As the field of innovation management matures, many entrepreneurs and companies have built solid capabilities in design thinking, rapid prototyping, portfolio management, open innovation, and the list goes on.
But a recent study of 1200 executives by PwC found that 54% of leaders struggle to align business strategy with innovation strategy. A whopping 72% say they're not out-innovating their competition.
So with all the awareness and investment in innovation, why does it remain such a big challenge?
The simple answer: most startups and corporate ventures measure their progress and success using SWAG (stupid wild ass guesses) over science.
I recently spoke with Eric Ries, the founder of the Lean Startup movement, and the author of the new book The Startup Way. Ries and I debated some of the most provocative concepts in his latest book, and agreed that Innovation Accounting may represent one of the most revolutionary opportunities to reinvent innovation.
Innovation Accounting: A Game Changer for Startups & New Ventures
Ries defines innovation accounting as "a way of evaluating progress when all the metrics typically used in an established company (revenue, customers, ROI, market share) are effectively zero." Said another way, innovation accounting quantifies the market value of new business opportunities that are fundamentally ambiguous and uncertain - the breakthroughs and disruptors.
Most companies use traditional financial metrics like market share or return on investment (ROI) to value innovation opportunities and investments. According to Ries, this basic approach is the source of many failed innovation programs since teams are encouraged to "pad predictions" as they vie for funding. By creating "fantasy plans," teams get more money up front, without a meaningful articulation of the underlying variables that will lead to success.
Ries argues that a new approach is needed, one that targets leading indicators (the things at predict market success) and that gives executives a way to link long-term growth to a system that follows a clear process for funding innovation. Ries describes three levels of innovation accounting, each increasingly more sophisticated as a new venture or startup evolves.
Level 1: Customer Focused Dashboards
Most innovation teams start with market forecasts and work backwards from there. But as Ries demonstrated in The Lean Startup, a more effective approach to building a new business is to identify and test specific assumptions - a ground up approach.
Applied to Level 1 Accounting, Ries recommends that teams first create simple dashboards that include a few metrics that are both actionable and measurable to help them get going. Examples include:
- Customer discussions (Number of customers talked to each week)
- Customer feedback (Number of customers that provide product feedback each week)
- Conversion rates (Number of customers that try the product)
- Per Customer Revenue (Amount a customer is willing to pay)
The goal of Level 1 Innovation Accounting is to create a measurable cadence in which real live customers "flow through the experiment factory." Rather than creating a product and unveiling it with a "ta da" at a big launch party, Level 1 dashboards ensure early focus on the things that really matter to validate the business opportunity by measuring customer input along the way.
Level 2: Leap of Faith Assumptions Dashboards
Level 2 Innovation Accounting starts when a team identifies its "Leap of Faith Assumptions" (LOFAs). LOFAs are essentially the most fundamental assumptions that underlie the business opportunity. The goal is to test and validate (or invalidate) these LOFAs through rapid learning activities like A/B tests.
Level 2 Innovation Accounting involves creating dashboards to track and measure the LOFAs that drive the business case. Ries calls the metrics that go into this dashboard "input metrics" since, collectively, they represent the critical inputs that make-up a successful business plan. The dashboard should be simple yet detailed enough to be considered robust by anyone in the finance department.
Ries recommends focusing on two categories of metrics for these dashboards, Value Hypothesis and Growth Hypothesis Metrics. Value Hypothesis Metrics track and measure "the specific customer behavior that indicates delight with the product." Examples include:
- Repeat purchase rates
- Retention rates
- Willingness to pay a premium price
- Referral rates
Growth Hypothesis Metrics track and measure the "specific customer behavior that will cause us to acquire more customers." Growth metrics should ideally focus on what Ries calls the law of sustainable growth - that new customers come from the actions of past customers. Example include:
- Word of mouth referrals
- Ability to take revenue from one customer and invest it into a new customer acquisition
- Ability to recruit new customers as a side effect of normal usage
The goal is to identify what needs to be done to achieve the measurable thresholds where each of these variables can grow sustainably on their own. When these thresholds are achieved, it indicates product-market fit has also been achieved and the business is ready to scale.
Level 3: Net Present Value Dashboards
Level 3 Innovation Accounting is the holy grail of valuing new business opportunities since the approach focuses on quantifying future success. Most traditional NPV models rely on pro forma forecasts based upon broad based assumptions around market size, market share, cost of goods sold, etc. - arguably the SWAGs that are responsible for the fantasy plans that corrupt most innovation portfolios.
Level 3 NPV Dashboards, however, aggregate specific metrics that represent the most important drivers of the long-term business model itself. Metrics on NPV Dashboards can include the same ones as used in Level 2 Innovation Accounting focused on testing LOFAs. The difference in Level 3 accounting is that everything rolls up into a real-time view of the financials of the business.
The good news is that since most companies already use Net Present Value (NPV) in weighing innovation investment opportunities, they're already familiar with how they work. Level 3 NPV Dashboards are structured the same way, but there's a subtle yet significant difference between traditional NPV assessments and those involved in Innovation Accounting.
In Innovation Accounting, NPV dashboards focus on leading indicators of business success and real-time data that clearly outline the venture's progress over time. For example, if a new venture is going to market using a Freemium business model like Dropbox, LinkedIn or Hulu, a set of customer-focused metrics can be applied to quantify progress and forecast success:
- Number of visitors
- Percent of visitors that sign-up for free accounts and become users
- Percent of users that pay money
- Amount of money paid by each user
Alternatively, if a new venture is creating a marketplace business model like eBay, Airbnb, or an App store that includes buyers and sellers, a different set of metrics may be needed:
- Number of buyers and sellers
- Number of product listings
- Number of transactions
- Revenue per transaction
Ries says that even "small improvements in a key conversion rate can take the business from x to 2x to 10x in dollar terms" and that "everything should be translated into future impact--and its attendant cash flow."
Most corporate ventures and startup teams update their forecasts and business plans on a periodic basis (usually before a big presentation). They use their spreadsheets and PowerPoints to pitch their business, not run their business. NPV Dashboards allow teams to run and re-run a full business case in real-time on a continuous basis. Since every customer experiment and A/B test results in new data, NPV Dashboards provide teams with the ability to instantly see the implications on the business model - the "direct translation of learning into financial impact" according to Ries.
From an innovation portfolio management view, NPV Dashboards allow executives or investors to do an apples to apples comparison between two or more new ventures or startups, even those focused on different markets or in different industries. Progress, growth rates, and projections are equalized so that the financial value of opportunities can be compared regardless of the different ages or strategies of the business ventures.
In today's data-driven world where 92% of companies measure their CEOs' success based on strategy development and execution, there's a disconnect when it comes to quantifying the value created from innovation. Perhaps the reason that 65% of companies say culture is innovation's biggest success factor is because the innovation process feels much more like SWAG than science. Management guru Peter Drucker once said, "what's measured improves." It's time to innovate the way we measure innovation.