One of the topics covered in finance is of particular importance to entrepreneurs: the value of flexibility. In recent years, valuation experts have come a long way in actually putting a price on it.

Although it is a bit technical, most people are surprised at how much value can be added by preserving flexibility.

Consider the development of an oil field. Suppose it will cost $100 million to develop the field and there are an estimated 20 million barrels of oil in the field. And suppose that it will cost $85 million per year to pump oil at a rate of 5 million barrels per year. And finally, suppose that at a price of $20 per barrel, 5 million barrels of oil could be sold for $100 million.

Most people would say that it makes no sense to develop the oil field since the field would only net $15 million per year for four years, and that does not compensate for the investment of $100 million.

But once you factor in the flexibility to pump oil or not pump oil each year, the value changes tremendously. You may choose to pump oil the first year. Then, if the price of oil drops too low the second year, you could choose not to pump and you are out only the price you paid for the right to pump - not for the pumping itself. Or if the price of oil jumps to, say, $40 per barrel, you can pump oil for enough of a profit to justify pumping it for a lower price during other years.

The flexibility to pump or not pump based on prices makes the project worthwhile to pursue. This flexibility means that the owner can avoid running losses simply by not pumping when the price of oil is below a certain price per barrel. The ability to avoid losses makes the project more valuable than what the simple expected cash flows would indicate.

One of the surprising side notes to this analysis is that uncertainty (volatility) becomes the friend of the entrepreneur, rather than the enemy it usually is. Increasing the volatility means the highs are higher and lows are lower. But the lower lows do not hurt since you would have decided not to pump anyway. On the other hand, the higher highs make the expected payoff even higher.

In short, flexibility has higher value when it is associated with a more volatile underlying investment.

Flexibility also explains a number of contracts we see in entrepreneurial ventures. For example, many angel and venture capital investors do not hand over to the entrepreneur the full amount needed for the venture up front. Rather, they dole out the investment in pieces every three months or so. This preserves the flexibility to stop investing if something goes wrong or if the entrepreneur is not hitting the performance targets.

As in the oil field example, flexibility allows investors to limit downside losses while still capturing upside potential by preserving the opportunity to make decisions once more information becomes available. As a result, an investment that appears to make no sense at all may turn into one that does because of the value of flexibility.

And that is how flexibility adds value.