Options have several characteristics that make them uniquely appropriate for managing projects facing high uncertainty environments.

Options have value even if never exercised.

Options don’t have to be exercised to have value. Similar to insurance, they derive their value from their ability to hedge risk. Unlike Discounted Cash Flow approaches (such as Net Present Value) which require future positive cash flow in order to have worth, options derive value simply from the choice they provide, regardless of whether that choice is ever implemented. As such they are the perfect instrument for valuing innovation projects whose future potential is unprovable.

Options expire.

Options have specific dates by which they must be exercised or else become worthless. These built-in expiration dates mean that innovation projects can never become zombies which go on ad infinitum. Many projects continue long past their sell-by date not because they are producing additional value but merely because as long as they persist failure remains undeclared. In contrast, the built-in expiration dates of options not only prevents spending good money after bad, but provide a huge opportunity benefit by allowing resources that would otherwise have been wasted to be applied to new projects with the potential for greater returns.

Options are economical.

Options cost only a fraction of what would otherwise be necessary on an NPV-based value basis. This means that innovation budgets which would be otherwise consumed by a mere two or three projects can instead consider dozens or even hundreds of opportunities for the same resources. Not only does this provide for a far more efficient capital allocation, it dramatically reduces the overall risk profile of innovation through iteration.

Options can be priced using well-known models.

Option pricing is a well-established discipline, backed by nearly fifty years of theory and practice. While their implementation in an innovation context might be novel, the fundamentals are well understood. This makes them prime candidates for use in a corporate governance regimen.

Options are dynamic and flexible.

Unlike NPV analyses, Options are dynamic and flexible, adapting as market conditions change. The value adjusts as new information becomes available, providing a more accurate view of the market and allowing for more precise management. New information is encouraged as part of the overall task of managing uncertainty.

Options encourage speed.

Options encourage speed in implementation not only due to the built-in expiration date, but to an aspect of option valuation called “time-decay”. Briefly stated, an option’s value is the combination of intrinsic value (what we know) and time value (what is possible in the future.) As the option ages and we get closer to expiration, the time value slowly evaporates, eventually leaving only intrinsic value. Thus, we are encouraged to move forward rapidly since there is a direct cost of standing still.

Options encourage truth.

NPV analyses are, when facing uncertainty, fabrications at best. Projects that are gauged by this benchmark are required to deliver on the expectations, no matter how unrealistic they may be. Options, in contrast, measure the reality resulting from market experimentation and testing; the goal is to determine the best course of action given the environment, rather than the delivering of expectations given the plan. This encourages reporting results that align closer to reality, as opposed to NPV approaches which encourage obfuscation or even outright deception when results fall short from plan.