The Importance of Optionality

At first glance, author Nassim Nicholas Taleb’s Black Swan Theory does not appear to have much to do with operating an entrepreneurial company.  Taleb’s theory focuses on the nature of significant and highly improbable events.  Notably, a central tenet of Taleb’s Black Swan Theory is that a Black Swan event is unforeseeable.   Why would a manager need to think about events that, by definition, she is unable to predict?  Surprisingly enough, Vinod Khosla, an influential venture capitalist, believes Taleb’s theory is highly relevant to the entrepreneurial community.  In his white paper entitled, “The Innovator’s Ecosystem”, Khosla uses Taleb’s theory to explain a core aspect of his investing methodology, and it is highly relevant to managers of entrepreneurial firms.


Khosla, of Khosla Ventures, uses Taleb’s Black Swan Theory to explain how he structures his investment portfolio.  He believes that major innovation in sustainability and information technology (the industries he participates in) will not happen gradually, but will occur rapidly due to black swan technologies.  That is, a few firms will develop new technologies that will have a disproportionately large effect on their industries.  Khosla invests in firms that he believes have this transformational potential.  However, he acknowledges that it is impossible to predict exactly what the black swan technologies will be.  He is only able to make informed guesses.  As a consequence of the high risk associated with these types of investments, the majority of Khosla’s portfolio firms will fail.  However, if one succeeds, it will have the potential to generate a return large enough to carry the entire portfolio.  Still, Khosla understands that the failure rate of his investments will be very high.  Therefore, he has structured his portfolio in a way that allows a large number of his investments to fail without having the potential to drive him out of business.  Since Khosla’s portfolio is resistant to any number of failures, he is able to operate for long enough to allow at least one of his investments to pay off big – big enough to generate a good (and maybe great) return for the entire portfolio.

What is important about how Khosla uses Taleb’s theory is how he allows for optionality.  He believes that a few of his investments will be wildly successful, but he doesn’t know exactly which ones.  He is unable to predict the future and he explicitly structures his portfolio in a way that accounts for his fallibility.  This can be thought of as optionality.  Khosla gives himself different options on how to act as he moves forward.  This structure is perfect for the highly unpredictable nature of venture capital investing.  There are thousands of scenarios that could play out with any one investment.  Having the ability to change course, double down, abandon a project, etc, is highly valuable.  He hasn’t committed himself to any one path.  Managers of entrepreneurial firms must take note!


Khosla’s use of Taleb’s theory is highly applicable to the operations of entrepreneurial firms.  Consider that, by their nature, entrepreneurial firms are pursuing their own sort of “black swan” event.  They are attempting to disrupt their industry by providing a product that is better in some shape or form than anything the market currently provides.  Because disruption is very difficult, entrepreneurial firms are inherently risky and investors will demand a large potential payoff if they are to invest their cash.  Therefore entrepreneurs need to go after potentially large “black-swans” that allow for the possibility to return big amounts of cash to their investors.


What managers must consider when going after their “black swan” is their need for optionality.  Entrepreneurial firms are, by definition, operating in environments that are dynamic and highly unpredictable.  No manager is able to foresee exactly how her firm will find its black swan.  Thus, managers must operate their firms in a way that allows them the option to change their strategy midstream.  They must avoid locking themselves into a single path and they must be able to change course for a low cost.

As an example, consider a hypothetical firm that has designed a new high-tech widget that allows users  to control their cable boxes by voice command.  This widget is attached to any cable box, and once installed, a user can verbally command the cable box to “turn to ESPN” or “find a shopping network”.  The two inventors of the widget (and the founders of the firm) believe that their device will be popular with independent consumer electronics stores.  They have tested their technology with many of their friends and family, most of whom frequent independent electronics stores, and have received rave reviews.  Their plan is to enter into business as a wholesaler.  They will raise money, find a manufacturer in China, place orders for specific quantities of their widgets, and source sales leads to electronics stores across the country.


To illustrate the concept of optionality within the context of this hypothetical company, we will consider two potential operating strategies the firm could pursue, Strategy A and Strategy B.


Strategy A: Now that the founders have created their technology and tested with friends & family, they could raise a significant amount of money, hire sales people across the country, and begin placing orders to their manufacturers in China in anticipation of sales.  If they have predicted everything correctly – from the competency of their manufacturer, to the number of electronics stores that will purchase their widget, to how much they can pay their sales force – they will be a huge success.  They will scale very quickly and will be poised to collect immense profits and continue to invest in further innovation and growth.


However, the problem with this rapid growth strategy is that they have provided for only limited optionality.  Their potential payoff is binary.  That is, they are going after their black swan on an “all or nothing” basis.  If all of their assumptions are correct – they will be a runaway success.  However, if they have not made the correct assumption on any number of strategic aspects, they will have only limited room to make an adjustment.  This is because they will have spent a significant amount of time and capital pursuing their initial strategy.  There may not be enough resources left to shift to a new course.  For example, the sales force they have hired may be specially suited to make sales to independent electronics stores.  What if the founders discover that independent electronics stores aren’t the best fit, and that a better strategy would be to sell their widgets over the internet?  Their sales force may be incapable of making a switch to an online marketing team.  The founders will be forced to fire their sales people and hire a new team focused on marketing their product over the internet.  This is costly both in time and money – neither of which the founders may have any left of.  The firm could be left dead in the water.


Strategy B: A different approach would be for the founders to spend money in a way that cheaply tests their assumptions about the market.  Under this strategy, because they are spending relatively small amounts of cash, they will be able to quickly pursue a different path if their original assumptions turn out to be incorrect.  Any failure to predict any certain outcome won’t cause the firm to fail.  The founders will be able to apply their new knowledge of the marketplace and begin down a new path.  In this sense, they are providing for optionality.


For example, consider the scenario that caused trouble for the founders under Strategy A: the widget does not sell well at independent electronics stores.  If they structure their operations on the assumption that the widget will sell well, without first testing that assumption, they open themselves to much downside.  All of the time and money spent on sales initiatives may be wasted, and the founders may be left without enough resources to pursue a different path.


The better operating strategy would be to first spend a small amount of money testing their assumption about independent electronics stores before they hire a sales team.  The founders should first prove that their strategy can work on a small scale before they spend more cash to expand.  For example, they may first decide to pick a single store to sell to.  If they can prove that their model works on a single store, then they may go forward and hire sales people to sell to a larger number of stores across different geographies.  Because this strategy is low-cost, it provides for optionality if the assumption turns out to be incorrect.  That is, if the founders find they cannot sell to their original electronics store, they have the ability to change course and try a different strategy.  As opposed to their original idea of immediately expanding across the country, they will have enough time and cash to test the validity of a new assumption, say, that they’ll be able to sell their widget over the internet.


Again, the moral of the story is optionality.  In a dynamic and unpredictable environment, it is very difficult (some would say impossible) to predict the future.  Optionality allows for firms to move forward in a dynamic way with the ability to pursue avenues that hadn’t been originally planned for.  A disproven assumption won’t mean the end of the road, it will simply mean that the course will be shifted and a different strategy pursued.


As entrepreneurial firms operate, managers must always remember that they are operating in an environment where change happens rapidly.  To describe how he invests in this environment, Vinod Khosla uses Nassim Nicholas Taleb’s “Black Swan Theory”.     Managers must always remember Khosla’s use of Taleb’s theory and be asking themselves questions surrounding the optionality of their operating strategy.  Questions such as:


  • What assumptions are we currently testing and what metrics are we using?
  • Could we be testing these assumptions in a cheaper way?
  • If our assumptions prove to be false, what are our other options?
  • If our assumptions prove to be false, will we have enough time and money to change course?
  • Who are the other sets customers we could sell to?  What are their price points?
  • Do our other options have the potential to generate the size of returns required by our investors?