What is the value of flexibility? 🕰️ 💵

To state a simple example, let's say you and me discuss starting a business. We'd be splitting our shares in the venture 50-50, where both would need to dole out 1000 bucks towards the initial start-up capital totaling $2000.

You're kind of interested, but you are hesitating.

You have lots to bring to the table, but you're slightly worried of losing your $1000. Neither are you sure about the long-term potential of our amazing new business idea.

At this stage in life, you have other options and you're willing to walk away.

Sensing that you're on the edge – what if I tell you that I value your expertise and knowledge so much that in order to sweeten the deal, I'm ready to provide you an added incentive in terms of flexibility, or a clause in our shareholder agreement that would enable you to increase your share in our venture by additional 20% in three years time at certain pre-determined price?

If we become a success, I stand to greatly benefit from this too, right?

But I need you, so here you go, please have that precious additional upside.

Now – you may think, this added upside seems indeed attractive... But what does it mean exactly? Proceeding onwards from here, we intensely ponder what other potential contractual options could we include to appropriately incentivize and better optimize the risks of our business relationship.

Coming back to the initial option where I offer you a 20% stake in three years' time – what is the price at which we should fix your right to acquire the 20% added stake in three years' time? What is the value of this contractual option? What is the value of any number of other similar types of contractual options when negotiating between two or more parties trying to conclude a complex, large-scale business transaction or agreement?

As Warren Buffett said: "Any option has value..."

In fact, with the common simple market-traded financial options' asymmetric characterstics that provide you the possibility but not the obligation to act, you can construct almost any kind of risk-payoff profile to suit your needs as visible in the picture below.

That, of course, comes at a cost.

Pictured are some of the more exotic option strategies.

What cost?

There are many tools out there to value options, but the whole topic is not as simple or clear-cut as you might think.

When we use strict formulaic tools to value flexibility, risk, or uncertainty, we might miss the bigger picture. One of Buffett's other taglines was that "price is what you pay, value is what you get".

Indeed, I may be willing to pay more than you for something that's more valuable to me personally than it is for you. That's common sense.

Highly liquid markets are great for determining the price of things, but what if the thing in question is not actively traded? And more generally though, what is the value of flexibility? Could there be a value-unit for a single factor of uncertainty within a given system or a context?

Many questions...

Be it an engineering system or the flexility to abandon an R&D project at a certain point in the unknowable future – as uncertainty continues to gradually resolve over time, we'll eventually learn whether our project or an engineering design proves to be viable. It's exciting but risky, isn't it?

Such bets are, however, exactly how many companies compete and create value!

Fundamentally, these and other questions are about controlling leverage, the all-powerful force and wonder in our market economy and the financial system. It's almost like physics – but enough of that physics envy already!

Anyhow, these things are exactly what I explored in my recently published Master's thesis late last year, combining real options thinking with simulation-based methods and analytics. Check it out if you find these topics interesting. One of my main goals was to try and best explain these things in simple terms to the average reader!

Ohh, and I visited Boston, New York and Washington D.C. recently – here's a photo of me at MIT, where in an elevator, I happened to run into my favorite professor Andrew Lo who teaches finance at the Sloan school of management. What a great moment it was... I highly recommend his open finance lecture available on YouTube recorded back in 2008 as the financial crisis unfolded. By now it has over a million views and counting, it's epic.

The man, the legend! 😁

New article: After-sale strategies – Navigating the treacherous implementation stage 🧭

😳 Sales professionals tend to relax too soon after concluding an agreement. Let's delve into the crucial but often treacherous stage that follows the closing of a deal – the implementation phase of your product or solution.

If you think it's time to ease down and relax immediately after your deal is closed, think again because you may be wrong!

In strategic sales, it's incredibly common for salespeople to decrease their activity and involvement with their customers when signatures have been exchanged, whereas experienced sales professionals know the real work between your organizations is only about to begin.

Stages of the implementation process. Adopted from Rackham (1991).

Continue reading here.

The Art of Action by Stephen Bungay 📝

📈 This book review has spiked the traffic on the LBS website

And for a good reason too! I think it's one of the best (and most extensive) book summaries I've written on the entire site, so feel free to check it out if you haven't already.

The Art of Action by Stephen Bungay

Santeri's comment

Many think that military principles and learnings should not have any bearing whatsoever on our civil lives, nor the management of contemporary organizations."We are past this way of leading..." they say, and "You cannot manage today's people in this manner..."

In essence, this book is the best effort so far to help correct the misunderstandings of what leadership under uncertainty is truly about and where the competitive pressures of "opposing wills" play-out on a constant basis – in military and at war.

Stephen explains excellently why military principles can be an effective way to think about leading, while simultaneously laying out some core reasons for why you should care about any of this at all in the first place.

Two outtakes from the book

🔮 Predictable versus an unpredictable environment

In a stable and predictable environment, it is possible to make quite good plans by gathering and analyzing information. We can learn enough about the outside world and our position in it to set some objectives.

We know enough about the effects any actions will have to be able to work out what to do to achieve the objectives. We can then use a mixture of supervision, controls, and incentives to coerce, persuade, or cajole people into doing what we want. We can measure the results until the outcomes we want are achieved.

We can make plans, take actions, and achieve outcomes in a linear sequence with some reliability. If we are assiduous enough, pay attention to detail, and exercise rigorous control, the sequence will be seamless.

In an unpredictable environment, this approach quickly falters.

The longer and more rigorously we persist with it, the more quickly and completely things will break down. The environment we are in creates gaps between plans, actions, and outcomes:

  • The gap between plans and outcomes concerns knowledge: It is the difference between what we would like to know and what we actually know. It means that we cannot create perfect plans.
  • The gap between plans and actions concerns alignment: It is the difference between what we would like people to do and what they actually do.
  • The gap between actions and outcomes concerns effects: It is the difference between what we hope our actions will achieve and what they actually achieve.

We can never fully predict how the environment will react to what we do. It means that we cannot know in advance exactly what outcomes the actions of our organization are going to create.

🎖️ Similarities between business and military

The following is a description of the nature of combat from an academic thesis about the nature of military thought:

  • Combat is an interaction between human organizations. It is adversarial, highly dynamic, complex, and lethal. It is grounded in individual and collective human behavior and conducted between organizations that are themselves complex. It is not determined, hence uncertain, and evolutionary. Critically, and to an extent in a way which we currently overlook, combat is fundamentally a human activity.

Compare that passage with this one characterized by Bungay (author):

  • Business is an interaction between human organizations. It is competitive, highly dynamic, complex, and risky. It is grounded in individual and collective human behavior and conducted between organizations that are themselves complex. It is not determined, hence uncertain, and evolutionary. Critically, and to an extent in a way which we currently overlook, business is fundamentally a human activity.

Continue reading the full summary...

Favorite quote 📖

👨‍💻 One day, as I was writing my master's thesis at the university library, I took a short break to walk around proceeding to pick up a random book which seemed interesting.

What caught my attention was a beautiful quote by Hermann Hesse talking about life, fate and despair – so why not share it with you.

Fate was not kind, life was capricious and terrible, and there was no good or reason in nature. But there is good and reason in us, in human beings, with whom fortune plays, and we can be stronger than nature and fate, if only for a few hours.

And we can draw close to one another in times of need, and live to comfort each other. And sometimes when the black depths are silent, we can do even more.

We can then be gods for moments, stretch out a commanding hand and create things which were not there before and which, when they are created, continue to live without us.

Out of sounds, words and other frail and worthless things, we can construct playthings–songs and poems full of meaning, consolation and goodness, more beautiful and enduring than the grim sport of fortune and destiny.

– Hermann Hesse in Gertrude.

Predictive versus prescriptive analytics 🤓

In the world of machine learning and data science, all the rave is currently about predictive analytics and deep learning as driven by breakthroughs in employing the transformer architecture. This way large language models (LLMs) are currently spearheading the proliferation of AI in our lives.

But what about prescriptive analytics and decision support systems (DSS)?

In my Master's thesis I studied how to better control leverage, value strategic options, and make more rational and better-informed strategic investment decisions using simulation and prescriptive analytics approaches.

Simply put, prescriptive analytics is about answering the question "what should we do?", and here I've stumbled upon the efforts of my supervising professor's Mariia Kozlova's work to extend our understanding of the value of simulation and decision support systems (DSS) in decision making.

She calls her method Simulation Decomposition, or "SimDec", which with its colorful output intrigues me as a powerful tool for sensitivity analysis and truly "prescriptive" analytics. I'm confident that more people should familiarize themselves with it and try applying it to their analytical problems.

Here's the direct link to the SimDec website. There you'll find interesting papers and open-source libraries for you to learn more, try it out and apply it to your data.

Let me know if you'd like to learn more about simulation or real options methods in the future, and I can try to do a great compact write-up on these topics in one of my later newsletter issues or YouTube!

End note

As always, thank you for your time and for being a great subscriber!  🎉

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Talk to you soon.

All the best,