The Time-Tested Value of Optionality

June 6, 2016

In this age of e-commerce, the ability to send something back hassle-free has become a customer expectation that now borders on a “human right.” The legal rights of the buyer, along with the history and nature of warranty, are the subject of many law school lectures. But “sending it back” actually has a history dating to the earliest of recorded time. The Bronze Age came to a precipitous end at approximately 1177 BC, but before it did, it contained the world’s first highly distributed yet deeply interconnected commercial market spanning more than 2,000 miles and encompassing many languages. Even then, “the delivery” of coveted products from a distance drove active commerce. The caravan was the USPS of the day, and carefully recorded in the tablet-written history of these times is the delivery of a single pair of Caphtorian-style (i.e., “high-end”) shoes. This particular pair of shoes was produced at one end of the civilization in Crete (present day Greece) and transported to King Hammurabi of Babylon (present day Iraq) on the other end of the market—a delivery that would have, at a minimum, taken months to execute. Similarly recorded is the king’s dissatisfaction; the shoes were returned.

Now on the front porches of the developed world, packages accumulate daily at a staggering rate. While we often read of the trends in online shopping, less frequently do we consider the transportation or transactional implications of “buying before trying” at scale. For many of the items we now comfortably and routinely purchase online, we have a history with the product, confidence in the brand, and a repeat buying experience. Most of these purchases represent a one-way ticket from seller to consumer—no need for return.

Yet, for a growing percentage of home-delivered purchases, the buyer has little or no true history with the product or brand. They’ve simply “experienced” it via a description, picture (zooming capabilities included) or promotional video along with what they can gather from other buyers’ experiences, often provided in five-star rating format. For a large portion of these types of purchases, customer dissatisfaction for one reason or another often dictates the common next stage of the journey: prompt placement back into the box onto which the return-shipping label is affixed, then back into the delivery system.

We have long had laws designed to help protect customers from defective products (e.g., lemon laws for big ticket items like cars), and the Consumer Protection Act to ensure products are safe from defects. Even the United Nations has its own Consumer Bill of Rights. From these and other societal covenants, consumer trust is established and producers are obligated to provide quality and reliability. Yet beyond these obligations, many businesses have been purposely built to exceed these expectations.

A couple notable examples—founded in 1912, the outdoor outfitter L.L. Bean has established a cult-like customer following with its “return it anytime for any reason” guarantee. In the earliest days of e-commerce, Zappos (acquired by Amazon in 2009, for $1.2B) established itself as a company that was built around facilitating the ease with which its products (shoes) could be returned, for free and with a full year to consider it.

But what is it worth to us to be able to send it back? Or perhaps more intriguing, what is the value and worth of returns and exchanges generally—both to the consumer and seller? In online retail, for example, there is generally a 15 percent rate-of-return of all purchases except in categories like apparel, where a 30 percent rate-of-return is not uncommon. But beyond increasing consumer confidence, what is the value derived from optionality-based transactional exchanges? This is a question that takes us beyond considering rates-of-returns. It invites us to consider how the best products are market tested and optimized, and to explore how “the innovation of transactional optionality” helps innovators convert ideas into commercial successes and satisfied (and loyal) customers.

It would seem that we truly are willing to pay a premium to know that until we’ve finalized our decision, we have the right to “send it back.” And generally, it’s worth it. All commerce relies on trust and the fact that confidence in the product and the integrity of the producer matters to us. We expect that if a product breaks, or if we simply don’t like it, we can return it and get most (if not all) of our money back. Knowing this, we buy items much more willingly and confidently and with minimal commitment to the sale.

Some of the more effective B2B transactions between commercialization companies and innovators have similar characteristics—and benefits. When doing R&D internally, a commercialization company, for all intents and purposes, has already bought the product. Namely, they have fully committed to the cost to develop the product. If the product fails, it is a sunk cost. But when working with partners who are developing something innovative, commercialization companies are often able to access technology and/or early-stage products using an “option-to-buy” based mechanism. This transaction format is similar to the right-to-return inherent in retail transactions, and it proves to be a powerful and effective financial incentive—for both parties.

In the case of the innovator, funding during the option period can provide critical resources to advance the development of its product or technology, advances that the company gets to keep. And the innovator has direct and early access to its primary customer (the commercialization company) for timely and critical product development input. For the commercialization company, the ability to defer the finality of fully owning the product enables it to build flexibility and diversity into its R&D operations, which are impossible to achieve when solely developing products internally. Of course, there are situations where option-to-buy isn’t the most desirable investment vehicle, but when appropriate, it is a useful tool to leverage.

History reminds us of many things, but perhaps most clearly is how little things change. Four thousand years ago, if you didn’t like the shoes you received, you sent them back, and this entitlement remains utterly pertinent today. After all those centuries, “sending it back” has just gotten a little easier. And, as in shoes, the right look, fit and flexibility can make all the difference in designing investment vehicles that are optimized for both buyer and seller.