Day 2 at the Lean Startup Conference 2018 — Innovation Accounting
The day 2 workshop I was looking forward to was the Innovation Accounting for Profit (and Fun!) workshop led by David Binetti.
“It ain’t what you don’t know that gets you into trouble, it’s what you know for sure that just aint so.” — Mark Twain
How do we create a new system when dealing with uncertainty?
It all starts with an idea, that going to bring you fame and fortune.
I know what to do, just get the resources to make it happen.
Finance says: “What’s the ROI?”
I have a spreadsheet where I’ve calculated NPV. I’ll just open it up. Return on Investment. I plug in all the numbers and everything is right.
Net present value (NPV) is determined by calculating the costs (negative cash flows) and benefits (positive cash flows) for each period of an investment. The period is typically one year, but could be measured in quarter-years, half-years or months.
NPV projections on innovation become a death spiral. We are going to go down, but then we are going to go back up. How much are we gonna make from now until 10 years, and that gives your annual value. The reality is you can’t see the one number on here that’s the real number. The one number that’s the truth. ONE TIME COSTS. That’s your investment. That’s the only number that’s accurate.
The rest is complete BULLSHIT! I can’t tell you the weather next week, how can I give you forecasts for products that don’t exist in markets that don’t exist 10 years from now?
The problem is the accounting is the PROBLEM.
NPV analysis says we are going to have hockey stick growth and we will eventually have all this profit. The problem is you can’t know until it’s too late. Until you launch. Huge success, spectacular failure looks the same at launch.
Divide accounting into 3 horizons. 1. innovate, 2. grow and 3. profit. For horizon 3, we want profit ROIC IRR. This is what 90% of all CEOs spend all night worrying about is how to maintain the stable profitability of the company.
BUT no, they don’t just spring out of the ground. We have the growth stage.
And in horizon 1, its costs, on-time, on-budget.
Costs? What do we do with them? We cut them out. What do we do with innovation if it costs?
The accounting is the problem. We need innovation accounting.
“Innovation accounting is a way of evaluating progress when all the metrics typically used…are effectively zero.” -Eric Ries
The vast majority is sustaining innovation. It’s the “If I increase sales by 10%” type of innovation. It could be disruptive, could be revolutionary. However, most is sustaining incremental progress, that is how companies stay in business. If you don’t do sustaining innovation you will be out of business.
The test is certainty.
If you’re above the line, a profitable business, everything is certain. Traditional metrics, waterfall, etc.
If you’re in horizon 2, you must continue to grow or find profit. Uncertain about your profit model. You must find one before your growth runs out. In horizon 2 if you stall before your growth runs out you lose. (Snap)
High certainty classic accounting.
High uncertainty innovation accounting.
I just want to make my numbers. when you’re in the growth phase and your growth fails, you’re done. The only time you have freedom is in the innovation phase.
As you move from the growth phase to profit and stall before you’re done.
Or during transition to growth. If you take money that expects growth and you do not grow you have failed.
This is what the cap flow is like. This is the profit horizon. But what we actually do, is tweak the numbers until we get the outcome we want.
NPV encourages you to LIE!
When you get down the line and you’ve spent the money, and finance comes knocking and says “Hey what about the NPV?” and you say “It’s coming!”. It’s what are you encouraged to do.
“How are things going?”
Metered funding. We only want to get the money we need at each particular phase.
Failure is an option in the innovation phase. Failure is not an option in the growth phase.
The value of your innovation phase is your ability to choose.
If you don’t have a choice and you have to move forward. You are already in a growth phase. You have to say I took the money and the answer is no. NPV only says the answer is always yes.
Measure the value of optionality, not the cost! What you spend is to PROVE product/market fit. Provide a positive ROI without the NPV death spiral.
That’s the whole heart of the value innovation model. We don’t know the value. Are they better, worse or stay the same? We are really judging the strike price.
As we reduce uncertainty we increase value. Instead of Gartner telling me what the industry is worth in 10 years. Run tests to find the actual probity.
If the tests fail you let the options expire do not continue to invest in the opportunity.
NPV is evaluating how good of a fortune teller you are.
Use the Trinomial Model to run simulations. This forms a recombining matrix of up values and down values. Like what’s used for Chicago stock exchange. You have the ability to take your leap of faith assumptions and test them. It worked or it didn’t work. You can conceptualize and setting a strike price on the value $100M at the top. if you continue along the top path of the matrix, everything went exactly the way that you planned the value will be $100M . Down and to the right goes to zero.
As we learn more about the market, we are testing against the market. Each one represents a test against the function. each node is the new value for the option.
How do we determine exercise vs expire?
You only scale if you cross the chasm. Options should be used for options testing. They should not be used for product/market fit. When you are past product/market fit you growth financing which means you need strict financing systems.
Everything in your innovation bucket as a hedging instrument. Do as little as possible to get the answer you need to get the answer to your question.
We don’t want just one shot. We want to break it down into as small components instead of doing something once for 1 million or do something 100 times for 10k.
Compound options are values of options predicated on the value of the next value up until you have a strike price for an actual security.
Small option of say 5k.
Then OK that works 25k.
Compound options breaks it out into its constituent parts. If you learn bad news you let your options expire.
The overall option itself is characterized by how often i get to try it in the marketplace, and the overall value. Even Uber didn’t start with a valuation of a billion.
Everything can be determined by finance, and predicting the future is not needed. If you use compound options you can reduce the volatility envelope which means you get a set amount of money and get to test all the ideas. by breaking it up into smaller parts, you can say every idea gets 5k. There’s no pitching. Every step up in valuation is already pre-determined. Let finance do this. Give them the fun.
This is how we determine who gets money. no longer do you need to say which ideas are good and bad.
Truth is what matters.
We want to know if it’s true or false. If this idea is a crapper, I want to get out of it as quickly as possible.
Traditional accounting only values positive or negative. If you’re losing money you need to be fired. Instead of positive or negative, you need yes or no.
Accurate bad news is infinitely superior to inaccurate good news.
It should be ok to come up with the negative answer as long as it’s true.
When things fail and the Street punishes you, where are you going to find innovators? It’s because you’re not even allowing them to run tess.
Your whole company becomes a creative-dampening field. Remember when you’re in a large company, their job is to find you, isolate you, and kill you.
Profitability. Predictability. Don’t rock my boat I need to make my quarter. So what does an innovator look like to them?
You have to accept that no is a legitimate answer. Any innovation accounting eventually needs to tie to your compensation scheme.
In the end, people do what they are paid to do.
If you don’t reward people for the answer of no, then you’ve set up your accounting structure for yes yes with no real innovation.