Breaking the Go/No Go Vise Grip on Innovative Growth
- Making Uncertainty Work for You
- Managing Uncertainty
- NPV and DCF: When and When Not to Use Them
This book is about extracting growing profits, sometimes big profits, from uncertainty while only marginally increasing business risk—by what we call Opportunity Engineering®.
A day does not go by without someone in the business media waxing eloquent about the pace of change, the increasing turbulence of technology, or the massive pressures of global competition. Writers and broadcasters go on and on about the increasing uncertainty this brings about, and all this uncertainty is generally couched as threatening. This foreshadowing is astonishing when you consider that boundless opportunities for big-win investments can lurk within uncertainty—uncertain yes, but with huge upside potential nonetheless.
We asked ourselves what causes firms and managers to generally regard uncertainty as a negative, when in fact opportunities for unusual prosperity lie in being able to exploit that very uncertainty. As we looked into the reasons why managers do not forge prosperity out of uncertain investments, we decided that it is really not their fault! We found that managers have not been given the right tools for investing in uncertain times. They are in the grips of a "Go/No Go vise," using tools for investment analysis that were created for more stable times. Discounted cash flow (DCF) calculations and net present value (NPV) analysis have them fixated on "making their numbers" or being treated as failures. These blinkers keep them locked into a Go/No Go decision-making pattern, either proceeding full steam ahead or stopping in their tracks (which, in the face of uncertainty, is usually No Go), when in fact they could be engineering the risk out of uncertain opportunities and going for high potential wins by slicing out their downside and boosting their upside.
The problem with the traditional approach (i.e., NPV) is that after an idea for a new product or service has been assessed and given the green light by senior management, and the development team lays out a project plan, they are expected to turn the idea into an asset that delivers expected returns; otherwise, they have failed. Figure 1.1 is an example of this classic Go/No Go thinking. It seems logical, but it has the unintended consequence of stopping innovation dead in its tracks, and it often piles up large losses, too. Why? Because if an idea has to turn into an asset "or else," the logical response is to focus on low-risk ideas that are close to a company's current offerings—those that are a safer bet. This conservatism might make sense for the individual manager, but if it becomes the norm it keeps companies focused on what worked in the past rather than focused on the future, where the opportunities for high growth lie. This risk avoidance snuffs out the experimentation and innovation that lay at the heart of all great companies' history, when their entrepreneurial spirit ran high. Indeed, from our consulting work, we suspect that many managers self-select out high-potential, uncertain ideas because they are afraid of being wrong and being criticized for it. This fear causes a narrow focus on incremental changes to existing products. The question is, can anything be done to change this deadly dynamic?
Figure 1.1 Go/No Go
Something can be done. For the past four years, we have been working on bringing you the right tool to manage beyond Go/No Go. We found it in something that we call Opportunity Engineering (OE), which allows you to assess uncertain opportunities and find ways of selecting only those where you can engineer the chance to capture their high upside potential and slice out the downside. OE allows you to select and pursue ideas that reach a long way into the upside potential and wrench out profits, while at the same time allow you to contain your risk to little more than your existing business risk.
Making Uncertainty Work for You
The key concept of OE is making uncertainty work for you rather than against you. In most uncertain projects, the potential profits have a probability distribution, as shown in Figure 1.2.
Figure 1.2 Probability of potential profits
If (and only if) you can Opportunity Engineer the project, you can in fact "slice out" the downside risk by engineering the opportunity so that the left tail of the distribution is removed, giving you an asymmetric return in which the actual probability of profits is confined to the opportunity space under the solid line of Figure 1.2. This opportunity space is bought at the engineered cost, which is all you need to risk to "buy" the rights to the potential upside offered by the project. If you cannot create this asymmetry, and the downside risk remains, you do not have an Engineered Opportunity, you have a WAG (wild-ass gamble)!
The importance of this insight is that now the more uncertain a project is, the better! Uncertainty widens the curve because there exists a larger universe of possible returns. More of the profits will be to the right along the curve where there is a greater chance of a higher profit, while there is no chance of a loss beyond the engineered cost. This probability distribution usually causes a good deal of discussion with executives we advise—it is a completely different way of thinking, but it makes sense as long as you can control the downside.
The same reasoning lies behind stock options in the financial markets: The greater the uncertainty surrounding a stock, the greater the option value, because the downside risk is limited to the price of the option.1 Therefore, higher uncertainty allows for a bigger potential upside win with a controlled exposure to a downside loss, namely the option's cost. For the same price, would you rather have an option on Google (a proxy for high uncertainty) or on P&G (a proxy for low uncertainty)? Google, of course!
The disconnect between traditional financial valuations and management intuition results from a bias against uncertainty. But a situation that is uncertain has to have some positive context, or else it is not uncertain, it is just plain bad. Right? So as long as the risk reward profile is designed to have a limited downside exposure coupled with a high upside—the asymmetric return that we discussed earlier—the more uncertain the project, the better! We call this positive uncertainty. It is at the heart of the transformational effect of OE.
OE creates a safe harbor where high-payoff, innovative investments can be aggressively pursued, because it changes the development process.
Instead of considering just whether Go or No Go, a project could be broken down into stages and dropped cheaply if the early stages aren't working out, or a project once underway could be redirected to a different product or market, or the venture or the venture's intellectual property could be sold off, or the project could be scaled up or slowed down or postponed, or the project could spawn a joint venture or precipitate a merger with another company. Clearly, OE opens up many possibilities, and usually none of these possibilities are evaluated when Go/No Go thinking is the norm.
Go/No Go as a decision-making model is simply too constraining, but it's very understandable why companies stick with Go/No Go thinking. First of all, it's what we were all taught in finance and accounting courses. Second, it is relatively easy to manage, whereas managing uncertainty is not. The trick is to engineer into the project early indicators that convert the uncertainty into more certain knowledge, quickly and cheaply, so that you can redirect or shut down with minimum loss. In other words, fail fast, fail cheap, and move on to the real winners. That, in essence, is the key to OE and to this book.