Is Innovation Accounting the Future of Startup Valuation?

What is innovation accounting? Eric Ries, the author of “The Lean Startups”, explains innovation accounting as a process of evaluation when all metrics in a company are zero.  

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Typically, startups that create a new product for the market are surrounded by ambiguity.  They have no accurate way of measuring opportunity. 

Production is based on the demand business owners perceive in the market. This leads to creativity and innovation, which means something new in the market. 

The new venture has no existing data or past statistics for valuation. That is why innovation in accounting introduces a structure that helps measure business progress and success. 

In the past, businesses used traditional methods like market share and ROI to evaluate startups. These methods did not provide accurate information. Instead, they exaggerated the business plan or predicted profits.   

Why Is Startup Valuation Important?

Valuation helps businesses know the number of shares of their company that they need to give away in exchange for finances. A higher valuation means a company can give investors less share or equity. 

Statistics show that in the U.S., there are 71,153 startups each year. That makes it essential for businesses to have an accurate valuation process for startups that will help them make the best business decisions. 

Innovation accounting lean startup helps in learning and understanding startups and their products. It helps to measure the growth potential of a startup accurately. 

During valuation, the value of a startup company is usually close to zero. This is referred to as the seed stage.  This growth potential will make investors interested in your business.

The Lean-Startup Methodology

Eric Ries explains the scientific approach to startup valuation using the lean startup methodology. This methodology uses customer feedback to speed up and guide the iterative development of business products. 

It is suitable for startups since they are developing new products or services in uncertain conditions. Here are the five principles that govern lean-startup methodology.

1. Entrepreneurs are Everywhere

The methodology emphasizes that an entrepreneur is anyone who has a startup. If your business is a startup, it means you can apply this methodology. 

The startup can be located anywhere, and it can be a business of any size.  Applying the lean-startup methodology will help you save resources and time. This is also possible through Innovation accounting that enables entrepreneurs to launch new businesses and enter a new market. Businesses can learn through coaching, consulting, and training.

2. Entrepreneurship is Management

The second principle shows that a startup is like any other business that needs proper management. The management might not look like the one for a traditional business, but a startup should have a management process in place. 

It means the management should be orderly and based on protocol. A proper management structure will enable managers to react to different situations that may be risky. 

It also helps the business leaders manage investors and empower employees to perform acceptable experiments. 

3. Validated Learning

Lean startups focus on validated learning that enables business leaders to build sustainable companies. This involves performing experiments on the new product or service. 

The experiments provide results that enable managers to make decisions using relevant and accurate data. This means business leaders are able to find out if their new product is able to solve customers' problems in the market. 

Managers find ways to adapt and pivot if the product or service is not solving the problem.

4. Innovation Accounting

Innovation accounting is part of the lean startup methodology that aims to create successful businesses. It requires businesses to be able to monitor progress objectively.

Businesses also need to set up milestones and prioritize work. This helps you make the right decisions for your startup. 

The decisions you make through monitoring and evaluation are based on data. This increases the chances of making the best decisions for your company.

5. Build-Measure-Learn

The build-measure-learn allows businesses to learn through MVP (minimum viable product). This is the product in which you conduct experiments and get feedback from your customers. 

It enables startups to build businesses based on accurate data to minimize risk. The-build-measure-learn principle helps businesses to learn and improve. It is a loop that should be repeated as follows. 

It requires a business to build the minimum version of a product (MVP) and take it to customers. The customers will use the product or service and provide feedback. 

Businesses collect feedback from customers in the form of data and perform an analysis. The analysis provides important insights about the product or service. 

Based on these insights, your business can learn about the needs of the customers and make decisions. The decisions you make can be to continue with the product, make necessary changes to satisfy the customers, or abandon the product. 

Build-measure-learn comes in three stages. Here are the lean startup stages during the business valuation

• Prototyping
• MVP
• Product-Market Fit
• Product-Scaling

Startup Valuation: Levels of Innovative Accounting

Understanding innovation accounting metrics help measure the performance of a startup. Ries suggests three dashboards that help understand such metrics in innovation in accounting. These dashboards are useful tools for startups to measure innovation.

Level 1: Customer Focus

The first level of lean startup innovation accounting focuses on the customer. These are activities that involve the customer and are part of a startup's product development. 

The purpose of this level is to ensure the product development is aligned with the user's needs. It also considers customer feedback. 

Collecting such information measures customer involvement in the product development process. For example, in the first level of innovation accounting, you need to focus on 

• Customer discussion. This is the number of product users that your business talks to
• Conversion rates. This is the number of users who tried out your product
• Customer feedback. The number of customers who give you feedback about your product
• Customer revenue. The amount customers are willing to pay for your product

Level 2: LOFA (Leap of Faith Assumptions)

The second stage of startup innovation accounting considers that you are introducing a new product in a market. This product is not tested.

The product is new, and no customer has used it. That is why the stage is known as a leap of faith stage. This means you will be making assumptions about your product and the market from the start. 

Level 2 aims to measure the truth about two assumptions. The first assumption is the value customers get after using the product. The second assumption is about the growth of your product. The second assumption focuses on how new customers will find out about your product. 

These assumptions are part of your product development. They are part of a lean startup through MVP and prototyping. Here are the value metrics of the first and second assumptions.

• Repeat customer purchase rate
• Retention rate
• Customers paying a premium price
• Referral rates
• Referrals by word of mouth
• Customer acquisition
• Recruiting new customers

Level 3: NPV (Net Present Value)

NVP provides information about your product's value as it is now. It is not like a business plan that tells the value of your product after 12 months. 

NVP is important in startup valuation because it depends on the drivers of your product instead of assumptions on market size, product cost, or market value. For example, NVP is based on your product’s performance drivers.

How Innovation Accounting Helps Measure Product Progress

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Innovation accounting does not provide static data. The lean startup innovation accounting is a constant cycle that follows the build-measure-learn principle. This means that new data is gathered as the product continues to improve. 

The process of product development changes as you obtain the latest information. Results of using new data in your product progress are visible. 

This is because the three levels of innovation accounting in practice ensure that your product is changing to suit your customers. It involves choosing your metrics, monitoring your data, and holding your project to account.

Benefits of Innovation Accounting

Innovation accounting provides interrelated information for measuring business success. Here are other benefits of innovation accounting for startups.

• Innovation in accounting is a process that allows you to perform a thorough examination of startups and assess your investment for value. 
• It also helps you to mirror future costs and results.
• Innovative accounting helps to emphasize the innovation efforts of startups. 
• It shows the success of teams working on innovative projects and helps them respond to the needs of their customers.
• It is a process that allows teams to stay focused on important assumptions about the new projects in their company.

Key Takeaway

Innovation accounting is one of the principles of lean startups that help solve the problem of the lack of historical data for startup valuation. Businesses can now use innovative accounting to choose metrics that will help track and measure what matters in their startups. 

The innovation accounting principle also makes measuring user engagement, assumption testing, and product value possible. It helps you create a better product for your target market. This means innovation accounting solves the problem of inaccurate evaluation that results from using traditional methods like market share or ROI. The principle provides a more dependable structure that leads to better decision-making.