Posted on November 21, 2012

Using Real Options to Build Flexible Companies

The premature pursuit of rapid expansion is one of the most common and easily preventable downfalls of failed start-ups. Entrepreneurs tend to get very excited about their chance to “make it big”, and then overinvest in aggressive growth strategies before first securing the necessary funding or revenue streams to sustain operations beyond the immediate-term. This myopic behavior is understandable in light of the psychological biases associated with launching a new business. The seductive allure of big profits captures the entrepreneurs’ attention, causing her to hyperfocus on upside opportunities, and underattend to downside risks. Singular fixation on big profit then detracts from critical assessment of the business’s vulnerabilities, and unpleasant contingency situations go unexamined, even if they are highly predictable. As an illustrative example, consider planning the launch of a new product. Suppose the big launch event generates slower-than-projected revenue growth. Will enough resources be left afterwards to take another shot at customer acquisition? Unpleasant contingency scenarios like this are easy to overlook and difficult to contemplate. Real options is useful for this task because it forces us to explicitly express our assumptions about these situations.

Real options theory is a financial framework that can be used to quickly identify weaknesses in the cost structure of a business model. The theory’s guiding principle is that the value of a company is greater if that company can flexibly adapt to changing business conditions. The future is difficult to predict, so there is risk associated with relying on specific predictions about how the future will unfold. To build a flexible business that is capable of adaptively responding to changing conditions, it is useful to think about the company in terms of its “real options”.

The following three “real options” are particularly useful to consider:

1) The Option to Scale
If demand or production capacity fluctuates, can management expand/contract the scale of operations gradually and suddenly?

2) The Option to Delay
If continuous non-stop operation of the business is infeasible, can management completely halt and then later resume operations?

3) The Option to Abandon
If the business must be abandoned, can management liquidate the assets for some salvage value?

Asking these questions reveals important information about a company’s capability to survive adverse business conditions. Consider real options early in the planning stages to help build a balanced financial outlook, and prepare for unanticipated speed bumps on the road to profit.