The Lean Startup: The Million Copy Bestseller Driving Entrepreneurs to Success

by Eric Ries

Unfortunately, standard accounting is not helpful in evaluating entrepreneurs. Startups are too unpredictable for forecasts and milestones to be accurate. I recently met with a phenomenal startup team. They are well financed, have significant customer traction, and are growing rapidly.

This is the kind of storytelling that takes place at most startup board meetings. Most milestones are built the same way: hit a certain product milestone, maybe talk to a few customers, and see if the numbers go up. Unfortunately, this is not a good indicator of whether a startup is making progress.

How do we know that the changes we’ve made are related to the results we’re seeing? More important, how do we know that we are drawing the right lessons from those changes?

To answer these kinds of questions, startups have a strong need for a new kind of accounting geared specifically to disruptive innovation...

For example, the business plan for an established manufacturing company would show it growing in proportion to its sales volume. As the profits from the sales of goods are reinvested in marketing and promotions, the company gains new customers. The rate of growth depends primarily on three things: the profitability of each customer, the cost of acquiring new customers, and the repeat purchase rate of existing customers. The higher these values are, the faster the company will grow and the more profitable it will be. These are the drivers of the company’s growth model.

By contrast, a marketplace company that matches buyers and sellers such as eBay will have a different growth model. Its success depends primarily on the network effects that make it the premier destination for both buyers and sellers to transact business. Sellers want the marketplace with the highest number of potential customers. Buyers want the marketplace with the most competition among sellers, which leads to the greatest availability of products and the lowest prices. (In economics, this sometimes is called supply-side increasing returns and demand-side increasing returns.) For this kind of startup, the important thing to measure is that the network effects are working, as evidenced by the high retention rate of new buyers and sellers. If people stick with the product with very little attrition, the marketplace will grow no matter how the company acquires new customers. The growth curve will look like a compounding interest table, with the rate of growth depending on the “interest rate” of new customers coming to the product.

HOW INNOVATION ACCOUNTING WORKS—THREE LEARNING MILESTONES Innovation accounting works in three steps: first, use a minimum viable product to establish real data on where the company is right now. Without a clear-eyed picture of your current status—no matter how far from the goal you may be—you cannot begin to track your progress. Second, startups must attempt to tune the engine from the baseline toward the ideal. This may take many attempts. After the startup has made all the micro changes and product optimizations it can to move its baseline toward the ideal, the company reaches a decision point. That is the third step: pivot or persevere.