1. Introduction

In real life, managers have a lot of flexibility when implementing their projects or business ideas. This is especially true in the entrepreneurial setting:

  • Startup companies have a lot of uncertainty in the business model
  • Many important business decisions are yet to be made (e.g., launch the product, pricing, market selection, etc.)
  • May important investment decisions are yet to be made (e.g., which machines to by, where to build production facilities, etc.).

Because of this flexibility, firms can observe how the market and the competitive environment evolves, learn what their true comparative advantages are, and make or adjust decisions based on these learnings. Clearly, also mature firms have flexibilities. In mature firms, however, the degree of flexibility would seem to be somewhat more limited, simply because these firms have already made some of the decisions outlined above and, therefore, have assets and structures in place that might not be easy to adjust.

Managerial flexibility is valuable. It is also often referred to as Real Options. The problem is that the traditional tools we use in finance typically ignore real options (DCF approach) or it is not clear to what extent the value of flexibility is reflected in the valuation (Multiples).

This section provides a rough overview of real options in entrepreneurial settings. We discuss how to spot such options, how to value them, and what to keep in mind when using option pricing models to value real options.