I Wanna Be a Rockstar: a Real Options Approach to Unlikely Success

One day Alex woke up and decided that more than anything in the world, he wanted to be a rock star.

He could picture himself, up there on a stage in front of thousands of fans, screaming into a microphone, with the lights shining down on his crazy hair and a thumping band playing behind him.

(And he didn’t hide that he loved the idea of making a truckload of money from his passion of making music.???)

Now Alex knew that his dream was far-fetched. But clearly, there are rockstars in the world who made it, like Mick Jagger and Jimmy Page, so it must be possible to become one.

So Alex asked his work friend Paula, a logical-thinking accountant with conventional tastes in music, to help him run the numbers on just how wild his dream was.

Paula ran through the long range of pre-conditions that Alex would need to fulfil, assigning probabilities and pay-offs along the way.

???? “You’d need to be top 10% in terms of musical talent, which might be the case already. You were great at Christmas karaoke.

But you’d need a relentless work ethic, which doesn’t sound like you Alex. You're lazy.

You’d need to show that you can fill a music venue with cheering fans, which is very difficult.

You’d need to secure a deal with a record company; they’re highly selective.

You’d also need to find a band who are very talented but don’t succumb to substance addictions…”

All in all, accounting for net present value, Paula estimated Alex’s chances of making $10 million as a rock star over 5 years at… 0.01% ??

So in statistical terms, rocking Alex could ‘expect’ to make a measly $1000 from his hypothetical musical career.

???? “You’d have to spend a ton of money on shiny clothes, fancy hair products and new musical instruments along the way,” Paula added.

“Plus you’d be missing out on your current salary during that time.”

Factoring in costs, and opportunity costs, Alex would most likely end up hundreds of thousands of dollars in the red from a 5-year rock n roll career interlude.

(Enough material to write a lot of blues songs.)

And there ended Alex’s dream of becoming a rock star.

???? “Thanks anyway, Paula." **sigh** "What was I thinking?”

Why accountants can’t account for innovation

At least Paula took the time to run the numbers for her friend Alex.

But she did so in the way that most financial analysts value uncertain things in the future:

1. Figure out the key variables. Associate conservative probabilities with each one.
2. Calculate the resulting cash flows and discount them (based upon inflation, cost of capital, risk factors etc) – to spit out a valuation

This Discounted Cash Flow (DCF) method of analysis works fine for relatively linear, predictable outcomes (like upgrading a piece of machinery, or increasing advertising expenditure on an existing product).

But DCF is a horribly ineffective methodology when uncertainty is high, and payoffs are asymmetrical – like for example when:

• Predicting whether someone will become a successful rockstar
• Launching a new tech startup with potential to become a unicorn
• Constructing a corporate innovation portfolio of industry-disrupting ventures

(Companies who use DCF to value innovation projects are shooting themselves in the foot.)

Far better, in these situations, where the distribution of potential outcomes is skewed to the extreme, to rely on what are called Real Options.

Quite simply, a real option in innovation refers to the flexibility your company has to invest in different phases of a project over time.

You don’t have to commit 100% on day one!

Like financial options, real options give companies the right —but not the obligation— to make further investments.

This allows you to start with a minuscule financial commitment, gather more information, then decide on future investments based on your early results.

?? This massively, MASSIVELY, reduces the risk of large, upfront investments.

And using Real Options means that many ventures otherwise deemed uninvestable (using DCF) are now perfectly investable.

You read that right: The superpower of Real Options is that they make the uninvestable investable!

How Real Options work

Let’s go back to Paula’s rockstar model and see where she could look at things differently so we can keep Alex’s dream alive for a little longer:

• Maybe the cash upside over 5 years isn’t $10 million but $50 million – which would make a huge difference. But we have no way of knowing for now. (We'll call this 'the Dream'.)

• Maybe Alex’s talent puts him in the top 1% of the population, rather than the top 10%. But would this make a difference commercially? Maybe not.

• A risk that Paula mentioned was Alex’s work ethic. Clearly to become a successful rockstar you need an almost superhuman level of obsession with your music. Does Alex have this? Well this is something we could test right away.

Paula could instruct Alex to take a week off work, shut himself off from the world in a cottage and do nothing but play and write music for 7 days.

[Outcome A] If after a few hours, Alex is bored and wants to do something else, then probably a music career isn’t for him.

[Outcome B] But if he emerges after 7 days, more energised than ever, having written 12 original songs – well this is clearly promising!

Paula now needs to update her ‘model’ to reflect Alex’s stronger-than-expected work ethic.

The next element to test could be whether Alex has the stage presence and charisma to inspire a crowd.

Rather than schedule a concert right away, at immense upfront cost, Alex could simply attend an ‘open mic’ night at a local live music bar and sing a few Bon Jovi songs as best he can.

[Outcome A] If he hates it, or if the crowd hate him, then he can make an emotionally disappointing, but low-cost exit from the bar. No harm is done (except to his ego).

[Outcome B] But if the crowd are cheering for more and he receives a standing ovation, this is another great sign. Maybe he does have the talent and the natural stage presence needed to become a rock star.

Each time we get new information (from the crowd, from the market) we need to update our ‘model’ – updating what were predictions with what are now facts:

“Alex probably lacks the work ethic” [prediction] has now become “Alex has the required work ethic” [fact].

“Alex will struggle to impress a crowd” [prediction] has now become “Alex can woo a crowd with his music” [fact].

Depending on the outcome of each step, Alex always has the option to quit, or to invest more of his time, money and energy into his dream.

By starting with the riskiest assumptions, and those cheapest and easiest to test, we can move through the different steps of the model incrementally.

Since each decision has several outcomes, we can build an entire ‘decision tree’ that illustrates the various payoffs.

We take advantage of the fact we can choose whether to persist and re-invest more (moving further along the ‘tree’), or whether to stop and withhold further investment.

This right to choose without obligation is what gives our approach option value. There is real, financial worth in optionality. An option is an economic asset.

Yet this flies in total contradiction to the traditional DCF approach, which ignores optionality and assumes that you commit all or nothing from the start:

In Paula’s mind, either you commit the next 5 years of your life to becoming, but probably failing to become, a rockstar. Or you abandon your dream immediately.

There’s no middle ground. There’s no decision tree. It’s just a single forecast.

And unless you have irrational levels of passion, almost nobody would look at Paula’s forecast and conclude that they can beat her odds.

DCF is a boulevard of broken dreams.

A portfolio of options

A quick thought experiment… Let’s imagine you have not one Alex, but 10,000 Alexes.

Scenario A: If each Alex is advised by a DCF-loving Paula, then out of the 10,000 aspiring rockstars, probably zero Alexes will take the risky rockstar route.

They will all look at her dire 5-year projections and conclude that the path is ruinous.?

Scenario B: But if we take a Real Options approach, and we get 10,000 Alexes to go through the different stages of commitment sequentially, we’ll get a radically different outcome:

• The first test we saw earlier was about work ethic: Maybe 6,000 of the 10,000 Alexes fail at this first hurdle. (60% failure)
• The second test was about stage presence: Maybe 4,000 of the 6,000 remaining Alexes fail on this metric. (67% failure)

So this means that despite the high failure rates, we still have 2,000 Alexes in the game, each with demonstrably huge passion and talent.

Clearly there are still more hurdles to clear, like securing a deal with a record company. But out of these 2,000 passionate, talented, above-average Alexes – there’s a real chance that a handful of them go on to become prominent music performers.

And it’s not absurd to believe that at least one Alex reaches such success that he can consider himself a rockstar.

So in scenario B, using Real Options, one or more Alexes make it all the way to rock stardom. And begin raking in millions of dollars. ????

Whereas in scenario A, using DCF, we killed off all the hopes and dreams of every single Alex right from the start. ??

“At least you didn’t try,” says Paula, misquoting Diana Ross.

Does this sound familiar?

If you’ve worked with innovative projects in a corporate environment, you’ll be familiar with the ‘DCF’ mindset.

(And with the death of many hopes and dreams.)

Stakeholders and finance departments are right to ask about the return on investment (ROI) of a new idea. Innovators can’t just say “give us the money and trust us”.

But what fails innovation in almost every company is that ‘the accountants’ apply the same valuation tools to explorative, innovative ventures as they do to standard, ‘linear’ investments.

Easy question:

If you’re a corporate decision-maker, should you invest 1 million euros in:

A. a worldwide Salesforce upgrade (projected to return 2.5 million euros after 1 year), or in

B. An unproven new tokenization platform (projected to return somewhere between zero and 100 million dollars after 5 years)?

With one eye on your promotion next year, and another on your massive mortgage, you (the decision-making human being) will almost certainly pick investment A.

(And to hell with the shareholders, who might benefit more from investment B.)

But aside from the blatant conflict of interest just described (what’s known as the ‘principal-agent problem’) this isn’t the right way to look at these investments.

A and B simply can’t be compared side-by-side.

Investment A is a more typical, ‘linear’ project. You can assess the expected value of a software upgrade using DCF.

It will almost certainly return a profit in the short term, but it will do nothing to ensure the long-term future of your business.

By contrast, for investment B, a Real Options approach makes more sense.

No sane innovation leader should be committing 1 million euros to an unproven tokenization platform upfront.

Rather, you should commit maybe 20,000 euros (2% of this budget) to testing out a first key assumption. (For example, whether enterprise clients will make use of a critical API.)

This is where innovation professionals come in: They can build quick and dirty experiments that teach us –based on real-world data, not someone’s opinion– to what extent our assumption is true.

Based on this learning, we now have the option to either commit a bit more money (e.g. 50,000 euros) or to stop the project and free up the rest of the budget.

In general, whenever we have the flexibility to defer investments to later, or to expand investments when the opportunity looks promising, or to abandon these investments if not – then we have optionality embedded in the project.

Which is usually the case with new, innovative ideas.

We know that most truly innovative projects don’t work out on an individual basis. This is why we have to be disciplined in keeping early investments small and in making follow-on investment decisions based on fact, not opinion.

But creating a portfolio of many options is what gives companies the greatest chance of realising true commercial breakthroughs with innovation. You need to exploit this optionality to make a profit.

Whereas looking at individual projects on a DCF basis is your guarantee that your company will produce no meaningful innovation.

Implementing Real Options

So who can make the Real Options approach happen inside your company?

It would be nice to think that a single intrapreneur could waltz up to the Head of Innovation and say “Hey, I’m going to start using a Real Options approach now”.

Good luck with that.

With the greatest of respect, very few people know about or appreciate Real Options inside big companies. Including in the Finance department, where many people learnt about financial options once upon a time.

Plenty of people ‘get’ the concept of Real Options once they learn about it, but very few make any serious effort to implement it.

The ‘DCF’ mindset can feel like one of these immutable factors of corporate life – like recurring meetings, or three-letter acronyms, or the word 'bandwidth', or Death by PowerPoint.

That said, the place to start with a Real Options approach in innovation is with who I call the FBI trio.

The FBI trio is a working group of three people of similar seniority: One from Finance (F), one from the core business (B) and one from the innovation function (I).

You can form an FBI trio at the most senior level of the organisation – e.g. the CFO (F), a Business Unit leader (B) and the Head of Innovation (I) – or for a single innovation project – e.g. a Financial Analyst (F), an Account Manager (B) and a Product Owner (I).

What’s important is that you bring together F, B and I: Finance, Business and Innovation.

Working together on a regular basis, and assuming that they have a genuine mandate to innovate, the FBI trio automatically have all the skills required to make a Real Options approach work:

• The Finance person can focus on how funds get released in stages
• The Business person can contribute their market expertise to quantify business assumptions to be tested
• The Innovation person can design business experiments that test these assumptions cheaply
• Together, they evaluate experiment outcomes and decide on what to do next (invest more or stop)

Do Real Options remind you of something?

If you’re familiar with the Lean Startup methodology, you’ll notice that Real Options are perfectly compatible with its principles:

• Indeed, they allow for pivoting, expanding, or abandoning projects based on new information
• They encourage us to test our assumptions, cheaply, ranked by their ability to destroy our idea
• More broadly, they also encourage a culture of ongoing experimentation and learning – along with a healthy irreverence for HiPPO*-style decision-making

(* HiPPO = Highest-Paid Person’s Opinion)

But there’s a final element of Real Options that is particularly powerful (an insight I owe to Claus Hirzmann ):

They allow intrapreneurs to express their dream in an explicit manner.

In most corporate contexts, people who propose a new idea are forced to temper their entrepreneurial vision by balancing two conflicting forces:

• On the one hand, you have to make your financial projections ambitious enough to make funding the project worthwhile
• On the other hand, you don’t want your estimates to appear too wild, lest you come across as delusional. Plus, if your idea does get funded, people are going to expect you to fulfil the ambitious targets you set for yourself.

So most people end up presenting a bland, just-about-believable hockey-stick chart, that predicts breakeven somewhere around year 3, based upon a range of BS assumptions.

But with Real Options, the person with the idea –or even better, the FBI trio– can express the full range of possible outcomes (from total failure to runaway success) and assign probabilities to them (probabilities that the trio will update as the facts unfold).

Conclusion

This brings us back to Alex, our wannabe rockstar.

If he's allowed to dream, to express the most successful scenario in his mind, it drags the range of possible outcomes upwards – influencing the overall expected payout of his career change.

But it also inspires others around him. We all love to work alongside passionate people with a clear, bold vision. Who deal in the art of the possible, not in ‘conservative estimates’.

In business innovation, Real Options allow innovators to express their dreams fully, rather than make them feel they have to put a corporate dampener on things (in order to seem serious, or whatever).

So instead of your portfolio being made up of a range of bland improvements and incremental tweaks, Real Options enable your innovation portfolio to incorporate a collection of truly transformative ideas.?

Lots of companies right now are struggling to show a positive return from innovation. Which is causing them to question the whole thing and even close down their innovation activities.

So if your company is in this situation, if you’re looking for a magic trick of some kind, one that will somehow make uninvestable ideas investable, you’re in luck:

? Real Options can help you achieve this.

Start incorporating them in your innovation processes asap. And maybe you too will become something of a rockstar.

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Happy reading and listening over lunch,

Stephen