Because traditional valuation tools such as NPV ignore the value of flexibility, real options are important in strategic and financial analysis.
—McKinsey Quarterly [1]
Improving Portfolio Outcomes with Real Options
By Joe Vallone, SAFe Fellow, Scaled Agile Inc., and Claus Hirzmann, Strategic-Finance SAS
Note: This article is part of the Community Contributions series, which provides additional points of view and guidance based on the experiences and opinions of the extended SAFe community of experts.
Abstract
To maintain portfolio flow and speed to market, leveraging Business Agility requires nimble funding of the Minimum Viable Product (MVP) and its Development Value Stream. Such funding is enabled by a financial rationale that matches the lean-agile development approach: Real Options. Real Options have been used in corporate finance for several decades, and most Finance people are familiar with them. This article introduces Real Options for funding lean-agile development, including concepts and usage in Lean Portfolio Management (LPM).
Real Options provide a suitable alternative to traditional NPV (Net Present Value) estimations that are ill-suited for funding complex systems development in the 21st century [2]. SAFe and Real Options work together to quickly leverage compelling yet uncertain business opportunities and provide greater transparency of financial risks. Thereby, Real Options can help C-level leaders fund initiatives using a Lean-Agile approach, resulting in acceptance of SAFe adoption for the enterprise. This ensures the quality and success of lean-agile transformations.
What Are Real Options?
Real Options and Net Present Value (NPV) are financial frameworks for measuring expected value creation; their formal results compare apples to apples. What differs between both frameworks is the kind of Lean Business Case they apply to: NPV applies to linear projects with predictable trajectories and a high degree of certainty about future cash flows (e.g. manufacturing). Real Options apply to EPICs and represent their repeated iterations of progress, discovery, and agile steering to navigate uncertainty (e.g. software and systems development). Innovative initiatives are better undertaken in a lean-agile manner to reduce risks, enabling financial leaders to seize opportunities.
Thus, Real Options complement the Lean Startup funding model of SAFe – start with a small batch size of features and iterate based on feedback using leading indicators. Specifically, Real Options measures the value creation expected from each PI. The resulting decision-making process enables nimble funding of business opportunities. This financial agility enables companies to take advantage of new opportunities, react to changing market conditions, and adjust their plans as new information becomes available – they achieve Business Agility!
Real Options can evaluate the expected value creation of new products and services, technologies, resiliency, and transformation. Applying Real Options benefits fiduciaries, like CEOs, CFOs / Finance, Product Managers, Epic Owners, and consultants such as SPC(T)s.
Real Options Applied to the Business Agility Value Stream (BAVS)
Assessing Value Creation
A lean-agile approach to business opportunities navigates the unknowns through an iterative process: At the start of each PI, we have uncertainty about possible outcomes. During the PI, we learn and discover actual outcomes. Then, we use the outcomes as leading indicators to decide the best course of action. From a financial perspective, this lean-agile approach represents a sequence of options. Each PI can be seen as providing the option to proceed to the next PI. Indeed, options represent all key properties of the work in a PI: uncertainty, discovery, and agility.
Thus, options are the suitable metrics for financially evaluating the outcomes in each PI, i.e., for assessing the expected value creation. Industry-standard methods for option valuation have existed for decades and include Black & Scholes, Cox, Ross, and Rubinstein, as well as the author’s techniques. They account for Agile investment adjustments, future financial returns, and the level of risk. i.e., uncertainty in value and occurrence.
Innovation: Business Agility Value Stream (BAVS) and Evaluating the MVP
In SAFe, the BAVS (Figure 1)enables us to leverage business opportunities by funding, delivering, and evolving the MVP. Nimble funding is paramount to delivering a successful outcome in the BAVS. Unfortunately, unknowns often lead to hesitancy in the funding decision; thus, sensing the business opportunity may be missed or left to competitors.
The solution is to fund the next step in the BAVS using Real Options. The Agile approach to MVP development decreases financial risks. This approach can be described in a Real Options-based Lean Business Case (LBC) that federates the contributions of all business functions. This prepares us for the next step in the BAVS, which is organized around value. The result is an Agile investment strategy using a fast-funding rationale.
The investment strategy itself is agile and allows one to invest more (persevere), pivot, decrease funding, or, if necessary, stop (fail fast), based on our ability to learn and adapt upon completing each PI, thus enabling the continuous delivery of value.
As we progress along the BAVS, we can observe how the value of the options on the business benefits evolves. This gives the Lean-Agile Leadership the objective data to make critical funding decisions about business opportunities. On this basis, the overall funding decisions are taken at the lean-portfolio level by considering overall budgets, alternative investment opportunities, overall risk levels, and the priority calculated by Weighted Shortest Job First (WSJF).
Considerations for using Real Options, NPV, and WSJF
Recommendations for the Appropriate Use of Each
For sufficiently predictable business cases, it is feasible to pre-define budget, schedule, and outcome; the course of action is linear. From a financial perspective, such a situation is appropriately represented and evaluated by NPV calculation. A positive NPV indicates value creation, and decision-makers will pre-commit to undertake all investments.
However, many business cases reach a level of uncertainty at which the NPV metrics is no longer conclusive: while being positive for optimistic scenarios, it turns negative for pessimistic ones. In such cases, it is helpful to manage uncertainties by taking a lean-agile approach, where each step provides the opportunity to navigate to the most suitable next step. From a financial perspective, such an approach is appropriately represented and evaluated by Real Options valuation.
Regarding WSJF, this metric applies to investment prioritization. It strives to minimize the Cost-of-Delay of the overall Epic portfolio, i.e. to minimize the delay-induced loss of value. The Cost-of-Delay can be calculated using the NPV or Real Options, depending on the chosen management approach, i.e. linearity or agility.
Managerial Considerations
Enabling C-level Leaders to Adopt Lean-Agile Methods
For C-level leaders, financial reasoning is fundamental. Thus, when pursuing a lean-agile company transformation, the financial methods should also transform to remain consistent with the operational methods. Concretely, business cases should also transform and no longer rely on a simple NPV calculation; they should deploy Real Options instead.
Moreover, annual project budgets must no longer allocate funds statically for one year but rather define annual envelopes for portfolios of various investment horizons. Using LPM and Participatory Budgeting methods, these funds are allocated in a lean-agile manner, enabling nimble funding of Business Agility Value Streams. Real Options can provide the Cost of Delay input for calculating portfolio prioritization metrics like WSJF.
Importantly, the Real Options based Lean Business Cases provide a formal framework for defining and agreeing on commitment despite operating in a lean-agile way. The commitment to sponsors is to execute the agreed tree structure of possible pathways, thereby creating iterative learning and an option on the value of successful outcomes.
Overall, Real Options finance should be an integral part of each lean-agile transformation process, ensuring acceptance and consistency of lean-agile functioning at every company level, including the C-level.
LPM Benefits from Budgeting of Investment Horizons
The SAFe investment horizon model classifies investments by uncertainty levels and ROI periods. Horizons 0 and 1 concern the current fiscal year, with low uncertainty levels. Thus, investment and divestment decisions can be based on NPV considerations.
Horizon 2 investments (Figure 2) are about next-generation products, and Horizon 3 investments are about longer-term explorations. Given their level of uncertainty, those initiatives should be managed lean-agile and financially valued by Real Options.
From an LPM perspective, it can be useful to manage each horizon with a dedicated budget and portfolio(s), such as to balance investments by ROI period, i.e. to invest in the present and the future appropriately.
Application to Participatory Budgeting
Participatory Budgeting requires a Lean Business Case (LBC) for each Epic. The LBC can use Real Options to articulate the financial valuation. This formalizes guardrails type 3 (approving significant initiatives) through the possible options the initiative can take. Updates to the Real Options-based LBC are encouraged if new insights appear, e.g., when new business opportunities become apparent.
LPM leadership can react quickly to business opportunities, as only the budget envelope is fixed yearly, not spending allocation. The actual budget- use is dynamic and a matter of the outcomes of ongoing initiatives and new business opportunities. Relevant selection and prioritization criteria include WSJF, most efficient resource use, risk levels, etc. For horizons 2 and 3, these criteria can be calculated by Real Options valuation.
Case study of a SAFe enterprise partner – Real Options in Real Life
Real Options based LBCs begin by describing the compelling yet uncertain business benefit. This covers both the desired financial benefits (R.O.I.) and the hypotheses made for reaching this optimistic scenario. The desired benefits are described by considering optimistic unit prices, optimistic sales volumes, and low unit costs.
PIs are designed to achieve clear-cut learnings regarding Epic hypotheses. One PI can investigate several hypotheses in parallel. The Epic itself may refer to technical (Enabler) or business-facing. Each Epic does not have a specific duration of execution until it reaches the Done state of the Portfolio Kanban system. Using the Leading Indicators from the Epic, each PI iterates toward the Epic’s business outcomes.
The LBC for the Epic can depict a tree structure towards all possible scenarios, often consisting of an optimistic scenario, medium scenario, and pessimistic scenario, each described by their respective financial returns.
Figure 3 shows an example from a multinational SAFe® Enterprise Partner who considered the creation of an innovative IT solution for the US market. Each PI (see blue bricks) provides an option on the next PI and ultimately on the financial returns (ROI, see yellow bricks). The investments in PIs are shown as red numbers above the blue bricks, the probabilities are blue percentages, and the possible returns are noted in green within the bricks.
The leaders of this business opportunity were excited by the potential business benefit. Reaching this benefit, however, was subject to three hypotheses: (1) The solution is technically feasible, (2) The general market feedback is positive, and (3) It is worthwhile to create a full-fledged solution v02.
To investigate each hypothesis, PIs were designed: (1) Try to build an MVP, (2) Show the eventual MVP to prospective customers to gather market feedback, (3) Perform pre-sales efforts in parallel to the R&D of v01, such as to understand the concrete market outlook.
The possible pathways were: If the MVP is feasible (PI #1), then continue and show the MVP to prospective customers (PI #2). If both PIs are positive, then invest in both the R&D of v01 (version 1) and pre-sales efforts (PI #3), else stop. Upon completion of PI #3, state the market outlook: If it is good, proceed with sales of v01. If it is very good, invest in the R&D of v02 and sell v01 meanwhile. Switch to sales of v02 when ready.
The actual Real Options valuation can be performed by commercially available software. In Figure 4, the Real Option values are labeled in the respective blue and yellow bricks, net of the initial investments (investments are shown as the small red figures above the blue bricks).
Result: The net Real Option value is +$7.2, i.e. it is worthwhile to start by investing in the first PI. The investments in the subsequent PIs are open and subject to the results learned from the preceding PIs. The investments may be adjusted or even stopped. This investment agility reduces financial risks.
Importantly, if this initiative had been managed in a linear, rigid manner, the expected NPV would have been –$23.3, i.e. the initiative would have been rejected right from the outset. This indicates the strategic importance of taking a lean-agile approach in combination with Real Options valuation to leverage uncertain business opportunities. Otherwise, the opportunity would have been missed.
A sound financial valuation of a lean-agile initiative must account for agility and specific risks. When neglecting the latter by simply calculating the probability-weighted NPV, the result can be wrong and misleading. In this case example, the result would be +$14.7 instead of the correct +$7.2! Therefore, true Real-Options valuation techniques are mandatory.
Summary of the Benefits
The benefits of combining SAFe with Real Options finance include:
- Enable C-level leaders: to endorse, drive, and federate Business Agility.
- Strengthen innovation: Minimize financial risks of large initiatives and make investment decisions using a Lean-Agile financial rationale.
- Create speed and flow: Lean Business Case and fast decision-making at the portfolio level, leverage opportunities, and accelerate Time-to-Market.
- Build a culture of innovation: Avoid personal risks [3] – adjustments are a sign of learning.
- Receive commitment: Use Real Options as a formal framework for specifying and committing to Agile developments & operations, internally or when sub-contracting.
- Maximize value creation: for individual Epics and the entire Portfolio Kanban of Epics.
Getting Started/Next Steps
Real Options Finance is fully compatible with SAFe®. Coaching and software tools are available from SAFe® partners. Performing a pilot for a current or recent Epic using the BAVS is useful to get started. This allows us to experiment with the usage and benefits of Real Options.
References
[1] McKinsey Quarterly, The Real Power of Real Options, Jun 2000, https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/the-real-power-of-real-options [2] Rita Gunther McGrath, Discovery-Driven Growth, Harvard Business Press, February 2009. [3] McKinsey & Company, Fear factor: Overcoming human barriers to innovation, June 2022, https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/fear-factor-overcoming-human-barriers-to-innovationLast Update: 26 September 2023