Navigating uncertainty: from scenarios to flexible options
Paul J. H. Schoemaker
Any entrepreneur knows that uncertainty is not the enemy but the source of new rent creating opportunities. As the nineteenth century British banker Nathan Rothschild observed: ‘‘Great for tunes are made when the cannonballs are falling in the harbor, not when the violins play in the ballroom.’’ To unlock these opportunities, how ever, requires a very different approach to strategy and implementation than what is taught in MBA programs or practiced in large companies today. Entrepreneurs need to be experts at navigating uncertainty and turning it into strategic advantage (Christensen, 1997; Foster, 1986; Hamel and Prahalad, 1994). Seldom will a business plan play out as originally envisioned. The challenge is to navigate the currents of uncertainty the way a surfer negotiates the breaking waves of the ocean. Agility, talent, in tuition, and dedication alone, however, may not be enough. Academic research has amply shown how poorly people deal with risk and uncertainty when left to their own devices (Gilovich, Griffin, and Kahneman, 2002; Kahneman, Slovic, and Tversky, 1982; MacCrimmon and Weh rung, 1986; Schoemaker, 2002).
The successful entrepreneur must know (1) how to develop and analyze multiple external scenarios, (2) craft nimble strategies with just the right amount of flexibility and commitment, (3) implement the selected strategies using a dynamic options approach, and (4) make real time adjustments through dynamic monitoring. As Louis Pasteur noted: ‘‘Chance only favors the prepared mind.’’ The key challenge is how to prepare the entrepreneurial mind to profit from chance. Prussian General Helmuth von Moltke observed: ‘‘No plan survives contact with the enemy.’’ As those in the venture capital industry know well, most business plans will likewise be changed considerably in the first few years once reality starts to interfere. Hence, a successful business plan must possess robust as well as flexible components as part of the overall strategy. Figure 1 summarizes one approach – which is developed further below, based on Schoemaker (2002) – that can accomplish this
Figure 1 Strategic compass
challenging goal. For other, largely complementary approaches to navigating uncertainty, see Courtney (2001) or De Meyer, Loch, and Pich (2002).
Develop Multiple Scenarios
Scenario planning is an effective tool for helping entrepreneurs make sense of the complex world they face. The basic idea is used to capture the full range of future uncertainties by means of a few compelling stories that describe very different external conditions the organization may face. Scenarios focus on macro and industry uncertainties – those issues the firm cannot control and must live with one way or another. Scenario planning is as much an art as a science. Numerous articles and books describe the basic philosophy; the underlying methodology itself is not difficult to grasp (Fahey and Randall, 1998; Ringland, 1998; Schoemaker, 1991, 1993; Van der Heijden, 1996). What matters most is to have high quality inputs and then to reduce all these insights into a limited number of internally consistent scenarios that collectively cover a wide range. In more sophisticated applications, the scenarios can be elaborated using system dynamic simulations (Sterman, 2000).
The main benefit of scenario planning is that the new enterprise is forced to rehearse a plausible future before it actually occurs, so as to be better prepared for specific surprises it may con front. A second major benefit is that entrepreneurs can explore new strategic opportunities that are suggested by the scenarios. For example, a recession scenario versus a high growth or technological breakthrough scenario may prompt very different strategic options. Good scenarios stimulate proactive strategies. A third benefit is that scenario planning can productively challenge managers’ most deeply held assumptions about the world (Mason and Mitroff, 1981). Scenarios can help surface the critical assumptions entrepreneurs make. As they used to say at Royal Dutch/Shell – one of the acknowledged pioneers in this area – scenario analysis is not so much about planning as about changing mindsets (Schoemaker and Van der Heijden, 1992).
Develop a Flexible Strategy
Many scenario planning processes fail because managers jump directly from the scenarios into specific actions, without taking time to develop strategies that exhibit the appropriate level of flexibility. Even though entrepreneurs may generally acknowledge that the world is highly un certain, they often lock the organization into rigid commitments. Just consider how many entrepreneurs overcommitted, near the height of the dot.com bubble, to marketing plans, leases, employment agreements, etc. that they later regretted. This mistake can be avoided by designing an appropriate level of flexibility into all those plans and strategies that are not robust across the various possible scenarios. Many scholars have emphasized the importance of maintaining strategic flexibility (Bahrami, 1992; Beinhocker, 1999; Ghemawat, 1991).
The basic approach to developing a flexible strategy is simple. First, the entrepreneur should list the strategies required to succeed in one of several scenarios. Then, a similar list should be developed for each of the other scenarios. Second, the entrepreneur should highlight those strategies that are common to every scenario. These are ‘‘no brainers.’’ The entrepreneur can go ahead and commit strongly to these ‘‘no regrets’’ strategies since they are needed in every scenario. Third, the entrepreneur should rank the remaining strategies in terms of how robust or fragile they are across scenarios. A strategy that makes sense in just one scenario is less robust (i.e., more fragile) than one that is suitable for, say, two scenarios. Fourth, the entrepreneur should invest stage wise in these fragile strategies (insofar as is possible) and conduct a financial analysis of each investment that includes a real options perspective rather than just a static net present value (NPV) approach (Courtney, 2001).
Real-Options Thinking
The basic idea behind real options thinking is to make small commitments when uncertainty is high, wait until more is learned about which way the world moves, and then either increase the investment (if the option is in the money) or pull the plug (if it is out of the money). To do this systematically, the entrepreneur may wish to construct a decision tree (Raiffa, 1968) for each investment such that it is clearly indicated (1) where the key uncertainties are that will be resolved within the life of the project and navigating uncertainty: from scenarios to flexible options 191 (2) what possible downstream actions the entrepreneur might take depending on how each un certainty plays out. Once a strategic investment is examined this way, it often makes sense to proceed with a small commitment when a purely static NPV analysis would perhaps argue against the project all together. Options analysis seeks to identify all post decisional points of flexibility and then impute an explicit value for any new information that may be learned after the initial commitment has been made. The essence of this approach is to pursue a staged investment strategy whenever uncertainty is high, rather than take an all or nothing bet (see Hamilton, 2000, for a good strategic overview).
In addition to staging strategic options to exploit the value of flexibility and new information, there are other ways to manage uncertainty that extend beyond the project itself. First of all, any investment should be viewed in the context of the complete portfolio of investments made rather than in isolation. Second, there are various techniques that may allow the entrepreneur to shift the distribution of returns around its mean (at a price). These include traditional insurance options, as well as such financial techniques as contingent contracts, hedges, or other forms of risk sharing. In addition, it is important to create sufficient organizational agility and flexibility – through early detection and fluid decision making – so that strategies can be quickly adjusted as the fog of the future lifts. Indeed, such quick footedness is usually viewed as an important advantage that good entrepreneurs have over larger, more inert organizations (Eisenhardt and Brown, 1998; Senge, 1990).
Monitor in Real Time
The last step in our model entails dynamic monitoring and timely adjustment. It does little good to buy an option on the future and then let it expire due to neglect when it is in fact in the money. With financial call options, an investor only has to monitor the price of the stock and the expiration date of the option. When dealing with real options, the monitoring system will typically be much more complex. Sales trends, customer behavior, economic indicators, as well as competitive moves, may all be factors that affect the embedded options, probabilities, or cash flows represented in the decision tree. Ideally, the entrepreneur will need a tailored dashboard for each strategic investment so that it can be deter mined, in real time, when to exercise down stream contingency plans.
There are multiple ways to monitor a scenario based strategy. One company set up an elaborate war room, so that it could visually depict and monitor the main drivers for each scenario. Once critical threshold values are crossed, a trigger may be sent for action. Another company organized online discussion groups where managers post messages (such as news paper clippings or factoids) about the external environment, with editorial commentary about possible implications for the firm. Still others establish committees that review the current strategy on a regular basis. Only the entrepreneur can determine what type of monitoring system will work best in any particular situation.
Conclusion
The model sketched and diagrammed in figure 1 draws on the research frontiers of decision sciences, organization theory, strategy, and cognitive psychology. It seeks to integrate the most practical contributions these various fields have made to navigating uncertainty. One only needs to follow the daily news to appreciate the risks of being unprepared for change. And yet the rewards for actively pursuing new opportunities are greater than ever before. More than any other capability, developing personal (human capital) as well as organizational skills in seizing initiatives in shifting or unpredictablecircum stances will remain the key to entrepreneurial success.
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