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Innovation Canada: A Call to Action

2. The Context of the Review (continued)

Innovation and Business Strategy

What influences the decision of an enterprise to make innovation the core of its competitive strategy? What leads some firms and not others to look constantly for ways to create or enter new markets, to develop new or improved products, to tolerate the disruption of introducing more efficient processes and organization, and to take the (calculated) risks that innovation always involves? Although there is no consensus on all the factors that come into play, the Panel adopted, as a working hypothesis, a modified version of the logic model developed by the CCA's Expert Panel on Business Innovation (Figure 2.4). According to this view, a firm's decision on whether (or not) to adopt an innovation-based strategy depends principally on the following six broad factors, the relative importance of which will vary with the firm's specific circumstances.

  • Market opportunities. A successful business strategy depends, first and foremost, on an understanding of the needs of the customer and the related identification of market opportunity. Business strategies focussed on innovation constantly seek better ways to meet existing customer needs – for example, the overnight courier – or ways to stimulate entirely new sources of demand – for example, the smart phone.
  • Structural characteristics. Is the firm in a sector that is traditionally innovation oriented, such as biotech or computers, or is it involved in the provision of a more standard product or service? Is the firm a subsidiary of a foreign company that conducts most R&D abroad? Does the firm sell its product to the end-user, or does it provide an intermediate input – for example, lightly processed resources – in a global value chain?
  • Competitive intensity. Must the firm continuously innovate to survive because it provides a product or service driven by evolving customer tastes? Is the firm active in a market (domestic or foreign) that is exposed to intense global competition and must therefore innovate to survive and prosper?
  • Climate for new ventures. Is the firm part of an innovation cluster in which there is a readily available supply of sophisticated venture financing, cutting-edge knowledge, highly skilled graduates and other firms with complementary expertise?
  • Public policies. Are legal and regulatory frameworks and policies – for example, in areas such as competition, corporate taxation, bankruptcy and intellectual property – conducive, or not, to business innovation?
  • Business ambition. What is the corporate culture of the firm? To what extent is it risk averse? To what extent is it dedicated to expansion?

It is beyond the scope of this review to address all of these factors. The Panel's mandate is focussed on federal government support programs for R&D that is undertaken by business or that is commercially oriented. The effectiveness of that support will nevertheless depend ultimately on the extent to which businesses in Canada are motivated to adopt innovation-based business strategies that require R&D to be performed. In this regard, competitive intensity provides the strongest motivation overall. In business, the "necessity" created by competition is often the "mother" of innovation. The Panel's advice in this review will therefore have much more impact on Canada's economic performance if it is complemented by a suite of policies to foster competition as recommended by the Competition Policy Review Panel (2008), also known as the "Wilson panel" (see Annex B). That panel pointed to several sectors that remain buffered from competition by various regulations, including restrictive foreign ownership rules. Regulated industries account for about 15 percent of Canada's overall business sector GDP (Gu and Lafrance 2010, p. 50; based on 2006 nominal GDP), which suggests that there is significant scope for regulatory reform to foster competition and, as a result, innovation and productivity growth.

Figure 2.4 A Firm-Centric Model of the Business Innovation Process
Figure 2.4  A Firm-Centric Model  of the Business Innovation Process

A business strategy focussed on innovation is what creates the demand for R&D as a key input. On the other hand, the extent of R&D undertaken by a company will also depend on its cost. Consequently, if government policies and programs reduce the supply cost of R&D for a business, it will likely undertake more R&D than would otherwise be the case. Research and development incentives may even be sufficiently attractive to induce a shift over time in a business's strategy toward a greater focus on innovation.

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Business Innovation: Beyond R&D

Innovation occurs throughout the economy, in all sectors and in firms of all sizes. Consequently, business innovation involves much more than R&D. This is abundantly clear in the OECD's definition of innovation cited earlier and in Box 2.1. Innovation is found not only, or even primarily, in sectors associated with high technology, although the effective use of technology continues to be a key driver of innovation and productivity growth in modern economies. Even in sectors where R&D is prevalent, many innovations are developed without it. For example, based on survey data from 22 countries (including Canada's manufacturing sector), a recent OECD report indicates that "a large share of firms develop their process, product, organizational or marketing innovations without carrying out any formal R&D. This holds true even for new-to-market innovators who successfully introduce innovations regarded as 'technological'" (OECD 2010a, p. 23).

Research and development is nevertheless of disproportionate significance for the economy, since it contributes in an essential way to innovation in many of the most dynamic firms and sectors that are at the leading edge of global growth and value creation – for example, firms that either produce or intensively use pervasive technologies like ICT, biotechnology and advanced materials. There is usually a close relationship between activities that are heavily knowledge based and those that require R&D. Business expenditure on R&D also correlates strongly with other standard indicators of innovation such as patents, exports of technology-intensive products and employment of people with advanced education. Moreover, the economic benefit of R&D spending is rarely confined to the R&D performer alone, and instead "spills over" to other firms, thus amplifying the economic impact. For all of these reasons, a thorough survey of the literature by the US Congressional Budget Office concluded that "a consensus has formed around the view that R&D spending has a significantly positive effect on productivity growth," while allowing that it is difficult to quantify the effect precisely (2005, p. 1).

The Panel, consistent with its mandate to address business R&D in the larger context of innovation, considered not only those government programs that foster increased business R&D investment directly, but also those that support the key factors that complement R&D in a firm's innovation strategy. These are captured in Figure 2.4 as the four categories of enabling inputs needed to implement an innovation strategy in cases where R&D is a key component. The four complementary innovation inputs are:

  • ideas and knowledge that underpin innovation
  • talented, educated and entrepreneurial people whose imagination and energy drive the development and implementation of innovative business strategies
  • networks, collaborations and linkages that enable innovation partners to pool staff and resources, and to share information, risks and costs
  • capital and financing that help entrepreneurs build a bridge between their innovative ideas and commercial viability.

This review is focussed on federal initiatives to help businesses develop or access each of these inputs. To set the context for the Panel's findings and recommendations in subsequent chapters, what follows is a discussion of the four identified inputs to R&D-based business innovation, drawing on recent studies to summarize the key facts and hypotheses.

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Innovation Input: Ideas and Knowledge

In the context of this review, the acquisition by a company of ideas and knowledge refers primarily to the output of R&D, whether performed in-house or sourced externally. There are, of course, many other channels by which businesses acquire the ideas that stimulate innovation. In fact, surveys of innovating firms demonstrate consistently that the great majority of ideas originate with employees, customers and other firms (Box 2.4). Nevertheless, converting these ideas into something of commercially significant value will often require R&D to be undertaken, and almost always when there are technical complexities to be understood and mastered. Moreover, firms engaged in R&D and close to the frontier of relevant technology are better placed to adopt or adapt innovations that originate elsewhere.

The total value of all R&D performed in Canada in 2009 was just under $30 billion, or 1.92 percent of GDP. The business sector accounted for the largest portion of this amount ($15.2 billion), followed by the higher education ($11.1 billion) and government ($3 billion) sectors (OECD 2011). The history of R&D spending (relative to GDP) of these three major performing groups is traced in Figure 2.5.

As discussed earlier, the higher education and government sectors are key players in Canada's innovation system and complement the role of business. Universities perform the great majority of basic research, although basic and applied research activities are increasingly intertwined. The R&D undertaken at colleges and polytechnics is often focussed on helping companies address commercialization challenges by turning those challenges into student-led applied research problems. Colleges and polytechnics also directly assist firms with their innovation needs – this is the case, for example, with the long-standing College Centres for the Transfer of Technologies associated with Quebec colleges and Cégeps, which assist innovative companies through technical support, technological development, and information and training (see also Figure 2.6). Government laboratories, meanwhile, conduct science in support of public policy mandates as well is in relation to certain commercially oriented activities.

Figure 2.5 R&D Expenditure in Canada, 1981–2009 (percentage of GDP)
Figure 2.5 R&D Expenditure in Canada, 1981–2009 (percentage of GDP)

Box 2.4 Where Do Businesses Get Their Ideas for Innovation?

The Panel undertook a survey of R&D-performing firms in Canada with a sample of more than one thousand companies randomly selected to be representative along the dimensions of size, region and sector. a A key question in the survey asked: "What are the most important sources for your firm's innovation ideas?" (respondents were able to identify multiple sources). More than a third (37 percent) first mentioned "employees" as the most important source of innovation ideas, and an additional 22 percent identified employees in further mentions. The next most important source was "clients/customers" (25 percent of first mentions). No other source of innovation ideas was first mentioned by more than 5 percent of the surveyed R&D-performing businesses.

a Further discussion of the survey is found in Chapter 5. (Return to reference a)

Most Important Sources of Firms' Innovation Ideas
"What are the most important sources for your firm's innovation ideas?"
[Open ended – Multiple responses accepted]
Most Important Sources  of Firms' Innovation Ideas
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Innovation Input: Talented, Educated and Entrepreneurial People

Canada's future as an innovation-based economy depends on ensuring there are sufficient numbers of talented, educated and entrepreneurial people. The primary source of such talent is our public post-secondary education institutions – the universities, polytechnics and community colleges (including Cégeps in Quebec) that produce the innovators and those who support innovative activity. These institutions are primarily funded through the provinces, although the federal government plays a role through transfer payments, student financial assistance and direct support for research training and innovation skills enhancements. The diversity of higher education institutions with varying missions and mandates provides Canada with the highly qualified and skilled people who are the bedrock of innovation. Each of these post-secondary education institutions has a unique role to play, producing workers for different components of the innovation ecosystem. Our university graduate programs produce the advanced Master's and PhD degree holders who can contribute breakthrough ideas that can ensure companies stay at the cutting edge of R&D; our universities and colleges produce Bachelor's degree holders who are often the front-line innovation performers; and our colleges produce technicians and technologists to facilitate the commercialization efforts of the firm. 1

It is the interplay among these complementary types of talent that builds an innovation economy. Since Canada's innovation gap is partly an education gap, improving our global performance will require the right mix in both the quantity and quality of talent. This demands a collaborative approach that brings together our post-secondary institutions, federal and provincial agencies as well as industry and other partners to ensure appropriate recruitment, training and deployment for industrial innovation needs. While Canada ranks first in the OECD for the percentage of its population with post-secondary attainment, it is middle of the pack in baccalaureate output and near the bottom for the number of doctoral graduates per capita. It is nevertheless encouraging that the growth in the number of doctoral degrees granted in Canada has been stronger – particularly in science and engineering – than in most comparable countries over the 2005–08 period, helping to improve our relative position (STIC 2011).

The earnings advantage of individuals with advanced degrees (relative to high school graduates) is less pronounced in Canada than in the US (Institute for Competitiveness & Prosperity 2010, p. 35). This is one indicator of relatively weaker demand by businesses in Canada for people with advanced degrees, and a situation consistent with a weaker commitment to innovation-based strategies by Canadian businesses. Statistics Canada has found that up to a fifth of doctoral graduates intend to leave Canada following completion of their degrees (Desjardins and King 2011). When they go, these graduates take with them knowledge and skills that could contribute to a more innovative and prosperous future for Canada.

Students learn not only through traditional classroom experiences, but also through hands-on research experience that exposes them to the realities of the business world and teaches the professional and entrepreneurship skills needed to fully contribute to their eventual workplaces. Employers see programs that encourage post-secondary student participation in research projects with business as having a number of benefits, including

  1. the chance to identify the best recruits,
  2. the ability to influence curricula to be more industry-relevant,
  3. exposure to new ideas and specialized equipment in educational institutions and
  4. access to a flexible workforce.

While domestic production of innovation workers is an imperative, demographic realities dictate that this is not sufficient to meet the expected industry demand; by some estimates, within 20 years there could be almost two million vacancies for skilled knowledge workers in Ontario alone (Miner 2010). An immigration system that targets necessary skill sets presents Canada with an opportunity to leverage the skills, insights and entrepreneurial talents of those born in other countries who come to Canada.

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Innovation Input: Networks, Collaborations and Linkages

Collaboration among businesses, governments and the higher education sector can contribute importantly to the conception and successful introduction of new products and processes. Businesses develop strategic partnerships in order to connect to global knowledge flows, share research results and R&D risks, pool skilled staff, commercialize inventions and help to access new markets. As a result, social and physical infrastructure linking collaborators and supporting networks are important for business innovation.

Effective collaboration between the business and higher education sectors depends on linking the "supply-push" of research and discoveries with the "demand-pull" of firms seeking to exploit the commercial potential of new ideas. As depicted schematically in Figure 2.6, this involves not only firms, universities, colleges and polytechnics, but also a spectrum of intermediary players that belong to an innovation "ecosystem" characterized by effective synergies, connections, and flows of knowledge and ideas. This is a complex mix, not least because of diverging incentives and organizational cultures among different institutions. These intermediary actors include the following:

  • technology transfer offices, which provide support to help bring university-generated research and intellectual property to the commercial sphere (others also perform this function, such as the Centres of Excellence for Commercialization and Research)
  • college applied research offices, through which colleges and polytechnics support firms with solutions for their specific commercialization needs
  • public research institutes and programs, such as government labs, National Research Council Canada institutes and others that are discussed in subsequent chapters
  • incubators, which offer technical expertise, mentorship and other services to help accelerate the development of entrepreneurial firms
  • angels and venture capitalists, who provide the risk capital that innovative start-up firms require to build a bridge between their new ideas and commercial viability.

In its overview of public–private collaborations, the STIC (2009, p. 34) explains:

While the overall picture is mixed, the balance of evidence suggests that many Canadian universities are first-rate scientific institutions. But in the context of the knowledge-based economy, it is not considered sufficient for a country's universities to produce ground-breaking scientific research in isolation … effective links between the three principal innovation funding/performing sectors [business, post-secondary education and government] are an important contributor to a successful national innovation system, especially as a mechanism for transfer of S&T into the commercial sphere.

STIC (2009, p. 34)

Canada ranks above the OECD average in respect of the percentage of higher education expenditure on R&D financed by industry – more than 8 percent in 2008 (OECD 2011). This means that post-secondary institutions are playing an important role as a resource for business innovation for certain activities and sectors. But the extent of collaboration appears to be relatively narrowly based, since Canada ranks near the bottom of OECD countries in terms of the proportion of businesses collaborating with universities for R&D (STIC 2009, p. 36).

Although commercialization of research-based knowledge is a key activity of public–private collaborations, networks and linkages, there are many other benefits stemming from such partnerships, including industry access to specialized equipment and personnel (particularly, potential future employees), and stimulation of new research questions and directions arising from problems faced by innovative firms (Figure 2.6).

Some have argued that concerns over the handling of intellectual property rights (IPRs), as well as restrictions that may be placed by corporate partners on the publication of research, are inhibiting productive collaboration between business and academic researchers. While such concerns may be well justified in certain cases, the vast majority of university research appears in the public domain in a timely way, allowing full access across the spectrum of potential industry users. With regard to IPRs, the Panel is not persuaded that any one model of ownership is best for all circumstances. Rather, negotiations over IPRs seem to be impeded most often by divergent valuations of early-stage intellectual property (IP). What inventors and institutions often see as an invaluable breakthrough, businesses may see as needing costly downstream development.

In addition to the above considerations related to IPRs, the Panel is concerned that Canada is not benefiting as much as it should from the valuable IP being generated in this country. While Canada produces IP in abundance, it is less adept at reaping the commercial benefits; too many of the big ideas it generates wind up generating wealth for others. The Panel believes that the government needs to explore this issue further. In particular, there is a need to develop the skills and knowledge of Canadian entrepreneurs regarding the effective management of their IP.

Figure 2.6 The Innovation Ecosystem: Converting "Research" into "Innovation" a
Figure 2.6 The Innovation Ecosystem: Converting 'Research' into 'Innovation'

a The horizontal axis represents the R&D continuum from curiosity-inspired fundamental research at the left to market-facing experimental development at the right-hand end. The focus of many post-secondary education institutions declines as R&D shifts from fundamental research toward development, although these institutions are active in applied areas, and colleges in particular are focussed in the mid-range of the spectrum. The R&D emphasis of business declines as the developmental and market-facing content diminishes. This creates an inherent structural gap in the mid-range of the R&D spectrum and requires a variety of intermediary institutions to complement the roles of post-secondary education and business participants in the innovation ecosystem. (Return to reference a)

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Innovation Input: Capital and Financing

Innovative start-up firms need access to risk capital to build a bridge between their new ideas and commercial viability. Risk capital can come from internal earnings or from external sources. With respect to the latter, it can take the following forms.

  • Seed and start-up capital to finance the very early stages of firms' development – activities such as proof-of-concept, product development and initial marketing – usually comes first from founders, family and friends, then from "angel" investors. The latter are typically individuals who have succeeded as entrepreneurs in technology-based enterprises and who are consequently able to provide not only financial investment but also mentoring of early-stage entrepreneurs in the angel's area of experience.
  • Venture capital provides financing for firms that survive the seed and angel-financed stage of development. Venture capital is generally provided through professionally managed funds combining the resources of a group of investors, which may also include public sector players.
  • Public markets, mergers and acquisitions enter the picture beyond the early stages of commercialization in response to the need for funds to support expansion, but before the company is able to access more conventional forms of finance such as bank or cooperative financial services loans.

Without an active presence in Canada of adequate sources of capital, some of the commercial benefits of innovations originating in this country could be exploited by firms in other countries with greater risk investment capacity and/or propensity. 2 This and related issues are addressed in Chapter 7.

The limited data available on angel investment in Canada suggest that "they are much less extensive, in relative terms, than comparable sources in the United States" (CCA 2009, p. 8). This has repercussions extending beyond the availability of financing, since early-stage investors are an invaluable source of mentorship and expertise. Rates of return of Canadian venture capital funds have been well below those in the US for both private and tax-assisted ("labour-sponsored") venture capital funds. The relatively low returns result from a number of factors, including subscale venture capital funds and a comparatively young venture capital industry in Canada that "has not yet developed sufficient breadth and depth of experience to select and mentor the best potential investment candidates" (CCA 2009, p. 8).

Capital investment in machinery and equipment also supports innovation within firms, as these assets embody the latest ideas, technologies and innovations developed by others. It is particularly noteworthy that the Canadian business sector has persistently lagged behind its US counterpart in ICT investment per worker (Figure 2.7). Given that the production and application of ICT played the central role in stimulating very strong productivity growth in the US over the past decade or more, the lagging ICT investment record of the private sector in Canada is a source of great concern. 3

Figure 2.7 ICT Investment per Worker in the Business Sector, Canada as a Proportion of the United States, 1987–2009
(current US dollars)
Figure 2.7  ICT Investment per Worker in the Business Sector, Canada as a Proportion of the United  States, 1987–2009 (current US dollars)

The Institute for Competitiveness & Prosperity (2010, pp. 39–40) underlines two main challenges that have inhibited the willingness of Canadian businesses to ramp up investments in technology: relatively high tax rates on capital investment and a lack of competitive intensity. Significant progress has already been made, and continues to be made, on the tax front – for example, a steady reduction in corporate tax rates, elimination of capital taxes and the further harmonization of provincial and federal sales tax regimes. The comparative lack of competitive intensity in Canada is more recalcitrant and is due primarily to a relatively small and geographically fragmented market and to policies that insulate some sectors from international competition. Initiatives to promote competition – and specifically, as noted earlier, those recommended by the "Wilson panel" – constitute an essential foundation for innovation policy in Canada.

Having now situated the Panel's mandate in the wider innovation context, the next chapter drills down into the programs at the core of the Review of Federal Support to Research and Development. Thereafter, the Panel presents its advice on how the government can enhance the impact of those programs.

1 Canada's rich and diverse landscape of about 250 post-secondary institutions includes 152 colleges, of which about 48 are Cégeps in Quebec, some are degree granting, some are known as institutes of technology and some are known as polytechnics. Many colleges are emerging actors in downstream innovation near the commercialization activities of small and medium-sized enterprises. There are 95 universities throughout Canada, many of which have world-class research capabilities. (Return to reference 1)

2 For example, a 2009 study published by Canada's Venture Capital & Private Equity Association states that "US-based funding generally supports later-stage companies and sometimes results in a shift of the company activities to the US. Building a strong and innovative technology-based economy in Canada requires a strong Canadian-based venture capital industry" (Duruflé 2009, p. 41). (Return to reference 2)

3 As part of the government's "Digital Economy Strategy," Budget 2011 provided $80 million of funding for a pilot initiative, through the Industrial Research Assistance Program (IRAP) and colleges, to boost the adoption of appropriate ICT by small and medium-sized enterprises (Department of Finance 2011). (Return to reference 3)