Real Options and Innovation: Introduction

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.


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).


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.


Indeed, many projects such as: joint ventures (Kogut, 1991), R&D (McGrath & Nerkar, 2004) or the development of firm- level 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).


Employees concerns for such risks are high if they have been required to invest in project-specific (or more generally firm-specific) 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).


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.


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.

Real Options and Innovation: Introduction

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