What has one of the greatest Harvard Business School’s strategists, Clayton Christensen, got to do with the UK’s Tax Advantaged Venture Capital Schemes? Well actually, quite a lot.

One of Christensen’s major ideas is called “disruptive innovation”. If you’re not familiar with this concept, you can read about it here, or watch a lecture about it here.

In short, Christensen theorises that there are three types of innovation – sustaining innovation, efficiency innovation and disruptive innovation.

Sustaining innovation maintains a rate of improvement of a product or service by either offering something more (new features) to what is currently being offered or better (upgrade) to what the mainstream consumer’s value.

Efficiency innovation is about making products and services cheaper to produce.

Disruptive innovation is an innovation that offers a very different package of attributes from one the mainstream customers historically value and look to what consumers may value tomorrow rather than today. And it may be that this type of innovation may perform worse on one or two dimensions that are particularly important to those customers.

What role do these innovators have in the economy?

According to this disruptive innovation theory, companies need to be working in a sort of “innovation life-cycle”, starting with disruptive innovation, moving into sustaining innovation and eventually into efficiency innovation. What is supposed to happen is companies should use the excess capital saved from their efficiency innovations to invest into new disruptive innovations. However, this is not really the case in today’s business world. Instead large, market leading firms are concerned with serving their current customers’ needs today, and not paying attention to what may be valued tomorrow or what other markets are developing. And quite honestly this isn’t their fault; many firms have margins to meet and financial objectives that don’t quite engender taking high risks on such a small market.

However this comes at a detriment to the economy. By not investing in the disruptive innovations and merely sustaining or becoming more efficient, less capital is put to work and jobs are just replaced or completely taken out of the economy.

Disruptive innovations put that excess capital to work, creating meaningful economic growth along with jobs. And because the big companies don’t view these as financially attractive, these types of innovations come from “small, hungry organisations are good at placing economical bets, rolling with the punches, and agilely changing product and market strategies in response to feedback from initial forays into the market” (Bower and Christensen 1995).

Why is this important for Venture Capital Schemes?

Hopefully you’ve already started to see some relevance here! If you’ve read our latest VCT Industry Report 2015/16 or read our upcoming EIS Industry Report 2015/16 you’ll find we make an investment case for small company investing on the basis that it supports a vital part of the UK economy.

According to the Federation of Small Business, “Small firms accounted for 99.3 per cent of all private sector businesses in the UK, 47.8 per cent of private sector employment and 33.2 per cent of private sector turnover in 2014” and the stats also show that these investments do in fact help small companies grow and creates jobs, which in turn flows into the macro-economy. And even more convincing are the potential returns if things go well if you happen to maybe spot a disruptive innovator: NESTA research says 56% of small company angel investments return less than cost, 33% returned 1-5x cost and 9% return 10x cost or greater.

We’re not saying all small companies are the next big thing but the chances of hitting 10x on a blue chip company who isn’t looking for a disruptive innovation may be much smaller and won’t do very much to help economic growth. And not all the companies that receive tax advantaged venture capital money are the only disruptive innovators out there, some are long established, healthy small businesses, but many of them are and this is why the government is keen to encourage them, because they know they fulfill an important role in the business cycle.