Real options theory in strategic management


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Strategic Management Journal
Strat. Mgmt. J., 38: 42–63 (2017) Published online EarlyView 15 November 2016 in Wiley Online Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2593
Received 30 April 2014; Final revision received 14 March 2016
REAL OPTIONS THEORY IN STRATEGIC MANAGEMENT
LENOS TRIGEORGIS1 and JEFFREY J. REUER2* 1 Department of Accounting and Finance, School of Management and Business, King’s College London, University of Cyprus, Nicosia, Cyprus 2 Leeds School of Business, University of Colorado, Boulder, Colorado, U.S.A.

Research summary: This article provides a review of real options theory (ROT) in strategic management research. We review the fundamentals of ROT and provide a taxonomy of this research. By synthesizing and critiquing research on real options, we identify a number of important challenges as well as opportunities for ROT if it is to enhance its impact on strategic management and potentially develop into a theoretical pillar in the field. We examine how ROT can inform the key tensions that managers face between commitment versus flexibility as well as between competition versus cooperation, and we show how it can uniquely address the fundamental issues in strategy. We conclude with suggestions on future research directions that could enhance and unify the thus-far distinct main approaches to real options research.
Managerial summary: Real options theory (ROT) applies the heuristics and valuation models originally designed for financial securities to the domain of corporate investment decisions (e.g., joint ventures [JVs], foreign direct investment, research and development [R&D], etc.) and strategic decision making under uncertainty. This article provides a synthesis of this body of research in strategic management and related disciplines. We suggest how ROT can address fundamental issues of strategy, including the dilemmas managers face between commitment versus flexibility as well as between competition versus cooperation. We discuss how three distinct approaches to real options analysis can complement each other, and we identify some of the main challenges and opportunities for ROT to become a theoretical pillar in strategy. Copyright © 2016 John Wiley & Sons, Ltd.

INTRODUCTION
This article provides a critical review and synthesis of real options theory (ROT) in strategic management research. ROT has produced important insights and empirical evidence on various topics in different streams of research in strategic management, such as market entry timing, modes of entry, and organizational forms (e.g., joint ventures
Keywords: real options; fundamental issues in strategy; strategic decision making; uncertainty; theory of the firm *Correspondence to: Jeffrey J. Reuer, Leeds School of Business, University of Colorado, Boulder, CO, U.S.A. E-mail: [email protected]

[JVs], acquisitions, etc.), foreign direct investment and MNC performance, cooperation versus competition trade-offs and so on, yet challenges remain in our understanding and application of ROT in the domain of strategic management. Taking stock of this literature and providing a synthesis is also important in light of three distinct approaches to real options research that have emerged over the years, each having its own strengths and limitations, but not as yet building on each other. For readers new to this theory, we cover the fundamentals of ROT by clarifying when real options exist and by highlighting some of their distinctive features and drivers. We also offer a taxonomy of research on real options, highlighting key areas in which

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Real Options Theory in Strategic Management 43

significant progress has been made as well as identifying areas in which advances have been limited and deserve further attention. Our categorization and synthesis of the relevant strategic management literature on real options also aims to present unifying interpretations and critical assessments to help identify some of the primary challenges and promising future opportunities for this literature.
Another important objective of our review is to consider the potential for extending ROT to engage with and address the fundamental issues of strategy that have occupied the field’s attention since its inception. In particular, we submit that ROT can offer new insights into the drivers of firm heterogeneity and competitive advantage (e.g., Peteraf, 1993), organizational form and associated build-borrow-buy decisions (e.g., Capron and Mitchell, 2012), cooperation versus competition trade-offs arising in many market and technology contexts (e.g., Smit and Trigeorgis, 2004), and the role of headquarters in multinational firms (e.g., Rumelt, Schendel, and Teece, 1994). In our review, we articulate ROT’s connections to these fundamental strategy issues by noting two trade-offs that often underpin strategic choices: between commitment and flexibility (e.g., Ghemawat, 1991; Smit and Trigeorgis, 2004) and between competition and cooperation (e.g., Teece, 1992). The commitment-flexibility trade-off reflects the importance of “staging” choices as one of the core elements of strategy (Hambrick and Fredrickson, 2001) as well as the classic advantages of a first mover such as preemption. The competition versus cooperation trade-off lies at the heart of competitive strategies and firms’ interactions with others (e.g., Chen and Miller, 2015), and relates to strategic choices concerning corporate boundaries as well as technology development and commercialization activities (e.g., Gans and Stern, 2003). Uncertainty, a key driver in ROT, critically informs these tensions, and because it also features centrally in other theories in strategic management, often in different ways, it provides a basis for comparisons as well as potential integration.
We further suggest that novel research opportunities exist to realize ROT’s potential through better integration of the three main approaches to conducting real options research, namely, real options reasoning, real options modeling, and behavioral perspectives on real options. These three approaches have largely developed independently and are sometimes presented as rival versions

of ROT in strategic management. We identify a number of opportunities that the field might pursue by marshalling them in combination, and we provide some guidance on what such a research agenda might entail. We also bring up a number of frontier areas for research that hold promise and pathways for strategic management research.
FUNDAMENTALS OF REAL OPTIONS THEORY
We begin by defining real options, which amounts to describing what makes them “options,” and then what makes them “real.” The term option—as opposed to alternative or possibility—is of importance in understanding the theory’s origins and boundaries and in developing and testing relevant hypotheses. An option is a right, but not an obligation, to take some future specified action at a specified cost. At its core is a fundamental decision asymmetry to take a future decision (e.g., invest) only if it’s beneficial to the decision maker, but not otherwise. In some organizational contexts, certain rights might be established through contracts (e.g., patents, JVs) or preferential access to investment opportunities (e.g., in an equity investment); alternatively, they might be established through idiosyncratic knowledge that a firm possesses (e.g., through learning by doing or research and development [R&D])1. The fundamental decision asymmetry of options involving the right but not the obligation to act also gives rise to an asymmetry in firm outcomes in the presence of uncertainty. For example, in the case of a call option to invest, the holder is able to access upside opportunities (through exercising the call by investing or expanding) while limiting downside losses (by not exercising it in the event of adverse developments).
Myers (1977) coined the term real options and envisioned bringing the theory of financial options to the realm of strategic decision making. Real
1 This definition of options as rights, or claims on future opportunities, is different from the informal usage of the term options, such as when a firm is said to take an “options approach” by undertaking a number of small and disparate activities, which may not confer clear rights. Moreover, just as a right must exist, it is equally important that the decision maker is not obligated to act in the future for an option to exist. In some contexts, however, firms may be compelled to undertake certain investments due to regulation, competitor actions, prior contractual commitments, or governance inseparabilities (e.g., Argyres and Liebeskind, 1999).

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44 L. Trigeorgis and J. J. Reuer
options were seen as “opportunities to purchase real assets on possibly favorable terms” (p. 163). These favorable terms hinge on adjustment costs, market power, or other imperfections in product or factor markets. Connections to strategic management’s focus on firm heterogeneity and competitive advantage are readily appreciated. In the case of financial options, an investor has the right to act to acquire a financial security (e.g., shares of stock) as the underlying asset, yet in real options, the underlying is a “real” asset. Incremental cash flows are tied to the construction or scale up of a plant, the development of a product in an R&D program or the exploitation of a patent, and so forth. ROT has consequently extended options thinking from financial markets, where options are based on traded contracts with specified terms, to real assets, tangible or intangible2. As a result, there are many different types of real options.
Table 1 provides a taxonomy of real options (Trigeorgis, 1996). In Panel A, we identify five basic types of stand-alone real options, namely: (1) the option to defer or stage market entry when facing exogenous, market demand uncertainty (e.g., Dixit and Pindyck, 1994; McDonald and Siegel, 1986) (e.g., a firm considering entry into an emerging product market or host country); (2) the option to grow (e.g., Kulatilaka and Perotti, 1998) (e.g., a firm taking a partial equity stake in another company when entering a foreign market with the possibility of expanding at a later date); (3) the option to alter scale (e.g., expand or contract), including the option to expand manufacturing capacity or an outsourcing arrangement (e.g., Leiblein and Miller, 2003); (4) the option to switch inputs, outputs, suppliers, and so on (e.g., a MNC able to reallocate production across foreign subsidiaries in response to changes in exchange rates (e.g., Huchzermeier and Cohen, 1996; Kogut and Kulatilaka, 1994)); and (5) the option to abandon, such as exit a market or sell a technology if conditions deteriorate (Chi, 2000; Dixit, 1989).
Most firms actually possess a portfolio of such options within and across these five categories. This suggests that the real-life decisions firms make regarding the acquisition, maintenance or exercise
2 Tangible assets underlying real options might include real estate, natural resources, R&D and patents, physical plants, and strategic acquisitions; intangibles include brands, unique business processes, flexible human capital, and knowledge developed in joint ventures or other cooperative agreements.
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of such options can affect the value of other options a firm has, so these interactions need to be accounted for when making these decisions (Anand, Oriani, and Vassolo, 2007; Trigeorgis, 1993b; Vassolo et al., 2004). Moreover, even for single investment decisions, such as timing entry into a market, a firm may possess both deferral and growth options at once (Folta and O’Brien, 2004), and their value can, in turn, be affected by other factors such as network effects and technology evolution (Chintakananda and McIntyre, 2014).
Unlike financial options, some real options may not be liquid or traded in organized markets (they sometimes may not yet exist, as in R&D)3; they may be asset or firm specific (and hence, partly irreversible), which gives rise to challenges such as information asymmetries, path dependence, and incomplete property rights; and their terms may not always be clearly defined. Inasmuch as earlier activities and prior investments open up or shape particular future investment opportunities, there is a temporal linkage between the firm’s previous and future activities or investments, even though this may not be immediately obvious to some executives. The notion of shadow, or hidden, options (Bowman and Hurry, 1993) suggests that a firm needs to uncover and appreciate these linkages and the opportunities that firm resource endowments and capabilities might create in the future. Firms that lack such early pre-investments, or do not appreciate the particular follow-on opportunities that stem from prior investments, may not be able to access the same future investment opportunity set, or do so on the same terms. Thus, informal labeling of mere possibilities as “options” can miss appreciating the importance of the preferential and heterogeneous access that different firms have to specific investment opportunities.
It also follows that terms of real options may not be clear-cut (e.g., the option maturity, or time to make a commitment, may be fuzzy or uncertain as it may expire on unanticipated rival entry), or they may be influenced by managerial actions and the behavior of external parties such as rivals. Such actions can also influence other parameters of a real option’s value, including the underlying asset value (i.e., the value of the cash flows associated with the investment) or exercise cost (i.e.,
3 For a discussion on incomplete markets or subjective utility-based risk averse entrepreneurial preferences see Henderson (2002, 2007).
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Real Options Theory in Strategic Management 45

Table 1. Strategic investment choices as real options

A. Basic real options Type of option

Investment choice/illustration

Defer or stage Grow Alter scale (expand/contract) Switch Abandon/exit

Delay or stage market entry when facing demand uncertainty Enter new or foreign market (with option to buy partner) Expand or contract plant or scale of outsourcing contract Switch suppliers or production across foreign subsidiaries Exit market (or sell technology for salvage) if conditions deteriorate

B. Extensions and complications for real options Option extensions

Complications

Portfolios of options and interactions Multiple sources of uncertainty Competition and preemption versus cooperation
Learning

Option substitutability or complementarity Different uncertainties favor different investments and might
change market timing and entry modes Competitive moves by others erodes the value of a firm’s option
to defer entry; collaboration (e.g., via joint R&D venture) can instead preserve option to wait Value of investing hinges on reduced endogenous uncertainty

Source: adapted from Trigeorgis (1996).

the cost of going forward with the investment). For instance, bargaining costs during negotiation ex post may raise the exercise cost, and thereby diminish the net benefits of exercising an option (Chi, 2000). Owners of such real assets might secure related benefits only for a limited duration, and often end up sharing their inherent benefits with other industry participants. Benefits are often remote, diffuse, or difficult to predict and secure. In all these respects, real options differ from financial options. Moreover, unlike financial options whose exercise does not affect the holders of other options, real options exercised in oligopolistic settings can affect (e.g., damage or preempt) other option holders such as rivals, whose reaction must therefore be accounted for in initial strategic decisions (e.g., upfront capacity selection). Real option terms may also differ across firms, driving heterogeneous firm behavior (e.g., a firm facing less firm-specific uncertainty than a rival may enter first, gaining first-mover advantages).
A further complexity inherent to options on real assets is that many different uncertainties can affect their value, and thus, firms’ investment behavior (e.g., see Dixit and Pindyck, 1994; Folta, 1998; Trigeorgis, 1996; Vassolo et al., 2004, for a discussion of multiple types of uncertainty affecting the value of real options). These can be broadly classified into exogenous uncertainties (e.g., market demand or some competitive uncertainty such as from
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random entry)4, endogenous uncertainties (e.g., technological uncertainty that might be resolved through further learning-type investment as in Dixit and Pindyck (1994) and Pindyck (1993), or behavioral uncertainties such as arising from the behavior of a JV partner, or other uncertainties over which the firm may have some, but perhaps limited, influence such as through nonmarket strategies to shape political risk. Some standard models and early applications were well suited for exogenous uncertainties (e.g., market demand) where the classic option models from financial economics readily applied, though more recent research also addresses the role of endogenous or technological uncertainty (e.g., Oriani, 2007; Oriani and Sobrero, 2008). Thus, one key challenge for the formal modeling of real options, compared to basic financial options, is that multiple sources of uncertainty can affect the value of many real options.
As real options involve rights to act on real tangible or intangible assets that may not always be clearly defined and those rights might potentially
4 Some market uncertainty can sometimes be endogenous in that an initial investment can yield information on whether a larger investment is later warranted. For instance, entry into a new geographic market often involves considerable uncertainty about the reaction of potential consumers but the entrant can find out whether the market is receptive to its product by actually selling it on a small scale for a period of time.
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46 L. Trigeorgis and J. J. Reuer
be shared with other parties, their (non)proprietary nature needs to be accounted for when applying options theory in the domain of strategic management. Sometimes the rights might be exclusive to one firm (e.g., outputs of R&D), but this is often not the case (Trigeorgis, 1996). Proprietary options are usually firm-specific (e.g., when based on knowledge from learning-by-doing) and the option value goes away at expiration if the firm chooses not to exercise it (Myers, 1977). In some cases, options may be traded on secondary markets that themselves may display certain imperfections (e.g., markets for technology). In the case of shared options held by many firms in a market, the exercise of an option by one firm to invest or enter the market can erode the value of the option to wait by rival firms. In such cases, the claim that a firm has on a future opportunity can be contestable and uncertain, and the risk of competitive erosion or even preemption can lead firms to commit early or in larger scale, rather than be flexible by investing incrementally or waiting to see how a market develops.
The value of waiting hinges not only on the actions of rivals, but also on how irreversible the market entry decision is. If it is easy to resell technology or other assets committed when entering a market, there is less need to wait for additional demand cues. Absent irreversibility, it doesn’t pay to wait, and absent uncertainty, there is no value to an option to wait either, so when there is both significant uncertainty and irreversibility, it pays to keep open the option to defer when proprietary (Dixit and Pindyck, 1994). Combined considerations such as competitive threats, the (non)exclusivity of the right, as well as the degree of uncertainty and irreversibility, or new opportunities an investment might open up can therefore jointly determine whether a firm should commit and enter an industry or be flexible to wait or stage entry.
The above discussion illustrates some of the main drivers of strategic investment that are unique to real options, but it also brings into focus the unique contributions of the strategic management field to this literature (e.g., Cuypers and Martin, 2007; Li, 2007; Li et al., 2007; Miller and Folta, 2002; Reuer and Tong, 2007). Panel B of Table 1 summarizes some of the main complications that commonly surround firms’ real options and strategic investment decisions. Some of these dimensions complicate formal real options modeling and the articulation of relevant hypotheses, but many of these complications are inherent to the transition from financial
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options to the realm of real options. Such complications need to be carefully accounted for in formal models of real options as they require adjustments to the original theory as well as in cases relying on metaphorical use of option theory to analyze corporate investments and strategic decision making under uncertainty. Panel B particularly focuses on four complications that deserve further attention and extensions in the literature: (1) portfolios of options and their interactions (e.g., substitutability or complementarity effects); (2) impact of multiple sources of uncertainty, and how they may change investment timing and entry mode choices; (3) competition and preemption versus cooperation trade-offs (e.g., how first movers or collaboration might erode or preserve the option to wait); and (4) learning effects (resolution of endogenous uncertainties).
ORGANIZATIONAL STRATEGIC DECISION MAKING UNDER UNCERTAINTY
Having described the fundamental characteristics of real options, we now briefly discuss the three phases of investing in real options in organizations and describe the basic stages of the real options chain or life cycle. This allows us to distinguish three distinct approaches to ROT in strategic management and to develop our taxonomy of the literature.
It is useful to first summarize the process of real options analysis in organizations as it helps classify research and reveal gaps in understanding and new avenues for research:
1. Problem structuring. This involves a qualitative, strategic depiction of the problem structure indicating the various managerial decisions or options, their timing and linkages, the main underlying uncertainties, and the key value drivers. An option map can be developed that is analogous to a decision tree representation, but focuses on option characteristics and interlinkages among options.
2. Valuation and modeling. At its core, this analysis involves collection of the primary input data to enable a standard discounted cash flow (DCF) estimation and determination of a base-case net present value (NPV) as a base (benchmark). After estimating additional option-driven input estimates, the analysis proceeds with use of
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Real Options Theory in Strategic Management 47

an option valuation model, such as binomial trees (e.g., Cox, Ross, and Rubinstein, 1979) or simulation, to estimate the Expanded-NPV (E-NPV) of an investment. This captures the value of active management represented by the set of embedded options. 3. Implementation planning. After arriving at a recommendation for a strategic investment, management can develop a contingent decision plan specifying conditions for the exercise of major options in different circumstances and develop an operating policy and decision milestones across investment stages5.
In parallel with the above basic stages of real options analysis practiced in organizations, research on ROT can further be characterized by basic stages in the real option life cycle (e.g., Bowman and Hurry, 1993). Each of these stages identifies a unique set of challenges and opportunities for firms to capture value. Specifically, analogous to product development processes in high-tech firms, Figure 1 identifies four basic life cycle stages: (1) Identify or recognize a hidden (shadow) option (i.e., discovery of opportunity); (2) Create (or acquire) a basic or extended real option via searching, gathering information, and acquiring or organizing needed resources at a cost (exploration or acquisition); (3) Manage, maintain, and strengthen the real option by incurring necessary preservation or enhancement costs (development); (4) Exercise the real option (exploitation). Like the types of investment analyses mentioned above, these phases need not occur in a linear and rational manner as serendipity plays a role, and the discovery and exploitation of new technological and market opportunities need not progress in such an orderly fashion. However, the fundamental distinct nature of the four stages above helps in characterizing previous real options research in strategy and identifying gaps.
The first two stages involve entrepreneurial-type activities, while the latter two require managerial skills and organizational systems in place. The figure suggests a complementary role for these activities. For example, it is not just the pool
5 Management must also consider requirements for realizing the theoretical option value, such as assigning teams to monitor trigger cues and exercise major options, reassess value at future critical milestones and put in place proper information, control, and management reward systems to align managerial incentives and action with the identification, development, and exercise of major real options.

of shadow options that creates firm value alone, but effective managerial decisions to implement and exploit the decision flexibility. This requires adequate organizational systems and management commitment. Broadly speaking, much of the literature has concentrated on Stage 4 (valuing and/or exercising a real option), while some studies have addressed Stage 2 (creation or acquisition of an option at a premium, or valuing the option premium). However, in our view, insufficient attention has been paid to Stage 1, identification of option opportunities through entrepreneurial-type discovery, and to Stage 3, the preservation, strengthening, and management of the firm’s real options portfolio. This suggests the need to carry out research across these stages of the real option chain rather than in isolation or using one single approach to ROT.
The above organizational discussion of the common elements and phases of real options analysis naturally allows us to present the complementary roles, contributions, and limitations of each of three prevalent approaches to real options decision making. The most common approaches to real options decision making are: (1) real options reasoning, which relies on logic and heuristics and presents real options as a way of thinking by executives; (2) real options valuation and modeling, which relies on formal analytical (mathematical or simulation) models to value options and derive hypotheses for research; and (3) behavioral perspectives, which focus on the implementation of real options in organizations. Each are reviewed below.
Real options reasoning (ROR)
Much of the strategy literature views ROT as a strategic and intuitive way of thinking (Folta and O’Brien, 2004; Trigeorgis, 1996), a logical tool or rhetorical device for creating or keeping options open and exploiting them. Essentially, ROR captures the formulation and testing of hypotheses based on verbal theorizing without the aid of analytical modeling. Prevalent use of ROR in strategy is natural given the difficulties of accurately mapping financial options theory into real investment decisions and the many complications of valuing real options highlighted earlier. ROR is most suitable when the key drivers of real option value can be identified and synthesized conceptually (McGrath, 1997), even if options cannot be valued formally. There are several ways that ROR can help organizations better structure their

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48 L. Trigeorgis and J. J. Reuer

Figure 1. Stages of the real option life cycle

strategic investment decisions under uncertainty. First, ROR generally encourages firms to undertake more uncertain projects since option value rises with uncertainty (McGrath, 1999), and as a rule, firms may have biases against making investments under uncertainty (capital budgeting practices rely on discounted cash flow analyses and NPV, which often undervalue such initiatives). Second, ROR suggests that investments undertaken in the presence of uncertainty be staged to keep open the upside potential while truncating downside losses (e.g., Trigeorgis, 1996). Third, ROR encourages proactive contingent management of investments with flexible decision choices that allow future modification depending on contingent circumstances (e.g., McGrath, Ferrier, and Medelow, 2004). Fourth, ROR encourages a portfolio approach involving many low-cost, staged investment bets (e.g., Trigeorgis, 1996). Research that uses this approach to ROT aims to capitalize on the qualitative insights of options theory, and this research has found applications in technology management, entrepreneurship, and international strategy, among others.
Real options valuation (ROV) or modeling
Most of the economics and finance literature, by contrast, focuses on real option valuation (ROV)
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and uses formal mathematical models or simulation to value options. Interested readers can consult Trigeorgis (1993a) for a review of this literature, and the books by Dixit and Pindyck (1994) and Trigeorgis (1996). Many of the classical readings and important modeling contributions can be found in Schwartz and Trigeorgis (2001). Formal modeling of real options offers a number of advantages, including being specific and transparent on key assumptions (that are often left implicit or unspecified in ROR), exposing critical boundary conditions or new theoretical relationships through comparative statics and numerical analysis, enabling the simulation of complex and interacting relationships, and often building directly off of original models in option theory. Mathematical or simulation modeling can be useful as a tool for developing propositions and comparative statics insights, and we would encourage more of this research within strategic management. Despite these clear and important strengths, this approach also has a set of drawbacks. For example, for purposes of mathematical tractability, ROV models often rely on restrictive assumptions that are not readily implementable in practice (e.g., Triantis, 2005). Nonetheless this research has shown that ROV can better explain market valuations and many investment decisions than traditional DCF-based approaches in diverse areas (e.g., Moel and Tufano, 2002). But while
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Real Options Theory in Strategic Management 49

ROV models can be rigorous, they can sometimes also become removed from the practical relevance and organizational realities that are of interest to strategic management scholars and practicing firms.
Behavioral perspectives (BP) on real options
This approach aims to come to terms with these organizational realities and give more attention to the human or behavioral nature of management and the constraints on the adaptive capabilities of organizations. Adner and Levinthal (2004) cautioned that the domain of applicability of ROT is limited when necessary conditions such as decision flexibility and information accuracy are not met due to real-life frictions, organizational realities, and implementation weaknesses. If information about the value of an asset at the decision time is imprecise, managers may underinvest in good opportunities or overinvest in bad projects (e.g., Coff and Laverty, 2007; Trigeorgis, 2014). As a matter of implementation, it is often difficult to identify latent or shadow options (Bowman and Hurry, 1993) or to value many real options when the terms of the option such as expiration are not so clear-cut (McGrath, 1999) or the valuation is project specific (Bowman and Moskowitz, 2001). Such constraints naturally lead to practical difficulties in the effective management of real options (McGrath et al., 2004). Managers are further constrained by bounded rationality (Trigeorgis, 2014), so ROT might embrace this behavioral assumption to better connect with existing streams of strategy research. Differences exist across organizations in their information processing and belief updating, contributing to differential effectiveness in executing real options (Leiblein, Chen, and Posen, 2015). While the promise is to bring real options to real-world organizations, a need exists to be clear about the challenges in doing so, including integrating theories with different starting assumptions. Working out the implications of bounded rationality, information imperfection, and behavioral biases is one such opportunity, just as research on real options implementation needs to be concerned about separating behavior compatible with rational real option-based decisions from other path-dependent behavior (e.g., Klingebiel and Adner, 2015).

A TAXONOMY OF REAL OPTION STUDIES
Based on the above three approaches to real options research, we classify studies according to whether they use a real options reasoning approach or formal modeling and specific analytical valuation methodologies (see Table 2). The top part of Table 2 provides representative articles on the five basic types of real options (reviewed in Table 1, Panel A). Our taxonomy of the literature leads us to draw out several broad conclusions about real options research. First, while theoretical and conceptual articles outpace empirical papers, there is a growing empirical literature on real options, and in this regard, the strategic management field has made important contributions to the broader real options literature. These studies examine the antecedents of strategic investments involving the purchase or exercise of various options as well as their valuation and performance consequences. The articles in Table 2 establish how real options are embedded in a broad range of firms’ strategic investments and activities, and as we discuss, often challenge received wisdom in important ways6. The table further highlights the many complications that arise for ROT in the realm of strategic decision making (e.g., portfolios of options and interactions across options, uncertainty affecting the value of different options at once, and multiple sources of uncertainty, competitive erosion, and preemption, learning, etc.). For instance, strategy research considers search and the role of learning in the context of corporate diversification as firms sequentially enter or exit industries (Chang, 1995, 1996), and other research features endogenous uncertainty as being central to firms’ corporate investment decisions. Additionally, strategy research has devoted attention to the implications of options in firms’ portfolios being super- or sub-additive rather than being independent of one another (e.g., Anand et al., 2007Trigeorgis, 1993b; Vassolo et al., 2004).
Second, a prevalent theme in real options research is the classic trade-off between firm commitment and flexibility (Ghemawat and del
6 For instance, joint ventures were long viewed as “marriages” between organizations, and in this view stability, longevity, and harmony were markers of effective collaborations. By contrast, ROT suggests that firms can partner in an uncertain domain and then be in a position to buy out a partner if uncertainty is resolved favorably, suggesting a new role for transitory collaborations in uncertain market contexts to capture value (Kogut, 1991).

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50 L. Trigeorgis and J. J. Reuer
Table 2. Main research themes and literature categorization

Main research theme

RO reasoning

Representative studies Valuation/modeling

Empirical

Mapping to basic options Defer or stage Grow
Alter scale (expand/contract)
Switch Abandon/exit Extensions and complications Portfolios and option
interactions Uncertainty and investment Competition and preemption
versus cooperation Learning Investment (market entry)
timing and scale (commitment versus flexibility) Investment structuring, organizational form (market entry mode), and contract/deal design
Multinationality (international networks)
Organization realities and implementation issues
Valuation and performance Market valuation
Performance measures

Trigeorgis (1996) and McGrath (1997)
Kester (1984) Kogut (1991), and Malos and Campion (1995)
Trigeorgis (1996)
Trigeorgis (1996)
Adner and Levinthal (2004) and Lee, Peng, and Barney (2007)

McDonald and Siegel (1986) and Dixit and Pindyck (1994)
Kulatilaka and Perotti (1998)
Pindyck,(1998)
Kogut and Kulatilaka (1994) and Sakhartov and Folta (2014)
Dixit (1989) and Chi (2000)

Campa (1994)
Trigeorgis and Lambertides (2014), Malos and Campion (2000)
Damaraju, Barney, and Makhija (2015) and Hurry, Miller, and Bowman, (1992)
Allen and Pantzalis (1996) and Rangan (1998)
Elfenbein and Knott (2015) and Arend and Seale (2005)

Trigeorgis (1996)
Dixit and Pindyck (1994)
Smit and Trigeorgis (2004)
Kogut and Kulatilaka (2001) Dixit and Pindyck (1994),
Trigeorgis (1996), Rivoli and Salorio (1996), McGrath (1997) and Chintakananda and McIntyre (2014) Buckley and Casson (1998), Leiblein (2003) and Cuypers and Martin (2006)
Kogut (1983) and Trigeorgis (1996)
Bowman and Hurry (1993), Bowman and Moskowitz (2001), Zardhooki (2004), Adner and Levinthal (2004), McGrath et al. (2004), Barnett (2008) and Klingebiel (2012)

Trigeorgis (1993b)
Chevalier-Roignant and Trigeorgis (2011)
Pindyck (1993) Dixit (1989, 1992); Kulatilaka
and Perotti (1998), Pindyck (1998), Sadanand and Sadanand (1996) and Ghemawat and del Sol (1998) Chi and McGuire (1996), Chang and Rosenzweig (2001) and Chi and Seth (2009)
Kogut and Kulatilaka (1994) and Huchzermeier and Cohen (1996)
Trigeorgis (2014)

Vassolo, Anand, and Folta (2004) and Anand et al. (2007)
Folta and O’Brien (2004) and Li and Chi (2013)
Li (2008) Folta (1998) and Quinn and
Rivoli (1991)
Kouvelis, Axarloglou, and Sinha (2001), Reuer and Tong (2005), Ziedonis (2007), Tong and Li (2011), Lukas, Reuer, and Welling (2012), and Tong and Li (2013)
Allen and Pantzalis (1996), Miller and Reuer (1998a), Reuer and Leiblein (2000), Tong and Reuer (2007), Belderbos and Zou (2009), Fisch and Zschoche (2012), Lee and Song (2012) and Tong and Belderbos (2014)
Moel and Tufano (2002), Miller and Shapira (2004) and Alessandri, Tong, and Reuer (2012)

Kester (1984) and Folta and O’Brien (2007)
Hurry et al. (1992), Kim, Hwang, and Burgers (1993) and Klingebiel and Adner (2015)

Oriani (2007) and Trigeorgis and Ioulianou (2013)
Abel, Dixit, and Eberly (1996), Miller and Reuer (1996), Berk, Green, and Naik (1999) and Bloom and Van Reenen (2002)

Allen and Pantzalis (1996) and Trigeorgis and Lambertides (2014)
Miller and Reuer (1998a, b), Tong and Reuer (2006, 2007), Tong, Reuer, and Peng, (2008) and Driouchi and Bennett (2011)

Copyright © 2016 John Wiley & Sons, Ltd.

Strat. Mgmt. J., 38: 42–63 (2017) DOI: 10.1002/smj

Real Options Theory in Strategic Management 51

Sol, 1998; Sadanand and Sadanand, 1996; Smit and Trigeorgis, 2004). This part of the literature typically focuses on issues dealing with investment timing, such as market entry and exit timing (Dixit, 1989) and decision delays or hysteresis (Dixit, 1992) as well as investment scale or capacity choices, such as investment contraction or expansion (Pindyck, 1998). A related literature focuses on the structuring of strategic investments, covering topics such as staging commitments (Baldwin, 1982), deal structuring, and contract design, including the terms of JVs and acquisitions (Lukas, et al. 2012; Reuer and Tong, 2005; Tong and Li, 2013), and how different types of uncertainty and their resolution shape market entry modes at the formation of deals and over time (e.g., Folta, 1998; Folta and Miller, 2002).
Third, we separately highlight the stream of research that has examined the value of multinational operations, not only because of the attention this topic has received and its breadth of coverage across the various approaches to ROT, but also because this is a paradigmatic area in which ROT has fundamentally challenged the received wisdom in an established literature. A long-standing body of work in international business (IB) has emphasized the static efficiency gains associated with internalizing exchanges rather than using licensing agreements in the presence of transaction costs (e.g., Caves, 2007). ROT instead portrays the multinational corporation (MNC) as a coordinated network straddling multiple host country environments, positioned to dynamically shift sourcing, production, and other value-chain activities across countries in response to exchange rate movements or other environmental uncertainties (e.g., Kogut and Kulatilaka, 1994). As a result of within-country growth options and across-country switching options that MNCs possess, they are in a position to both take advantage of upside growth opportunities in their multinational network as well as reduce exposure to adverse movements (e.g., in exchange rates) and limit downside risks (e.g., Miller and Reuer, 1998a, 1998b; Reuer and Leiblein, 2000). Recent research considers the conditions that enable MNCs to exercise switching options to contain downside losses, including coordination and control of foreign subsidiaries (Tong and Belderbos, 2014; Tong and Reuer, 2007). The multinational network hypothesis received extensive attention in terms of both ROR (e.g., Buckley and Casson, 1998; Kogut, 1983; Trigeorgis, 1996)

and formal modeling (Huchzermeier and Cohen, 1996; Kogut and Kulatilaka, 1994).
Fourth, the studies in the table indicate that strategic management research is unique in addressing many organizational realities, constraints, and implementation issues that can inform ROT. These include implementation stages and plans (e.g., Bowman and Hurry, 1993; Klingebiel, 2012), managerial limitations and the suboptimal exercise of options (e.g., Moel and Tufano, 2002), agency conflicts and managerial incentives (e.g., Alessandri et al., 2012), management quality and real options awareness (e.g., Bowman and Hurry, 1993; Driouchi and Bennett, 2011), and various cognitive biases in decision making (e.g., Trigeorgis, 2014; Zardhooki, 2004).
Finally, a set of studies listed at the bottom of Table 2 have addressed market valuation challenges and examined traditional as well as new measures of firm performance. Given the critical importance of an asymmetric payoff profile for real options that results from firms having the right but not the obligation to act in the presence of uncertainty, much empirical research on real options has focused on whether and when firms can indeed access upside opportunities while containing downside risk. Research has developed better-suited performance and risk measures for testing these asymmetric predictions from ROT (e.g., Reuer and Leiblein, 2000; Tong et al., 2008). Literature examining the firm value and performance implications of real options has extended our knowledge in assessing market valuation (e.g., Kester, 1984; Oriani, 2007; Oriani and Sobrero, 2008; Trigeorgis and Ioulianou, 2013) and firm performance beyond standard measures such as Tobin’s q and abnormal returns (Abel et al., 1996; Allen and Pantzalis, 1996; Berk et al., 1999; Bloom and van Reenen, 2002) to more direct option-based or asymmetric measures such as market-implied growth option value (e.g., Alessandri et al., 2012; Tong et al., 2008; Trigeorgis and Lambertides, 2014) or downside risk and economic exposures to foreign exchange rate movements (Miller and Reuer, 1996, 1998a, 1998b; Tong and Reuer, 2007). The main advantage of such option-based or asymmetric measures is that they are more closely tailored to testing the predictions of ROT and helping better ascertain if firms are able to derive specific asymmetric benefits as predicted by the theory, helping differentiate ROT from alternative theories in strategy and management.

Copyright © 2016 John Wiley & Sons, Ltd.

Strat. Mgmt. J., 38: 42–63 (2017) DOI: 10.1002/smj

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Real options theory in strategic management