The Option Mindset

Understanding the option mindset is perhaps the most difficult thing to grasp about innovation accounting when you come from an a traditional approach. But it’s absolutely critical to have this mindset when developing your innovation governance structure. It’s easy to misunderstand that the option’s value comes from a different source that the future revenue potential.

Here’s a really simple example. Let’s say you’re planning a dinner party for friends at a really fancy restaurant that books months in advance. So you make reservations for a particular time and then see if your friends can make it. Now that reservation is an option. You’ve given yourself the ability to make a transaction in the future (ie, having dinner) while waiting for more information from the market (seeing if your friends can join you.) Now, let’s say your friends aren’t able to make it after all, so you cancel the reservation. But here’s the question that gets to the heart of the option mindset. Was it a waste of time to make that reservation? After all, you didn’t go to dinner. So what was the point? Well, anyone who’s trying to get seats at a full restaurant, or tickets to a sold out show, or a seat on an overbooked plane when you just want to get home, will immediately understand that there’s value in having the ability to make the transaction, even if the transaction itself is never made.

Options manage uncertainty, whether for a dinner reservation, stock transaction, house purchase, crop failure – or innovation project. We want the ability to wait until we have more information before we actually have to make the transaction, while still preserving the choice to do so. Options serve this purpose. That key concept – that an option has value even if it’s never exercised – is at the heart of any innovation accounting regimen.

Under traditional accounting, the decision to proceed is made before any actual knowledge is gained. Yes, great care is taken to build expansive assumptions about what must happen in the future in order to be successful. We call that a business plan, but the knowledge itself – what actually happens as opposed to what we assume will happen – is not available because nothing yet has taken place. Under conditions of certainty, that’s a totally appropriate approach. But when we’re facing extreme ambiguity, it’s foolhardy.

With innovation accounting, we still have assumptions but the goal is not to get better at making them believable (ie, the pitch), but instead to get better at turning those assumptions into actual knowledge, ie, learning. And this is important our assumptions might be, “No. No, we don’t want to proceed with this idea.” Under the traditional approach, the “no” result is an indication of failure because the assumptions were used to justify the project’s existence in the first place. Moreover, if we only justify our investments based on the promise of future growth and profit, then any knowledge we gain that runs contrary to those promises will be ignored, rejected, or even misrepresented outright.

But options give us the ability to manage risk in uncertain environments because they are designed specifically to delay an investment decision until more information about the market. Thus we can base our efforts on the value of the choice itself (ie, the option to proceed or not proceed) and readily accept whatever informaiton the market provides.

Now, if this still a bit difficult to grasp, let me use an example that I use in all of my workshops. I ask the attendees, “Do you have life insurance?” and many hands go up. Followed by, “How much do you pay for that life insurance?” and generally the order is on several thousands dollars a year. “How long?”, usually decades. And then I ask, “What’s the ROI?” And that’s when I get the quizzical looks. I continue, “You mean to tell me for decades you’ve spent thousands of dollars per year for something that has never paid you a dime? What a terrible investor you are.” And then the realization starts to dawn on the audience that, of course, the value in life insurance does not come from its direct ROI.

No one buys life insurance looking for a payout. Instead, you are spending a small amount of money – called a premium, just like options – so to protect your family against a low-frequency but high-impact event. This is how we should think about disruption. Nobody wants their existing product lines to be disrupted but we do have to acknowledge that they happen. So, the money that we spend during the option stage of the innovation accounting life cycle is justified by the fact that this is our profit insurance premium. This is what we’re spending so that we can gain information about the market, and reduce our risk in the unlikely event that our existing product lines are disruptive.

Now, when this starts to be introduced into your organization, there will be plenty of times when it can be very difficult to accept. Here’s a typical example: I was once working with a large consumer medical company that was having difficulty with their innovation projects. They were experimenting with a new way to deliver medical care online, but were struggling because the product manager seem to be dragging her feet on the project. Now, as I learned, the manager was capable, intelligent, and experienced, and seemed more than willing to make tough decisions. Moreover, they had run a great number of small scale experiments, and had gained a ton of real market knowledge, and very little of this knowledge had been shared outside of the core team. The problem was that nearly all of the evidence supported abandoning the project. The reason for the dragging of feet wasn’t a lack of commitment or courage: it was that the answer was “no”.

When I presented the findings to the general manager of the team, I specifically made the point that the PM running the project was doing a particularly good job. She had run multiple experiments, had a solid methodology, had criteria in advance for determining success, and was reaching the correct conclusion that the project idea was not supported by the evidence. Rather than sanction her, she should be lauded for the learning that she had done.

However, the GM was unpersuaded. The exact quote that I remember was, “We are not here to learn. We are here to make money.” We danced around this a bit as I did my best to explain the discovery process, the value of choice, the importance of option as a value, but it all fell on deaf ears.

It was quite literally incomprehensible that I was arguing for the product manager to be rewarded for, quote “Doing nothing.” Suffice to say that the PM got the message, found another job, and the replacement dutifully launched the project to huge losses. Now, of course, the original project manager had learned all this already, but because the accounting regimen of the firm didn’t value that learning, she had no way to be successful in bringing that learning to light. So under those circumstances, she was making a smart economic decision: obfuscate and delay as much as possible and hope something changes in the meantime. Perhaps this sound familiar?

To change these economics, we need to value the option, and the possibility of no which that option obviously implies. If we can make that change, then any information we get – yes or no – makes the option more valuable. This then aligns the corporate governance structure to our goal of knowing, rather than assuming. We don’t worry about the product manager and general manager in conflict, because they share the same goal. That is the option mindset, and no innovation accounting approach is complete without it.

Hopefully this has been a clear indication of the value of an option based approach when facing uncertainty. However, if you’re still unconvinced, I’ll make one final pitch. Just think back on the past dozen or so breakthrough innovation projects for your firm. Almost certainly the result was binary: either it was incredibly successful exceeding the original NPV calculation by an order of magnitude, or (more likely) it was a spectacular failure, losing all of the original investment and some good money after bad. In other words, it was either all or nothing – and in this very real sense your breakthrough innovation projects perform just like options. The only real difference is that while an innovation option will generally be priced in the thousands or perhaps tens of thousands, your traditional project will cost millions. So it’s not like you aren’t using options; you’re just massively overpaying for them.