Google X: Let's Start Investing in Proven Innovators

Business Week recently published an amazing article about Google’s advanced research and development arm: Google X.  Google X is the successor to the Los Alamos labs of our grandparent’s generation, the Xerox PARC’s of the 1990’s and the NASA laboratories before the budget cuts of the last decade.  Google X is working on some pretty incredible and transformative projects: wearable computers (Google Glass), the first self-driving car, advanced nuclear reactors and some next-generation wind turbines.  The laboratory is led by the best and brightest that Google can find, including their co-founder and former CEO Sergey Brin.  Google brings these bright minds together and provides them with the resources and inspiration needed to drive innovation, and in return Google retains the intellectual property rights to their creations.  In a period where America is starved for innovation and questions about economic leadership are abound, it seems that there would be few better places to invest our resources than in R&D efforts at places like Google X.  So, how much is Google spending each year to achieve some of their truly inspiring results?  According to their annual report, Google spent just $6.8 billion on total R&D in 2012.  For context, that compares to the $140.8 billion spent by the Federal government on research and development.  So, what if there was a way to provide Google X with similar financial resources as the Federal government? What if we were able to provide Google X with a $50.0 billion annual R&D budget?

David Einhorn, the managing partner of the hedge fund Greenlight Capital, recently gave a presentation supporting the idea that Apple should issue large amounts of preferred stock in order to return cash to shareholders.  Einhorn is famous on Wall Street for his out-of-the-box and often contrarian investment picks, which are usually supported by an excruciatingly rigorous analysis and PowerPoint presentation.  With Apple, Einhorn argues that there is an enormous demand for “safe assets” given the great level of uncertainty in the markets, and that preferred shares issued by an enormous and well-respected multination corporation such as Apple could be as appealing, if not more appealing, to investors than buying ever increasing amounts of sovereign debt.  If investors are willing to turn over their savings to the Treasury, which has a dubious track record of producing any material commodity of significant value, then surely they would be willing to lend their savings to the corporation that has produced the iPod, iTunes, PowerBook, iPad and iPhone (maybe iTV?!)?  Einhorn goes on to say that Apple could use the proceeds from issuing these “iPrefs” in order to fund a dividend to common shareholders or other financial engineering approaches to enhance shareholder value.  But what if Apple, or other companies, didn’t use that money for financial engineering, but rather used it for actual engineering?

What if Google issued $50 billion worth of iPrefs each year in order to fund its R&D efforts at Google X?  Each iPref would pay a quarterly non-cash dividend of one share of Google common stock into perpetuity.  The value of the iPref would be determined by the expected future value of Google’s common stock.  Therefore, if the research work at Google X produced products that were commercially successful, then the iPrefs would receive a return on investment from their common shares.  In the interim, iPref investors would receive a steady dividend payment in the form of Google shares, which investors could then sell for cash on the market.  For investors who wanted a fixed cash return, rather than stock, they could simply enter into futures contracts with a broker: the investor would agree to sell the shares they received from their iPref dividends each quarter for a set period of time in exchange for a fixed dollar amount.  Based on current share prices and assuming a 5.0% dividend yield, my estimation is that issuing $50 billion in iPrefs would dilute Google’s common shareholders by less than 0.9% each year.  In other words, if Google X’s research projects were able to increase Google’s corporate profits by more than 0.9% annually, then both common and iPref investors would receive a positive return on investment. 

Why would an investor prefer an iPref instead of either a normal Google share or a bond issued by Google?  For starters, iPrefs would have no contractual default risk, which provides investors with certainty that their investment will not get locked up in bankruptcy court if Google ever ran into financial distress.  Secondly, the promise of new common share dividends into perpetuity means that the iPref investor will gradually accrue a larger ownership stake in the company, which would allow the investor to exert influence on the management of the company in the case that it was under-performing.  If the investor only owned common stock, then they would have to buy additional shares with additional investment in order to increase their ownership and influence.  Finally, the promise of share dividends into perpetuity would provide greater stability in the price of iPrefs relative to the underlying common stock, which would make them a superior store of value.

Most importantly, investors would seek Google (or Apple, or Microsoft, or Exon Mobil, or Berkshire Hathaway, or General Electric, or IBM, or Pfizer) iPrefs because their value is tied to Google’s ability to create and deliver products and services that consumers value.  Using iPrefs to transfer enormous amounts of our financial resources to these enterprises would allow them to take on much larger problems in order to develop more comprehensive solutions over much longer time-frames.  How quickly could Google field a self-driving car if it spent a $2.5 billion a year to have an additional 10,000 employees working on the project worldwide (Google has a total of 20,000 R&D employees today)? 

For a very long time we have been using financial innovation to promote unproductive economic activities, particularly in the higher education space.  Surely it’s about time to start reversing that trend.