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