David Binetti discusses the challenges of using traditional accounting methods to evaluate the ROI of innovative projects with highly uncertain outcomes. He proposes the use of “innovation options” as a way to better manage this uncertainty and align the interests of product teams and finance teams. The key points are:

• Traditional ROI calculations often rely on unrealistic revenue projections, creating a “trap” where product teams are held accountable to overly optimistic forecasts.
• Innovation options allow teams to value the opportunity to learn and test assumptions through iterative market experiments, rather than commit to a single revenue projection.
• The value of the innovation option is calculated using financial option pricing models, which capture the range of potential outcomes and the value of flexibility.
• Tracking the changes in the innovation option value over time provides concrete KPIs that finance can use to assess progress, rather than relying solely on revenue forecasts.
• This approach also provides a way to quantify the risks of different innovation strategies, allowing for more informed portfolio management decisions.
• Using a binary classification matrix to evaluate business decisions, similar to how clinical trials are evaluated.

“Innovation accounting” is an  approach to measuring the value of innovation projects as an insurance policy against disruption to the core business. Focuses on risk and uncertainty metrics is superior to traditional valuation methods that can lead to poor decision-making.

Thanks to Sean Murphy

“My Lean Startup 2014 Conference Innovation Accounting Workshop succeeded due in no small part to Sean Murphy’s counsel. His remarkable breadth of knowledge and tactical experience developing and delivering talks was critical to my planning efforts. In particular, his insight in applying the three horizons model to my innovation accounting framework brought the presentation cohesion and a key theoretical underpinning.  I can’t thank him enough; the workshop would not have been nearly as effective absent his guidance.”