an order of magnitude difference in the percentage, savings, or extra funds to use elsewhere.
The total global R&D spending reached ~$2.23 trillion globally in 2018 compared to ~$1 trillion in 2008-10, and ~$500 billion in 1995. Aside from some spikes in industries like healthcare, the software industry carries the highest R&D spending.
The data below demonstrates a few different pivots for R&D spend benchmarks in an absolute sense, in the absence of any variables that have an impact on R&D.
Technology companies should target to fall in the benchmark ranges below based on their stage. Start-ups are not included as the range would not be meaningful given most of the funds are typically used to get to market quickly.
(*) This article takes into perspective a simplified R&D percent of revenue calculation based on total yearly revenue and does not take into account capitalization accounting needs and used the formula: R&D % of Revenue = R&D Expenses / Revenue.
From an industry perspective, technology companies are the most R&D intensive. On average, leading software companies invest between 10–15% of their revenue in R&D. In a report by Crunchbase that analyzed 108 companies, provides some in-depth granularity. For example, the average R&D is 23% for SaaS (e.g. Dropbox, Atlassian, DocuSign, Salesforce, Wix), 32% for Social Media (Facebook, LinkedIn, Twitter), 10% for Marketplaces (eBay, Expedia, Etsy, Zillow), 18% Content Distributors (Yahoo, Google, Netflix), 15% e-commerce (Overstock, Shutterfly, Amazon), and 13% for Hardware (Tivo, GoPro, Apple, Roku).
Another interesting view is the amount of spend which seeks to understand the extent of investments from larger companies. Recode conducted this analysis for large US-based companies. While the R&D spend itself may not be the only yardstick of success and innovation, the large investment, even when inefficient, gives a competitive advantage and makes it difficult for smaller companies to compete.
A view of mature companies across most industries based on the S&P 500 (source: PwC Strategy) gives a comparative baseline where most are below 5% with the exception of 13 sectors. Some industries such as biotechnology that have major R&D spend spikes or are cyclical in nature have been omitted so as not to skew the averages.
IT Services: 6.45%, Electronic Equipment, Instruments: Components: 7.40%
Healthcare Equipment/Supplies: 7.60%, Life Sciences Tools and Services: 7.60%
Capital Markets: 7.70%, Hotels, Restaurants, and Leisure: 8.70%
Internet and Direct Marketing Retail: 10.95%, Healthcare Technology: 13.20%
Pharmaceuticals: 13.30%, Semiconductors, and Semiconductor Equipment: 14.50%
Communications Equipment: 16.90%, Internet Services: 17.95%, Software: 19.35%
8 Variables That Can Impact The R&D Spend
State of the Product (e.g. legacy): If a software company has significant technical debt or a legacy architecture, they may be in need to invest more to do a transformation or upgrade the product in order to ensure a healthy growth path
Types of Product: A company that is purely product-based (e.g. SaaS) may need to spend much more on R&D compared to sales-led companies (e.g. Services)
Pre-IPO or Pre-Investment Year: Companies typically increase their spend pre-IPO or pre-investments to do upgrades, manage risks, or meet compliance needs
Company Size: The spending significantly varies based on the company stage or growth outlook. A company that has an aggressive growth outlook will probably spend larger amounts on R&D. A start-up is likely to spend most of its funds on R&D. A company in transformation mode is also likely to spend a higher amount
Lack of Focus: An excessive R&D spend can be a symptom of a lack of focus on the key product priorities or leaky side projects that are never getting to market
Industry: Some industries tend to have cyclical spikes in R&D spend especially in healthcare such as biotechnology and pharmaceuticals
Other Dynamics: The general market outlook, profitability, pricing, customer churn rates, gross margin health, and employee attrition can all impact the R&D
Organizational and Engineering Efficiency: Aside from the amount spend, a major impact is attributed to how well and how efficient the execution is. Companies can significantly reduce their R&D spend through efficiencies with software development best practices, leveraging the right tools, and organizational designs. For example, adopting and sticking with Agile, implementing DevOps, having a healthy level of automation, upgrading the tools, or leveraging cloud technologies can add measurable efficiencies aside from the product quality improvements
Other Related Complementary Strategies
None of these actually measure R&D directly but applying those strategies as well can provide more confidence about whether the R&D spend is in line or adequate.
The Rule of 40
The rule of 40 is a common simple metric asserting that growth rate and profit margin should equal 40%. The formula is used by investors to measure performance. It is more geared to measuring growth and less valuable on a standalone basis. The rule formula is either Revenue Growth + EBITDA Margin or a weighted approach (Revenue Growth * x%) + (EBITDA Margin * y%) when growth over profitability is desired. This is especially true for smaller companies with more ambitions to achieve scale and maximize exit multiples. Brad Feld offers great insights into the rule of 40.
The Old Rule of 40/20/20
While this is an old rule introduced for marketing design by Ed Mayer in the mid-1900s, some adapted it with the intention to balance the spend where 40% of revenue goes to Sales&Markerting, 20% to R&D, and 20% goes to G&A. It’s not a sophisticated formula that helps surfaces overspend situations.
R&D is everything incurred in the process of developing or creating a new product or service while G&A is a subset of the operating expenses comprising rent, utilities, insurance, legal, and some salaries.
Customer Lifetime Value Formula
Clint Jackson expands on the idea of relating R&D to customer value which may provide a custom estimation eliminating other variables and provide a simple tool to calculate.
Taking time to understand how the R&D compares to peers in an industry group by size, geography, and company stage is an important reality check that executives should use as a tool on regular basis. Intentional spend whether dialed-up or down gives control and confidence in the execution capabilities.
The benchmark should not be taken in an absolute vacuum, but factors that affect the overall R&D should be considered in order to fine-tune and adjust. Some of these factors especially around efficiency execution can have a significant impact on the R&D.
About the Author
Hazem has been in the software and M&A industry for more than 26 years. As a managing partner at RingStone, he works with private equity firms globally in an advisory capacity. Before RingStone, Hazem built and managed a global consultancy, coaching high-profile executives, conducted technical due diligence in hundreds of deals and transformation strategies. He spent 18 years at Microsoft in software development, incubations, M&A, and cross-company transformation initiatives. Before Microsoft, Hazem built several businesses with successful exits namely in e-commerce, software, hospitality, and manufacturing. A multidisciplinary background in computer engineering, biological sciences, and business with a career spanning a global stage in the US, UK, broadly across Europe, Russia, and Africa. He is a sought-after public speaker and mentor in software, M&A, innovation, and transformations. Contact Hazem at firstname.lastname@example.org