Real options theory of entrepreneurship

What is the real options theory of entrepreneurship?

Real options theory is concerned with investments in real assets that are similar in structure to financial options like put and call options that allow investors to bet on the upside or downside of stocks without tying up too much capital (Bowman and Hurry, 1993)

According to McGrath (1999), real options theory is supposed to be superior to net present value analysis and other time value calculations, especially under conditions of uncertainty. The fundamental idea behind real options theory is that an opportunity that has a way out is worth more that one that does not have a way out. For example, startups can be merged, one startup can be stripped of resources to help another, a team can be moved from one opportunity to another etc...
Thus, entrepreneurs and investors in entrepreneurial ventures are apt to view failure as a learning opportunity that contributes to the assessment of future projects. Real options thinking reduces the social cost of failure and thus increases the risk that potential entrepreneurs and investors will be willing to take in the future.

Lee et al. (2007) use real options logic to argue that bankruptcy laws should not punish entrepreneurs too severely because it could have the unintended consequence of reducing the number of individuals pursuing opportunities that are both very high risk and very high in potential reward.

O'Brian et al. (2003) find that individuals considering entrepreneurial entry decisions seem to use a real options logic. They find the entrepreneurs are less likely to enter into an industry where uncertainty is higher and where investments are irreversible.

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Sources:

Bowman, E. H. and Hurry, D. (1993). Strategy through the option lens: An integrated view of resource investments and the incremental-choice process. Academy of management review, 18(4), 760-782.

Lee, S. H., Peng, M. W., and Barney, J. B. (2007). Bankruptcy law and entrepreneurship development: A real options perspective. Academy of Management Review, 32(1), 257-272.

McGrath, R. G. (1999). Falling forward: Real options reasoning and entrepreneurial failure. Academy of Management review, 24(1), 13-30.

O'Brien, J. P., Folta, T. B., and Johnson, D. R. (2003). A real options perspective on entrepreneurial entry in the face of uncertainty. Managerial and Decision Economics, 24(8), 515-533.



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