Real Options (RO) has been indicated to valuate projects with high uncertainty. However, literature points to challenges and asks for an organizational understanding of its use. So: Why do managers search for the RO approach to valuate radical innovation projects? Based on five in-depth case studies, we discuss hidden organizational and managerial issues related to the search for RO to valuate radical innovation. We argue that managers search for RO to cope with the “paradox of organizational fit”, and later, to deal with the “newness prison”, employing RO Structuring and RO Integration to allow exposure to radical innovation.
A critical challenge for firms is to define a proper approach to evaluate radical innovation (RI) projects, characterized by high uncertainty. Decades of scholarship have shown that inadequate managerial approaches are able to extinguish radical initiatives (e.g., Christensen et al., 2008), leading to incrementalism in the portfolios (Cooper, 2013). Indeed, the financial valuation of RI is a complex task (Paulson et al., 2007). While incremental innovation relies on historical data related to well-known technologies and the market, radical innovation deals with uncertainties from different sources (Rice et al., 2008), including “unknowns-unknowns” (Meyer et al., 2002) and a lack of, or poor, data. A number of studies have indicated that traditional financial tools, such as Net Present Value (NPV), Return of Investments (ROI) and the like, are not suitable to valuate RI projects, since they are not capable of dealing with the lack of past data, uncertainty, the investment reversibility in innovation. Additionally, they do not take into account managerial flexibility – the possibility of changing the project path during its execution (Huchzermeier and Loch, 2001; Santiago and Vakili, 2005; O’Connor et al., 2008; Kester et al., 2009; Goffin and Mitchell, 2010; Wang et al., 2015). Some authors consider Real Options (RO) as a more suitable approach to the context of RI (e.g., Huchzermeier and Loch, 2001; Santiago and Vakili, 2005). RO would support the technical valuation of radica projects, making them easier to justify and manage and would also quantify managerial flexibility, allowing these projects to appear financially more attractive (Perlitz et al., 1999; McGrath and Nerkar, 2004). Even though there has been a technical development of RO methods, there is still an ongoing concern expressed in innovation literature (Huchzermeier and Loch, 2001; Santiago and Bifano, 2005; Wang et al., 2015): that firms struggle to implement RO effectively (Reuer and Tong, 2007). Studies have found important challenges and barriers to RO: its intrinsic mathematical complexity, the non-intuitive results it produces, the lack of awareness of its mechanisms by most of the decision-makers, and the difficulties that still exist in modeling really disruptive projects, containing “unknowns-unknowns” (e.g., Fredberg, 2007). Nevertheless, some scholars have indicated that firms continue to search for RO in order to valuate innovation projects (Wang et al., 2015).