Real options analysis

Turning uncertainty into an advantage

The fundamental challenge of innovation is uncertainty. Taking a long time is not a problem if you know exactly how much time is needed. High initial cost is less of a concern if you are confidence of how many units you can sell over its lifecycle. Annual planning is much more straight forward when there is no viable alternative that competition can use to bypass your innovation. These are all reasons why innovation gives many executives the hibby gibbies. As a matter of a fact, this kind of uncertainty often leads to a condition called "analysis paralysis" where there is always one more piece of data that can be added to reduce the uncertainty.

But, with a bit of planning, this uncertainty can be turned into a competitive advantage. Be you a VC, a corporate development head, or an innovation officer, what better way to outrun your peers with a systematic way of reducing the many uncertainties in innovation.

Horizon planning and tech vs. market matrix

Horizon planning is usually used for senior management planning. It is a way of segmenting the strategy by time. Horizon One is the most immediate with concrete products and customers where most of the attention is paid. Horizon two and three are further out in time and include a higher level of uncertainty as well as long term projects. The strength of horizon planning is that it allows the management to clearly articulate what needs immediate attention (Horizon one) while acknowledge and make time for longer term activities (Horizon two and three.)

Another tool that seems to be used regularly in the CTO's office is the technology vs. market matrix. While the exact flavor differs, technology goes from Core to New and the market goes from Existing to New. The resultant four quadrants allows you to plot where all projects are from legacy to game changing. If a project falls into Core+Existing, you can usually get the BU to pay for it. Conversely, if a project resides in the New+New quadrant without a strong sponsor, you would have a lot of explaining to do (better yet, don't even go there.)

Both Horizon planning and the two-by-two matrix are great ways to convey a lot of information to the busy senior team. The one common failure point, however, is that these only provide a snap shot of what is going on today with no consideration for even known uncertainties.

Real options analysis

Real options analysis took its cue from the world of financial options. Most projects, like financial options, have multiple variables that would impact its outcome. To the extent that financial options model, namely Black-Scholes, provides a reasonable way to approximate the value of an option at any point in time, given what is know; the aim of real-options is to do the same for real projects in the real world.

The basic insight is that you view the possible outcomes in a tree structure. Each key milestone, e.g. technical, commercial, or regulatory, has impact on the value of the project. So, unlike the more traditional analysis using NPV calculation where there is only one possible value per variable, a real-options analysis incorporates a range of possible values while giving a single NPV-like value at the end.

Many people have worked on this topic. Professor Ian MacMillan of Wharton at University of Pennsylvania have done extensive work on this and other issues related to the innovation process. For a practitioner perspective, Mr. Scott H. Mathews of Boeing has worked on this topic and came up with the Datar-Mathews model which provides a convenient way to model real-life projects.

Add this management tool

I like incorporating real-options in the management conversation, in addition to other tools like horizon planning and matrix. It is a good way to explicitly acknowledge the dynamic nature of the market place. At the same time, because it does derive a single value, the result is simple enough so that it is not going to scare senior team from tuning out the analysis.