Accounting for innovation requires a dedicated set of metrics

I recently had a familiar conversation – again – with a fellow student of the innovation process. “It’s always the CFO,” he said in discouragement, “being so risk-averse that they become a real roadblock to the whole innovation and growth process.” Such programmes are inherently uncertain. But there are ways of mitigating the internal civil war that often afflicts the dialogue between those entrusted with fiscal responsibility and those trying to drive their organization into new areas of opportunity.

A great place to begin is with an open-minded discussion about what metrics are suitable – and by definition which are not – for the management of uncertain projects. As a general rule, the measures that feel comfortable for finance types are pretty useless. The net present value rule, for instance, assumes that you can predict anything about future flows of revenue and costs. It further assumes that you’ll take every project you invest in to market. Neither is true. In a new opportunity area, nobody knows what the future will hold. And you might decide to stop a project long before it reaches anything like maturity. Furthermore, the project might have generated transferable ideas or other benefits for your business, even if it doesn’t make its way to commercialization.

A better measure is to consider the value of a new programme in terms of the option value it creates for your organization. Real, as opposed to financial, options, are small or at least staged investments that your organization makes that buy you the right – but not the obligation – to make choices in the future, when you have more information available.

It is analogous to taking out a financial option in which you can choose to exercise it or not, depending on how the markets unfold. With a real option, however, the valuable optionality is created by how the projects are managed, rather than by what the market ends up doing. The ability to stop – to decide not to move forward – is critical to option value because it gives you the choice to limit your losses. In effect, if you thought of a range of possible outcomes, you’re eliminating the negative portion of the range by allowing a project to cease.

A further complication is that most corporations of any size will be managing not just one or two options as a start-up might, but many options in a portfolio. And as innovation has become more of an imperative, getting better at managing those portfolios is critical for a successful innovation programme.

One way to consider how to manage these is to think in terms of levels of uncertainty. Innovations that make the core business better are much more predictable than innovations that represent an entirely new opportunity space. By mapping projects against the levels of uncertainty in a portfolio, one can see if the investments being made align with the firm’s strategy. Moreover, it gives strategists – and their finance colleagues – permission to stop projects if new, unfavourable information has emerged.

A fascinating example of this is Dyson’s recent decision to discontinue its electric car project. It had begun with high hopes, but subsequent entry by larger carmakers and their intended pricing strategy – basically subsidizing the cost of the car – meant Dyson’s products were unlikely to be profitable. Nonetheless, despite Sir James Dyson’s disappointment, the car venture may well have paved the way for breakthroughs in battery and other technologies which could sow the seeds of a future growth venture. The options, in other words, continue to be strategically useful.

With apologies to the late John Lennon, sometimes innovation is what happens while you are busy making other plans. The trick is to frame that high-minded truth in a way that doesn’t scare off those whom you need to fund the activity.