Monday, April 23, 2007

Real Options Approach to Innovation Management - Part I

Most strategic decisions require significant investments and therefore it is critical that organizations manage these investments carefully for continued growth and survival of firms. Pursuing innovations are strategic decisions too, especially strategic innovations, which are product or process innovations with unproven business models that have potential to change the rules of the existing business. What separate strategic innovations from regular product or process improvements is the degree of expense of a single experiment, the duration of each experiment, and the ambiguity of results. Strategic innovations require huge investments, over a long period of time, and with uncertain financial rewards. The rewards, however, of successful strategic innovations can be manifold: high growth in revenue and profitability, market dominance, and renewed faith of investors and analysts. A few of the celebrated examples of strategic innovations are: online book retailing by Amazon, direct selling by Dell, introduction of mini-mills by Nucor, low cost no-frills airline service by Rynair.

Strategic investment decisions, like strategic innovation, have three important characteristics. First, the investments made are either partially or fully sunk and cannot be recovered, in other words investments are irreversible. Second, returns on these investments are uncertain or the future benefits from investments are uncertain. Third, organizations have some flexibility with respect to the timing of the investment, or timing of different phases of investments. A good example of strategic innovation, showcasing the above three characteristics, can be of pharmaceutical companies entering into alliances with biotechnology companies and universities. Pharmaceutical companies invest into research projects led by biotechnology companies or universities and these investments are irreversible and the outcomes of most of these projects are uncertain. The development phase of these projects run up to a decade before commercialization can begin. Therefore, most of the alliance contracts have provision of payments over a period of time depending upon the successful progress of the project. If the projects do not show promise of product development and commercialization, the contracts have provision of stopping future investments. This flexibility in investment decisions limits exposure to risks while providing opportunity to invest further based on future assessments. These characteristics of strategic investment decisions make them especially relevant to be analyzed through real options approach.

Real option approach to investment decisions can be discovered in various settings and we discuss two of them here to showcase its applicability to wide range of situations. The two examples which employ real options thinking are hiring of professors and the process of awarding grants by National Science Foundation (NSF). There seems to be a real options thinking in the way academia generates knowledge by hiring professors. Most professors come in with a limited contract and then they need to show promise in the development of new ideas and knowledge. If they are successful the contract options are renewed (i.e. most untenured professors start out with a 3 year contract and then it is extended for another 3 years). Upon successful demonstration of innovative capabilities and output – tenure is given. The other interesting example of real option thinking is the process of awarding grants by NSF. NSF gives out grants, for exploratory projects, then they may choose to continue their investment if initial results are found to be acceptable or else stop further investments if the project does not show promise. This restricts wastage of resources to initial funding and provides opportunity to work with applicants incase the projects become worthwhile.

[Posted by: Sanjeev Jha]

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