New venture start‐ups and technological innovation

The purpose of this paper is to compare investment in innovation (e.g. R&D) between new venture start‐ups before commercialization and operating businesses after commercialization.

Real options methods were used to model a new venture start‐up as a perpetual call option on an operating business that grows with R&D. The operating business uses R&D to improve actual earnings while the start‐up uses R&D to improve prospective earnings. When the start‐up entrepreneur commercializes his/her new product, device, or service with conventional investment (e.g. plant, property, and equipment to begin production), prospective earnings convert into actual earnings.

The ability of the start‐up entrepreneur to avoid commercialization costs upon failed R&D makes R&D more valuable to the start‐up entrepreneur than to the manager of the already operating business (for whom commercialization costs are sunk) and despite R&D costs that the start‐up incurs without the revenues that only commercialization generates. The value of R&D to the start‐up can be so great that the entrepreneur invests in R&D before the manager of an otherwise similar operating business in similar business conditions.

Without favoring either a priori, the authors show that under broad circumstances, a new venture start‐up undertakes R&D before an already operating business. The authors also discuss the empirical implications of the results.