Real Options: A Smarter Way to Fund Innovation

Why NPV Falls Short for Innovation

The rigidity of NPV often stifles innovation. “The NPV paradigm of all-or-nothing is no longer applicable. What will help is progress, step by step,” says Claus. One of the biggest pitfalls of NPV is that it assumes a project will follow a fixed, linear path. However, in reality, most innovative initiatives evolve dynamically.

Claus highlights that NPV creates two key issues. First, high-potential ideas may be dismissed too early because their upside is not yet quantifiable. Second, projects that do move forward can become too big too soon, making it harder to pivot or stop them if needed. This rigidity often leads to innovation teams “gaming” financial projections to secure approval, which results in misaligned incentives.

NPV demands commitment to the entire project at the outset, leaving little room to account for the unpredictability inherent in innovation. “We must not lie to ourselves,” Claus states. “By listening to the business team, we admit there are many possible outcomes, some with a positive NPV, others with a negative.”

In one case, Claus recalls an IT company’s ambitious plan to enter the U.S. market with a groundbreaking product. Technical feasibility, market acceptance, and commercial success were all uncertain, making NPV an unsuitable tool for evaluation. Rejecting the project outright would have resulted in a loss of potential, and moving forward without addressing uncertainties would have been reckless. The solution? A paradigm shift from NPV to options-based financing.

How Options-Based Financing Works

Options-based financing replaces the rigidity of NPV with flexibility, allowing incremental investment decisions based on new information. Rather than committing to an entire project upfront, this approach evaluates key uncertainties at every stage. Claus describes it as creating a tree structure of potential pathways to navigate uncertainty in a structured way. If we invest in the first step, we get the opportunity to maybe move on to the next step.

By structuring investments as sequential, discovery-driven steps, real options allow organizations to defer larger commitments until critical assumptions (such as technical feasibility, market demand, and scalability) are validated.

Each investment is a choice rather than an obligation, giving companies the flexibility to increase, decrease, pivot, or discontinue funding based on real-time learning. Importantly, stopping a project under this approach is not a failure, but a strategic decision that prevents unnecessary financial risk.

“Investing in this first step buys us an option on the next step and so on. We are able to clearly evaluate on this basis by doing the math,” Claus says.

The process begins by defining the ultimate goal and identifying uncertainties that could affect outcomes. Innovation teams then break the project into manageable steps, each addressing a specific uncertainty. For example, in an IT project, the team starts with a prototype to address technical feasibility. If successful, they move on to market acceptance, followed by a more considerable investment in R&D. This step-by-step approach minimizes risk while enabling progress.

Six Key Benefits of Options-Based Financing

1. Corporate Finance Actively Drives Innovation: According to Claus, “Real options satisfy both innovators and sponsors. Acknowledging the innovators’ vision ensures the investment decision is not frustrating. If rejected, it’s acceptable because we captured the dream.” This approach creates a constructive collaboration between innovation teams and corporate finance.
2. Improved Competitiveness: “With options, we capture opportunities that we may have simply missed by using the NPV criteria,” Claus explains. This method encourages the exploration of high-risk, high-reward initiatives that could lead to breakthroughs.
3. Faster Time-to-Market: Options-based financing is fast and nimble. “We don’t wait for the next funding cycle,” Claus notes. “This approach allows us to be very reactive and align funding with real-time project needs.”
4. Maximized Value Creation: Claus emphasizes that value creation occurs at both the individual project and portfolio levels. By prioritizing based on cost-of-delay metrics, organizations ensure their resources are allocated where they will have the greatest impact. Unlike NPV, which often leads to either overcommitting too early or rejecting high-potential ideas too soon, real options ensure investment decisions evolve based on learning. This prevents premature shutdowns of promising projects while avoiding unnecessary risk from committing too much, too soon.
5. Reinforced Strategic Alignment: “Real options are the embodiment of OKRs (Objectives and Key Results),” Claus says. By integrating options into funding models, companies ensure their innovation efforts remain aligned with broader strategic goals.
6. Ease of Implementation: “It’s actually very easily put in place,” he explains. The transition to options-based financing is more straightforward than many assume. “From a business case perspective, it’s actually the very same teams working on these business-as-usual cases represented by NPV. You’re asking for the same assumptions. They can handle options-based cases because the inputs (investments, durations, probabilities) are the same.”

Managing Risk at the Portfolio Level

One key strength of options-based financing is its ability to address risk at the portfolio level. Innovation portfolios require a delicate balance between exploratory and exploitative initiatives. “We do not want exploratory initiatives in competition with exploitation because exploitation will win it all,” Claus warns. Instead, exploratory projects are ring-fenced, allowing for dynamic resource allocation and prioritization within their category.

While individual projects may fail, the portfolio as a whole thrives. A portfolio-based approach to real options ensures that risk is distributed strategically, rather than placing all bets on a single high-stakes project. Claus highlights that real options allow for dynamic reprioritization, adjusting investments across multiple projects as new information emerges. This prevents exploratory initiatives from being crowded out by short-term profit-driven projects, maintaining a healthy balance between innovation and operational stability.

“It’s not about the individual tree; it’s about the entire forest,” Claus emphasizes.

By diversifying risk and focusing on the broader portfolio’s performance, organizations ensure that the successes outweigh the failures, driving long-term innovation growth. “Each investment step provides an option on the next,” he says. “It’s about striking the right balance of progressing as long as justified but stopping when necessary.”

Practical Insights for Implementation

Claus highlights the importance of bridging the gap between innovation teams and finance executives. “We are reconciling the worlds of innovators and sponsors,” he says. To achieve this, organizations should involve cross-functional teams in building business cases, openly address uncertainties, and leverage tools like cost-of-delay analysis to prioritize effectively. “Express your uncertainty. Manage it step by step. This is how we minimize risk while making progress,” he advises.

Real options serve as a decision-making framework and a communication tool that connects innovators and finance teams. By explicitly defining key uncertainties and mapping possible paths forward, companies can ensure that financial executives and innovation leaders speak the same language which leads to better alignment and more confident investment decisions.

Weighted Shortest Job First (WSJF) is an essential tool for implementing options-based financing. It helps prioritize projects dynamically by assessing the cost of delay in relation to the required effort. “Cost-of-delay isn’t an out-of-pocket cost but an opportunity cost,” he notes.

By minimizing these costs, WSJF ensures that resources are allocated to maximize portfolio value. For instance, in one scenario, Claus highlights that investing one Euro without delay could avoid 8.87 Euros in cost-of-delay. “This prioritization method empowers teams to make more informed and impactful decisions in real-time.”

He also suggests using real options as a negotiation tool that all parties can understand. “It’s a clear-cut language,” Claus explains. “People align on the business assumptions because they’re expressed in a familiar, structured way.”

A New Mindset for Corporate Finance

For corporate innovation professionals, switching from NPV to options-based financing is a movement toward smarter, more dynamic decision-making. Claus emphasizes, “With this approach, corporate finance becomes a marvelous driver of innovation.”

By shifting from a rigid budgeting mindset to an adaptive funding model, organizations can embrace uncertainty as a strategic advantage rather than a liability. With real options, investment decisions become faster, more data-driven, and more aligned with long-term innovation success.

This marks a fundamental evolution in how companies fund and manage innovation, ensuring both financial discipline and breakthrough potential coexist.