Real options on knowledge assets: Panacea or Pandora's box?

H ow can firms make the right investments to create a competitive advantage in the high-velocity environment of the new economy? The broad consensus is that they must invest in knowledge assets, which form the basis of a dynamic capability. Unfortunately, standard investment tools taught in business schools, such as discounted cash flow (DCF) models, discourage investments in intangible and uncertain assets such as knowledge. The problems with DCF fuel the excitement around applying real options models to evaluate strategic investments. Drawing on the analogy to financial options, the logic of real options is that firms can make small investments (establish options) that provide an opportunity for, but not the commitment to, pursuing full investments (exercising options) later. Because a firm can wait until uncertainty dissipates before making a full commitment, it can capture potentially huge gains while avoiding the risk of devastating losses. Acknowledging the benefits of real options, we shall nevertheless explore here how the nature of knowledge assets itself may end up costing a firm dearly if the wrong decision is made on whether to option them. Knowledge-based options differ from financial options in at least two important ways: (1) significant uncertainty remains at the exercise decision, and (2) the value of knowledge depends on its transfer and integration within the firm. Thus, managers may erroneously exercise options (as in the provocative statement above regarding 3M) or drop options that would lead to a competitive advantage. Either choice can be very costly.