UNDERSTANDING EXPLORATION OF NEW CAPABILITIES USING REAL OPTIONS AND DIVERSIFICATION LENSES * Roberto S. Vassolo Krannert Graduate School of Management Purdue University West Lafayette, IN 47907-1310, USA Tel: (765) 746-5444 Fax: (765) 796-3483 Email: roberto_vassolo@mgmt.purdue.edu Jaideep Anand Corporate Strategy and International Business University of Michigan Business School Ann Arbor, MI 48109-1234, USA Tel: (734) 764-2310 Fax: (734) 764-2557 Email: jayanand@umich.edu Timothy B. Folta Krannert Graduate School of Management Purdue University West Lafayette, IN 47907-1310, USA Tel: (765) 494-9252 Fax: (765) 494-9658 Email: foltat@mgmt.purdue.edu * We are grateful to Gautam Ahuja, Will Mitchell, Dan Schendel and Mark Shanley for guidance and helpful suggestions.
ABSTRACT Real options formulations and diversification models represent the two dominant ways of thinking on how firms cope with technological and market uncertainties. Yet, they have developed independent of each other and the literature has missed interesting opportunities for cross-fertilization between them. In this paper we begin with the observation that firms often simultaneously invest in multiple options and develop a model of the interaction among such multiple options within a single firm. We integrate two conceptual lenses from the diversification literature into a real option model. First, we investigate the effects of correlations between the outcomes in different options. Second, we analyze the effects of investments that are fungible across project options. We show that under different conditions multiple options can be sub-additive (due to redundancies in outcomes) or super-additive (due to fungible inputs). We test the implications of our model with data from the biotech industry and find supporting evidence. Our model and results have some interesting implications for the real options lens in general, and for investments in multiple technological and market-entry projects in particular. 2
A growing body of research has developed to enhance our understanding of how firms make investments for accessing new capabilities in high velocity environments. Recently, Kogut (1991), Bowman and Hurry (1992), Kim and Kogut (1996), McGrath (1997), and Folta (1998), among others, suggest the use of real option theory to explain how strategic flexibility influences firms’ pursuit of new capabilities. Strategic flexibility can be characterized as “real options,” that can be initiated through minimal or partial commitments (Sanchez, 1993), while strategic commitment involves full investment in a course of action. The standard result from this view is that uncertainty raises the value of holding the option. The real option literature to date has tended to focus on individual options (i.e., one option at a time). However, strategic flexibility in most firms typically takes the form of a collection of real options. We extend previous work in this area in two important ways. First, we consider that a firm’s investment opportunities should not be evaluated in isolation. When firms have multiple real options that interact with one another, their individual values may be non-additive. The implication is that the timing or likelihood of exercise of a single option may be influenced by the presence of correlated options in the firm’s option portfolio. The nature of such interactions and the conditions under which they may be small or large, as well as negative or positive, may not be trivial. Second, we use advances in the resourced-based view of the firm to isolate the conditions where interactions are non-trivial. As such, we provide an important step in marrying diversification literature with real option theory. This also provides an important departure from prior work in finance that does not consider firms are asymmetrically positioned to initiate and exercise their real options. The remainder of the paper is organized as follows. The next section presents the model and derives propositions relating to the factors that determine the value of firm’s options in the presence of multiple overlapping options. Section three applies the model to the specific context, where firms’ collection of equity-based alliances is characterized as a portfolio of real options on new technological opportunities. In this sense, we follow prior work that has characterized equity-based strategic alliances as real options (Folta, 1998; Folta and Miller, 2002), but extends prior work by focusing on how interactions within the portfolio influence option exercise. Section four introduces a sample and measures to test our hypotheses. Finally, results are discussed and future directions for research are offered. MODEL AND PROPOSITIONS Option theory is useful for valuing the flexibility inherent in managers’ investment decisions. Compared to traditional valuation methods, such as net present value (NPV), it more accurately accounts for the value of flexibility when investment decisions involve some irreversibility and the outcome of an investment is uncertain. Trigeorgis (1987) suggested that the value of a firm’s investment is a function of it traditional NPV and its option value. With few exceptions, a characteristic of previous studies in the real option literature is a focus on isolated options that are independent of other options held in a firm’s portfolio. Hereafter, the focus of this study is on the implications of this assumption using the example of two investments, α and β , by a single firm. The assumption of independence suggests that the value of α and β , are: = + V NPV OV α α α [1] = + V NPV OV , β β β where NPV refers to the passive NPV and OV to the (flexibility) option value. Under the independence assumption, the value of both investments can simply be added together: 3
= = + + + V V NPV OV NPV OV . [2] α + β α α β β However, under certain strategic conditions (e.g., R&D activities), it is common to observe that firms make multiple investments seeking the same output (Madhok, 1997). In other words, they duplicate their commitment to increase the odds of achieving a first-mover advantage. Also, many of the assets required for carrying out these investments are intangible or tacit and, therefore, fungible. In other words, they are public goods within the firm (Penrose, 1959). The consideration of these investments as real options introduces particular complexities that affect the additivity nature of their values and, therefore, violates the independence assumption. Hereafter, these violations are mentioned as the portfolio effect ( PE ), and the equation of overall valuation becomes = = + + + + V V NPV OV NPV OV PE . [3] α + β α α β β αβ The feature that the output of several investments is correlated and competitive generates sub-additivity in their total value. This is because the “duplication” of the investment effort, since succeeding in one investment significantly erodes the strategic value of the remaining ones. The presence of correlation, therefore, diminishes the total value of the portfolio of strategic commitments, that is = ρ < PE f ( ) 0 . [4] αβ αβ In this type of model (competitive options) it is not possible to have a positive effect of uncertainty correlation. Stulz (1982) and Johnson (1987) were the first to examine the valuation implications of correlated options held simultaneously by an investor. In their view, the option holder has the ability to switch to the option with the highest value among the correlated options. Since switching to the highest valued option erodes the value of the remaining options, there is a decreasing marginal return to holding correlated options. Firms rich with intangible or tacit resources have few capacity constraints on these resources and can apply them readily across the organization. More relevant to the research question, however, is that these resources often create greater fungibility – meaning they can be used more readily as public goods within the firm and its investments. Fungibility represents a firm-level capability that enables a firm to benefit from economies of scope, reducing the cost of each investment. If the firm can leverage its assets into the current strategic investments, the total value of the portfolio will present super-additivity . The correlation here is not between the investments but between the firm ( F ) and its investments. This relationship can be expressed as = ρ ρ > PE f ( , ) 0 . [5] αβ α β F F The presence of these two types of phenomena introduces an intriguing trade-off in the valuation of the strategic investments of the type described above. The relative size of the positive and negative valuation effects will determine whether the portfolio effect is sub-additive or super-additive. Figure 1 assesses the expected relationship under different situations. *** Insert Figure 1 about here *** To summarize, the propositions are two fold: Proposition 1: When a firm invests in multiple projects, correlations among the outcomes of the projects lead to a sub-additive value of the combined options. Proposition 2: When a firm invests in multiple projects, fungibility of shared resources with the projects leads to a super-additive value of the combined options. In summary, uncertainty per-se is not enough to determine the potential value created in the portfolio of options; it is also necessary to include the level of correlation among options and the degree of fungibility between the option and the focal firm. A failure to consider either 4
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