WHAT IS NOT A REAL OPTION: CONSIDERING BOUNDARIES FOR THE APPLICATION OF REAL OPTIONS TO BUSINESS STRATEGY
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姝 Academy of Management Review
2004, Vol. 29, No. 1, 74–85.
WHAT IS NOT A REAL OPTION: CONSIDERING
BOUNDARIES FOR THE APPLICATION OF REAL
OPTIONS TO BUSINESS STRATEGY
RON ADNER
INSEAD
DANIEL A. LEVINTHAL
The Wharton School, University of Pennsylvania
We argue that the greater the extent to which choice sets evolve as a consequence of
firms’ exploration activities, the less structured the firms’ abandonment decisions
become and, in turn, the less distinguishable a real option is from more generic
notions of path dependence—a sequential stream of investment in and of itself does
not constitute a real option. While organizational adaptations can extend the appli-
cability of real options, they impose tradeoffs that may lead to the underutilization of
discoveries made in the course of exploration.
The concept of real options has created con- behavioral theory of the firm (Cyert & March,
siderable excitement in the management litera- 1963) or evolutionary economics (Dosi, 1982; Nel-
ture in recent years (Kogut & Kulatilaka, 2001; son & Winter, 1982; Penrose, 1959) who have long
McGrath, 1997). The appeal of real options is been sensitive to path dependence. What is dis-
quite natural. Firms face uncertain futures, and tinctive about the use of real options as both an
the investment opportunities they face are, to an analytic tool (Dixit & Pindyck, 1994; Trigeorgis,
important degree, a function of their prior in- 1997) and a strategic heuristic (Luehrman, 1998;
vestment commitments. Thus, at a surface level, McGrath, 1997) is that the real options logic of-
the real options framework appears to precisely fers the prospect of assigning actual values (car-
fit firms’ strategic challenges by linking current dinal in the former case or ordinal in the latter
actions to uncertain futures. In addition, relative case) to stage-setting investments.
to other justifications for exploration, such as However, while the logic can always be used
rationales for slack search (March & Simon, to generate values and orderings, the validity of
1958), real options provide a rhetoric that com- these results depends on some key assumptions.
fortably fits the standard language of corporate The technical violations of strict real options
finance. Less obvious than the benefits offered assumptions and the methods for their accom-
by the real options framework but equally im- modation are, by now, well known (e.g., Cope-
portant are its inherent limitations in guiding land & Antikarnov, 2001). More subtle, however,
organizations’ decision making under uncertainty. and more limiting to the validity of real options
The underlying logic of the real options frame- as a tool in organizational decision making are
work is based on the realization that future in- violations that stem from organizational pro-
vestment opportunities are contingent on prior cesses in the face of different modes of uncer-
investment commitments. Thus, in contrast to tainty resolution.
net present value analysis, real options analysis The real options framework is intended to ex-
accounts for the sequential nature of choice pro- ploit the flexibility inherent in sequential in-
cesses. Such an observation is not alien to re- vestments. We argue that this flexibility stems
searchers working within the tradition of the from the possibility of abandoning investment
initiatives, rather than from the simple substitu-
tion of a stream of smaller payments for a larger
We thank Bert Cannella, Javier Gimeno, Bruce Kogut, lump sum payment. This implies that the effec-
Christoph Loch, Anand Swaminathan, Peter Zemsky, partic-
ipants at the 2001 Strategy Research Forum and the Jones
tive management of real options requires a high
Center Workshop at Wharton, and our three reviewers for degree of rigidity in the specification of the
their valuable comments on prior drafts of this manuscript. agenda of the initiatives and the criteria for
742004 Adner and Levinthal 75
their success. We consider the implications, pos- approaches and more generic path-dependent
itive and negative, of such constraints and com- processes, and we suggest how they might be
pare them to more generic path-dependent ap- distinguished empirically.
proaches to managing investment under
uncertainty.
REAL OPTIONS
In the next section we briefly lay out the for-
mal structure of real options. We then examine Real options investments are characterized by
some of the critical assumptions that underlie sequential, irreversible investments made un-
the application of options to firms’ investment der conditions of uncertainty (Dixit & Pindyck,
decisions. When uncertainty resolution emerges 1994). The framework suggests that purchasing
as an outcome of firm action, the sharp temporal a real option on a strategically important oppor-
demarcation made in the options literature be- tunity allows firms to postpone commitment un-
tween “Stage 1” and “Stage 2” investments is til a substantial portion of the uncertainty about
called into question. In such settings, beyond the opportunity has been resolved. After making
learning about a specific initiative, the flexibil- an initial investment, management is then to
ity associated with later investment decisions turn its attention to other matters and wait for a
often stems from the possibility of discovering a signal as to whether or not it is appropriate to
wide variety of related opportunities, even in the harvest or cultivate the initial investment.
face of unfavorable initial outcomes. We show Consider the events that transpire prior to the
that the greater the extent to which initiatives exercise of financial options, on which the real
are open ended, the more problematic the appli- options model is based (Figure 1). First, an in-
cation of the real options framework is. Flexibil- vestor purchases an option (Stage 1). Then, dur-
ity in search can undermine the flexibility asso- ing the course of the holding period, the value of
ciated with abandonment. Abandonment is the option changes in response to external
essential for limiting downside risk, a key virtue events. Throughout the holding period, the fi-
attributed to real option investments. We con- nancial markets provide a clear signal as to the
sider how organizational processes, such as the current value of the option. Finally, events tran-
allocation of decision rights that limit the range spire so that the investor chooses to exercise the
of possible action and the specification of well- option, or, alternatively, the expiration date
defined temporal boundaries, can extend the specified in the option contract is reached and
applicability of real options reasoning but force the option expires (Stage 2). Investments with
strategic tradeoffs of their own. We conclude by this structure are optionlike in that Stage 2 in-
considering differences between real options vestments are not a necessary consequence of
FIGURE 1
The Structure of Real Options76 Academy of Management Review January
having made an initial Stage 1 investment but, FIGURE 2a
rather, can be conditioned on the realization of Boundaries of Applicability for Net Present
interim information. Value and Real Options
Note two critical features of this process: (1)
the value of the option (and the underlying as-
set) is exogenous to the investor’s activity—the
investor cannot take steps to make the intrinsic
characteristics of the asset more attractive; (2)
the market signal of option value is readily ob-
servable and is independent of the investor’s
behavior. If these properties carry over to an
investment of a nonfinancial sort (such as in
plant and equipment, or in technology licenses),
then the logic of options can directly carry over.
The greater the extent to which these properties
are violated, the more problematic the applica- FIGURE 2b
tion of an options framework is. Boundaries of Applicability for Real Options
The “wait and see” setting of financial options and Path-Dependent Opportunities
represents the extreme case of investment envi-
ronments, but one for which the methodology is
ideally suited. Because much attention in the
management literature is focused on the ways
in which the firm can affect outcomes and vari-
ances (e.g., McGrath, 1997), it is important to
examine what happens to the applicability of
options logic as we move away from a world of
wait and see to a world of “act and see,” in
which uncertainty resolution is endogenous to
firm activity.
BOUNDARIES OF REAL OPTIONS
the application of real options becomes more
The boundaries of the logic of real options are challenging analytically and, focal to this pa-
often considered in relation to the breakdown of per, organizationally.
net present value analysis: to the degree that When target markets and technical agendas
investment choices have the property of high are flexible (see Figure 2b), the discrete invest-
uncertainty and irreversibility, a real options ment logic of real options is eroded, and activities
valuation provides a better characterization of may be characterized more appropriately as more
the investment’s true value than does a net generic path-dependent processes that fall under
present value calculation because of the latter’s such labels as probe and learn (Lynn, Morone, &
inability to account for the value of delaying Paulson, 1996), incremental search (March & Si-
commitments (see Figure 2a). mon, 1958; Nelson & Winter, 1982), or innovation
Less examined but no less important are the journeys (Van de Ven, Pollery, Garud, & Venkat-
boundaries along which real options logic is araman, 1999). Alternatively, if the scope of the
itself strained. As we move from a world of real option investment is fixed a priori—that is, if the
options on tradable assets, in which the firm has opportunities on which one is taking an option can
no hand in resolving uncertainty and the set of be clearly specified at the inception of the op-
possible actions in response to this uncertainty tion—then the decision to abandon an initiative
resolution can be specified at the time of the can be clearly articulated and the flexibility asso-
initial investment, to real options on strategic ciated with an option investment can be readily
opportunities whose outcomes are intimately maintained.
linked to firm action, the clean demarcations In the context of financial options, one can
between investment stages begin to blur and clearly state a priori when a given option will be2004 Adner and Levinthal 77
“in the money” and worth exercising. However, lenges to abandoning options that can deter
in the case of real options on strategic opportu- firms from exercising the very flexibility that
nities in which new possibilities are identified made the real options approach attractive in the
as a consequence of a firm’s actions, such a first place.
prior specification may not be possible or even The degree to which an initiative is circum-
desirable. Experiments, even unsuccessful ones, scribed is itself dependent on organizational
not only provide information about intended in- choices concerning project scope. If an initiative
vestment paths but also provide information is highly circumscribed in terms of what appro-
about other possibilities—possibilities that may priate target markets are and what temporal
not even have been envisioned at the time of the and technical boundaries must be respected,
initial investments. Outcomes that are negative then the degree of flexibility in the potential
vis-à-vis the initial proposed initiative may still directions of the initiative is limited, but at a
suggest or engender other possible actions. For price. Imposing rigid criteria for abandonment
instance, the failure of a technology develop- may result in the underutilization of discoveries
ment effort to reach a given technical hurdle in made in the context of initiatives that are fail-
a specified time horizon does not preclude addi- ures with respect to their initial agenda but that
tional efforts or different approaches; similarly, introduce promising possibilities not previously
if a new product fails to win acceptance in a imagined.
given target market, it may still be successful in This highlights the need for proponents of real
other possible target markets.1 options logic to consider a more nuanced organ-
At a basic logical level, the boundless set of izational perspective that incorporates the dif-
possibilities associated with a strategic invest- ferent views that exist within an organization.
ment initiative presents a problem analogous to The firm cannot be regarded as a unitary actor.
that posed by Popper (1959) in the context of Managers charged with pursuing an opportu-
hypothesis testing. Popper’s proposition is that a nity and executives charged with evaluating a
hypothesis is never proved; rather, it is not dis- portfolio of opportunities will differ in their be-
proved in any given test. Conversely, in a given liefs as to when an option ceases to be attrac-
attempt to realize an opportunity, we can only tive. Such differences are a function of their in-
prove that an initiative can be successful in a centives and opportunity structures, and they
particular setting; we cannot use negative out- serve to compound the psychological biases re-
comes to preclude the possibility that it will be garding sunk costs and escalating commitment
successful in other target markets or with fur- that can act to deter strategic redirection.
ther technical refinements. These considerations are largely overlooked
This “impossibility of proving failure” is an in the theoretical (e.g., Dixit & Pindyck, 1994;
inherent feature of firm initiatives under uncer- Trigeorgis, 1997) and managerial (e.g., Amram &
tainty and poses a fundamental challenge to the Kulatilaka, 1998; Luehrman, 1998) work on real
applicability of the real options framework. Fur- options in strategy, in which researchers tend to
ther, because actors at different levels of an treat the firm as a monolithic actor. They are
organization have different perspectives on the also largely overlooked in empirical work in
attractiveness of a given opportunity, they will which scholars tend to look at investment deci-
disagree as to the proper framing of termination sions that are not integrated within the firm’s
decisions. Thus, the open-ended nature of the organizational activities (e.g., investments in ac-
search for success raises organizational chal- quisitions and joint ventures). The importance of
organizational factors in determining the appli-
cability of options logic increases as real op-
1
Knight’s (1921) distinction between risk and uncertainty,
tions theory is extended from the evaluation of
which lies at the heart of notions of entrepreneurship (Kirz- investments in physical assets, for which the
ner, 1997), is closely related to the distinction we are making resolution of uncertainty is exogenous to firm
here. Real options are well suited to incorporate risk, an action and the scope of possible firm response to
uncertain realization from a well-specified probability dis-
this uncertainty is relatively constrained (e.g.,
tribution. In contrast, the inherent unknowability that char-
acterizes Knightian uncertainty poses a significant chal- making use of a plant in a foreign country to
lenge to characterizing means and variances of key option potentially take advantage of swings in relative
analysis parameters. wages), to the evaluation of investments in stra-78 Academy of Management Review January
tegic opportunities, for which the resolution of to the asymmetry of proving and disproving a
uncertainty is largely endogenous to firm action, hypothesis in empirical research. Popper (1959)
and the scope for possible modifications in the argues that it is logically impossible to prove
initial initiative is vast. that a hypothesis is true; we can only show that
it is not false, up to a specified probability level.
In contrast, a managerial initiative can only
CHALLENGE OF ABANDONMENT be shown to be successful in that some market
or technical criteria are met; an initiative,
Ambiguity of Stages in Real Options such as the development of a new technology,
An investment’s flexibility is revealed in the cannot conclusively be shown to be incapable
project abandonment decision. Options are flex- of succeeding.
ible not because they substitute a stream of Consider what we learn when a new technol-
smaller payment for a larger lump sum payment ogy is “tried.” We may learn that, in a given time
but because the payment stream can be aban- period and with a given level of investment,
doned in light of negative outcomes. The less researchers were not able to meet certain tech-
well-defined the abandonment decision, the nical milestones. Similarly, we may learn that a
less valid the perception of flexibility and the particular market context was not receptive to
less appropriate the nominal application of real the technology in its current form. However,
options logic. In the absence of proofs of failure these results are not impossibility theorems.
and strict, structured abandonment deadlines, They do not demonstrate that, with more time
firms face a difficult organizational challenge to and more resources, these technical milestones
exploit the flexibility offered by the sequential could not be met. Nor do such results demon-
nature of optionlike investments. As noted ear- strate that other market settings might not re-
lier, there is an important asymmetry between spond positively to the technology in its current
positive and negative signals that is analogous form or that enhancements to the technology or
FIGURE 3
Malleability of Technical and Market Focus to Firm Activity2004 Adner and Levinthal 79
a reduction in cost will not lead to success in the efforts to enhance the value of the initial initia-
current market setting. tive, time to expiration becomes an endogenous
Thus, the significance of any specific market choice. From a valuation perspective, longer op-
response is constrained in market space to a tion durations lead to higher option values and
specific segment, and constrained in time to a increase the risk of overvaluation. From an or-
specific development state. Figure 3 maps the ganizational perspective, flexibility in duration
potential malleability of a project to interim leads to negotiations over termination criteria,
feedback, in terms of the opportunity to affect which increase the risk that firm investments
the technical agenda of the project and the mar- will be governed by influence processes and
kets in which the project will be evaluated, after idiosyncratic justification, rather than by a co-
an option has been purchased. Again, what is herent portfolio strategy.
critical is that these new directions need not A fundamental difficulty raised by broad flex-
have been identified at the time of the inception ibility in response to interim signals is that
of the initial option investment. They were not while real options valuation techniques are
part of the justification for the initiation of the well tailored to offering go/no-go guidance on
option, but they became critical for the continu- project initiations, they are relatively equivo-
ation of the investment effort. The greater the cal regarding what to do after an initial “go”
potential for ex post discovery of possible new recommendation.
directions for the original initiative, the greater Clearly, the real options valuation framework
the difficulty in deciding when to abandon the can be reapplied to the evaluation of a given
opportunity. initiative at a future time, when some uncer-
The problem of abandonment is compounded tainty is resolved (e.g., compound real options).
by the fact that most options on strategic oppor- Structured reevaluation, however, becomes in-
tunities do not have an explicit, exogenous ex- creasingly difficult as uncertainty gets resolved
piration date. How long the firm can keep the in increasingly incremental steps that are a
option open, whether in persisting in develop- function of firm activity.3 Incremental discovery
ment efforts in nominally promising pharma- leads to difficulty in drawing precise distinc-
ceuticals or in market creation efforts for emerg- tions among a series of independent options, a
ing technologies, is often difficult to specify ex single compound option, and more generic path-
ante.2 When there is no explicit time limit on dependent search activities. The division of time
into discrete decision points is typically artifi-
cial. Does the pharmaceutical firm that started a
2
The fact that a real option may lack an explicit expira- research project on Monday make a conscious
tion date need not imply that the option persists indefinitely. choice on Tuesday to continue with the project?
In particular, competitive forces may result in the effective
Ultimately, the structure of the discovery activity
expiration of an option. However, even in cases where the
competitive environment drives option expiration (e.g.,
McGrath, 1997; Trigeorgis, 1997), the timing of expiration
cannot be specified ex ante. In addition, when the opportu- are impossible to assess with accuracy for many strategi-
nity can be exploited in multiple markets, a rival’s entry into cally important opportunities. Furthermore, for analytic trac-
one market does not necessarily lead to the expiration of the tability, these models necessarily ignore many important
option in other markets, so even in these settings ex post factors, such as the complexity and duration of competitive
endogeneity is present. Strategic interactions also present responses, identified in recent work on competitive dynam-
another dimension of endogeneity to the problem of evalu- ics (e.g., Ferrier, Smith, & Grimm, 1999).
3
ating options that leads to an additional set of challenges. Trigeorgis (1997), for example, notes that a rich set of
As opposed to “standard” real options settings, where ex- compound options poses analytic and computational chal-
pected payoffs are exogenously determined, “competitive” lenges to the actual evaluation of real options. Consider that
real options analysis requires an accounting for the ways in of the six factors that determine option value (value of un-
which the firm’s actions affect rivals’ responses. The benefits derlying risky asset, exercise price, time to expiration, vol-
of delay and exploration that are derived from sequential atility of the value of the underlying asset, foregone cash
investments must be weighted against the potential benefits flows, discount rate), the first four are especially difficult to
offered by commitment and preemption (Ghemawat, 1991). specify with confidence for the case of strategic opportu-
Although still in infancy, theoretical attempts to marry nities. See Bowman and Moskowitz (2001) for a reexami-
real options with game theory (e.g., Grenadier, 2001; Kulati- nation of the effectiveness of the application of option
laka & Perotti, 1998) suggest that analytic results can be analysis at Merck, and Lander and Pinches (1998) for a
obtained. These results, however, are very sensitive to un- discussion of the modeling challenges to making real
derlying assumptions about parameter values — values that options analysis “practical.”80 Academy of Management Review January
FIGURE 4
‘‘Option Traps’’ That Hinder the Abandonment of Opportunities
and the scope of the authority of the project team positive in the sense of increasing the likelihood
define these distinctions and thereby draw the of success, clearly hampers their ability to aban-
boundary of applicability for options logic. don initiatives when the learning outcomes are
negative (Garud & Van de Ven, 1992). For this
reason, the way in which the selection and re-
Organizational Factors
source allocation mechanisms are manifested
Because holding options open entails both or- throughout the organizational hierarchy is fun-
ganizational and financial maintenance costs damental to the challenge of exploiting the flex-
(Garud & Nayyar, 1994), managing abandon- ibility inherent in real options.
ment has direct implications for firms’ success These organizational drivers are compounded
in managing real options. The “option traps” by psychological deterrents to abandonment.
presented in Figure 4 highlight the forces that Given the difficulty firms have in incorporating
undermine timely project abandonment in dif- the logic of sunk costs (Russo & Schoemaker,
ferent uncertainty resolution regimes. The chal- 1989), their tendency toward escalating commit-
lenge of project abandonment is complicated by ments (Staw, 1981) and overconfidence (Camerer
the nature of organizational resource allocation & Lovallo, 1999), the political impetus not to
(Bower, 1970) and the different perspectives and show failure (McGrath, 1999; Sitkin, 1992), and
incentives of stakeholders at different levels in the natural desire to succeed, the challenge of
the organization. abandonment— giving up on an opportunity
This contrast is most succinctly characterized that has a chance for success—is a large one.4
as the difference between “holding the option” This, essentially, is the dark side of managing
and “being the option.” For executives at high projects with product champions (Maidique,
levels in the organization within whose purview 1980) and skunk works (Kanter, 1988), where the
lie a number of distinct initiatives, an individual systems and support mechanisms put in place
initiative may have an optionlike quality in that to create an impetus for starting innovations
the abandonment of the particular project may act directly against their objective reassess-
not entail significant consequences. However, ment and termination. Indeed, the challenges
the managers focused on that particular project associated with abandoning projects can be
may see greater potential in its pursuit, both
because they are not aware of the larger set of
alternative investments available to the firm
4
and because of the career consequences associ- Investment in joint ventures creates an organizational
boundary that should make it easier to monitor, separate,
ated with its abandonment. These consider-
and abandon an option investment (e.g., Kogut, 1991). Even
ations, in turn, act to increase these managers’ in this ideal setting, however, the evidence of firms’ effec-
dedication to achieving success with respect to tiveness in managing exit and minimizing downside risk is
a particular initiative. This dedication, while mixed (Reuer & Leiblein, 2000).2004 Adner and Levinthal 81
greater than those associated with initiating exploiting the lessons learned from unsuc-
them (Brunsson, 1982; Garud & Van de Ven, cessful or only partially successful initiatives
1992).5 (e.g., Sitkin, 1992).
Real options logic makes a fundamental con- Our aim is not to dispute the importance of
tribution to the structuring of risk. When de- continued search activity. Indeed, we note that it
ployed in real organizations, however, this logic is at the heart of well-admired processes such
must be complemented with appropriate con- as skunk works, probe and learn, and so forth.
trols (Block & MacMillan, 1993; McGrath & Mac- Rather, our aim is to highlight the difficulty such
Millan, 2000). These controls need to reflect the processes raise for conceptualizing and manag-
evaluation traps created by flexible sets of pos- ing real options. Specifically, the more freedom
sible responses to interim signals and the way afforded to an option manager (i.e., the more
in which initiatives may be usefully redirected.
active his or her role is in resolving uncertainty),
Given the vast set of possible paths that an
the more likely the option is to take on a life of
investment effort may take, the “flexibility” of
its own, independent of the requirement speci-
abandonment that is central to the evaluation of
fied by the logic governing the firm’s portfolio of
real options calls for an off-setting rigidity in
specifying the set of allowable courses of action options. When the selection and evaluation cri-
at the time of the initial investment. teria differ across levels of the organization,
The degree of flexibility in response to interim which is increasingly the case as managers
signals is likely to vary with the unit of analysis have more control and are more vested in their
being considered and where the boundaries of projects, freedom of action at the level of the
the decision-making entity lie. At the level of the project is not consonant with the consistent ap-
firm, it is difficult to presume that the firm can proach to portfolio management at the level of
commit itself to a narrow range of response to the firm. Making investment decisions under the
information that may emerge for an initial “op- assumption of clear-cut abandonment points,
tion” investment. Indeed, such a commitment when organizational conditions are such that
may not be sequentially rational (Selten, 1975). abandonment is unlikely to occur or unlikely to
However, at lower levels of the organization, be timely, is likely to render an initial real op-
subunits may be constrained in the range of tions valuation to be quite misleading. Since
initiatives that they pursue (Galunic & Eisen- real options framework is a theory of allocation
hardt, 1996), whether limited in the range of tar- and control, this raises a question as to the mer-
get markets that can be addressed or the set of its of its application under such conditions.
technical approaches that can be explored. It is In sum, firms invest in the active develop-
at these lower levels that real options may re- ment of technology, and not in passive bets as
side. Disciplined project management can foster to winners and losers. Given the impossibility
organizational environments that facilitate real of proving failure and the absence of formal
options strategies. Projects can be artificially expiration dates for an option investment, a
constrained through milestones, strict dead-
firm’s internal selection regime dictates its
lines, and regimented market focus to over-
ability to manage options. A well-managed
come the challenge of the impossibility of
real options strategy must necessarily guard
proving that all possible avenues of opportu-
against the natural momentum that builds up
nity are unpromising and, in turn, that the
abandonment of the initiative is appropriate. around hopeful activity.
Such practices, however, run the risk of under- Another way of characterizing our argument
about the importance of abandonment is to rec-
ognize that, from the perspective of the option
5
In our own conversations with managers in high-
initiative, the key is to avoid false negatives
technology firms known for the depth and breadth of their (type II errors), in which valuable opportunities
innovative capacity, they consistently spoke of the chal- are foregone. However, from the perspective of
lenge of shutting down projects. At one firm, “death row” managing the option portfolio, the key is not to
was used to describe a set of projects that the organization
had formally recognized as in need of termination but
forget about avoiding false positives (type I er-
that, for various reasons, kept getting stays of execution rors), which tie up resources that are better used
and surviving. elsewhere.82 Academy of Management Review January
ALTERNATIVE SEARCH PROCESSES A natural question to ask is when might such
less specified discovery processes be preferred
While the notion of real options as a way to
to the more explicit decision calculus of real
frame decision makers’ choices under uncer-
options? One complexity in considering this
tainty is relatively new to the management lit-
contrast is what one is to take as a character-
erature, the problem of organizations confront-
ization of a real options process. In our view, as
ing uncharted worlds is well established. A
a behavioral matter, the use of real options may
long-standing strand of the literature has high-
not vary so greatly from the behavior that stems
lighted the role and importance of search pro- from slack search. Indeed, one of the merits of
cesses. Search may be local and problem the real options framework is that it provides a
driven, but it also may comprise more opportu- procedurally rational justification for processes
nistic, and less local, exploration. This latter of slack search. In that sense, real options are a
notion of slack search (March & Simon, 1958) has powerful tool for the “technology of foolishness”
been picked up and interpreted in terms of ideas (March, 1988).6
of autonomous innovation (Burgelman, 1983) and Alternatively, we can make the reference
skunk works (Kanter, 1988)—ideas that have not point decision processes that more closely ad-
only been offered to capture existing behavior here to the precepts of real options decision
but also held out as normative suggestions for making. One virtue of the real options approach
how organizations may cope with uncertain is that since the initial stage-setting invest-
futures. ments are more explicit and, in turn, more visi-
These images of search efforts, relatively ble to higher-level actors within the organiza-
loosely controlled but modest in financial com- tion, the organization will have a better sense of
mitments, lack the procedural rationality of real its portfolio of initiatives. An organization may
options decision making. No explicit decision is feel that it wants some initial exploration in a
made as to what constitutes the appropriate variety of technologies or markets and would
amount of slack search at a given time; rather, have a better sense of its overall exposure under
the organization is viewed as having, or is en- the real options approach than under a system
couraged to develop, a heuristic or norm regard- of slack search
ing the appropriate level of resources to be al- The tradeoff to this benefit is, as we have
located to such efforts. argued above, that to make exploration initia-
Another clear distinction between this broad tives conform to the structure of a real option,
category of path-dependent principles and the the boundaries of these initiatives should be
real options framework is that specific initia- tightly specified ex ante. If an initiative to ex-
tives are not endorsed or necessarily examined plore the value of a particular technology or
by higher-level actors within the organization. particular market application wanders in re-
Slack is introduced into the resource allocation sponse to feedback from initial efforts or shifts
system such that modest initiatives can occur in markets and technologies, the discipline re-
without direct corporate oversight. Of course, if quired by real options is lost. However, such
such initiatives identify opportunities that ap- discovery processes are often heralded as valu-
pear to be worth pursuing and worth commer- able means by which innovation occurs (Adner
cial development, it is likely that greater re- & Levinthal, 2002; Day, 1990; Lynn et al., 1996).
source commitments will be necessary, and, as While these more generic path-dependent pro-
a result, higher-level organizational actors will cesses of exploration do not address the aban-
need to be convinced of the initiative’s merits. donment challenges we have highlighted, un-
This commitment of more substantial resources like real option approaches, they do not make
and the organizational approval of such com- implicit assumptions about termination that are
mitments is akin to the “striking” of a option. critical to their validity.
Again, though, it is important to note that the
initial initiative was never chosen by the or-
ganization; rather, the organization chose to al- 6
By “technology of foolishness,” March (1988) refers to
locate sufficient slack such that such initiatives mechanisms that legitimate the allocation of resources for
might emerge. search and discovery processes.2004 Adner and Levinthal 83
Clearly, to the extent that the potential paths 1. stricter action mandates for business units
a stage-setting investment may take are inher- and project teams;
2. formalized milestones and go/no-go proce-
ently limited, the real options framework is more dures;
readily applied. In addition, in such settings the 3. incentive systems, organizational cultures,
potential downside of its application in terms of and allocation mechanisms that are more
foregone opportunities that are discovered ex tolerant of failure; and
post is sharply diminished. Such a perspective 4. review procedures that are more sensitive
to the presence of different incentives at
suggests that real options may be better suited different levels of the organization.
to well-specified investments, such as overseas
production facilities and innovation licenses, More broadly, in terms of empirical research
than to less structured opportunities, such as the on the use of real options in organizations, we
development of new product technologies in the would hope to see demonstrations of patterns of
face of a wide set of possible technical solutions systematic and structured decision making that
and market applications. demonstrate divergence from both net present
value analysis and unstructured path depen-
dence, as well as data that consider project ter-
CONCLUSIONS
mination, not just the initiation and pacing of
In some sense, our argument simply places investment.
the notion of real options in the broader context Firms face complex and highly uncertain in-
of sequential decision making. Actions are vestment environments. The real options frame-
taken, beliefs are revised, and subsequent work usefully highlights the links between cur-
choices are made. One is then left with the em- rent actions and the set of future possibilities.
pirical question of how to distinguish real op- However, to the extent that exit criteria are not
tions from the broader class of sequential deci- well posed in a world of action and open-ended
sion-making processes. Demonstrating that search, this framing can be overly seductive.
firms’ investment paths involve a sequential While real options logic may justify investments
process of scaling up is, in itself, insufficient. that would be rejected under the calculus of net
There are a wide variety of processes that would present value, these “justified” investments may
generate such a pattern, such as adjust- well destroy value when implicit assumptions
ment costs and time compression diseconomies about abandonment flexibility are wrong. In set-
(Dierickx & Cool, 1989), and incremental learn- tings where the range of responses to the reso-
ing (Cyert & March, 1963), that are not directly lution of technical and market uncertainty is
linked to ideas of real options. largely unconstrained, the utility of applying op-
As a result, we must move beyond measures tions logic is unclear. For such strategic invest-
of the performance characteristics of firms’ ments, in contrast to financial options, exit cri-
project portfolios, whether average project teria are not self-evident. Rather, in such
losses at real options firms are smaller (because circumstances it may be more useful to identify
they have limited downside risk) or average the possible sequence of experiments that will
project gains relative to losses are larger at real test the most promising market and technical
options firms (because losses are limited but paths available to the firm.
upside risk is unbounded). Rather, we should To be clear, our purpose is not to question the
examine the way in which the portfolio is ad- internal logic of real options. We do feel, how-
justed over time and, in particular, firms’ ap- ever, that grouping all path-dependent activity
proaches to abandonment. under the real options label overextends real
Thus, in terms of observed behavior, we would options logic as tool, framework, and even as
expect real options firms, relative to their tradi- metaphor, and undermines its effective applica-
tional counterparts, to tion. We believe that understanding a theory’s
boundaries serves to make it more powerful and
1. abandon projects earlier and more precise. We argue that the cause of options
2. have higher project abandonment rates.
thinking is best served in considering the
Similarly, in terms of organizational pro- boundaries of the domain of applicability of this
cesses, we would expect real options firms to logic for business strategy, and in defining its
have place within the broader set of tools that are84 Academy of Management Review January
available to address decision making under un- Continual structuring by intertermporal technology
certainty. In this regard, we suggest that the transfer. Strategic Management Journal, 15: 365–385.
answer to the question “What is (and is not) a Garud, R., & Van de Ven, A. H. 1992. An empirical evaluation
real option?” has as much to do with the or- of the internal corporate venturing process. Strategic
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Ron Adner is an associate professor of strategy and management at INSEAD. He
received his Ph.D. from The Wharton School, University of Pennsylvania. His research
examines the impact of the demand environment on technology evolution and com-
petition, as well as the organizational challenges that confront firms competing in
heterogeneous demand environments.
Daniel A. Levinthal is the Julian Aresty Professor of Management and Economics at
The Wharton School, University of Pennsylvania. He received his Ph.D. from the
Graduate School of Business, Stanford University. His research interests focus on
issues of organizational adaptation and industry evolution, particularly in the context
of technological change.You can also read
