The two following diagrams explain “Managerial Flexibility”. That is the so-called “Managerial Flexibility”. Their parameters rely on a stochastic process of the underlying price – where only the market has the capability to affect it.Ĭonversely “Real Options” involve the founders’ and investors’ behaviour: you have the capability to understand and learn what is happening and the ability to shape your decisions. However “Real Options” differ from “Financial Options”. Even the Earn-Out and Claw-Back clauses have been modelled as financial options. The right to undertake a real investment has been shaped as a call option while the right to sell something, as for example the opportunity to make a spinoff of a branch, has been summarised in a put option. In modern financial literature, those “options” have been assimilated to financial options. We can say that you hold “options” in your hands: options to make, or not make, certain investments. Model’s adaptation to a tech startup environmentĪn opportunity gets undertaken if market trends, industry movements and startup metrics run in the desired direction it gets discarded if the feeling about the future is not crystal clear or if it predicts unfavourable performance.Founders and Investors’ ability to undertake certain investments or not: The Managerial Flexibility.Here’s the summary of the key points that will be approached in order to outline the model: Of course, they will still be crafted that way, but this approach tries to replicate the behaviour of a tech startup and proposes practical valuation ranges. Valuations are created as a negotiation between the two parties (founding team and investors) on the ratio between the investment sought and the percentage of equity that founders want (and are able) to give out. Thank you for reading CFI’s explanation of Real Options.Looking to raise money and struggling to figure out your startup valuation? Using the variables above, we can easily use the methods used for pricing financial options such as binomial model, Black-Scholes model, and Monte Carlo simulation to price real options. In order to use the techniques for pricing financial options for real options, we should define the relevant variables.Įxpenditure required to acquire asset/Upfront investment As for example, the option to expand can be viewed as a call option, while the option to abandon can be viewed as a put option. Some real options behave similarly to calls some behave similarly to puts. However, in a real-life setting, the NPV approach can be hard to perform correctly.įortunately, the pricing of financial options approaches can be applied to price the real options. We will use the option if the NPV is positive and dismiss it if the NPV is negative. For example, for an option to expand the business operation, we can forecast the future cash flows of this project and discount them to the present value at the opportunity cost. The NPV method is the most straightforward approach to real options pricing. Option to switch is the option to shut down a project at some point in the future if the conditions are unfavorable and resume it when the conditions are favorable (an oil company can shut down the operation of one of its plants when oil prices are low and resume operation when prices are high).Option to contract is the option to shut down a project at some point in the future if conditions are unfavorable (a multinational corporation can stop the operations of its branches in a country with an unstable political situation).Option to wait is the option of deferring the business decision to the future (a fast food chain considers opening new restaurants this year or in the next year).Option to abandon is the option to cease a project or an asset to realize its salvage value (a manufacturer can opt to sell old equipment).Option to expand is the option to make an investment or undertake a project in the future to expand the business operations (a fast food chain considers opening new restaurants).The most common types are: option to expand, option to abandon, option to wait, option to switch, and option to contract. Real options may be classified into different groups. The concept of real options is based on the concept of financial options thus, fundamental knowledge of financial options is crucial to understanding real options. A real option allows the management team to analyze and evaluate business opportunities and choose the right one. The concept of a real option is crucial to the success of a business as the ability to choose the right business opportunity bears a significant effect on the company’s profitability and growth. Real options are a right but not an obligation to make a business decision.
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