Do you have a great idea for improving your industry? For most people, inventing a new product is foreign territory. There are multiple steps (and costs!) involved in bringing an idea to life — like market research, product design and prototyping, patent and legal fees and marketing, just to name a few.
At Edison Nation Medical, we have worked with thousands of inventors and entrepreneurs over the past decade, and we’ve learned a lot about which ideas are viable and which are not, particularly from a financial point of view. We do know that innovation requires expertise and money.
The question is, how do you know if your idea is worth investing in? And, if it is worthy of investment, how much?
ROI is a performance measure used to evaluate the efficiency of an investment. To calculate ROI, the return or net profit derived from the investment is divided by the total resources that were invested (the initial investment plus any subsequent costs). The results are expressed as a percentage:
ROI = (Net Profit)/(Invested Resources) X 100
The primary advantage of an ROI calculation is its ability to quantify the benefits of investments and returns of varying size. For instance, if Jack and Cindy invest in two different products and Jack makes $50,000 in profits and Cindy makes $100,000 in profits, you might think that Cindy made a better investment.
But if Cindy’s costs were $80,000 and Jack’s were only $10,000, Cindy’s ROI is 25 percent and Jack’s is 400 percent, making Jack’s investment the better one. The absolute dollar value of profits generated is meaningless without considering the investment that was required to generate those profits.
Net Present Value (NPV) and Internal Rate of Return (IRR)
As informative as ROI may be, its greatest shortcoming is that it ignores the importance of “time value of money.” Consider two projects (“A” and “B”) that may require the same investment and eventually earn the same return; if the return for “A” occurs in just one year while the return for “B” is not realized until year five, the better investment is “A.” Calculating the time value of money is especially important for new product introductions that typically entail a long developmental lead time and generate returns that vary year by year.
To do this, create an Excel spreadsheet and follow these steps:
- Change in Working Capital
- Capital Expenditure
= Free Cash Flow
Then calculate the following important ratios:
Going back to our earlier example, Cindy’s IRR on her $80k investment in the first five years turns out to be 13 percent with a payback in two years. This is not a bad outcome for a personal investment, and it beats the returns she might get on a money market fund, but it is not a “25 percent return” as the ROI suggests.
Likewise, Jack’s product idea is still a very attractive investment, assuming he can keep costs to $10K and generate the anticipated profits as quickly as expected. But for him to represent his invention idea as having a potential “400 percent return” would also be incorrect since his true rate of return is 209 percent. The NPVs for both investments in this case are positive, and thus should be pursued.
Innovation Is a Business Opportunity
Why is any of this important to an inventor? Adjusting the forecast model may give insight into how best to proceed in bringing a new product to market. If the initial investment can be minimized through a shared developmental program, a project’s IRR can actually improve – depending on changes to the project’s return and the timing of those returns.
In our experience, those who view their invention as a business opportunity (and keep their emotional attachment to their idea out of the equation) are the most successful. Calculating the fundamental financial metrics is a critical first step to ensuring that you are making smart business decisions grounded in real data. If your idea still looks financially viable, it may well warrant the investment of significant time and money. If not, you may want to start brainstorming your next big idea instead.
Bobby Grajewski is President of Edison Nation Medical, a healthcare product and medical device incubator and online community for people that are passionate about healthcare innovation. Prior to joining Edison Nation Medical, Grajewski, a serial entrepreneur, co-founded two online companies (Heritage Handcrafted and eCollectors) and spent 5 years in venture capital and private equity both in the middle market and at larger LBO firms.