Beginner's Guide to Innovation Accounting for Startups

This is a beginner’s guide to Innovation Accounting for Startups. Here we discuss:

Why startups are different from large enterprises
The role of metrics
Traditional, vanity, and actionable metrics
Three levels of innovation accounting

Read on to find more.

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With a failure rate of 90%, the process of establishing startups is precarious. There is a lot of uncertainty in the discovery, ideation, building, and marketing of a product. Due to this, entrepreneurs are constantly second-guessing themselves.

The number one reason for startup failure (42%) is due to misreading market demand, according to CBInsights. The second most significant reason startups fail (29%) is running out of funding and personal money.

The extremely high rate of failure can be attributed to the fact that startups don’t have a system to track their progress, validate their product premise (& demand), and provide relevant metrics for funding. With such depressing numbers weighing down the startups, how can they deliver customers a cost-effective product?

The solution to this problem lies in Innovation Accounting.

Innovation accounting provides a numerical system to quantify the risky progress of startups in an uncertain environment. Eric Ries, the author of the book The Lean Startup, defines Innovation Accounting “as a way of evaluating progress when all the metrics typically used in an established company are effectively zero.”

Why Metrics Matter?

Any startup is established on the foundation that it solves an existing problem by developing an innovative solution. Metrics provide the basis to measure any relevant data regarding the product, i.e., the solution. The functioning of the product and how it can be improved can be predicted and measured using accurate metrics.

Products are designed based on customer needs, and metrics are data measurements used to evaluate how customers engage with them and determine the success of a product. Metrics are used to monitor progress by measuring product performance.

The main goal of measuring product performance is to enhance its effectiveness using metrics. These metrics also provide valuable information for calculating the startup team’s progress toward their business goals.

But the next question is which metrics to use?

Traditional Metrics

The prevalence of big successful companies has brought forward a plethora of information regarding measuring progress and success. Startups look up to traditional metrics to secure funding because large enterprises have traditionally used these metrics.

And the result? They fail miserably because these traditional metrics serve no purpose to startups as they are new ventures and don’t have any parameter or metric in place.

The traditional metrics, such as net cash flow, P&L statements, and ROI, take a long observation time to track as they vary over a long period. Using long-term metrics for new ventures that have just started and have little to no revenue makes no sense as they don’t have hard facts and figures.

Startups are inherently different and work on a different rhythm as compared to traditional businesses. They introduce new business models having no reliable data or even fundraising strategies. With the ever-changing technology, market trends keep on changing fast in the startup circle.

As for the case of very successful startups, some may even be disruptors and change the underlying market assumptions and create new markets. This uncertainty of the startup business nature makes traditional metrics useless.

On the contrary, the pressure of providing traditional metrics can do more damage and cause further complexity to teams based on speculative assumptions. As startups don’t possess the required data for traditional metric calculation, they make inflated projections for funding approval.

Since investors know that startups are risky ventures, they either undervalue the startup or don’t fund it. In both cases, the startup ends up on the losing side.

Although these metrics have a solid basis for evaluating a regular business, they have failed to evolve to meet the demands of fledgling startups. The high uncertainty and inaccurate forecasting coupled with the startup environment renders the traditional way of tracking progress using financial accounting invalid.

Due to this mismatch of metrics, startups don’t get a clear picture of their progress in the growth lifecycle. From the initial stage of ideation, depending on the different growth phases of startups, there is a need for specific metrics to measure various operations.

It is necessary to create a framework that corresponds to various product assumptions for startup progress and guides it incrementally toward business growth and agility and provides an approach for funding innovation.

Vanity Metrics

Since traditional metrics don’t work for a startup’s product measurement, it is crucial to know which metrics provide validated data and which are just for show.

Vanity metrics are feel-good metrics that distort reality by projecting a false sense of inflated product performance but are not relevant to the product hypothesis. They neither deliver insight to improve the product nor how the customer uses the product. They also don’t assist in decision-making about the MVP — whether to pivot or persevere.

These are easy to collect but are misleading in nature. The development team must carefully filter these out of the scope to ensure only actionable metrics are used. Actionable metrics, in contrast, provide information about the features that contribute towards the enhancement of the product.

Let’s take the example of the number of downloads. If a startup has 5,000 product downloads, it doesn’t tell anything about how many of these downloads have turned into registered accounts. Without adequately analyzing those registered accounts, how can this metric help with product-market fit?

Actionable metrics such as conversion rate, retention rate, and user acquisition cost guide the new venture to validate its product and business model. They are obtained by evaluating split tests, per-customer metrics, cohort analysis, funnel metrics, and many more.

The metrics are separated into actionable and vanity metrics based on business goals and defined objectives. First, to classify them, they should accurately represent the real world, i.e., there should be genuine data points and not temporary data points due to any transitory benefits, seasons, or reasons.

Secondly, the metrics should assist in making decisions for the product, and lastly, the results represented by the metrics should be reproducible.

Accelerating Performance

As specified by Ries, innovation accounting has three consecutive levels for each product’s growth. Level one starts from the most basic organizational dashboard, and it gets progressively more complex as the new dashboard is built upon the data of the previous one.

Level 1 Dashboard

The first level is customer-centric, with a manageable and straightforward dashboard to validate the product premise. It is used to track the product progress from the start to align the product with user needs, i.e., what the user wants.

This level measures user engagement by observing what’s working for the customer and whether the startup is delivering on it.

Examples of metrics for the level 1 dashboard include:

Customer Discussions — Number of users interacted with each week
Customer Feedback — Number of users that provide product feedback each week
Conversion Rates — Number of users that have tried the product
Per Customer Revenue — Product usage amount the user is willing to pay

This dashboard gives a basic idea of where the product stands right now with the first few customers. The idea is to observe numbers over time and compare them on a percentage basis to see if they’re improving or not.

If they do, the metrics are further observed and more metrics are added based on customer feedback. If they don’t, then the entrepreneurs should pivot to those metrics which are showing progress.

Level 2 Dashboard

The second level focuses on market readiness, i.e., client interaction in an untested market based on value and growth hypothesis and product assumptions. This level generates actionable metrics validating assumptions for the product value, market fit, and new user interaction with the product for scalability.

Examples of level 2 dashboards for value hypothesis metrics include:

Retention rates
Referral rates
Repeat purchase rates
Willingness to pay a premium price

Examples of level 2 dashboards for growth hypothesis metrics include:

Word-of-mouth referrals
Ability to recruit new customers
Ability to take revenue from one customer to invest into a new customer acquisition

Level 3 Dashboard

The third level of innovation accounting deals with the monetary value of the product after assimilating level one and two data. It delivers Net Present Value (NPV) that provides critical information about the product value at present based on market performance.

This level reveals product performance financially and realistically based on actionable metrics optimized after repeated iterations. The metrics on this level vary based on the type of business model and vertical in which they operate, e.g., freemium, e-commerce, Enterprise, Subscription, and marketplace business model.

Examples of metrics for the level 3 dashboard include:

Number of visitors
Percent of visitors that sign-up for free accounts
Percent of users that pay money

Number of buyers and sellers
Number of product listings
Number of transactions

These three levels of innovation accounting provide a rigorous method to define the progress and success of startup growth in a dynamic business environment. They allow ideas to get traction and become self-sustaining.

Strategic Progression

Entrepreneurs require an innovation system to measure success for new ventures. It should accurately capture all the necessary metrics that characterize the variability of the product to offer a clear roadmap to success.

It also applies to established companies that want to introduce innovation and are looking for ways to quantify performance and have a measurement system in place. Organizations that view innovation as a way forward for growth face difficulty with the traditional financial system as they can’t measure innovation. Therefore, businesses are looking to innovation accounting for business advancement.

Innovation accounting caters specifically to innovators and provides a complete system to engineer successful startups. By following the proper process from the MVP to obtaining results for investment, a superior product is created that is well-received and profitable.

By using incremental innovation, businesses can achieve long-term growth by developing projects that solve customer problems. Innovation Accounting provides the power to do the right things at the right time, navigating a clear path to success.

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