Reading: Startups as Real Options

When we think about managerial flexibility, we generally have one of the following four types of flexibilities in mind:

• Option to delay (or defer): We don't have to make all investment decisions today. A pharmaceutical company, for example, can delay investments in equipment to produce a new drug until it knows whether or not the drug receives FDA approval.
• Option to adjust: We don't have to implement all projects as planned. We can alter production scheduls in reaction to price changes or we can alter the product, the target audience, or the price segment in as we learn about the product and its attractiveness on the market.
  One of the most famous examples of an "option to adjust" is probably the sticker from 3M. What started out as a project in search of a super effective glue for drilling machines, ended up with a glue that does not really work. In the process, they discovered that there is the potential for a completely different product and adjusted the project accordingly.
• Option to expand: If we see in the early stages of a project that there is large demand for the product, we can expand into new markets or differentiate the product offering. Put differently, instead of rolling out a product globally with all the investments this takes, we can first "test" the product in a specific part of the market and then decide based on these test results. 
  In the United States, a traditional marketing adage is "if it plays in Peoria, it will play anywhere." Many (retail) companies first tested their products in cities such as Peoria (OH) or Albany (NY), because these cities apparently have demographic characteristics that are representative of large parts of the U.S. market.
  
• Option to abandon (stop): If the product receives less demand (or more competition) than expected and a continuation of the venture looks unfavorable, we can stop the venture instead of pursuing it to the end as originally planned.
  A company that searches for oil in the gulf of Mexico but does not find any can stop the project before making all the investments associated with rigs, pipelines, etc.

If we are dealing with a project or firm for which we think that one or multiple of the options described above are relevant, we should consider the value of these options when assessing the value of the project or firm. 

Unfortunately, valuing options is not straightforward, especially in the case of real options. In the following sections, we present the three most common approaches to (real) option valuation, namely:

• Decision trees
• Binomial method
• Black-Scholes model.

It is important to note that the result of these valuation approaches will rarely be very accurate in real-life applications. The reason is that they either require us to overly simplify the valuation situation or make a set of restrictive assumptions that are rarely met in practice. Therefore, we should take the result of these models always with a grain of salt.

Still, it is important to know what, in principle, determines option value. Maybe not so much to be able to attach a specific value to an option but to understand what the drivers of value are and what management can do to enhance option value.