Real Options
in Strategic Management
Advances in
Strategic Management ∙ Volume 24 (2007)
Tony W. Tong
and Jeffrey J. Reuer
A fundamental issue
in the field of strategic management concerns firms’ strategic choices and directions
(Rumelt, Schendel, and Teece 1994). Reflecting
this central concern, a substantial amount of research in the field has examined
the antecedents of a wide range of strategic decisions by firms as well as their
performance implications. Whether
strategic decisions involve internal investments in technology or external corporate
development activities, they generally involve resource commitments to future
initiatives under uncertainty. As a
result, the role of uncertainty has received a great deal of attention in
strategy research, and there has been recurrent interest in how firms might
better manage strategic decision making under uncertainty.
Research
has long recognized the key role that uncertainty plays in organizations and
management (e.g., Cyert and March 1963; Thompson 1967), yet a recent and novel treatment
of uncertainty comes from real options theory.
In contrast to traditional views that managerial discretion is limited
in the face of uncertainty or that organizational inertia dominates, real
options theory maintains that firms can engage uncertainty and benefit by investing
in options to respond to uncertain futures and by managing the investments in a
sequential fashion as uncertainty is resolved (Kogut 1991; Dixit and Pindyck
1994; Kogut and Kulatilaka 2001). Recent
advances in strategy and finance have suggested that real options theory potentially
offers a powerful valuation tool as well as a systematic strategy framework to evaluate
and structure resource investments under uncertainty, and that successful use of
real options can lead to the benefits of downside risk reduction and upside
potential enhancement (Bowman and Hurry 1993; Kogut and Kulatilaka 1994a; Trigeorgis
1996; McGrath 1997; Amram and Kulatilaka 1999).
In
undertaking this volume, our objectives are two-fold. First, as interest in real options theory continues
to grow, there have also been questions on the greater promise of real options
theory in strategy. While advocates believe
that real options theory informs strategic decision making under uncertainty, others
also see difficulties surrounding the theory’s larger applicability to
strategic management issues. We suggest
that part of this dialogue reflects broader questions on how real options
theory might link to the foundations of the strategy field, and we identify four
fundamental questions for real options theory to advance in strategy. Second, the strategy literature on real options
has developed rapidly, and research has examined diverse aspects of the theory. As such, our second objective is to catalog,
synthesize, and critique the extant real options research in strategy. This effort can delineate the ways in which real
options theory contributes to strategy, and it also can reveal certain avenues
for future research on real options. The focused volume therefore can provide a
forum for researchers to tackle key questions, discuss promising opportunities,
and map out the future research agenda for real options theory in strategic
management.
In
the following section, we briefly review the origins of real options theory,
trace its developments in strategic management, and outline three reasons why
it has become important for the field. This
review and assessment leads to an overarching framework that we also use to organize
the remaining 17 chapters in this volume, and we highlight how these articles are
built on the framework and contribute to our expanded knowledge. We conclude by offering four fundamental
questions that we believe lie at the interface between real options and
strategy and can help move forward real options research in strategy in
important ways.
The
Development of Real Options Theory
The Origins of Real Options Theory
Real options theory
begins by drawing an analogy between real options and financial options. A financial option is a derivative security
whose value is derived from the worth and characteristics of another financial security,
or the so-called underlying asset. By definition, a financial option gives its
holder the right, but not the obligation, to buy or sell the underlying asset
at a specified price (i.e., the exercise price) on or before a given date
(i.e., the expiration date). Financial
economists Black and Scholes (1973) and Merton (1973) pioneered a formula for
the valuation of a financial option, and their methodology has opened up the subsequent
research on the pricing of financial assets and paved the way for the
development of real options theory.
The
notion of real options was developed from Myers’ (1977) seminal idea that one
can view firms’ discretionary investment opportunities as a call option on real
assets, in much the same way as a financial call option provides decision
rights on financial assets. By way of
analogy, a real option has as its underlying asset the gross project value of
expected operating cash flows; its exercise price is the investment required to
obtain this underlying asset; and the time to maturity is the period of time
during which the decision-maker can defer the investment before the investment
opportunity expires (e.g., Myers 1977; Trigeorgis 1996). Formally stated, real options are investments
in real assets, as opposed to financial assets, which confer the firm the
right, but not the obligation, to undertake certain actions in the future (e.g.,
Trigeorgis 1996; Amram and Kulatilaka 1999).
Comparisons of financial and real options can be found in standard textbooks
(e.g., Brealey, Myers, and Allen 2006).
Real
options research in finance and economics has developed a taxonomy of common real
options that are often embedded in an investment, including deferral options,
options to stage investments, options to alter operating scale, abandonment
options, switching options, and growth options.
In addition, an investment frequently involves a combination of some of
the common real options above, and their combined value often differs from the
sum of the value of each option in isolation (Trigeorgis 1993). Investments such as technology development or
venture capital also may consist of sequential stages, and such multi-stage
investments comprise compound options, whose underlying asset is not a real
asset, but another option (Roberts and Weitzman 1981; Trigeorgis 1996). To the extent that an investor can hold a
portfolio of options simultaneously (Merton 1973), a firm undertaking multiple
investments at a point in time may also experience option portfolio interactions,
in that options embedded in one investment may shape the value of other options
held by the firm and therefore the overall value of the option portfolio (e.g.,
Triantis and Hodder 1990; Luehrman 1998; Smit and
Trigeorgis 2004).
The
real options literature in finance and economics tends to have an analytic focus,
employing real options analysis to evaluate firms’ investments under
uncertainty and to model the optimal conditions for undertaking such
investments. For example, earlier
research in this literature has evaluated investments in natural resources and flexible
manufacturing (e.g., Brennan and Schwartz 1985; Triantis and
Hodder 1990), analyzed the optimal timing of investing in land
development (e.g., Titman 1985), and studied the relationship between options
to alter operating scale and the value of the firm (e.g., McDonald and Siegel
1985; Pindyck 1988; Majd and Pindyck 1989). Pindyck (1991) and Dixit (1992) reviewed the
literature on investment under uncertainty, and Dixit and Pindyck (1994)
provided extensive discussions of theoretical advances. Two recent developments relating to strategy are
noteworthy, however. First, research has
paid increasing attention to the competitive environment surrounding firms’
investments and the strategic aspects of real options, which have important implications
for competitive strategy (e.g., Kulatilaka and Perotti 1998; Grenadier 2000;
Smit and Trigeorgis 2004). Second, research
has also used real options theory to analyze investments in building strategic resources
such as R&D, as well as other corporate development activities such as
acquisitions and diversification, in the broader context of corporate strategy (e.g.,
Childs and Triantis 1999; Matsusaka 2001; Bernardo and Chowdhry 2002; Pacheco-de-Almeida and Zemsky 2003).
Compared
to the large amount of theoretical work in this literature, there have been relatively
few large-scale empirical studies, a point lamented by Schwartz and Trigeorgis
(2001) and others. The available
empirical analyses of real options in finance and economics have largely continued
the focus of analytic work in the areas of natural resource investments and real
estate development (e.g., Paddock, Siegel, and Smith 1988; Quigg 1993; Moel and
Tufano 2002), and have also examined the implications of particular options for
the value of the firm (e.g., Berger, Ofek, and Swary 1996). Empirical work on investing in strategic resources
and corporate development is lacking, however, and option implementation issues
related to organization, incentives, and the like have yet to be probed in more
depth (Trigeorgis 1996).
The Development of Real Options Theory in Strategic Management
Initial interest in real
options in the field of strategic management began to emerge in the early 1980s,
when management researchers first expressed dissatisfaction with traditional
financial techniques such as the net present (NPV) value approach to resource
allocation and strategic decision making (e.g., Hayes and Garvin 1982). These techniques make it hard to account for follow-on
investment opportunities often embedded in a corporate investment project, or to
capture managers’ flexibility in adapting their decisions to evolving market and
technological uncertainty, a view also shared by financial economists such as Myers
(1984) and Kester (1984).
Kogut
was among the first to formally conceptualize and empirically test real options
in strategic management. His seminal
work started in the context of multinational corporations (MNCs) and the
coordination of their operations across countries. In a series of articles, Kogut (1983, 1985,
1989) maintained that multinational operations confer the MNC a string of real options
in order to capitalize on the high levels of uncertainty and heterogeneous
opportunities present across countries. For
instance, he suggested that international investment confers the MNC valuable growth options, and an initial
investment in a foreign country often carries a large option value, since the
investment can unlock opportunities for future expansion. Kogut also emphasized that the MNC holds
a portfolio of switching options that offer operating flexibility by allowing
the firm to shift value chain activities across geographically-dispersed
subsidiaries as uncertain environmental conditions evolve.
A
number of studies have expanded Kogut’s initial contributions in several concrete
ways. Kogut and Kulatilaka (1994a), for
example, developed a model that captures the option value of production
switching between two country locations in the presence of volatile exchange
rates. Kogut and Chang (1996)
empirically tested the idea that an initial investment may serve as a platform
for subsequent expansion, and they found that Japanese firms’ direct investments
in the
Kogut’s
pioneering contributions also pertained to the areas of governance and
organizational choice in the corporate strategy domain. He provided the first theoretical arguments
and empirical evidence that joint ventures (JVs) provide firms real options to expand
sequentially into new and uncertain markets (Kogut 1991). By investing in a JV, a firm is able to limit
its downside losses to an initial, limited commitment, while also positioning
itself to expand, but only if future conditions turn out favorably. In line with the theory, he found that the firm
undertakes expansion by exercising the option by buying out its partners when
the JV experiences a positive demand shock, but the firm continues to hold onto
its investments in the JV when negative demand signals materialize.
A significant
amount of theoretical and empirical research that followed has sought to extend
this paper by examining the firm’s choice of particular governance modes and related
governance design issues. First, using
formal models, Chi and colleagues have
examined the circumstances under which the option to acquire or sell out a JV
provides positive economic value for partners, investigated the conditions
under which firms may hold the option rights, and analyzed governance structure
issues such as the allocation of equity stakes between the partners (Chi and
McGuire 1996; Chi 2000). Reuer
and colleagues studied the real options embedded in various types of JVs (Reuer
and Tong 2005, 2007; Tong, Reuer, and Peng 2007), and their findings indicated
that JVs enhance firms’ growth option values, yet only under some well-defined
conditions. Second, Folta (1998) studied
firms’ decisions to undertake JVs versus
acquisitions by viewing JVs as providing deferral options and sequential
commitments, and he found that firms are more likely to invest in JVs over
acquisitions when facing high levels of uncertainty. Folta and Miller (2002) built on Kogut’s
(1991) focus on option exercise decisions, but went beyond JVs to investigate minority
equity investments. Building on Dixit
and Pindyck (1994) and continuing Folta’s (1998) focus on deferral options,
Folta and colleagues examined firms’ market entry decisions and presented
findings consistent with real options theory (Miller and Folta 2002; Folta and
O’Brien 2004; Folta, Johnson, and O’Brien 2006). Collectively, this set of empirical evidence
has begun to develop toward a real options theory of market entry and organizational
governance that can complement existing theories: market entry modes differ in their attributes
and embedded options, and they respond to uncertainty in different ways,
leading firms to use them discriminately to structure their investments.
Around the same time as Kogut’s work, Bowman and Hurry
(1987, 1993) were working to develop an option theory based perspective of strategic
management. Bowman and Hurry (1993)
proposed options as a strategy heuristic for understanding sequential resource commitments
under uncertainty, and central to their theory development is the notion that the
options lens “offers an economic logic for the behavioral process of
incremental resource investment” (p. 760).
Hurry, Miller, and Bowman (1992) found that Japanese venture capitalists
tend to make small individual investments, yet a large number of investments, in
order to capture a wide range of future opportunities, which they suggested is
consistent with an ‘options
strategy’ of seeking new technology. McGrath (1997) advanced a real options logic
of technology options by suggesting that firms can make so-called amplifying
preinvestments to influence uncertainty to their advantage; in a subsequent
paper, she developed the notion that entrepreneurial initiatives can be viewed
as real options and suggested that they be managed using real options reasoning
(McGrath, 1999). In parallel to some of
these lines of research, Kogut and Kulatilaka (1994b, 2001, 2003) aimed to
integrate the literatures on real options and capabilities by proposing that real
options theory provides a heuristic framing of viewing capabilities as
generating platforms to respond to future uncertain opportunities.
Given
the strategy field’s interest in understanding the actual behaviors of firms
(Rumelt et al. 1994), it is not
surprising that, compared to real options research in finance and economics, research
in strategy has paid considerably more attention to issues surrounding option
implementation. While in principle real
options theory can be applied to evaluate resources and strategic investments
that are not publicly traded (Mason and Merton 1985), strategy researchers have
long suggested that various challenges can surround both the valuation and
implementation (e.g., creation, maintenance, and exercise) of real options in organizations,
in part due to several issues accompanying “domain translation” (Kogut and
Kulatilaka 2004). Indeed, this basic idea
finds its roots in the initial contributions in the field and has run through
the whole stream of real options research in strategy. For example, Kogut (1985) pointed to the
difficulty that managers may have in recognizing valuable options embedded in the
firm’s investments, a view also shared by Bowman and Hurry (1993). Moreover, just because a firm recognizes the
embedded options does not mean that it has the management and organizational system
to support their implementation (Kogut 1989; Kogut and Kulatilaka 1994a, 1994b). In addition, managers might not use the
correct information to assess real options or might evaluate them incorrectly
due to the lack of suitable proxies (Bowman and Moskowitz 2001; Miller and
Shapira 2004). Finally, managerial and
organizational factors might further alter option maintenance and exercise
decisions: managers may be prone to escalation
of commitment, they may not follow the optimal exercise policies due to incentive
problems, and they may find it hard to monitor the complex cues for exercise
because of bounded rationality (Kogut 1991; Garud, Kumaraswamy, and Nayyar
1998; McGrath 1999; Coff and Laverty 2001; Adner and Levinthal 2004).
The Importance of Real Options Theory for Strategic Management
Real options theory provides
a set of analytic tools and heuristics to evaluate and deal with the uncertainty
that pervades strategic decisions. Indeed,
Rumelt et al. (1994: 26) identified
uncertainty as among the top five “monkey wrenches” that inspired research departing
from the neoclassical theory of the firm, and that has given rise to the birth
of the strategic management field. Given
the essential role of uncertainty in strategic decisions, we suggest that the increased
importance of real options theory for strategic management can be explained by at
least three factors that may also suggest why real options theory is unique.
First,
real options theory requires research to revisit the received wisdom, and
offers unique predictions, on firms’ decisions for many types of strategic
choices under uncertainty. Consider the
following three examples. As alluded to
earlier, the real options view challenges the traditional perspective of joint
ventures as marriages, under which longevity and stability were key indicators
of success. According to real options theory,
firms can unlock value at the joint venture termination stage, and an important
role exists for joint ventures that are transitional investments by design. As a second illustration, foreign direct
investment has long been considered a solution to the substantial transaction
costs accompanying the market exchange of technology or other assets. By contrast, real options theory instead
emphasizes dynamic efficiency gains, downside risk reduction, and the firm’s ability
to seize upside opportunities over time by shifting value chain activities
across borders in response to different uncertainties. Finally, at a more general level, real
options theory provides new rules for resource investments by suggesting that
real options shift firms’ investment thresholds away from the NPV>0
criterion. While the details on the
threshold effects of various real options have been illustrated elsewhere (Pindyck
1988; Dixit and Pindyck 1994; Trigeorgis 1996), the insight offered by real
options analysis can be briefly summarized as follows: a firm may use a reduced investment
threshold and decide to invest even if the NPV is negative, if the embedded
growth options are sufficiently valuable; by contrast, a firm may use an
elevated investment threshold and decide not to invest even if the NPV is
positive, if the embedded deferral
options are sufficiently valuable and the associated opportunity costs of
investing in the current period are significant.
Second,
real options theory uniquely posits an asymmetric payoff structure for
investments with embedded options by suggesting that real options enable firms
to reduce downside risk while accessing upside opportunities. The asymmetry in performance outcomes is due
to the discretionary decision rights that options create, i.e., the right to
select an outcome in the future only if it is favorable. Compared to other theories, real options
theory therefore suggests that, the greater the level of uncertainty, the
higher the potential payoff to the option holder, given that the initial
investment is limited and downside losses are contained (Bowman and Hurry 1993;
Hull 2003). Another key aspect the
theory emphasizes is that maintaining flexibility under uncertainty has option
value, and this value can account for a substantial proportion of the value of many
investments. Theory and empirical findings
also suggest that such option value varies significantly across firms and
industries, and of importance to strategic management is what the sources of
heterogeneity might be and how option value influences firms’ strategic choices
and resource allocation policies (Kester 1984; Tong and Reuer 2006).
Third,
real options theory sheds new light on firms’ resource allocation processes by
informing strategic decision making. Strategic
planning has long embraced such concerns as follow-on opportunities, incremental
resource commitments, and sequential management of information and uncertainty,
which are all central to firm strategy; yet by their nature planning models
lacked the kind of tight decision criteria prescribed by investment models in traditional
finance theory. Real options theory can
help improve strategic decision making by bringing the discipline of
financial markets into qualitative
strategic planning tools, and also by incorporating strategic
realities into traditional
capital budgeting models that do not explicitly account for the
value of flexibility and managerial discretion (Trigeorgis 1996; Amram and
Kulatilaka 1999). While effective implementation of real
options analysis for resource allocation needs to overcome organizational and
other challenges, real options theory holds out the promise of integrating
strategic and financial analyses for corporate strategy (Bettis 1983; Myers
1984).
OVERVIEW
OF the Volume
The above three reasons
why real options theory has become important for strategic management also
correspond to three major streams of real options research in strategic
management, which we label as real options investment decisions, implementation
of real options, and performance outcomes of real options, as summarized in
Figure 1. Below we outline the three
streams of research, and we use this framework to structure the chapters in
this volume and highlight their contributions.
Figure
1
A Framework for Real Options
Research in Strategic Management
Before
discussing the individual chapters that make up this volume, it is fitting to
describe the development of this collection as well as offer our thanks to
several people and institutions, without whose support this project would not
have been possible. In late 2004, we
identified scholars in strategy and finance doing research on the above three
topics and invited them to contribute original research papers to a volume
devoted to real options in the Advances
in Strategic Management series. In
June of 2006, roughly forty authors and participants gathered at the
Advances in Real Options Research in Strategy
We begin this volume
with a section including four chapters that delineate the recent advances in real
options research in strategy, given that little work has systematically reviewed
and analyzed existing contributions in the field. The first chapter by Li, James, Madhavan, and
Mahoney reviews key applications of real options theory in strategic management
and proposes several areas for future research.
Their review suggests that real options theory provides unique insights
into firms’ investment under uncertainty; in particular, the theory has thrown
new light on two topics of significant interest to strategy researchers: investment and divestment, and organization
and governance. The review also
indicates that real options embedded in strategic investments are valuable and have
important performance implications for the firm. Their work concludes that real options theory
has the potential to develop into an emerging, dominant conceptual lens in
strategic management. The next chapter by
Li provides a systematic analysis of the theoretical and empirical contributions
of real options theory within international strategy. Her analysis builds on a framework that
overlays three critical topics of research in international strategy
(multinationality, market entry mode, and market entry timing) with three major
approaches used in existing real options research in the field (real options
modeling, real options reasoning, and empirical testing). She also outlines potential contributions
that real options theory could make to two major streams of research in
international strategy: research on transaction
costs economics and research on internationalization theory. The third chapter, by Cuypers and Martin,
focuses on real options theory’s applications in research on joint ventures, a
particular investment and governance mode that has drawn a substantial amount
of attention in the strategy field.
Their synthesis of the real options literature on JVs highlights real options
theory’s connections with several alternative theories on JVs, and they also examine
how various options can affect a JV’s development within and across different
stages of the venture’s life cycle. The
final chapter in this section by Reuer and Tong categorizes and critiques the
empirical research strategies that have been used to test real options theory
in strategic management. Their research discusses
studies that examine the timing and structuring of firm’s investments, and their
particular focus is on studies that examine the performance implications of
firms’ real options investments. Their analysis
suggests that considerable evidence has accumulated for real options theory,
and they also indicate the need to pay attention to the costs associated with real
options within distinct investment stages as well as across different stages.
The
chapters in this section suggest that real options theory is well suited for studying
strategic decision making under uncertainty in various investment contexts, and
they also call for more theoretical and empirical work that can help advance
the theory in several concrete ways. In
particular, there is a need to better articulate real options theory’s link to
other theories in the field and to specify the theory’s appropriate
boundaries. In addition, more and
stronger tests are also required to fill the gap that still exists between
theory and practice as well as to resolve some empirical inconsistencies
documented in the literature. To better
understand real options theory’s applicability, researchers can extend the
theory to new application areas, study several types of options that have
received relatively less attention as well as option interactions, and pay more
attention to the implementation aspect of real options.
Real Options and Strategic Investment Decisions
The second section focuses
on firms’ strategic investment decisions using real options theory. Research in this stream often starts by identifying
different types of real options embedded in strategic investments. This research then examines how the presence
or absence of these options may affect the timing and structuring of such
investments under uncertainty and other environmental conditions. Research on the timing of investments has
developed models to derive the optimal conditions under which firms are making
investments (e.g., Kulatilaka and Perotti 1998; Leiblein and Ziedonis this
volume; Lin and Kulatilaka this volume) and has empirically tested whether the
actual investment timing is consistent with real options theory’s predictions
(e.g., Kogut 1991; Campa 1994; Folta and O’Brien 2004; Folta and O’Brien this
volume; Nerkar, Paruchuri, and Khaire this volume).
The
chapters in this section contribute to existing research on the timing of
investments in several ways. The first chapter
by Lin and Kulatilaka extends previous theoretical research by considering firms’
investment decision in a specific industry setting, network industries, where strategic
advantages arising from early commitment generate a valuable strategic growth
option. Their study suggests that under
high uncertainty, the strategic growth option often dominates the deferral option,
thus reducing firms’ investment thresholds and encouraging investments; in
addition, the intensity of network effects enhances the value of the strategic
growth option. The chapter by Folta and
O’Brien examines the likelihood of firms making acquisition investments which have
embedded growth options and deferral options.
They use a novel technique to isolate real options’ effects on firms’
investment thresholds, and they find that firms’ thresholds affect the
likelihood of acquisition in ways consistent with the theory’s predictions. The chapter by Leiblein and Ziedonis applies
real options theory to study firms’ technological adoption strategies when there
are multiple generations of technologies that are introduced successively. Their conceptual model identifies several conditions
that differentially affect the value of deferral and growth options embedded in
technological adoption, which in turn determines firms’ optimal adoption
strategy under those conditions. The
chapter by Nerkar, Paruchuri, and Khaire extends recent research that views
patents as real options, and they suggest that patents provide their holders with
the right but not the obligation to sue potential infringers. They study the exercise of the option to sue
in a novel setting – business method patents – and their findings suggest that the
likelihood of a patent being litigated is positively associated with the value
of the patent and the extent of disclosure in the patent.
Research
on the structuring of investment has tended to focus on how firms structure their
investments, such as the design of investment patterns and investment portfolios
(e.g., Kogut 1983; Hurry et al. 1992;
Vassolo, Anand, and Folta 2004; Anand, Oriani, and Vassolo this volume). Research in this stream has also examined
organizational governance and investment mode choice, such as alliances versus
acquisitions (e.g., Chi and McGuire 1996; Folta 1998), assuming that a broader
corporate investment decision is in place.
The chapter by Anand, Oriani, and Vassolo in this section analyzes several
factors that determine the value of a portfolio of real options and therefore
can affect the composition of an option portfolio. Their core idea is that building an effective
option portfolio requires attention to balancing growth and switching options, and
they discuss how the value of an option portfolio depends on the width of the
portfolio as well as the correlation among the underlying assets for each
option. Their research thus also has useful
implications for the implementation of real options, which is the focus of the four
chapters in the next section.
Organizational and Managerial Dimensions of Real Options
Researchers have
moved beyond strategic investment decisions to examine the implementation of
real options in real organizations. While
as a theory of investment, real options theory does not speak directly to
managerial and organizational capabilities required for implementation, more
research in this area can help to specify the theory’s boundaries and enhance its
managerial relevance. Most of the
existing research in this area is conceptual in nature, describing various
opportunities and challenges facing firms implementing real options. While specific topics vary, this research has
tended to emphasize the importance of managerial or organizational dimensions
during the various stages of option implementation, such as option creation and
identification, option evaluation and maintenance, and option exercise.
Managerial
and organizational factors can affect option implementation at different investment
stages. For example, management processes
and organizational structures can influence firms’ identification of real
options and their investments in real options (e.g., Kogut 1985; Bowman and
Hurry 1993). The first chapter in this
section, by Maritan and Alessandri, uses a capabilities perspective to link investments
in real options to firms’ resource allocation process. They first identify four components of the
returns to an investment, deriving from industry-specific elements, as well as
option and non-option elements, and they link these components to specific levers
of the resource allocation process. They
also suggest that research focus on the organizational and managerial aspects
of the investment process from option creation to option exercise. This suggestion is consistent with the
broader view that the evaluation, maintenance, and exercise of real options may
need to deal with various management and organizational challenges (e.g., Kogut
and Kulatilaka 1994a, 1994b; Coff and Laverty 2001; Adner and Levinthal 2004). The following two chapters in this section
further extend this view. Coff and Laverty
suggest that managing real options in different organizational forms can incur different
organizational costs, and therefore the organizational form that an option takes
can have a profound effect on option exercise decisions. Their research also prescribes several organizational
and management processes that may facilitate the management of real options in
organizations and thus help to achieve real options theory’s promise in
strategic management. Adner recasts recent
discussions on the appropriate applicability of real options theory to
strategic management in terms of the characteristics of the resource
reallocation process in organizations. His
research considers some managerial and organizational drivers of mismatches
between initial resource allocation logics and subsequent resource reallocation
realities, and it highlights the need for a better understanding of the
resource reallocation process in order to improve the appropriate usage of real
options logic in organizations. In
contrast to these chapters focusing on the challenges surrounding option
implementation at different stages, the final chapter in this section, by
Fister and Seth, analyzes one specific management challenge – how to encourage employees’
investment in firm-specific human capital – using real options theory. Their application of real options theory
points to several conditions that would lead to the use of certain contractual
mechanisms to encourage such investment, and they discuss how various
mechanisms might serve such a purpose through their impact on the value of the
various options embedded in employment relationships.
Performance Implications of Real Options
The final section of
the volume relates to an emerging stream of research that empirically
investigates the performance implications of real options. As observed in Reuer and Tong (this volume),
research within this stream has used both so-called generalized measures and customized
measures to study the firm outcomes of real options investments. Generalized measures refer to market returns,
market values, traditional risk measures, as well as other proxies that have
also been used for testing other theories.
Customized measures, in contrast, are specifically geared toward testing
the unique payoff structure associated with particular real options, and the
existing research has used such measures such as downside risk, growth option
value, abandonment option value, asymmetric exposures to uncertainties, and so
forth.
The
first chapter in this section by Chi and Levitas conceptualizes patents as technology
options and empirically examines the option value of a firm’s patent portfolios. Their research isolates the real options’
effects by considering factors that tend to influence option value but not cash
flow value. They do so by investigating
how flexibility in excising options embedded in patents (proxied by citation
dispersion) may moderate the effect of patent citations on the firm’s market
value, based on a theorem that is developed in Merton (1973) and also discussed
by Bowman and Hurry (1993). The findings
show that patent citations have a more positive influence on firm value when
the citations are more dispersed and when there is a higher level of
uncertainty, both of which are consistent with real options theory. The chapter by Oriani examines the value of a
specific real option, i.e., technology switching option, which allows a firm to
exchange an existing technology with a new technology. Specifically, he develops a model of the
market value of the firm that explicitly incorporates a technology switching
option, and he empirically tests the impact of this option on firms’ value. His findings suggest that the technology
switching option is valuable and that its value is enhanced for firms having a
higher probability to exercise the option.
The following chapter, by Alessandri, Lander, and Bettis, also
empirically values specific real options, in this case corporate growth
options. Their research builds on
Kester’s (1984) initial contribution to estimate a firms’ value of growth
options, using different valuation models that represent different assumptions
and techniques. Their findings indicate
that a firm’s growth option value is a function of the macroeconomic and
industry environment in which the firm operates, as well as firm-specific
factors, suggesting the need for finer-grained study of real options at
different levels of analyses. The final
chapter in this section, by Guler, takes a different, yet complementary approach
to studying the performance implications of real options. Her research investigates venture
capitalists’ investment policies in managing their portfolio companies, which
are considered real options investments.
Her findings indicate that firms differ in their capabilities to manage
unsuccessful projects but not successful projects, reflecting earlier
research’s suggestion to focus on firm heterogeneity in studying the
performance implications of real options.
Fundamental
Questions for Real Options Research
in Strategic
Management
The set of chapters
in this volume, combined with previous research, illustrate the increasing
interest in real options theory in the strategy field. This work also demonstrates the rich theoretical
content and wide empirical application of real options theory within strategic
management. At the same time, real
options theory is still at a relatively early stage of development, and many
important issues will need to be tackled if the theory is to attain a status
comparable to a number of other perspectives in currency in strategy research.
As
an initial step in identifying and cataloguing some of the most pressing areas
for research, we asked all of the participants at the conference to flag one or
two key issues worthy of future research.
Rather than simply listing these research topics, we attempted to
distill them into a smaller number of fundamental questions that scholars need
to address. During this process, we were
mindful of Rumelt et al.’s (1994) proposal
of four fundamental questions in strategy to differentiate this field of
inquiry. We offer these questions to
highlight some issues that are fundamental to real options research in strategy,
in order for the theory to obtain the promise that researchers have envisioned for
it (Bowman and Hurry 1993; Kogut and Kulatilaka 2001; Barney 2002; Mahoney 2005). As fundamental questions, they may challenge the
current state of knowledge, yet we also believe that efforts to work on these
questions can not only help real options theory make greater contributions to the
strategic management field, but they can also bring into focus the distinctive
contributions that strategy research can make to real options theory. Below we discuss the four questions and we include
some additional questions under each broader category.
How Can Real Options Theory Address the Foundations of Strategy?
The
field of strategic management is concerned with the firm’s strategic choices
and directions, which can have an enormous influence on organizational
performance. In its most strict form, real
options theory can help parameterize
sources of uncertainty and attach values to the various options embedded in the
firm’s strategic decisions and investment choices. At a broader level and used in metaphoric
terms, real options theory can offer a more positive view of uncertainty
and a more constructive view of managerial discretion by advising firms to
attend to key value drivers for the various options embedded in strategic
choices.
Strategy
is also fundamentally interested in the heterogeneity in firm behaviors and
performance outcomes. Like some other theories
within organizational economics, real options theory does not seek to address firm
heterogeneity directly. However, there
are significant opportunities to enhance the conversation between real options
theory and firm heterogeneity. For
example, firms must engage in strategic investments to build or acquire resources
and capabilities under considerable uncertainty and ambiguity (Lippman and
Rumelt 1982; Barney 1986; Dierickx and Cool 1989). As one fundamental theory to aid in investment
decision making (Dixit and Pindyck 1994), real options theory can enhance our understanding
of why firms may differ by modeling firm’s investments in a more analytic way (e.g.,
Pacheco-de-Almeida and Zemsky 2003). Indeed, research
has suggested that firms can use real options theory to guide their investments
to build heterogeneous resources and capabilities (Baldwin and Clark 1992, 2000). Firm heterogeneity can also be used to
explain particular predictions of real options theory (Tong and Reuer 2006). For instance, firm heterogeneity and the associated
asymmetric expectations across firms may lie at the heart of the reason why firms
may exhibit different investment behaviors when facing the same uncertainty,
whether the investments are made for strategic factors, real options, or
financial securities (Barney 1986; Chi and McGuire 1996; Hull 2003).
The
following sub-questions connect to this broader question, which is of
particular interest to strategic management:
·
How can
real options theory explain competitive advantage? How can firms facing the same options achieve
differential performance? If firms face
different options and this creates heterogeneity in resources and performance,
what is the source of the firm heterogeneity in the first place?
·
How can
real options theory speak to corporate strategy? What are the implications of viewing the firm
as a portfolio of options rather than a bundle of resources and capabilities? How can research use real options theory to
explicate the development of core competencies?
·
How
important are the option properties of organizational governance structures in
explaining boundary of the firm choices?
How Can Real Options Theory Connect to Other Theories in Strategy?
The distinctiveness
of real options theory for strategic investment decisions compared to other
theories has been discussed in a previous section, and its uniqueness also explains
strategy researchers’ initial enthusiasm for the theory. Real options research clearly should continue
to highlight the theory’s unique aspects as a standalone theory, by further
examining the critical questions and predictions the theory poses and by emphasizing
the theory’s unique constructs as well as the links between these constructs
and strategic decisions or organizational performance. Equally important, conceptual and empirical
research should work to tease apart the theory’s predictions from those of
rival theories and better identify real option theory’s boundaries in strategic
management.
Another
way to advance strategy research on real options is to combine the theory with
other theories to examine particular questions or phenomena. Such an integrated approach has the potential
advantage of offering a more complete understanding of the questions examined,
and recent research has made headway in this direction. For example, strategy research has combined
real options theory and transaction cost economics to explicate the conditions
under which firms may invest in JVs and has considered related alliance design
issues (e.g., Chi and McGuire, 1996). Connecting
real options analysis with the resource-based view has the potential to improve
the analysis of firms’ corporate development trajectories such as the
directions and patterns of diversification (e.g., Kim and Kogut, 1996; Matsusaka,
2001; Bernardo and Chowdhry, 2002). Incorporating
the resource-based view and related notions of firm heterogeneity also holds
the potential to explain the heterogeneous expectations and investment
behaviors of firms facing the same external uncertainty (e.g., Tong and Reuer
2006). In addition, integrating real
options theory with other theories of organizational governance can better inform
corporate strategy decisions such as make or buy decisions and the firm’s
vertical boundaries (e.g., Leiblein and Miller, 2003). Ample opportunities also exist for extending
real options theory into contexts with agency problems, competitive rivalry, or
other sources of endogenous uncertainty, and strategy research has barely
started to consider real options theory in tandem with agency theory, game
theory, or organizational learning theory.
Clearly,
both of the two approaches are valuable and can be appropriate in different
research designs, yet they also present some additional questions for scholars
to consider when framing their research and designing studies on real options:
·
In
general, what is the best way forward for real options theory to make greater
contributions to strategy research, as a standalone theory or as a theory
integrated with others?
·
More specifically,
how should research implement each of the two approaches? What are some of characteristics of the
questions to which real options theory should be applied? What phenomena can real options theory potentially
explain better than other theories? What
are the most interesting empirical horse races to be run?
·
What
other theories can be profitably combined with real options theory, and in what
contexts? How can the boundaries between
the theories be delineated carefully while also acknowledging shared concerns and
points of connection?
How Important is Formalism in Real Options Theory?
Real options theory
has been applied in strategy research in many different ways, yet in a certain
sense, studies using the theory might be arrayed along a continuum ranging from
very formal work to metaphoric applications.
At one extreme, formalism can help identify the workings of real
options, isolate the embedded options, and pin down the option value drivers,
yet important strategic realities may need to be assumed away or differences in
assumptions in financial and strategic domains glossed over. At the other extreme, metaphoric usage of
real options might better attend to strategic or organizational realities and
broaden the applications to which option theory might speak, yet it may not
reflect concerns or variables directly featured in formal models of real
options. Therefore, the question is: how important is formalism in the use of real
options theory in strategic management? In
this connection, it is worth noting that such a question is useful to ask not
just for a particular theory such as real options, but the question also has
great applicability to other theories within the strategy field. The advancement of a good theory often needs
to attend to such conflicting considerations.
Formalism
need not be equivalent to an exclusive focus on option valuation models per se, however. For strategy research, what appears to be more
important is to determine what questions to investigate that are core and
interesting to our field of inquiry, whether using analytic or empirical models
to evaluate investments or strategic choices in a rigorous fashion. Metaphorical usage of real options also can
be valuable for certain applications. For
example, research has suggested that corporate managers more often use real
options theory as a framing device or decision framework rather than as a formal
valuation tool, yet such practices have been powerful and have also in many
ways transformed managers’ and investors’ views on strategic investments such
as R&D, information technology, and other platform investments (Triantis
2005). Clearly, the challenge for
research is to determine the proper balance between formalism and metaphoric
usage of the theory so that applications of real options are still sound and sensitive
to alternative explanations. While research
needs to consider the kind of topics and contexts for real options as well as weigh
the level of maturity achieved and knowledge accumulated, the following
subsidiary questions also might be considered:
·
When
should real options theory be used as an analytic tool versus a heuristic? How can research establish a strong connection
to the features in formal models in using real options theory as a heuristic?
·
How can
strategic and organizational realities be incorporated into analytical models
of real options? How can real options be
modeled more explicitly and precisely in order to link theory with empirics
more tightly?
·
What is
the best way to determine the real options characteristics in various assets
and investments? When does it pay to
designate a strategic choice or investment as an option?
What is the Role of Management and Organization in Real Options
Theory?
To
the extent that the trading of options on financial assets with posted prices may
still be subject to inefficiencies, great frictions must exist in the acquisition
of real options on strategic assets in factor markets as well as in the development
of such strategic options within organizations.
For example, organizations are run by boundedly-rational managers with
their own cognitive limitations and behavioral biases, and they may have
limited attention and may face difficulties in recognizing complex cues accompanying
multiple sources of uncertainty (Kogut, 1991; Miller and Shapira, 2004; Barnett,
2005). In addition, organizations may
not have the appropriate structures or supportive systems in place (Kogut,
1985; Coff and Laverty, 2001), and managers might also misuse their discretion
and deviate from optimal decision criteria as a consequence (Trigeorgis, 1996; McGrath
et al., 2004). Real options theory is a theory of investment
decision making that places a high demand on managerial and organizational capabilities
for execution. Despite the soundness of
the theory, any of the factors above can threaten to destroy option value at various
stages of option implementation (e.g., recognition, creation, maintenance,
exercise, etc.).
Viewed
from another perspective, however, to the extent that managers and firms factor
these considerations into their decision calculus and develop corrective
mechanisms, they can help contribute to option value creation. Indeed, the existence of frictions in the
process of the development and exchange of real options has helped open up an
important opportunity for strategic management research to make significant
contributions to real options theory. One
of strategic management’s distinctive competences is to provide a holistic view
of the firm by bridging strategy formulation to management and organization. Employing this distinctive competence, strategic
management research can tackle important questions at the heart of the successful
implementation of real options, and such work will advance both the theory as
well as its practice, which research in other fields will find hard to achieve (e.g.,
Hartmann
and Hassan, 2006). Toward
this end, the following sub-questions are put forth:
·
How do
specific management and organizational factors matter for real options? How does the importance of management and
organization vary across firms and strategic contexts?
·
How do
firms actually implement real options analysis?
How do managers perceive various sources of uncertainty and apply real
options analysis or reasoning in ex ante
strategic decision making processes?
·
What
challenges in other option investment stages (e.g., recognition, creation, and
maintenance) should we devote more attention to, in addition to challenges
surrounding option exercise? How should
firms measure and reward the creation, maintenance, and exercise of options in
organizations, especially when some managers develop assets and others operate
them?
Clearly,
the four questions are not isolated, and they connect to one another to address
some common themes or broader concerns.
For example, the first two questions primarily focus on how real options
theory can better contribute to strategy research, and the latter two turn to ask
how strategy management can make significant contributions to real options
theory. Also, these questions are likely
not collectively exhaustive, and other useful questions can certainly be
suggested; nevertheless, we believe that most of them can be related to the
four questions here in one way or another.
These four questions are therefore fundamental to our understanding of
real options theory in strategic management and key to future progress of
research in this area.
This
volume illustrates how real options theory has significantly contributed to
strategic management research, as well as how scholars in strategic management
are uniquely positioned to advance the theory.
The chapters demonstrate the diverse applications of real options theory
in strategy, and they also point to a range of methodologies and analytical
lenses that future strategy research could leverage to improve existing
understanding of the theory. The volume
and the conference have also identified several pathways for real options
research to advance and develop into a major theoretical perspective in the
field. Our hope is that this volume can
serve as a useful guide to real options research in strategic management for
interested readers, and as a catalyst for additional research on this theory in
coming years.
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