99 - ‘Real options’ thinking: Win the right, lose the obligation

12-09-2023

decision-makingentrepreneurship

(why firms are better off thinking like venture capitalists)

Sometimes, having _more _options is less important than having more flexible options.

I’ll tell you when.

The most common decision-making template you may have followed involves you taking a decision with the information at hand and then forgetting about it. New information post-decision has little value, if at all, to you. This works swell if the future has few surprises in store. If your original intelligence remains solid over time.

But if it doesn’t your Big Plan is in ruins. You have no back up because you bet big on one version of the future. That’s when you’re likely to rub the genie and beg for an extra option or two.

There’s a term that captures the thinking of more flexible options to improve your chances of success during uncertainty. It’s misleading when you first hear it. That term is real options thinking.

Let me first explain where you may be misled. The options in real options are not related to securities, like put or call options that you may exercise upon a certain trigger. The real in real options refers to an asset (physical or otherwise) whose value may change with time.

Although I would rather call it conditional commitment. You’re committed to a plan provided a certain set of conditions prevail. Should those change, you have the option of changing the plan. To retain this flexibility, you have given up and are willing to give up something of value.

But let me not sell this as some new idea. You already are conditionally committing. Just the label doesn’t ring a bell. These are some situations I bet you identify with.

Insurance - You’re willing to pay an annual premium to enjoy financial cover in case of loss of life or a medical emergency. If nothing untoward befalls you, you simply lose that premium.

Refundable flight ticket - You pay a premium to have the option to change your flight should your plans change because something came up. Or you pay less for a non-refundable ticket and lose any optionality.

Booking amount _for property _- Rather than committing to a large investment upfront, you delay your decision until more information becomes available. This allows you to take advantage of new opportunities as they arise while minimizing the risk of investing in something that’s a compromise. By delaying the decision, you create the option to invest later (or not) when the outcome is more certain.

If you already are familiar with the concept and have put the idea into practice, what more do you need to know?

Options for business decisions don’t often present themselves as buy a refundable ticket or a non-refundable ticket. Most of the time you don’t even know you’ve room for a refund. Or you have little idea how to structure a decision such that it offers you flexibility to switch tracks should circumstances demand so at a later point.

Such decisions could be about entering a new market, launching a new product, or pumping money into R&D. The choices in such decisions are not a dime a dozen. Optionality has to be built in. That needs a shift in frame. Without a shift in frame, you’re likely to miss creative get-out clauses.

That shift in frame is stepping away from how you conventionally predict the future returns on an investment. Convention says one way of valuing assets is via something called discounted cash flow analysis. Find out the current value of all future investments you’re going to make in a period of time and weigh that against the current value of whatever it is that you’re putting money into. The difference is called net present value.

If net present value is negative, then you are going to lose more money than you make; if positive, then you’ll make more money than you lose.

This math works best when you can be reasonably certain of the future. When the future is stable, the math spits out a simple number. When volatility is contained, the number can be relied upon for reasonably long time intervals.

(Most?) Execs are happy with this. They don’t look beyond the numbers. They value the options right in front of them, exercise them. They don’t work on identifying room for new options and then structuring decisions in a way that helps them exploit opportunities later on.

In fact, sometimes the costs are so high and obvious and the benefits so distant and contingent that a decision based on real-options thinking may appear hare-brained. Like in this instance from the Enron 1999 annual report.

In 1999 we built three single-cycle gas-fired power plants to produce 1,340 megawatts of peaking power. This power supports our market positions when power is scarce. The power provides greater flexibility to our merchant operations and increases reliability in previously underserved markets.

The report goes on to state that Enron will build 3 more such power plants to ‘serve the nation’s most active and volatile electricity and natural gas markets.’

The text is innocuous. Its meaning is anything but. What Enron was saying is that the company was willing to let these 6 power plants sit idle for the better part of the year only to fire them up for the most volatile periods when electricity prices shot up (when power is scarce). Enron was betting that the cost of building and maintaining these plants was worth the benefit of just one crazy fortnight a year when prices would shoot up 100X-200X.

Now imagine you’re a top Enron exec pushing for this decision with your executive peers and the board. The company goes on to build these gas-fired plants. One quarter, two quarters, a year—the big payday hasn’t arrived. Power prices are stable. The pressure mounts. The board asks questions, shareholders ask questions. Maybe we overestimated the volatility. Suggestions abound. Kill these white elephants. Cut losses. You wish you had stuck to the math.

The book Wharton on Managing Emerging Technologies sheds light on why real-options thinking can be daunting in high-stakes business decisions.

The expected strategic benefits of options are never realized or turn out to be worth far less than anticipated. Moreover, many managers do not even get to this point in the discussion…. Many investments or acquisitions that offer significant upside potential because of the options they create are not considered at all.

What the book says is something that each of us instinctively knows. It is okay to be wrong as a group. It is death to be wrong alone. Batting for a decision that is hard to defend carries with it the risk of being made the scapegoat should your bet not come good. This is a real impediment to real-options practice.

So, why should you be poking around instead of accepting what the spreadsheet throws out?

Because reality doesn’t give a hoot for your carefully laid Big Plan. Markets don’t believe in consistency, technology doesn’t obey linearity. Volatility means that it is best if we’re in a position to double down or back out, expand or contract.

What the math hides is the upside potential. Here’s a question number crunching does not ask: What are you willing to give up to be in a position to exploit the upside potential? What are you willing to commit (and possibly lose) to retain future flexibility in the decision you’re making today?

If you can as a decision-maker do a better job of creating and managing real options, you can enjoy an advantage over most of your competitive field.

How?

1️⃣ Drop the notion that once you take a decision your job’s done

Let me go back to something I said at the start. That the most common decision-making template is to survey the information at hand as static, make a decision based on it, and sit tight. That’s the decision-maker’s job.

Sadly, it is not. It is not that easy. In a dynamic market, future information is hard to predict, hence it should be valued highly if you have means to use it. This means if you want better results than the rest, your job’s not done with one decision. You’ve to structure your initial decision in a way that allows you room to change strategy based on changing information. You’ve to actively look for real options.

**2️⃣Once you’ve made a habit of looking out for new options, work to structure your decisions so that you can exploit future uncertainty. **

  • Unbundle decisions. Instead of one monolithic decision at the start, think of multistage decisions.
  • Look for the inflection points separating one stage from the next over the course of a project (often set as tripwires). These points are when you can modify execution paths. In-house R&D investment not working out? Perhaps you can license competing technology.

Don’t worry if you can’t buy more options. Buy instead more flexibility within an option such that it bumps up the overall value of the option.

**3️⃣Have a diversified portfolio to de-risk against any single losing bet **

In uncertain times, companies have to think like venture capitalists. Those that do adopt a portfolio approach to their decisions. Not every decision has to lead to a positive outcome, but the entire portfolio of decisions has to be in the green.

Getting every decision right, every option exercised is impossible. It is impossible to predict the value of new knowledge. Knowledge itself is combinatorial and its value is dependent on other inflection points like social adoption and regulation. With so little in your control, how can you predict such a future?

Imagine if the Enron gas-fired plants ended up a money-sucking disaster. It would be easy to say, We’ll stick to the Big Plan from now on and go by what is right there in front of our eyes instead of planning for some extreme scenario. Or you could say, This one tanked but the next one may make up for it if we continue with building optionality in corporate decisions. You’re not worried about losing a hand as long as you’re in the game.

I wish there was some straight tactical advice to practice real options thinking. If it were it would be something like: Change your mindset and start embracing uncertainty as opportunity.

Here are 3 rules of real options thinking:

  1. You pay upfront to retain optionality later
  2. It increases your set of future opportunities
  3. It is your hedge against uncertainty
  4. Time horizons are long and information will change (even many a time) after your initial decision

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