Growth Options Management
Growth Options Management
The investment opportunities with the greatest value creation potential often arise at points of discontinuity caused by technological innovation, deregulation, or shifts in consumer behavior. For example, digital technology, telephone deregulation, and home computing are opening up the possibility of exciting growth prospects in pay-TV, cable and wireless telephony, and network-based services. Yet investing in these opportunities is risky since potential losses could be substantial.
Companies have two obvious strategic choices in such uncertain growth situations. Either they can commit themselves to full investment and hope it pays off, or they can wait and reevaluate once market trends become clearer ? by which time bolder competitors may have taken the lead. However, in many markets there is a third possibility ? that of acquiring a growth option.
A growth option buys a company the ability to participate in future growth without substantial risk to shareholder value. An approach has been developed ? the growth option stairway ? to help companies in a wide range of industries and competitive situations use growth options successfully
Buying growth options should not be an excuse for random investments lacking strategic logic. Growth options have three distinct features. They carry no obligation to make a full investment; they are considerably cheaper than full investment; and, most importantly, they give the buyer a preferential position from which to make a full investment over competitors without an option. This preferential position may arise from one of four sources: the exclusive ability to make the investment due to a proprietary license or technology; better information on markets, customer behavior, or technology performance; higher expected revenues deriving from establishing a brand or developing distribution channels; lower expected costs due to skills developed and supplier relationships.
Take as an example the emergence of digital television technology and the potential growth opportunity it offers in European pay-TV. The importance of sport in the success of BSkyB's analog pay-TV service in the UK has prompted a number of entrepreneurs to buy leading soccer franchises. These represent growth options to participate in the transition to digital TV as there is no requirement to invest fully in digital pay-TV and the price tag is nowhere near the cost of launching a full pay-TV service. Most importantly, however, the owners of major clubs have significant influence over which company emerges as the leading digital pay-TV operator, and they retain the option to launch their own service in the future.
Once a growth option has been recognized, it must be valued to determine how much might justifiably be spent. The levers that determine the value of a growth option can be linked to those of financial options. Consequently, growth options can be valued using the same techniques as those used to value financial options, such as Black-Scholes and the Binomial Method. However, the estimation of some of the key inputs will have to be based on business judgment. For example, the growth option equivalent of time expiry would be the time it takes for the preferential position afforded by the option to be eroded. That would depend on how long it might take for a new generation of technology to emerge, or when there will be regulatory intervention.
Unlike financial options, growth options have to be nurtured for maximum potential. Continued innovation could, for example, ensure a company holds its technology lead, thereby extending the time to expiry and so enhancing the value of the option. An alliance with a low-cost supplier would increase the expected value of operating cashflows, while efforts to exploit joint economies with existing businesses could reduce the launch costs or exercise price. Both these actions protect and enhance the value of the option.
The timing of the decision to exercise a growth option is critical. Companies should exercise a growth option when the preferential position is about to be lost, perhaps due to the expiry of a franchise, or when a fully committed competitor is about to extract most of the value from the underlying investment. However, there needs to be a good degree of certainty that exercising the option will pay off.
Option-based approaches do not only apply in high-tech or research-intensive industries. They also apply where competitor action creates uncertainty and a potential industry discontinuity. Growth options have been successfully used in industries as diverse as retailing and financial services.