Implications of Real-Options Thinking

The flexible principles and practices of XP create several kinds of real options. These options enable us to view XP as a process that maximizes value. The insight gained can be expanded to other contexts as well, from risk and contract management to compensation and incentive systems.

A Different Attitude toward Risk Management

More careful, risk-averse companies get left in the dust.

Dan Scheinemann, Cisco

We've seen that although project uncertainty may endanger the value of a project, uncertainty in the environment increases the value of real options embedded in a project. Risk-averse companies get left in the dust because they are not able to take advantage of external opportunities that accompany risk.

The most important implication of this argument is the need for an expanded view of risk management. The real-options approach refutes the notion that all risk is bad, that all risk has to be reduced, and especially, that all risk reduces value. This observation shifts the emphasis from the project-level idea of contingency plans, which have the connotation of something going wrong, to the idea of contingent investments, where it is economically justifiable to move toward risk, knowing that value is best maximized through active management [Favaro2002]. In other words, in an environment of high uncertainty, the emphasis shifts to managing risk from reducing risk. In fact, options theory goes one step further: It maintains that it is total risk, not only project-level or market-level risk, that needs to be managed.

Contractual Innovation

One of the most recent uses of options is in the design of innovative contracts with nonlinear payoffs. For example, a contract with a ceiling price or a floor price can be synthesized through a combination of buying and selling call and put options. In general, any set of contingent payoffs payoffs that depend on the value of an underlying asset can be priced as a combination of options on that asset. Thus derivative concepts can be used to engineer contracts using a mix of financial and real options, combined appropriately to manage risk. In Silicon Valley, these concepts are being used regularly to work out financing for venture capital start-ups and for licensing agreements. For an example of the use of contractual options in license agreements, see [Erdogmus2001A].

The options perspective can also be applied to XP contracts. In a white paper, Beck and Cleal [Beck+1999] note that XP contracts have characteristics of options in the sense that the features to be implemented are optional they don't necessarily have to be implemented. That is, the scope of contracts is not predetermined.

XP contracts are not fire-and-forget. The customer and the development team have a set of decision points, which give them the ability to actively manage the contract. The customer exercises its options by asking the team to implement a set of features. As the team completes new features, the customer has to decide which new options to exercise next. These may be options that were in the original scope, options that were under consideration originally but not in the original scope, or newly discovered options. Thus, as successive iterations resolve uncertainty, the customer has decision points in which to intervene and maximize new opportunities while minimizing downside effects.

One surprising insight that can be gained from this perspective is that XP contracts add the most value when feature benefits are least certain. When a feature is deeply in-the-money (that is, the value of its immediate implementation is high), the feature should be implemented. Conversely, when a feature is deeply out-of-the-money (that is, the value of its immediate implementation is highly negative), it should not be implemented. However, when the feature is at-the-money, the NPV of immediate implementation is around zero, and the customer is uncertain of its benefits. In this latter case, the option to delay implementation may add a great deal of value, because the future is likely to resolve that uncertainty. This is precisely where the YAGNI principle makes the most economic sense.

Similarly, additional value can be created when the customer has a choice to implement the best of a set of alternative features. Such a choice is represented by a best-of, or rainbow, option. In an option on the best of two assets, the investor holds two options but is allowed to exercise only one of them, effectively creating a hedge. Options theory can demonstrate that best-of options have the most value when the underlying assets are negatively correlated that is, if one asset goes up, the other goes down. Intuitively, this makes sense because it gives the holder of the option a real choice rather than a hypothetical one. In this light, XP contracts can also be seen as a portfolio of best-of options, where the customer is offered a set of suggested features plus the alternatives. A choice between contrasting alternatives is more valuable to the customer than one between related alternatives.

The Role of Discipline

The nonlinear thinking that underlies real options also has profound implications for information technology management in an increasingly uncertain environment.

An organization embracing this thinking systematically identifies leverage points where flexibility would be desirable, analyzes these leverage points, and structures projects with options that take advantage of them. Projects are continually refined to embed in them further options that increase their value.

An organization embracing the real-options approach becomes less averse to total risk. It recognizes that opportunity and risk go hand in hand. Consequently, it encourages and supports learning investments that explore new opportunities.

Paradoxically, an option derives most of its value from rational exercise. Therefore, if the organization is to move responsibly toward valid contingent investments with many embedded options, more rather than fewer projects will be started (although many of these will not be taken to completion due to rational exercise). To create and maximize value, decision makers need the discipline to abandon projects when their option value no longer justifies further investment. This attitude has serious repercussions in terms of how compensation and incentive systems should be redesigned. It will be important for management not to penalize teams for killing projects that aren't working out, moving from a philosophy of killing careers to a philosophy of killing projects. Project abandonment needs to have a positive connotation if done for the right reasons, not the negative connotation that it has in a myopic perspective of risk management.

An interesting anecdote for this line of thinking comes from the entertainment industry. A screenwriter is highly rewarded for the successful completion of a screenplay, even if a film is never made from it. The reason is the recognition of movies as high-risk, high-payoff projects. Simply the fact of creating the option to make a film (by developing a finished, professional-quality screenplay) is correctly recognized as having high economic value. The possibility that the option to make the film may not be exercised (or that the project may be abandoned in midcourse) is fully accounted for. By the same token, venture capital firms invest in a portfolio of highly risky projects. Most fail, but the few that succeed justify the investment in the portfolio as a whole.

It may seem that such an approach is destined to remain up at the relatively abstract levels of strategic planning and never be seen down in the trenches, where development is carried out. This is not at all the case. Recall that XP explicitly encourages technical experiments miniprojects within projects, or spikes in XP terminology that quickly test new ideas. These experiments ultimately are either incorporated into the main project if successful or abandoned otherwise. Developers are rewarded for this kind of creative exploration even if only a few of those experiments succeed.

In an options-oriented management system, the incentive and compensation package should be aligned with the concept of rational exercise one of the cornerstones of option pricing. Such alignment encourages teams and individuals to undertake the kind of experimentation that will create valuable options for the project's or the firm's future and to not fear for their jobs if some of those options are not realized. One of the four values of XP, courage, is fundamental here: To impact the creation of economic value, courage should imply not only the courage to create and exercise options, but also the courage to practice rational exercise in a disciplined way.