The ROI of Innovation – What is it?

As product managers, we are often asked a single question when we propose a new product: What’s the Return on Investment (ROI)? What’s the ROI of innovation?

Money bag - Tests cost money to run and impact the ROI of InnovationThere has to be a Return on Investment (ROI) or we can’t get funding for the project. The details of this conversation may vary depending on if we are an entrepreneur talking to and investor, an intrapreneur pitching to our business unit manager, or head of a skunkworks pitching to the CFO. But the general theme is the same.

  1. Finance requires a 4 year projection of revenue showing an ROI
  2. The visionary grudgingly creates a realistic spreadsheet projection of the next 4 years revenues that shows a 100 million dollar market.
  3. Finance denies funding because the returns are too small. Finance declares, “If it’s not a billion dollar market, we don’t invest.”
  4. The visionary, adjusts the market size and margins until the spreadsheet shows 1 billion dollars.
  5. Finance divides the projected revenues by 10 to account for “visionary enthusiasm” and then approves it because 100 million is pretty decent.

WTF just happened?

There must be a better way to decide on innovation investments than this.

Shared Fiction

It reminds me of when I see someone waving at me at a party, so I wave back to be polite, not knowing who the hell this person is.

Of course, they were waving at someone else behind me, but assume, since I was waving at them, they must know me and walk over to have a chat. Even after 10 minutes of conversations where we’re both fairly certain the other person has no idea who we are, we continue the charade out of courtesy.

Everyone in this scenario knows it’s a complete charade and suspects that everyone else also knows it’s a charade, but everyone plays along because it would be impolite not to.

Until someone dares to question the shared fiction out loud, it will continue.

Harmless Fiction

Cocktail party civility is a harmless fiction. The fiction around pitching new innovation projects can be deadly.

It’s deadly because if we know one thing for certain, companies are dying faster than ever.

Average company lifespan on S&P 500 Index (in years)

The average lifespan of an S&P 500 company has declined from 80 years to 15. If you work at a large company, that fact should terrify you.

The Absurdity: The ROI of Innovation

What’s the ROI of innovation? What about a potentially disruptive innovation?

Let’s start with something easier. What’s the ROI of buying health insurance?

(Let’s assume we’re in the US where there isn’t state sponsored health care.)

Hint: It’s negative.

Stethoscope - What's the ROI of health insurance?Without doing any math, we know it’s negative because health insurance companies would quickly go bankrupt if they lost money on every person that bought health insurance. It’s the same reason we can be assured that the odds are against us if we gamble in a casino. The casino would be bankrupt if the odds weren’t in their favor.

On average, we’re bound to lose.

Does that mean we should never buy health insurance?

No. We want to buy health insurance because the downside of a health problem is potentially catastrophic.

Death - A problem everyone has and corporate startups are no exceptionWith medical costs what they are (at least in the US), the cost of a major surgery is sufficient to bankrupt us. Or even worse, we simply might not be able to afford cancer treatment. Unless, like Walter White, we have a spectacular backup plan, we’re dead.

Spoiler alert: Walter White died anyway.

The Joy of an Unused Option

Health insurance doesn’t make any sense in terms of ROI (or Net Present Value if you’re into that sort of thing.) The only time it makes sense is when we know we’re about to get sick.

Does that mean we should be unhappy unless we’re able to cash in on our health insurance by having a triple valve bypass?

If we don’t have to use our health insurance, we ought to be absolutely thrilled! It’s not a waste of money just because we didn’t get sick.

Buying health insurance is like buying the option of going to the doctor. We don’t have to go. But we can if we need to.

The option has value, even if we don’t use it.

Happiness in Disruption

Congratulations on Your FailureIn innovation, we should also be thrilled when innovation projects fail. Particularly if they are disruptive to our core business.

If they fail, it means that the potential disruption is probably not as much of a threat as we thought.

If they succeed, sure…we’re disrupted. But at least we disrupted ourselves! We have a chance to profit and sustain ourselves through that disruption.

The alternative is to let others disrupts us.

Which would you rather do?

Investing in innovation is investing in the option to launch a new business. Even if it might fail or we decide against it in the long run, the option still has value!

Innovation Options

Innovation accounting & innovation options

This is a deep topic (as is all innovation accounting) where I have been heavily influenced by my conversations with David Binetti. For those that are interested in calculating the value of innovation options, I’d recommend a conversation with him and to check out his new project called Innovation Options.

You won’t be disappointed and yes, I’d be happy to introduce you.

Lessons Learned

So…what should I post next? Tweet to tell me what to write:

Show me how to test product market fit!

or

How can I do lean startup in my friggin' huge company?

11 comments

  1. Very interesting! Thank you for sharing this post

    I used To work with options when we tried to put the fair value To a pre revenue Startup, when I worked in a Business angel nerwork in Chile. But I never knew if I did it well

    It would be nice to know more about innovation option metodology

    Best!

    Patricio

    • Tristan says:

      I find options to be pretty complex for calculation and there are a lot of ways to do it. After speaking with David I build my own spreadsheet and enjoy the math, but I am not convinced it is a useful way of measuring value unless we are dealing with a hundred or so innovation projects simultaneously.

      Do you have any of your model you can share publicly?

    • Tristan says:

      Yes, kind of. David proposes using a trinomial tree with the market potential as the upper bound and the number of iterations the team can make as the number of nodes.

      • The Black-Scholes model is not applicable in this case because it can only be used to price European-style options (i.e., can only be exercised on a single date at termination.) Innovation projects don’t follow this rigid schedule, and as such pricing models suitable for American-style (exercise anytime) options are more appropriate. I use a trinomial as a good balance between fidelity and simplicity, but you could use a binomial or any other form of model.

        I’m writing up a post that goes deeply into the math. Follow me on Medium to see it when it comes out. @dbinetti

  2. This is a great topic that both reveals a lot of opportunities for companies that step up to it, and also explains a lot of value that’s being not realized in the economy right now.

    A very good resource for thinking about innovation accounting is this white paper from Robert G. Cooper of the Stage-Gate org. http://www.stage-gate.com/resources_portfolio_wp50.php. Two of the fundamental ideas are to 1) have a budget bucket specifically devoted to higher risk innovation discovery, and 2) to timebox risk-reduction activities around the higher risk/higher value innovations, so you can invest a little at a time without committing the full cost at the outset.

    I know that “stage-gate” per se is considered very old school for all us lean and agile folks, but many of the ideas are still applicable. Especially for big, very valuable (and therefore very risky) product innovations.

    • Tristan says:

      Thanks for sharing the white paper Nils! I think stage gate works fine with Lean Startup, it’s just that we have a lot more stages and gates. Hopefully one a week! 🙂

    • Many of the ideas are certainly applicable, but I still believe it is a very different model. Though it does break things into chunks, those chunks are still sequentially oriented as part of a fundamentally linear process. The gates are binary: go/kill. In this sense it is an effective risk-mitigation strategy that focuses on contingency planning in case things go wrong from the original assumptions.

      In contrast, lean in general — and this model in particular — does not merely mitigate risk, but reduces it through iteration. There is no contingency planning because we don’t presuppose there is only one answer. Instead, we take multiple trials which may result in new knowledge that couldn’t have been anticipated from the outset. This is why the option tree can go up or down in value, while stagegate can be only up (realizing original NPV value) or out (recouping part of the original investment/saving opportunity costs).

      • Tristan says:

        I don’t think that’s necessarily true. Stage gates are binary yes, but what we use as the investment decision is up to us. We can use the Innovation Option as the criteria for the gate and say, “if the value on the trinomial tree is beneath our criteria, we stop.”

        Stage gates are a pretty loaded term so it’s perhaps easier to ditch the terminology, but if it’s already ingrained the corporation, changing the gate criteria to fit with a more lean approach to value generation might be a possibility.

  3. Rami Gazit says:

    Tristan, thanks for this thought provoking post.

    I think that my failure as a big corporation in an innovative project most likely can not lead to any conclusion that this disruption or a very similar one is not doable by others, be it startups or big competitors.

    Therfore I don’t see it as insurance but rather as a saving account which is made of high risk shares, like equity of a startup company, early days.

    Basically companies need to make a decision if they invest in high risk innovation and how.
    If they don’t take this innovation risk than they accept by default the other risk, i.e., being disrupted and then getting out of business, faster than ever before. The multiplication of the second risk probability and the potential damage makes the decision clear. We need to assume the innovation related risk.

    Of course, then comes the questions of how much to invest in risky innovations, how and on what to bet for minimizing the risk. And of course here come the lean startup and a relevant innovation maturity model to help us.

    And there is also risk in disrupting yourself but you can manage the process better vs being disrupted, and once again, you don’t really have a choice. You can try to start by disrupting some other players on your value chain (other risks exist here) or your competitors, and move to some self cannibalization later.

    • Tristan says:

      That’s a great way to look at it. Yes, it’s high risk savings account or high risk hedge fund.

      I like the insurance metaphor just as a way of getting out of the “What’s the ROI?” conversation on an individual project.

      If we have enough innovation projects overall, certainly we can start calculating the ROI just like it’s easier to calculate the return on a hedge fund. The diversification smooths out the volatility of individual projects.

      Comparing it to insurance isn’t a good 1-to-1 comparison…but as a metaphor, it’s a good communication tool that most C-level folk, including the finance department, can quickly understand. It simply doesn’t make sense to invest in individual innovation projects from an ROI or NPV approach.

      Once we’re talking about innovation projects as high risk investments, then we can move the conversion to an Options (or investing) frame.

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