Quick reference
Key formula / structure
Pay a little now for the right, not the obligation, to invest more later. Set the trigger before you spend. Decide at the gate.
Memory aid
Only the money you can still decline is an option.
TL;DR
Name the one uncertainty that would change the decision and when it will clear. Split the investment into what must be paid now and what can wait. For each later stage, write the condition that releases the money and the one that stops it, and name who can stop it. Compare the cost of staging with what it could save. When the uncertainty clears, decide on the next stage as a new investment.
What Is Real Options?
Real options treats an investment as a series of choices rather than one decision. You pay a small amount now for the right, but not the obligation, to invest more later. When the uncertainty clears, you decide: invest more, wait, or walk away. Stewart Myers coined the term; Timothy Luehrman applied it to strategy in the Harvard Business Review in 1998.
In financial terms, a business strategy is much more like a series of options than like a single projected cash flow.
— Harvard Business Review's summary of Timothy Luehrman, "Strategy as a Portfolio of Real Options" (September 1998)
A standard forecast treats a project as one stream of cash: commit the money, collect the returns. Real options notices that managers rarely have to decide everything at once. A pilot before a factory, a license before an acquisition, a deposit before the full price: each buys the right to decide later, with more information, while capping what can be lost now. That right has value, and the more uncertain the outcome, the more it is worth. The framework's discipline is in the second half. An option is only worth something for the money that can still be stopped. A deal described as staged, but paid mostly at the start, protects only its small staged part. A sequence of investments the company would never actually stop is not an option either. So the useful questions are concrete: how much is committed today, what event would tell us to go on or stop, and who has the authority to stop?
A real option in four moves
From one big bet to a staged decision.
Pay a little now
The price of the right to decide later
Name what you'll learn
The uncertainty that will clear
Set the trigger
Written before the money is spent
Decide at the gate
Invest more, wait, or walk away
Origin & context
Stewart Myers, the corporate finance economist, coined the term real options. Timothy Luehrman brought the idea from finance into strategy in "Strategy as a Portfolio of Real Options," published in the Harvard Business Review in September 1998. The article's summary puts the core claim this way: in financial terms, a business strategy is much more like a series of options than like a single projected cash flow.
Builds on: Stewart Myers, Coined the term real options; Timothy A. Luehrman (1998), Strategy as a Portfolio of Real Options, Harvard Business Review (September 1998); Tom Copeland and Peter Tufano (2004), A Real-World Way to Manage Real Options, Harvard Business Review (March 2004).
Real Options in action
AbbVie and Stemcentrx
The part that could wait was the part that was saved
On April 28, 2016, AbbVie agreed to buy Stemcentrx, a South San Francisco biotech built around one late-stage cancer drug, Rova-T. The price was about $5.8 billion in cash and stock, about $2.0 billion of it in cash. And, in AbbVie's words, "Stemcentrx investors are eligible to receive up to $4 billion in cash for additional, success-based milestone payments."
The real options question is how much of the price could wait for the evidence. Here the answer was in two pieces. The $4 billion was an option: owed only if the drug succeeded. The $5.8 billion was a commitment, paid when the deal closed on June 1, 2016, before any trial result was known.
Rova-T failed. After its Phase 3 TAHOE trial failed, AbbVie recorded a pre-tax impairment of $5.1 billion on the Stemcentrx research assets in 2018. In 2019, after the Phase 3 MERU trial failed to show a survival benefit, it ended the program and wrote off the remaining $1.0 billion. The milestones were never met, so the $4 billion was never paid. The staged part of the deal did what an option should. The part paid up front had no such protection.
AbbVie terminated the Rova-T program in 2019. The up to $4 billion in milestone payments was never paid; the research assets bought with the upfront price of about $5.8 billion were written down by $5.1 billion before tax in 2018 and by the remaining $1.0 billion in 2019.
Atlassian
Waiting for the deal size that pays for a salesperson
Atlassian grew for years selling its software without commissioned salespeople. As its chief revenue officer, Cameron Deatsch, put it, "So, the first commissioned salesperson, Atlassian started in 2014."
What changed was the size of the deal. Atlassian launched a premium version for large installations, which it called Data Center, at a significant step-up in cost. "That increase in cost, the ASP (Average Sales Price), went from $4,000 to $48,000," Deatsch said.
Stratrix's Take: waiting is an option too. A sales team is a large, lasting cost. Holding off until the average deal was big enough to pay for one let Atlassian make the hire once the uncertainty had cleared, rather than before.
Atlassian's first commissioned salesperson started in 2014, after the average selling price of the Data Center product reached $48,000.
Using it in the room
Use it when a large commitment is being shaped and a key uncertainty will clear within a known time: before an acquisition's terms are set, before a market entry is funded, before a large hire or build. Use it again at each gate, when the next stage's money is due.
Questions to ask
- ?What is the one thing we do not know that would change this decision, and when will we know it?
- ?How much of the price must we pay before we know it?
- ?What would the other side accept as a staged price?
- ?What result releases the next stage, and what result stops it?
- ?Who has the authority to stop, and have they agreed in advance?
The 30-minute version
Five minutes to name the uncertainty and its date. Ten minutes to split the money into now and later. Ten minutes to write the go and stop triggers for each later stage. The last five to name who decides at each gate and when the first gate falls.
Core Components
The price of the option
What you commit now to keep the right to decide later. It should be small next to the full investment; if it is not, most of the risk is already taken.
Example
A company pays for a six-month pilot plant before deciding whether to build the full factory.
The uncertainty that will clear
The specific thing you do not know today and will know later: a trial result, a regulator's ruling, a customer's order size. Without it, waiting buys nothing.
Example
Whether a drug in late-stage trials will succeed.
The trigger
The event, set in advance, that decides whether the next stage goes ahead. It is written before the money is spent, while judgment is still clear.
Example
The next payment is owed only if the drug reaches a named regulatory milestone.
The choices at the gate
Invest more, wait, change course, or walk away. An option is only real if walking away is a live choice someone is allowed to make.
Example
A board agrees in advance that a failed pilot ends the project, with no second pilot.
The committed money
Everything paid before the uncertainty clears. This part has no option protection at all, whatever the deal is called.
Example
The cash and stock paid at the close of an acquisition, before any milestone is tested.
When to Use Real Options
Structuring an acquisition under uncertainty
Problem it solves: The target's value depends on an event that has not happened yet, such as a trial result or a contract renewal.
Real-world application
A buyer moves part of the price into payments owed only if the target's drug passes its trials.
Entering a new market
Problem it solves: Nobody knows whether customers will buy, and a full launch would commit most of the budget before anyone finds out.
Real-world application
A retailer opens three stores in a new country, with a rule for what sales level funds the next thirty.
Timing a large hire or build
Problem it solves: The cost is certain and the payoff depends on something that is still growing.
Real-world application
A software company holds off building a sales team until the average deal is large enough to pay for one.
Managing a research portfolio
Problem it solves: Many projects compete for money, and most will fail.
Real-world application
An R&D team funds ten early projects cheaply and sets the result each must show to earn the next round.
Before calling a deal an option, add up what is paid before the uncertainty clears. If that is most of the price, the option protects only the remainder.
How to Apply Real Options: Step by Step
Before you start
- →A decision large enough that staging it matters
- →A real uncertainty that will clear within a known time
- →Someone with the authority to stop the next stage
Name the uncertainty
Write down the one thing you do not know that would change the decision, and when you will know it.
Tips
- ✓Make it observable: a result, a ruling, an order size
Common mistakes
- ✗Naming a general worry instead of a specific unknown
Split the money
Divide the investment into what must be committed now and what could wait until the uncertainty clears.
Tips
- ✓Ask the other side what it would accept as a staged price
Common mistakes
- ✗Calling a deal staged when most of the money is paid at the start
Set the trigger
For each later stage, write the condition that releases the money, and the condition that stops it.
Tips
- ✓Tie triggers to events outside your own team's control or judgment
Common mistakes
- ✗Leaving the stop condition vague, so every result looks like a reason to go on
Price the option
Compare the cost of staging (a higher total price, a slower start, a rival moving first) with what you could avoid losing if the uncertainty goes badly.
Tips
- ✓A rough range is enough for most decisions; formal valuation needs stated assumptions
Common mistakes
- ✗Using an option value to justify a price the plain forecast would reject
Decide at the gate
When the uncertainty clears, decide on the stage as if it were a new investment: go on, wait or walk away.
Tips
- ✓Have someone who did not sponsor the first stage review the second
Common mistakes
- ✗Treating money already spent as a reason to keep spending
Showing the result
One slide: a timeline of the commitment. On the left, the money paid now. In the middle, the event that will clear the uncertainty and its date. On the right, the later stages with their amounts, each with the result that releases it and the result that stops it. Shade the committed money; draw the money that can still be declined in outline.
On the slide
- ✓The amount committed before the uncertainty clears
- ✓The trigger and amount for each later stage
- ✓Who decides at each gate
Left off
- ✕An option value with no stated assumptions
- ✕Stages nobody would actually stop
- ✕Formulas the board does not need
Each corporate growth project is an option in the sense that managers face choices--push ahead or pull back--along the way.
— Harvard Business Review's summary of Tom Copeland and Peter Tufano, "A Real-World Way to Manage Real Options" (March 2004)
Value & Outcomes
Primary benefit
It shows how much of a big commitment can wait for the evidence, and turns that part into a choice instead of a bet.
Additional benefits
- ✓Caps what can be lost before the key uncertainty clears
- ✓Makes the stop condition explicit before momentum builds
- ✓Gives a reason to value flexibility that a single forecast leaves out
What you'll learn
- →How to separate committed money from money that can still be declined
- →How to set triggers before the first stage starts
- →Where option reasoning helps and where it can be used to overpay
Typical outcomes
Best Practices
📋 Preparation
- •Name the single uncertainty that matters most
- •Find out what the other side will accept as a staged price
- •Agree who can stop the next stage
🚀 Execution
- •Keep the first commitment small next to the whole
- •Write go and stop triggers before spending
- •State the assumptions behind any option value
🔄 Follow-Up
- •Review each gate as a new decision
- •Record why each stage went ahead or stopped
- •Compare outcomes with the triggers you set
💎 Pro Tips
- •The right to walk away is the option; a sequence alone is not
- •Waiting is an option too, if the uncertainty will clear
- •Count what is paid before the evidence arrives
The trigger for walking away is easiest to set before the first dollar is spent. After that, every stage feels like a reason to continue.
Limitations & Pitfalls
Formal option values rest on assumptions that are often not spelled out, and different methods can give different answers. Adam Borison's review of the methods makes this point, and quotes the corporate finance authors Brealey and Myers saying replicating-portfolio arguments cannot justify applying real options.
Mitigation: Use the reasoning to structure the decision; if you put a number on the option, write down every assumption behind it
Many of the problems with real-options analysis come from using the Black-Scholes-Merton model, built for traded financial options, on projects that are nothing like them, as Tom Copeland and Peter Tufano argued in 2004.
Mitigation: Prefer a simple decision tree or binomial model fitted to the project
The approach works least well where it is most tempting: a new product unrelated to anything existing, or a research venture whose results are hard to predict, as Dixit and Pindyck noted.
Mitigation: For those, rely on the staging and the triggers rather than on a computed value
It does not say what to build or buy. It only shapes how to commit to a choice already worth making.
Mitigation: Decide on the opportunity first; then use options to stage the commitment
An option is only worth something if someone will actually stop. Teams that never walk away own a sequence, not an option.
Mitigation: Name the person who can stop the next stage, and the result that would make them do it
What comes before and after
Run first
Names the futures the commitment must survive, and the uncertainties worth staging around.
The plain forecast real options starts from, and the number it adds flexibility to.
Run next
Runs the staged plan: a decision at each gate, against the triggers set in advance.
Records the triggers and why each stage went ahead or stopped.
Where this comes fromStewart Myers (the term); Timothy Luehrman (strategy as a portfolio of options) introduced this.
Sources & further reading
- Timothy A. Luehrman (1998). Strategy as a Portfolio of Real Options. Harvard Business Review (September 1998).The article's summary: a business strategy is more like a series of options than a single projected cash flow.
- Wikipedia. Stewart Myers. Wikipedia.Myers coined the term real option.
- Adam Borison (2003). Real Options Analysis: Where Are the Emperor's Clothes?. Real Options conference papers.The term coined by Stewart Myers; unstated assumptions behind the valuation methods; Brealey and Myers, and Dixit and Pindyck, on where the approach does not hold.
- Tom Copeland and Peter Tufano (2004). A Real-World Way to Manage Real Options. Harvard Business Review (March 2004).Growth projects as options; problems from the Black-Scholes-Merton model; binomial models as simpler.
- AbbVie Inc. (2016). AbbVie to Expand Oncology Presence Through Acquisition of Stemcentrx and its Novel, Late-Stage Rova-T Compound for Small Cell Lung Cancer. AbbVie (April 28, 2016).About $5.8 billion in cash and stock, about $2.0 billion in cash; up to $4 billion in success-based milestone payments.
- AbbVie Inc. (2016). Form 8-K: completion of the acquisition of Stemcentrx. U.S. Securities and Exchange Commission (June 1, 2016).The deal completed on June 1, 2016, with upfront consideration of about $5.8 billion.
- AbbVie Inc. (2019). Form 10-K for fiscal year 2018. U.S. Securities and Exchange Commission.The failed TAHOE trial and the $5.1 billion pre-tax impairment in 2018.
- AbbVie Inc. (2022). Form 10-K for fiscal year 2021. U.S. Securities and Exchange Commission.The 2019 termination of the Rova-T program after the MERU trial, and the further $1.0 billion impairment.
- The Motley Fool (2019). 3 Lessons From AbbVie's $5.8 Billion Blunder With Cancer Drug Rova-T. The Motley Fool (September 4, 2019).The milestones were not met, so the $4 billion was never paid.
- WorkOS. Achieving the First $100M in Revenue Without a Sales Team (Crossing the Enterprise Chasm podcast). WorkOS.Cameron Deatsch on Atlassian's first commissioned salesperson in 2014 and the Data Center price step-up from $4,000 to $48,000.
More Management Frameworks
Other frameworks in the Stratrix library.
OODA Loop
The OODA loop is John Boyd's cycle of observe, orient, decide and act, repeated as a feedback loop. Most people remember it as a race to decide faster. Boyd put the weight on orientation: the picture of events in your head, which is where a fast team goes wrong.
Strategy DevelopmentStrategy Diamond
The strategy diamond says a strategy answers five questions: where we will be active, how we will get there, how we will win, our speed and sequence of moves, and how we will earn our returns. The two that look like execution, the route and the order, are choices in their own right.
Strategy DevelopmentBusiness Model Canvas
A visual strategic management tool that describes, designs, challenges, and pivots a business model through nine interconnected building blocks covering value creation, delivery, and capture.
Strategy DevelopmentCore Competency Analysis
A framework for identifying an organization's unique bundle of skills and technologies that provide access to multiple markets, contribute significantly to customer value, and are difficult for competitors to imitate.
Strategy DevelopmentGE McKinsey Matrix
The GE McKinsey matrix places each business in a portfolio on a nine-box grid by how attractive its industry is and how strong the business is, then sorts it to invest, invest selectively, or sell. It scores each business alone; the risk often sits in the ties between them.
Strategy DevelopmentStrategy Map
A strategy map, from Robert Kaplan and David Norton (2000), draws a strategy as four layers of objectives joined by cause-and-effect arrows. The boxes are easy; the arrows are the strategy, and each one is a bet you can price and own.
Tools to try
- Ansoff move finderFramework: Ansoff Matrix
- Business model canvas builderFramework: Business Model Canvas
- Five Forces scorerFramework: Porter's Five Forces
- SWOT builderFramework: SWOT Analysis
- Change readiness checkFramework: Kotter's 8-Step Change Model
- SMART goal builderFramework: SMART Goals
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