This isn’t going to be one of those rants against ‘beancounters’. We have actually collected and analysed data which tells us that traditional accounting and valuation methods will damage innovation performance. To be fair to my accounting collegues (some of my best friends are accountants) the main conclusion from our study is that we need a different type of accounting to manage the innovation process. In particular it’s the project selection step (or the filtering step in Tim’s aggregate, filter, connect model) where planning and valuation methods can make or break innovation.
In the study we surveyed Australian biotech executives on how they used financial criteria to select innovation projects. With responses from about 100 firms, we were able to see that there were two styles of innovation planning.
The traditionalists used best estimates of market size, cash flows and chances of success to arrive at a value of the project. For those of you with a working knowledge of financial management, their style was closely aligned to net present value analysis.
The other group placed less emphasis on prediction and valuations and were prepared to stage investments in the project. As the project showed promise (or not) funding would be increased or discontinued. In finance terms, these were the ‘real options’ managers. Like a stock option, they were prepared to ride the uncertainty by taking an initial stake in the upside but also recognized that options are valuable because they limit how much will be lost if the project doesn’t perform after the early stages of development.
When we compared these financial management orientations to innovation performance (as measured by patents, which is valid in biotech) the first result was unsurprising. Real-options management was positively and significantly correlated with innovation. However, the second result was a bit unexpected.
The traditionalists using mainstream planning approaches (NPV managers) were negatively correlated with innovation performance. In other words, imposing strong traditional financial criteria for project selection made the firm less innovative than firms that had no particular financial criteria for the selection of projects!
I think this leaves us with three takeaways for managing innovation.
1. Innovation means trying things out and failing. Attempting to provide detailed plans and forecasts regarding what is going to work will mean missed opportunities.
2. Large firms with traditional planning processes and valuation tools need to create different procedures for managing innovation.
3. We need to change the way we value innovation projects and include the upside of uncertainty in our assessment. While we focus on the downside risks with innovation projects, how many of us consider that risk has an upside too. Risk reduces the value of businesses in traditional valuation tools.
This research paper was written with Mat Hayward, Andrew Caldwell and Peter Liesch. It is currently under review for a journal.
Abacus picture from Flickr by Obraka under Creative Commons license
It will be very interesting to read your final paper, particularly detals around the definitions.
Questions that came to mind were:
Is your definition of innovation solely focused on patents (output)?
Is NPV valuation negatively correlated because it can kill projects? (Is there any way to tell if the projects should have been killed?)
I like the staged approach – as it allows some allowance for ‘risk’ into project selection, but wonder if the only reason something is considered negative is if it kills projects….
Were the traditionalists or the real options managers using a conjoint analysis (or balance scorecard?)
Would be very interested in reading your final paper – are you able to forward any details on expected publication date, journal name, or even a working paper?
Thanks for taking the time to post your preliminary findings online!
Sincerely,
(at) createpei
These are are great questions on the research. Our journal reviewers asked some of these questions as well. Perhaps it would be easiest for me to send you the working paper. Could you email me at j.steen(at)business.uq.edu.au so I can send you a copy.
My great great grandfather was a shipbuilder on Prince Edward Island. I’m told it’s a very pretty place.
Can we identify a specific accounting style followed by Venture Capitalists? Since their job is to raise money and fund innovation, one would think they would have mastered the accounting/innovation art. They do seem much more aligned toward the “real options” process you describe. Why not just import their style (or model) of accounting into enterprises?
As a partner in an early-stage VC firm, we do the staged approach (“real options”) and tho not perfect (since it’s implemented by humans), it’s been very very effective at maximizing the upside and minimizing the downside – we’ve used it for about 6yrs or so with good success.
Really interesting idea Brian. There are some surveys of capital budgeting methods which show that ‘real options’ are used by some firms, but certainly not the majority. I haven’t come across a survey that looks at VCs but it would be really interesting to know how they are different from other industries. McKinsey have been advocating the technique for some time now, but our research is the first to use survey data to link ‘real options’ to innovation performance.
Tim went to an Angel Investor conference last week and it seems that VCs are retreating from the tech sector to businesses that are more easy to value. Business Angels seem to be filling the gap here. http://timkastelle.org/blog/2010/02/financing-innovation-report-from-the-aaai-conference/
Thanks Deborah. It does seem to be the best way to extract value from uncertain investments.
Why do you say so that accountants kill innovation? I am sure this would be a question to all people who believe on this. I love innovation and this will also help me improve.
I wrote this post last March and the ensuing debate was of a very high standard. The Australian CPA magazine ran a feature story which carried both sides of the argument. I have summarized this in a subsequent post called ‘innovation and the new reencounters’ . Just use the blog search engine and you will find it.
John