Uncertainty and the entry decision

Neoclassical investment theory analyses the simple net present value of the in-vestment and as long as it is positive the inin-vestment should be made. The deci-sion making rule for investment entry is:

Enter If: NPV >= 0

This traditional approach neglects additional optional value of the investment project and neglects the influence of uncertainty of on the investment decision that is pertinent in the real option approach to capital budgeting decisions.

Usually investors fear uncertainty when having to make an investment as it diminishes the predictability of the profit (Dixit and Pindyck, 1994). Real op-tion theory perspective inverts the usual thinking about uncertainty found in the organizational literature since uncertainty can create opportunities when it is properly understood (Amram and Kulatilaka, 1999).

As noted earlier market uncertainty is a form of exogenous uncertainty and is unaffected by actions and can only be resolved over time. Premature invest-ments under high market uncertainty impose certain risks as the hypothetical investor disregards the value of waiting and receiving new information that might influence the attractiveness of the investment. Recent research on real options suggests that increasing exogenous uncertainty ‘may not categorically dissuade entry investment through a monotonic decrease in the option premium’

(Folta and Miller, 2002; Amram and Kulatilaka, 1999; Kulatilaka and Perotti, 1998) leading to the fact that when there are competitive advantages of early

entry, higher exogenous uncertainty can increase the likelihood of commitment and firm formation which we will discuss later in this chapter.

Under the option framework when dividends (opportunity costs of not exercis-ing) are not existing it is always optimal to delay exercising the call option as long as possible (for proofs see Miller and Folta, 2002 or Dixit and Pindyck (1994) who showed that it is never optimal to exercise an American option prior expiration date when no dividends or opportunity costs are present). It is known from financial option theory that the value of the option increases with increasing uncertainty regarding the underlying asset. Similar to a financial op-tion, options on new technologies become more valuable when market uncer-tainty is high, that is when the future value of the underlying asset (e.g. tech-nology) fluctuates strongly. This finding is consistent with innovation literature which has recognized that technology value increases if the underlying demand’s potential variance and uncertainty increases (McGrath, 1997).

Exercising the option entitles its owner to a series of cash flows by committing a largely irreversible investment (X) by creating a spinout. The incremental value from maintaining flexibility by withholding the investment to increasing com-mitment and exercising it, is given by V = D – X – C,⁵ where D is the present value of forgone dividends for not exercising the option early, X the exercise price depicting the investment necessary to create the spinout and C the call option value. Call option value (C) represents the opportunity cost associated

5 The full notation can be written as V(t, , ) = D (t, , ) – X( t,) – C (t, , ), where  represents market (exogenous) uncertainty andtechnological (endogenous) uncertainty.

with exercising the option (Miller and Folta, 2002) whereas Dividends (D) are potential cash flows only realized if the option is exercised prior expiration date and therefore represent the opportunity cost of not exercising the option and de-laying investment. The dividend term is given in detail by D = DC + DT + α * DG– DD + DL– DP,⁶ where DC are the discounted cash flows directly related to the real call option over the remaining option duration period, DT are the dis-counted cash flows after the option expiration date, DG is the value of the com-pound growth options that are only available if parent real option is exercised, α is a multiplier that enhances the value of the growth option if moving early gives the firm an the ability to expand beyond initial expectations (Liebermann and Montgomery, 1988), DD is the value of the option to defer investment which value disappears when option is exercised early, DL captures the value of tech-nology learning due to investment commitment and exercising the option, DP re-fers to strategic pre-emptive investments of competitors that reduce the value of the dividend payments. It should be noted that the optimal exercise time is when the present value of V reaches a maximum ( 0



 t V ).

Dixit and Pindyck (1994) have shown that the most valuable options which are affected by market uncertainty are the growth and deferment option which will be the focus of this study when analysing the effects of markets uncertainty on the entry decision. Further, one should point out the fundamental difference between firms competing in mature industries versus firms competing in

knowl-6The full notation can be written as D(t, ,) = DC (t) + DT (t) + α * DG (t,) + DL(t,) -DP (t)

edge intensive industries which our sample represents. Miller and Modigliani (1961) have characterized the market value of the firm as being composed of present value of cash flows plus the present value of growth opportunities. The total market value of firms in knowledge based and emerging industries is pri-marily based on options to grow in the future (Myers, 1977). These options to grow can be seen as compound options on the initial real option and can only be obtained and its value captured by exercising the initial option and committing to investment.

Folta and O’Brien (2004) analysed how growth and deferment options affect the investment decision and showed that existing firms will enter new markets ear-lier rather than later when the net present value of the investment project is higher, forgone cash-flows (if entry is delayed one period) are higher as well as the option to grow (compound option) is more valuable and the option to defer is less valuable. Our research focuses on the entry of new firms. Both DG and DD

are monotonically increasing with uncertainty as all other options are. The op-tions to grow especially for new entrants are very sensitive to the uncertainty conditions they are found in compared to the option to defer. Early mover ad-vantages and direct entry can result in immediate benefits and larger market share especially for entrants that are entering a high technology environment where technological advantages are strongly related to the competitive advan-tage of the firm. Further looking at implications from option pricing theory it can be seen that growth options are more sensitive to uncertainty compared to options to defer because their maximum value is not bounded (Folta and O’Brien, 2004) whereas the option to defer can never be larger than the initial

The variable DG in the dividend function considers the value of the previously mentioned compound options and therefore predominantly reflects competitive advantages gained from moving early in emerging industries (Lieberman and Montgomery, 1988). The timing of the investment decision is primarily domi-nated by growth and deferment options and as shown earlier the sensitivity of the growth option towards market uncertainty is larger than that of the option to defer with increasing market uncertainty. This results in a nonmonotonic be-haviour of market uncertainty on the investment decision to found a new firm.

Furthermore, since for low market uncertainty the sensitivity of a growth option is small compared to the option to defer, the option to defer becomes the domi-nant value driver in low uncertainty environments. On the other hand if uncer-tainty is very high the sensitivity of the growth option increases and the option to grow becomes the dominant driver of investment value. Considering our value function we can see that if this relationship holds, as previously stated that this is the case in knowledge intensive industries, all other things being equal, following hypotheses are valid:

Hypothesis 1: The impact of market uncertainty on entry is nonmonotonic

Hypothesis 2: Market uncertainty will negatively influence the likelihood of commercializing patents through spinouts when uncertainty is low, and

posi-tively influence it when uncertainty is high

High technology companies are mostly created from high technologies in emerg-ing markets that are prone to technological uncertainty (Abernathy and Utter-back, 1978; Schumpeter, 1934). Researchers have also recognized that early stage technologies with high technological uncertainties are more likely leading to spinout formation. However they were unable to make this idea precise by placing in a formal theoretical setting (Shane, 2004b).

Technological uncertainty represents the uncertainty about the success and fea-sibility of the developed technology and the uncertainty if the underlying tech-nology will satisfy quality, performance and standards that were initially in-tended (Dixit and Pindyck, 1994). In the academic spinout context technologi-cal uncertainty can be considered as the uncertainty about the time, effort and other resources needed to successfully create the spinout and develop the under-lying technology according to its specifications. The major difference between market uncertainty which is exogenous and technological uncertainty which is endogenous is that endogenous uncertainty can be resolved through active in-vestment of time and resources by its holders and by learning and actually un-dertaking the investment. Therefore technological uncertainty is intrinsic to the university and entrepreneurs of the spinout as it is them who can actively re-solve it internally by undertaking the technology development and finalizing it.

Since technology development is part of the cost of investment, its uncertainty will increase with the volatility of the cost of investment. If an investment has a negative net payoff but its variance of the cost is adequately high, there is still a possibility that it can be economical to invest. Similar to market uncertainty, higher technological uncertainty increases the value of the real option (C). As

we have shown earlier in our value function higher option value defers invest-ment in the absence of dividends.

Parallel to Roberts and Weitzman (1981) we argue that the ability to learn about a technology enhances dividends and capture this value in our dividend function by DL. DL represents a dividend from learning about a technology by actively investing in it and resolving the uncertainty around it.

We believe that one of the incentives of early technology commercialization through spinout formation is uncertainty resolution of the total investment that is inherent to the investor. Therefore if investing provides information and re-solves technological uncertainty, earlier investment in form of a spinout is more likely to occur.

Hypothesis 3: Greater technological uncertainty increases the likelihood of commercializing patents in form of a spinout (exercising the call option)