The idea of projects as sets of nested options has been floating around the management literature for a decade. In a 1998 article in the Harvard Business Review, Timothy A. Luehrmann laid out the concept.
The key idea is that when you evaluate a potential project – a building or a new product or a website – you should remember that you typically have the option to abandon/stop or continue at times during the project timeline. Few things in business are all-or-nothing, bet-the-house. Most things are contingent, and an investment, even if it doesn’t work out as planned, can open up other possibilities in the future.
Websites are particularly well suited for this type of evaluation because websites are easily changed and endlessly expandable. Serious people who run websites generally understand them as permanently under development.
If you properly evaluate a project as a series of options, it can change your evaluation quite significantly from considering the project as a fixed series of cash flows.
Let’s consider an example.
Our example website requires $60K to develop. There is a 17.15% chance of success, and if successful, the site will be worth $250K. If unsuccessful, we will be able to sell the site or run it in a reduced or other manner for some cash flow. We assume the “salvage value” of a failed site is $10K.
Expected value is:
-60 + (0.1715)(250) + (1-0.1715)(10) = -8.84K
In the conventional method of project evaluation, this is a bad investment. The expected value is negative. You should not proceed. If you want to get more precise, you could factor in the time value of money and a probability distribution for the expected values. But for the purposes of our example, this simple evaluation is good enough.
Now let’s evaluate the same project, breaking it into steps of incremental investment. We assume that stage 1, the initial investment, is $10K After stage 1 is complete and the website is in some partial stage of development, we are able to evaluate it and decide whether to proceed. We assume there is a 70% chance we will want to proceed and a 30% chance we will abandon. If we abandon, we assume the salvage value is $2K.
In stage 2, the investment is another $10K. At its conclusion, there is a 70% chance we will proceed. Salvage value is still $2K.
In stage 3, the investment is $20K. At its conclusion, there is a 70% chance we will proceed. Salvage value is still $2K.
Stage 4 is the final stage and is $20K. At its conclusion, there is a 50% chance of success and 50% chance of failure. Salvage value of a failure at this point is assumed as $10K. If the project is a success, it is worth $250K.
This table shows the value of the project if it is stopped at any point. By multiplying the probability that we will decide to stop by the value at each stage and then adding all the values together, we can find the mathematical expectation of the endeavor.
Stage
Investment
Go probability
No-go probability
Salvage Value
Value if abandoned
Chance of abandoning at this stage
Weighted Stage value (stage value times chance)
1
10
70%
30%
2
-8
0.3
-2.4
2
10
70%
30%
2
-18
0.21
-3.78
3
20
70%
30%
2
-38
0.15
-5.59
4 (failure)
20
50%
50%
10
-50
0.17
-8.58
4 (success)
250 (successful project)
190 (successful project)
0.17
32.59
Overall
60
12.24
The expected value is $12.24 K.
Note that this is just like the first example if we invest through all stages. The overall chance of success is 17.15% and the salvage value of a failure, if we do the full development, is $10K. But by looking at the website as a series of stages with the option of abandoning the project at different points in development, the overall expected value has been changed from negative to positive. We now see that the project is indeed worth pursuing.
I can hear your objections:
1) But Dan, you chose the numbers in your example so the nested option method switched the go/no-go decision!
My response: Yes, I chose the example numbers to demonstrate that this method can change the attractiveness of a project. I was making a point. Real projects are often attractive given the conventional method or not attractive given the nested option method.
2) But Dan! Where am I supposed to come up with these numbers for my project? Even in the conventional method I have to make guesses on the costs and values and probability of success, and now you want me to come up with even more numbers which are just as subject to guesswork!
My response: Yes, I recognize unreliable numbers as an obstacle to employing this method. Our industry is still young and developing and there are no accepted heuristics or reliable techniques for estimating the value of websites. More mature industries have worked out ways to estimate asset values, and we in the web development business can only wish we had their level of assurance. Office buildings, thoroughbred racing horses, the rights to make a Stephen King book into a movie – people expert in those industries can assign values with some degree of certainty. Ask four independent real estate professionals to appraise a property and they’ll probably come up with values within 15% of each other. Ask four experienced buyers and sellers of websites how much any given site is worth and you’ll get answers all over the map.
So yes, I recognize that it’s a challenge to estimate values and probabilities for the nested option method – more in our industry than most. The exercise can still be worth going through even if you recognize the limitations posed by uncertainty with the estimates. Thinking in terms of options can help clarify your thinking about potential website investments.
