Download Real Options and Innovation

Real Options Theory,
Firm-Specific Capital Investments,
and Implications for Innovation
Yong Li (SUNY Buffalo)
Joe Mahoney (University of Illinois)
Heli Wang (HKUST)
Real Options and Innovation: Introduction
Innovation is the creation and use of new products, processes, and
technologies, or the discovery and use of unexploited pre-existing
opportunities (Nelson & Winter, 1982; Schumpeter, 1934).
Externality-based, transaction-based, and information-based
(hidden action and hidden information) market imperfections,
plus risk-aversion (Stiglitz, 2000) can lead to an underinvestment
in innovation. A fundamental challenge is how to stimulate
entrepreneurial innovation at the individual, organizational,
and societal levels for economic growth and prosperity.
Real Options and Innovation
Conventional wisdom in organizational economics concerning
risk and uncertainty (e.g., the behavioral theory of the firm,
agency theory, and transaction costs theory) may lead to an
underinvestment bias in financing entrepreneurial innovation
(Dixit & Pindyk, 1994; Kogut & Kulatilaka, 1994).
Real options theory offers the insight that uncertainty is not
necessarily something to be avoided but rather can be seen as a
window of opportunity to create value by leveraging opportunity
sets while limiting losses, and thereby can be seen as a heuristic
to address an underinvestment bias.
Real Options and Innovation
The real options literature suggests an expanded net present
value (NPV) framework in which the value of an innovation
consists of both static NPV and the value of real options
(Myers, 1977).
A real option is a property right without an obligation to invest
further depending on how uncertainty resolves. A real option
investment provides a firm with the strategic flexibility to
abandon a project or to make follow-on investments as new
information arrives (Trigeorgis, 1996).
Real Options and Innovation
Under conditions of high uncertainty, this feature generally
gives a real option investment greater value than an inflexible
(irreversible) full-scale investment (Chi, 2000; McGrath &
Nerkar, 2004).
In the innovation context, flexibility includes the option to wait
at the outset, and once the innovation is undertaken, the option
to stage the financing of an innovation, to increase the
investment or expand into related areas upon initial success, to
contract or abandon the innovation project, or to switch to other
innovation projects (Li & Mahoney, 2011; Trigeorgis, 1996).
Real Options and Firm-Specific Human Capital
 Innovative projects are characterized by high uncertainty so
they can be considered as real options.
 Innovative projects require technical employees’
human capital investments. Many innovations have
firm-specific features (e.g., through firm-specific
R&D, which requires employees’ firm-specific
investments (Helfat, 1994)).
 Employees’ incentives are thus very important to consider
when launching such innovative projects, as the likelihood
of success of the projects is not only determined by exogenous
uncertainty in the external environment, but also determined
endogenously by employee incentives and efforts.
Real Options and Firm-Specific Human Capital
Indeed, many projects such as: joint ventures (Kogut, 1991),
R&D (McGrath & Nerkar, 2004) or the development of firmlevel capabilities in general (Kogut & Kulatilaka, 2000), cannot
be carried out without the participation of other key stakeholders
such as customers, suppliers, or employees --- the latter being
the focus here (see also Wang, He & Mahoney, 2009).
In such cases, although the abandonment option reduces the
firm’s downside risk, it also may increase the risk burden of
employees, as their human capital investments specific to the
project may become less valuable when the project is abandoned
(Miller, 1998; Wang & Barney, 2006).
Real Options and Firm-Specific Human Capital
Employees concerns for such risks are high if they have been
required to invest in project-specific (or more generally firmspecific) human capital: skills tied to the particular project with
very limited alternative uses in other business settings
(Becker, 1975; Williamson, 1985).
Therefore, any increased likelihood of abandoning a real option
investment raises concerns among employees about losing the
economic value of their firm-specific human capital commitments
in R&D projects, unique technologies, specific procedures and/or
relational assets (Dyer & Singh, 1998).
Real Options and Firm-Specific Human Capital
Employees concerns about the devaluation of their firm-specific
human capital investments can affect their economic incentives
to make investments necessary for the success of the project.
When a real option project decreases employees’
incentives, the project is negatively affected, sometimes
more than offsetting the economic value of increased
flexibility (see Wang & Lim’s (2008) two-stage
investment model).
Indeed, the firm may face the issue of credible
commitment due to time inconsistency problems of
how to ex ante commit not to abandon an innovative
project that is no longer desirable ex post.
Real Options and Firm-Specific Human Capital
As Wang and Lim (2008) note, to the extent that managers’ and
employees’ incentives may be misaligned with shareholders
interests in making these decisions, then the real options lens
needs to be joined with property rights theory.
The upshot of this research is that if we fail to consider property
rights incentive effects (Grossman & Hart, 1986; Rajan &
Zingales, 2001), then the application of real options models, in
isolation, could result in suboptimal innovation performance.