Our colleague Michael Froehls shares the fifth and final piece in his strategic planning series. Read it to stay ahead of how strategic planning practices are evolving.
Real Options: The Key to Successful Corporate Strategy
In the previous article in this series, I suggested ways to put strategic back into strategic planning, including using innovative discovery tools to uncover new tactics you hadn’t previously considered – and ones that your competitors are unlikely to copy. But unless you understand the concept of real options, no strategy will be successful.
What is a Real Option?
A real option is the right – but not the obligation – to move forward with a business investment opportunity. Think of options as business initiatives that don’t last forever: They have expiration dates or are confined to a specific timeline. Options also cost money because you have to pay to have the right to follow through (or not) at will.
You are probably familiar with financial options in the form of company stock (or call) options. If the company’s stock price goes up during a certain period, you have the right to exercise your option; you buy the share at the pre-set exercise price, and then sell the shares in the market for the higher market price. Should your company stock go down, though, you let the option expire at no additional cost to you. It’s the same with so-called real options, be they patents, business ideas, access to a new market or new technology, or a pilot project. In all these cases, you might do a follow-up investment (e.g., using your patent to develop a product, expand in the foreign market after learning the ropes of the country) if and when the conditions are right. Otherwise, you don’t do anything and have only lost the option money.
Growth Options, Insurance Options, and the Option to Wait
There are three important options for a business.
A growth option is like a financial call option. You invest a bit of money into something that might have a high pay-off under certain conditions but that cannot be guaranteed. That’s what venture capitalists do. Because many growth options expire worthless, you should invest in a few with the idea that at least one might do so well that it will offset the cost of the others. Innovative companies know this and allocate money to invest in several business ideas in parallel.
A defensive or insurance option is equally important but is often overlooked in large companies. It’s comparable to a put option in financial markets. If your business is threatened, you might have to invest even if there is no visible positive payback. For example, if competitors might vastly improve their customer interface, you might need to invest in a similar project just to keep up and maintain your competitive position. The cost of doing so is your insurance policy of not losing customers. However, it is often very hard for business units to convey this concept during the strategic planning process because the insurance benefits are not visible in the plan numbers. How do you convey the direct costs associated with losing 20 percent of your customer base if you did not make the investment? The numbers in the plan are only the costs of the options themselves next to flat revenues. Risk is difficult to quantify.
A third type of option that is truly valuable but rarely used consciously is the option to wait. Delaying decisions often has value as new information emerges. A typical example would be to have a small group of employees on staff that does nothing but continuously monitor competitors or other potential threats to the franchise (e.g., emerging technologies that can disrupt your business). It’s like paying a sailor to look out for a potential storm from the top of the ship. The payoff would be the opportunity for management to act fast once important information is reported. Funny enough, most companies would never pay for such an option to holistically monitor their surroundings. They would view such staff as superfluous with no clear output and would instead fly blindly or rely on various disjointed risk management units. We can’t know for sure, but if banks and insurance companies had monitored their surroundings more closely, some might not have fallen on hard times during the financial crisis of 2008 and 2009.
Another waiting option would be to have the strategy of never being a first mover in a market but, rather, a fast follower. The cost of this option to wait might be fewer profits than the ones generated by a successful first mover, but it’s made up for by the reduction in risks because the company only moves forward after confirming the validity of the competitors’ market actions.
The Difficulty for Companies to Think in Real Options
Large corporations – longing for projects with fast payback and deterministic outcomes – are notoriously bad at managing options. Projects are kept going for too long because they were chosen in a one-time decision instead of being managed as a multi-stage investment or option that should be allowed to die. New strategic ideas are shut down because their payoff is uncertain instead of being viewed as growth options as part of a larger portfolio. Executives are tied to their (pet) projects for compensation benefits and are loath to cancel projects that have outlived their usefulness for fear of being viewed as a failure.
On the other side, best practice companies seek and identify options, manage their processes, budgets, and people accordingly, thereby being truly strategic in our fast-changing times. If you work in strategic planning or are CFO or a business unit leader, introducing the concept of options in your company will make a difference.
In the last five articles, I have covered the strategic planning process, its amazing benefits and shortcomings, and provided ideas to make it more efficient and effective. There is no silver bullet, but a careful design, an acceptance of limitations, an adoption of innovative tools, and thinking in options can make your SPP a value-add, not a resource-drain.
Let me know how it works in your company.
Author: Michael Froehls
Management Consultant, Author, and Lecturer, Outthinker
Michael Froehls, PhD, is an independent management consultant associated with the NY-based advisory boutique Outthinker that helps companies design innovative growth strategies