Strategy as Optionality

We're living in a VUCA world. Everyone utters this buzzword to the point it has become almost meaningless. For one thing, there has always been volatility, uncertainty, complexity, and ambiguity in the world. Read any military history and this becomes poignantly clear. The first consequence of war, it is often lamented, is unintended consequences. The best laid plans crumble, often catastrophically, in the fog of war. So what's really new under the sun? Are we really thinking about what the implications are for corporate strategy if VUCA is to have any relevant meaning?

The conclusion most often drawn is we need to go faster. The data seem to confirm this is the right interpretation. Though the past is no predictor of the future, the evidence suggests that corporate lifespans are shrinking over time. Why, though? One part of the answer is certainly Schumpeterian creative destruction. Markets are perhaps getting more efficient at replacing those companies which are too slow to adapt to changing customer needs, but this has always been true. Customer behavior is notoriously difficult to predict and even detect. Fads come and go along with the business models which capitalized on them. Again, nothing new. What is new, however, is that the amount of capital needed to challenge incumbent business models is getting smaller and smaller and the capital markets savvier and savvier. Startups which can demonstrate early traction have access to almost unlimited capital, and new technologies make the capital requirements necessary to threaten incumbent players less burdensome. As Rita McGrath has pointed out, the borders which used to define the boundaries of an established market vertical are either blurring or vanishing entirely, meaning threats can come from unforeseen origins and quickly.?

Considering the above, it is clear that urgency is warranted. Urgency certainly implies we need to move faster, but I don't think that's actually the right conclusion to draw. In a business world replete with the fog of war, direction beats speed. Even better would be velocity which includes both direction and speed. But how do we choose the right direction when we know nobody has the ability to pick winners ex ante?

One approach, which we might call the deterministic approach, is to set a concrete target in the future, a vision so to speak, hopefully not a hallucination. If you have a compelling vision, all you need to do is execute towards it. Good strategy work with this approach is determining how to reach the future target given the company capabilities. Some even take the approach that the how doesn't matter as long as employees are inspired enough; they'll figure it out. But what if the target is wrong? As economists say, it's difficult to make predictions, especially about the future.

Having worked in venture capital, it became clear to me that startups and venture capitalists have a better approach to modern strategy which includes both direction and speed - velocity. In a world, dare we say VUCA world, with high variance and astronomical failure rates, it is foolish to go all in upfront on a mere notion or whim without evidence of traction. That does not mean you have no vision or target, but I wouldn't even call it a vision or target; it is a rather a strategic thesis, a belief about how you might create a repeatable and scalable business by solving a compelling customer problem. It might seem like a slight nuance, but the implications are enormous. A thesis must be tested, whereas a vision is fixed. We admit upfront that a thesis might be wrong, and if we take the scientific approach, our null hypothesis is that it is wrong. Why do I say startups have a better approach? They embed optionality and thesis testing into their strategy.

What is optionality? Optionality means you have the right to take an action, but not the obligation. To give you an idea of how this works, we can look at venture capital funding rounds. Venture capitalists do not give a startup all the funding it will ever need upfront. Instead, they embed optionality in the form of funding rounds with well known standards of evidence of traction. At the pre-seed stage, they want to see a compelling idea with lots of customer interviews. From seed to Series A, they want to see evidence of product-market fit, meaning you have found a compelling problem to solve with a solution at least 10x better than the existing solution on some relevant dimension. After Series A, they look for a repeatable sales process, industrialization, and productization. The funding is only released when at each stage the startup has demonstrated adequate evidence of traction.

Why is this an example of optionality? Venture capitalists only pay for the right to find out whether the startup has demonstrated enough traction at each stage, but they do not have an obligation to fund further. Even more intelligently, they realize that your greatest risk is when you know the least, and they fund accordingly with appropriate discount rates to account for this risk. They only scale funding at the speed of traction or learning. They also know that an idea is not true at conception; it only becomes true with traction. The most successful startups change directions several times over the course of validation. As many have pointed out, startups are not faster than corporates; they are simply better at changing directions quickly. They are able to do this because they have no choice but to treat strategy as optional.

What does this have to do with corporate strategy? Well, if VUCA is real, then everything. A modern strategy department cannot treat core business as static or given. All strategy formulation must be geared towards creating optional directions in which the corporation could go given its capabilites and the competitive environment. However, it cannot treat the direction as fixed or sacrosanct; it must test the direction quickly, cheaply, and dispassionately. After all, this is what VUCA implies. We cannot assume we have infallible foresight. We must have the courage to test our strategies. That's what it means to treat strategy as optionality.