Real options
Rita Gunther McGrath
Origins of the Concept
Investment analysis in the field of finance fundamentally changed with ability to assess derivatives, also called financial options (Black and real options 215 Scholes, 1973). A financial option contract conveys the right, but not the obligation, to make an investment (usually termed ‘‘exercising’’ or ‘‘striking’’ the option) at some time in the future. A ‘‘put’’ option refers to the right to sell a stock (the underlying asset) at a specified price, while a ‘‘call’’ option conveys the right to purchase stock at a specified price. If the option is not exercised at the agreed time, it ‘‘expires’’ and becomes worthless. If the value of the underlying asset makes it worthwhile, the buyer sells or buys it and capitalizes on the difference between the option contract amount and the asset’s actual value.
Three characteristics of value in financial options are worth noting. The first characteristic is the containment of loss. Because the exposure of an investor is limited to the price paid for the options contract, the loss such an investor might incur is limited, relative to the potential losses if the investment was made in the underlying asset rather than the option. The second characteristic is the expansion of upside potential. Because the benefit to an options investor is not limited, the potential upside to be gained is substantial. Third, investments in financial options are sequential: the decision to exercise an option or let it expire is made after the decision to invest. Investing in options under uncertainty allows an investor to limit losses by making commitment decisions only when uncertainty has been eliminated (because the actual price of the underlying asset is known at the time of exercise).
The theory of real options extends the logic underlying the investment in financial options to organizational resource investments. Originally explored with respect to capital budgeting (Myers, 1977), real options reasoning has been used to analyze many types of organizational resource commitments, including strategy evolution (Bowman and Hurry, 1993; Dixit and Pindyck, 1994), R&D (Mitchell and Hamilton, 1998; McGrath, 1997), joint ventures (Kogut, 1991), governance choices (Folta, 1998; Folta and Miller, 2002), and entrepreneurship (McGrath, 1999). The essential argument is that, under uncertainty, the value of an investment in a real asset will be greater when a similar approach is used to that used to invest in a financial option. Thus, an options oriented investor would seek to minimize the downside exposure of his or her investment, to maximize the upside potential, and to sequence decisions so that major commitments are deferred until uncertainty has been reduced.
Options Reasoning as the Basis for Investment under Uncertainty
Options reasoning offers an alternative to (or at least a different perspective on) conventional rules for investment. Conventional wisdom relies on the net present value rule. Scholars interested in real options have proposed that in addition to present value, option value matters. The big risk of ignoring option value is a down ward bias on return calculations (Myers and Turnbull, 1977: 332), leading to a systemic aversion to investments in uncertain projects, such as those involving entrepreneurship, innovation, R&D, or capability creation (Kester, 1984; Kogut and Kulatilaka, 2001).
A key source of option value has to do with creating flexibility through preserving future decision rights. As Merton (1998: 339) points out: ‘‘The common element for using option pricing here is . . . the future is uncertain (if it were not, there would be no need to create options because we know now what we will do later) and in an uncertain environment, having the flexibility to decide what to do after some of that uncertainty is resolved definitely has value.’’ Empirically, options reasoning has been found to be more consistent with the pattern of choices actually made by organizations than are other investment alternatives (most typically, dis counted cash flow models). For instance, firms impose higher hurdle rates for investment than would be dictated by the NPV rule, and stick with investments that are underperforming longer than it might suggest (see Dixit, 1992, for a discussion of hysteresis effects).
For many scholars, the attraction of options reasoning lies in developing heuristics, or even decision rules, that would provide better insight into strategic resource allocation processes (Bet tis and Hitt, 1995). Bowman and Hurry (1993: 760), for instance, suggest ‘‘the lens offers an economic logic for the behavioral process of incremental resource investment.’’ One essential assumption is that strategic resources accumulate in a path dependent manner, meaning that 216 real options the future value of resources acquired today cannot be perfectly anticipated.
Current Debates
As the real options research stream develops, scholars have begun to explore its limitations. Reuer and Leiblein (2000), for instance, found that contrary to what might be expected from options reasoning, there was no mitigation of downside risk in their pursuit of multinational ventures. Coff and Laverty (2001) question whether options analysis applies in cases of in vestments in knowledge assets because the nature of the underlying asset created is not clear. Adner and Levinthal (2004) argue that real options logic applies only to a narrow range of organizational investments, because as choice sets evolve over time, the structured investment, and particularly abandonment decisions that are central to the operation of the theory, cannot be distinguished from more generic behavioral processes that guide managers in making any sort of path dependent decision.
Normatively, options reasoning has been partly blamed for the excessively optimistic valuations achieved during the Internet bubble of the late 1990s (Kogut and Kulatilaka, 2004). Over valuation and over investment are thus seen as consequences of excessively optimistic judgments of future potential. Another risk attributed to options reasoning is a potential for escalation of commitment due to (among other things) reluctance to terminate failing pro jects (Ross and Staw, 1986; see also Zardkoohi, 2004).
Real Options Reasoning in Entrepreneurship
Because investing in entrepreneurial ventures, independent start ups, or ventures sponsored by established firms involves many of the same characteristics as making investments in options, some scholars have suggested that the options lens can help illuminate aspects of the entrepreneurship process that are poorly explained by using other approaches (McGrath, 1996, 1999). Investing under uncertainty has long been central to theories of the entrepreneurial venture (Knight, 1971) and to theories that attempt to explain the gains to entrepreneurial activity (Baumol, 1993; 2002; Rumelt, 1987). Entrepreneurial ventures further involve path dependent investments in which later opportunities are only accessible because earlier investments were made (Ronstadt, 1988; Gregersen and Dyer, 2003).
The investment pattern relevant to options reasoning has long been advocated as appropriate for entrepreneurs, and often taught in the entrepreneurship classroom (Vesper, 1990). Professors have often advised their entrepreneurship students to keep investment limited until key uncertainties are resolved; to be pre pared to aggressively pursue the upside; to stage, sequence, and monitor their investments; and to be prepared to abandon an idea when the upside no longer merits investment.
Options reasoning may also fruitfully be used to understand entrepreneurial investment and motivation, two key issues that have concerned both entrepreneurship scholars and other constituencies (such as public policy advocates). Scholars have found, for instance, that import ant decisions in entrepreneurship have not been made on the basis of objective exogenous criteria (such as earning less than the cost of capital). Rather, such decisions are often made on the basis of subjective criteria, such as the attractive ness of continued investment in a small business relative to other opportunities offered the entrepreneur, an implicit judgment of option value (Gimeno et al., 1997). Similarly, Bhide (2000) observed that the most significant decision point for entrepreneurs with respect to risk is not starting up, but rather the more substantial follow on investment required to develop their fledgling businesses. This pattern echoes the sequential ‘‘option followed by exercise’’ pat tern options reasoning seeks to explain. Options reasoning also provides an economic logic for why individuals might invest in new ventures, despite considerable evidence that failure is highly likely (McGrath, 1999). For entrepreneurship scholars, options theory contributes to the range of perspectives on which they may draw to understand entrepreneurial behavior under conditions of uncertainty.
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