Imagine yourself as a product manager for a large Fortune 500 firm with a new product idea. So you go to finance and say, “Hey, I’ve got this idea and need some funding.” And they say, “Great, the firm needs new innovation – what’s the ROI?”.

So no problem, calculating Return on Investment is easy: you just have to put together a spreadsheet that figures out the future return less the current investment. Of course finance will probably discount your estimates a bit, so you might want to pad up the numbers, but as long as the result is above zero you’ll get your funding. Simple, right?

So you start by figuring out how much funding you’ll need to build, launch, and market your new product. You do budgeting all the time for your existing product lines, so knocking out the Investment part is easy. Halfway there!

But then you move on to the Return, and now you start to get a little nervous. Revenue forecasting with an existing product is fairly straightforward: you count the customers, tally the sales, and drag your cells on the spreadsheet to the right because you have the numbers on the left. But this idea is new, and so you have no customers to count, no sales to tally — and no cells to drag. You’re facing a lot of uncertainty.

Still, you can’t produce an ROI without the R, so you try your best to figure out the answer. You look at the latest market forecasts, you read a few Gartner reports – heck, you might even throw in the latest Forbes article about the “next big thing”. And after all that research, you hold your breath and make up the numbers as best you can. Oh, and don’t forget that padding; after all, you’re not the only one pitching new ideas so this better be a really compelling ROI. Then you go to finance and hope for the best – with more than a little apprehension not only for the pitch, but the quarterly progress reviews where you’ll be asked about all that revenue you promised.

Good Luck!

I’ve worked with hundreds of corporate innovators, and they are just as smart, committed and capable as any lone entrepreneur working out of his garage. But we really are putting them in an impossible position: finance is expecting reliable predictions despite massive uncertainty and will mark progress accordingly. If they hit their numbers, they get a pat on the back for doing their job, yet still far from the payout the entrepreneur sees — but if they miss they are considered unreliable and best, and, if the disaster is big enough, they might lose their job — all because they had this great idea.

And when you think of it this way, it’s amazing corporate innovation happens at all.

Yet before we point the finger at finance, we have to recognize that they are just as important as the product manager. Finance allocates the scarce resources of the firm among competing interests, and that’s not an easy job. And if we’re not supposed to use ROI then what’s the alternative? Just write checks to everyone – no accountability, no metrics – just spray and pray? That makes even less sense.

The fundamental issue is that as Yogi Berra famously quipped, “it’s tough to make predictions — especially about the future.” But the mechanics of traditional accounting require us to exactly that. It demands certainty from the outset, and doesn’t adjust when conditions change. In today’s markets, where uncertainty and change are the norm, that approach is ludicrous on its face – and borne out by a corporate innovation failure rate typically pegged at over 97%.

This failure isn’t due to the product managers, or finance, and not even those Gartner reports. It’s a traditional accounting system that forces us the most critical decision at the precise moment we have the least information. We don’t need traditional accounting, we need innovation accounting.

So what is innovation accounting? I like this definition from Eric Ries, who popularized The Lean Startup and is the founder of the Long-Term Stock Exchange: Innovation Accounting is a way of evaluating progress when all the metrics we’d typically use in Traditional Accounting are effectively zero. It’s a corporate governance framework designed specifically to handle the high uncertainty environments characteristic of breakthrough innovation, while maintaining the core features of consistency, materiality and comparability required of any effective accounting system.

Why accounting?

Why should we worry about accounting at all? What’s the purpose? Well, precisely defined, accounting is a system that identifies, records and communicates information that is relevant, reliable and comparable, to help managers make better decisions.

And that’s why accounting forms the basis of modern management. Because you can’t manage what you don’t measure. Or more important for innovation, because measuring the wrong things leads directly to wrong management.

Now most of us are familiar with financial accounting, balance sheets, profit and loss statements, the basics that guide overall business cycle. But there is also cost accounting for day-to-day management, forensic accounting to discover fraud, tax accounting to manage taxes – different accounting systems that take different forms, because they accomplish different purposes. And so to that canon, we want to add innovation accounting, which is specifically designed to deal with the process of product development when facing high uncertainty.

Traditional accounting approaches that work well in mature businesses tend to fail – sometimes spectacularly so – when used for new product innovation. The problem is that these methods (such as Net Present Value, or NPV) employ revenue projections in their calculations which are, quite simply, impossible to accurately predict for nonexistent products in nonexistent markets. This intrinsic flaw produces skewed outputs which ultimately result in misapplication of capital, heightened risk, and the creation of perverse incentives that impede innovation.

In contrast, an Innovation Accounting framework recognizes that breakthrough product innovation is inherently uncertain, and uses an approach that accounts for this ambiguity. One such approach is based on an option-pricing model, which I call Innovation Options, which you can read more about here. Using an innovation option enables effective corporate governance that aligns to the innovator’s need for flexibility in adapting to rapidly changing market conditions.

The key difference between the two approaches is that while the NPV approach discounts uncertainty, the option model embraces it. NPV attempts to provide a “guarantee me the future” solution with predictably poor outcomes. Moreover, NPV doesn’t develop durable skills and experience: people can become better at discerning signal from noise, but they can never become better fortune tellers. Our cognitive predisposition towards survivor bias encourages us to lionize the mythic entrepreneur-hero who succeeds while ignoring all those who failed, indulging the desire that the answer is knowable in advance. This is the path to disaster.

In contrast, the Innovation option approach says, “we can’t predict the future and so we can’t guarantee growth from any one idea. Therefore, we need to provide a lot of optionality to the firm and exercise those options that have proven themselves in the market.”

Accordingly, we must move away from “introduction as launch” and move to “introduction as choice”. Do not focus on the task of innovation as one of execution and delivery of the promised growth; instead see it as exploration of opportunities for the firm, most of which will fail. This means we want to explore a greater number of opportunities, which necessarily means an accounting regimen that is faster, cheaper, and smaller on a per-opportunity basis.