Things were simple when I worked in the games industry. If the company’s owner liked an idea, he invested in it. One guy’s gut feel drove our entire investment strategy.
Back then, in the 90’s, a typical console game cost maybe £1m to develop. Our boss could afford to invest in several at once, giving himself a pretty decent chance that at least one of them would make money. And he only needed one or two successes to pay for a long tail of flops.
Nowadays, a high profile console game costs upwards of £20m to develop. Even large companies can only afford to carry a small number of failures of that size. Gut feel just doesn’t cut it any more.
The film industry went through this transition years ago. Some would say it’s become risk averse, investing primarily in sequels and suchlike, but it’s also developed some pretty impressive strategies for dealing with uncertainty.
Real Options are one of those strategies.
A real option is anything that gives you the ability, but not the obligation, to undertake some course of action in the future. For example, booking a hotel room gives you the option to stay in that hotel for a night. But you don't have to stay, you can also cancel the booking.
Until the point where you’d need to pay a cancellation charge, this option is free. And even after that point, it could be worthwhile to risk paying a small charge to keep the room open, just in case you need it.
Real options allow you to defer commitment. You retain the ability to act, say to invest in a new product, while you gather more information. Once you’ve learned more about the situation, you can make better, more informed decisions.
So how do film studios use real options? Here are a couple of examples.
When a studio starts producing a film, they also start to think about sequels. Analysis of their investment patterns suggests that they invest slightly more in the production and marketing of films that might lead to sequels.
That investment buys them an option. If the initial film succeeds, they have a strong basis for a sequel. But they aren’t yet committed to that sequel – they only decide whether to invest in it once they’ve seen the initial film’s sales.
Likewise when they launch a film they don’t commit the full marketing budget upfront. Instead, they defer a significant proportion of their spend until they’ve seen the results from the opening weekend.
If the film does well, they ramp up the marketing. If not, they cut their losses. As much as a quarter of a film’s marketing budget might be optional – the studio only commits it when they have firm evidence that the film will do well.
We can learn a lot from this in our digital portfolios. There’s certainly no lack of uncertainty in the online world. I like to think about Chris Matts’ and Olav Maassen’s three principles for managing real options in product development when I’m making decisions:
Options have value. You’ll always know more in the future than you do now. So a deferred decision is a more informed decision, one that’s more likely to add value.
In order to do this, I need to create options. (After all, if there’s only one option, there’s no decision to make.) Once I have those options, I can start unlocking the value in deferred decisions.
Options expire. This is the flip side of the first principle. You can’t defer decisions indefinitely. You need to time to implement them – to assemble teams, build relationships, develop systems, negotiate contracts, book media slots, etc.
Once you’ve passed the point where you no longer have time to implement an option, then it’s expired and no longer has value. You can't keep your options open forever.
Never commit early unless you know why. Many organisations value “decisiveness”. They reward people who make rapid decisions. And many people are comforted by this: it’s a relief to be clear about where they’re going, what they’re going to do.
But there’s a price for this relief – it destroys the value tied up in all their other options. Don’t destroy that value unless you're getting something in return.
Sometimes it pays to be decisive. In an unsettled environment, your decisiveness can itself change the game. Set a clear direction, for example, and other players will follow you.
This can create momentum towards your chosen destination. Likewise, if a team is stalled, establishing a clear cadence of delivery (no matter what they deliver) may the first step towards recovery. You need to get a ship moving before you can steer it.
At least as often, however, it pays more to keep your options open.
My old boss, back in the games industry, was decisive. He listened to his gut and made rapid decisions about where to invest. It was impressive to see. But sadly, that company no longer exists.