J. Service Science & Management, 2010, 3, 235-240
doi:10.4236/jssm.2010.32028 Published Online June 2010 (http://www.SciRP.org/journal/jssm)
Copyright © 2010 SciRes. JSSM
The Method of Real Options to Encourage the R &
D Team
Junfeng Gao1, Lan Jiang2
1School of Management and Economics, University of Electronics Science and Technology of China, Chengdu, China; 2Tian Fu
College, Southwestern University of Finance and Economics, Chengdu, China.
Email: zhsing@163.com
Received February 21st, 2010; revised March 27th, 2010; accepted May 1st, 2010.
ABSTRACT
In some projects, the R & D appears to be a failure, and according to traditional methods of encouragement motivation,
it is hard to get any awards for the R & D team. But there is a valuable option implied in it. This article discusses the
method of real options to encourage R & D team when the enterprises can not achieve the desired economic benefit in
the case of high-risk project or the immature market. The process of method includes: Identify the real option type of
high-risk projects, Design the incentive mechanism and Design specific exercise ways.
Keywords: The High-Risk R & D Project, Real Option Incentive, R & D Team
1. Introduction
The emphasis of the researchers in the enterprise is to
explore or update new products or services, which req-
uires high technology and strong innovation and needs
inter-disciplinary team work and multi-professionals’
participation. The collaboration of R & D project team
requires companies to adopt collective rather than indi-
vidual compensation system [1].
But team incentive is more complicated in actual work,
especially in high risk R & D project. When enterprises
fail to achieve the desired economic benefit in the imm-
ature market, it is a big problem to motivate team effec-
tively. It is unfair for the R & D team if we deny its con-
tribution, because the lessons at least can help us avoid
similar risk, and the technology experience accumulated
can establish good foundation for the latter project. If
there is no reward, no one would do these high-risk pro-
jects or they maybe change job with these expensive ex-
perience. However, if the reward is paid, what is the cri-
terion of incentive and how to evaluate contribution of the
project should be considered. And this paper will intro-
duce a new incentive method-real option incentive plan.
2. A Brief Overview of Literature
A team incentive system sends a message to employees
that their team’s output and performance is valued by the
organization [2]. If team performance is not rewarded,
such performance is not likely to be optimal [3,4]. Ex-
isted literatures discuss many incentive ways to R & D
from a management perspective, which are: 1) team
gains sharing or profit-sharing, 2) team goal-based incen-
tive systems. 3) team discretionary bonus systems, 4)
team skill incentive systems, 5) team member skill in-
centive systems, 6) team member goal incentive systems,
and 7) team member merit incentive systems [5]. The
typical methods include spiritual incentives such as rec-
ognition, confer honor, promotion [6], and material in-
centives such as compensation incentive [7], stock incen-
tive [8], stock option [9] and so on. However, because
these incentives are based on different performance indi-
cators, such as financial indicator, internal operating tar-
get and customer indicator [10], so can not solve the in-
centive problem of high-risk R & D project.
As an expansion of financial option theory in real
(non-financial) assets option, real option change inves-
tors’ view to risk and make them pay more attention to
the value of opportunities [11]. In recent years, scholars
have put forth real option incentive approaches for the
executives [12] and R & D personnel [13]. The former is
to balance business investment and strategic investment,
focus on guiding operators to develop the future strategic
growth opportunities; the latter is based on the com-
pounded options and relatively effective for the multi-
stage technology projects or successful projects. But both
do not come down to the incentive problems of high-risk
R & D projects. There is little literature to discuss real
The paper is supported by National Natural Science Foundation o
f
China
(
P
r
o
j
ect No. 70772069
)
.
The Method of Real Options to Encourage the R & D Team
236
option contained in high-risk projects which is more
complecatied. For believing experiences in high-risk R &
D projects can create development opportunities for fol-
low-up technology projects and help enterprises avoid
risks, so we focus on how to identify such options cre-
ated by these opportunities and to design effective incen-
tive ways.
3. The Comparison of Real Option and
Other Incentive Ways
There are many team incentive ways and compensation
incentive is common. Compensation incentive is divided
into two ways. One is fixed pay incentive based on pro-
jects’ performance, such as improving all members’ base
pay or giving a raise, which has stronger short-term ef-
fect. When employees find there is a positive relationship
between hard work and reward, the incentive effect is
obvious; In addition, some key R & D staff has generally
higher level salary in the same industry after giving a
raise several times and will not easily change jobs, which
is favor of R & D team’s stability. However, this incen-
tive is also controversial. One contention focuses on that
reward is difficult to cut in the future and no flexibility,
which often becomes a major cost burden. Another is it
may let some people over-rely on historical performance
in long-term and bring negative effect to follow-up re-
search.
To avoid the shortcomings of the fixed salary many
companies adopt another variable pay incentive, such as
project incentive, profit-sharing plan, flexible salary sys-
tem etc. The advantage of this incentive approach is that
incentive compensation varies with the project perform-
ance, which is very flexible. But it belongs to short-term
incentive and the effect does not last for a long time. In
addition, the biggest drawback is it can not resolve the
incentive problem of high-risk and store project. When a
project can not obtain direct economic benefits or face
failure, it is hard to find the incentive standard.
Team incentive also includes stock option and other
forms, which are long-term incentives. The common pra-
ctice is to give project team option that allows them to
purchase a certain percentage of enterprise common stock
according to pre-set price in a given period. When the
price of stock increases, project team can share benefit
from stock appreciation. But company’s stock price may
not related to a single project directly, and may be ma-
nipulated and fluctuate with the whole stock market. So
this incentive effect is not direct. In addition, it also can
not resolve the incentive standard problem of high-risk
and store project.
To solve the above incentives’ shortcoming, this paper
design real option approach which can evaluate the high-
risk R & D project roundly, especially the value of po-
tential risks, and establish a fair standard for incentive.
The enterprises can adopt short-term or long-term incen-
tive accordingly, such as exchanging the value of real
option of the current project as bonus (short-term incen-
tives), or allowing R & D team share the profit of latter
project (long-term incentives). However this way needs
many data and it is some difficult. The above methods of
incentive are shown in Table 1.
4. The Design of Real Option Incentive
In order to conduct real option incentive, we must iden-
tify the type of real option high-risk projects contained,
and then design incentive scheme.
Table 1. The comparison of advantage and disadvantage of team incentive ways
Type of
incentives Advantages Disadvantages
fixed pay
incentives
Stronger short-term incentive effect and in
favor of R & D team’s stability
Lack of flexibility, often becomes a major cost burden.
Make some people over-rely on historical performance in long-term; bring
negative effect to follow-up research projects.
variable pay
incentives
Incentive compensation varies with the
project performance, very flexible;
The effect does not last for a long time.
Hard to find the incentive standard;
Can not resolve the incentive problem of high-risk and store project
Stock option
Income is comparative with performance
and risk,
Have a long-term incentive effect
Company’s stock price may not relate to a single project directly, and may be
manipulated and fluctuate with the whole stock market.
Cannot resolve the incentive standard problem of high-risk and store project
Real option
Can evaluate the project roundly, especially
the value of potential risks, and establish a
fair incentive standard; And enterprises can
adopt short-term or long-term incentive
accordingly
Needs many data and difficult
Copyright © 2010 SciRes. JSSM
The Method of Real Options to Encourage the R & D Team237
4.1 Identify the Real Option Type of High-Risk
Projects
Although not to achieve good financial returns, high-risk
R & D projects can bring enterprise a lot of intangible
resources and capabilities, which includes the accumula-
tion of knowledge, technical capabilities, project organ-
izational skills in the field, etc.; even includes innovation
network resources, some Know-How or technology pat-
ents. These intangible resources and capabilities at least
can help enterprises avoid risks, reduce losses in follow-
up projects, as well as provide more opportunities for
enterprises’ development. Enterprises can make full use
of these opportunities in the future, and from which we
can identify opportunities value of project in different
situations and the corresponding type of real option, as
shown in Table 2.
4.2 Design the Incentive Mechanism
In this incentive mechanism, the income of R & D team
is composed of salary and a part of the value of real op-
tion:
i
I
AV
(1)
In Equation (1):
""
I
means the income of R & D team.
""
A
means annual fixed salary.
""
i
V is the bonus that R & D team shared with the
value of real option in project No. i.
()
0
0
i
i
i
CNPV
VNPV CNPV

(2)
In Equation (2), when Net Present Value (NPV) of
project with traditional methods is negative or equal to
zero, we should regard the value of real option , not
NPV as the value of the project, because there is no sig-
nificance for NPV if the project is given up or switched.
When NPV is positive, we should regard total value, that
is the sum of NPV and real option value of , as the
value of the project, because which can reflect the cur-
rent and future performance more comprehensively.
C
C
In Equation (2), i
is the proportion of the value of
project No. i. The value of i
depends on R & D team’s
contribution rate to total project. Calculation of contribu-
tion rate may refer to the method of calculating the dis-
tribution of technical factors (at this time revenue of the
project should be regarded as the value of total project),
which presented in some relevant literature [14,15].
When calculate total value of the project, we should con-
sider it separately according to .
Generally speaking, when , the value of
0or 0NPV NPV
0i
NPV
should be larger. In practice, the value of i
is also
determined by three factors: firstly, by the specific busi-
ness target and strategic objective; secondly, by the
competition for talent within the industry; Thirdly, by the
result of negotiation and game between firms and R & D
team, which depends on both sides’ dominant position
and information symmetry, etc.
4.3 Design Specific Exercise Ways
There are many exercise ways of real option incentive.
For example, if exchange option value to a certain per-
centage of bonus, it can be seen as a European-style
two-value put option, and when the project achieved its
purpose, the option seller would pay a pre-agreed reward.
If total value of the current project (including NPV and
the value of real option) can be shared by the R & D
team, actually it can be considered as call option, which
allows team to share the profits of the follow-up project
or sell a part of stock for arbitrage at higher price. In
practice, call option includes American or European op-
tion, American option allows its holders to buy or sell the
subject at any time of the validity, and European option
allows only implementation at the due date. If it is
American option, which means option holder will be
allowed to share equity of the follow-up project at the
agreed price (or dynamic price in accordance with one
method) before the appointed time. In fact the two op-
tions can be used as incentive, and usually American
option’s operation is more complex than European op-
tion’s.
Table 2. The type of real option contained in high-risk projects
The action of high-risk projects Value of opportunities Corresponding type of real
option
experience and lesson can help enterprises
avoid risks in follow-up projects
Well identify risk and reduce loss by deferring investment,
contracting investment, giving up investment
The option to defer
The option to contract
The option to abandon
resources and capabilities accumulated provide
more opportunities for enterprises’ develop-
ment
Build foundation for similar technical upgrading.
Be able to switch to another project.
Intangible assets accumulated facilitate to enterprises’ ex-
panding in future.
The option to growth
The option to switch
The option to change scale
Classification of real option comes from [11]
Copyright © 2010 SciRes. JSSM
The Method of Real Options to Encourage the R & D Team
238
5. A Case of Real Option Incentive
Take option to switch for an example, we collect the
relevant data of a R & D project of a high-technical com-
pany to test it. Located in China, this company mainly
engaged in developing 3G communication technology. In
early 2007 the company conducted 3G-based mobile
software, and its R & D developed in three phases. Its
original input cost is 60 million. Every year, each phase
can be finished with generation, , of product A.ⅠⅡⅢ
And the product can be replicated and sold. This project
was influenced greatly by the State’s policy on 3G, and
faces a high market risk. Based on past similar project
data analysis, the market was forecasted to have a good
probability of 40 percent, the probability of a bad market
at 60%. After the first year, if the market is good, we can
get the profit of 60 million; if the market is not good the
profit is 12 million. In the following two years, if the
market is good the profit is high and cash flow will dou-
ble on the basis of the former year, but in the poor market
cash flow is only half of the former year. Let’s select the
company’s comprehensive capital-cost as a risk discount
rate (20%), and calculate the net cash flow (NPV).
E.g., in the good market condition of the former two
years, the expected value of cash flow in the second year:
(240 0.4060 0.60)(120%) 110

Similarly, we can calculate other discounted value of
net cash flow in every phase, result shown in Figure 1.
The final NPV expected value is 11.68 million:
71.6860= 11.68
So this project is worth to invest with NPV method.
5.1 Traditional Incentive Idea
However, in fact after one year market has changed, and
we found some competitors appeared, and the probability
of good or poor market would become 20% and 80% in
the next year, but the risk probability of market was un-
changed in the following 2 years. At the same time the
project get one patent that can be grounded for another
product and some enterprises will bid 50 million for it.
Obviously, when the first phase of R & D was completed,
the NPV was negative:
(105.4260) 0.2(21.0812)0.8
(120%)6010.38
NPV 
 
That means the project was failed, so R & D team can
not get any encouragement according to traditional com-
pensation or stock option incentive way.
21.08
22
27.5
60%
R&D project
60
60
12
40%
60%
120
30
40%
60%
24
6
40%
60%
240
60
40%
60%
60
15
40%
60%
48
12
40%
60%
12
3
40%
110
105.42
5.5
71.68
Figure 1. The cash flow of the project
Copyright © 2010 SciRes. JSSM
The Method of Real Options to Encourage the R & D Team239
5.2 Real Option Incentive Program
Now if we consider real option, the evaluation to the
project is entirely different. When R & D in the first
phase was completed, cash flow was only 33.08 million
in the poor market (that is, cash flow expected value after
one year in poor market: ), if we
switched to another product at this time, the value of the
previous R & D was 50 million. Obviously, such a con-
version opportunity is valuable. Actually it is option to
switch: the agreed price is 50 million, maturity period is
1 year, the current price of the subject is 49.62 million
(hat is, expected value of current cash flow, [(
21.08+12=33.08
105.42 60)
), maybe
rise to 165.42 million (that is, expected value of cash flow
after one year in good market: 105 )
or drop to 33.08 million due to date (that is, expected
value of cash flow after one year in poor market:
). We can use
0.221.08 120.8] ()
21.08+12=33.08
(1 20%)49.62
.42 + 60 =165.42
binomial tree model
[16] and set up the probability of price raise is “P”. With
the hypothesis of symmetric information and risk-neutral,
we can get the value of this real option at risk-free inter-
est rate of 3.87%, which is bank interest rate for
one-year.
0.0387
165.4233.08(1) 49.62PPe
0.1398P
That is to say, the probability of the call option is
13.98% of which value is 55.8 million (165.42 50
). And the probability equals 1 P when the
value of the call option is zero, that is 86.02%.
115.42
Expected cash flow of the option to switch is:
115.42 13.98%086.02%16.13
Discount at the risk rate of 20%, get current value of
option to switch:
16.13 / (120%)13.44
Therefore, project team will be able to share a part of
this value as an incentive with real option incentive ap-
proach when finished the first phase. The firm can de-
termine the proportion αi as 10% based on strategic ob-
jective and current industry competition. So, R & D team
may get 1.344 million as a reward. It is reasonable for the
both because this project can build foundation for an-
other product’s R & D and contribute to the company’s
development. Considering that being start-up period and
need more liquidity for more follow-up R & D projects,
the company decided not to use bonus but share the value
of latter project in the future.
5.3 Comparative Analysis about Advantage of
Real Option
The high-risk project is common for any firm. Real op-
tion incentive put forwarded in this paper is one of ways
to solve how to encourage R & D team in such project,
which advantages include: 1) to avoid short-term goal-
oriented, companies can determine benchmarks of team
incentive based on the follow-up value of high-risk pro-
ject; 2) To design more flexible incentive methods,
companies can use different types of real option or de-
sign different exercise methods; 3) If we combine real
option incentive with other motivation methods, the ef-
fect will be more targeted-oriented and more comprehen-
sive.
6. Conclusions
This article discusses the method of real options to en-
courage R & D team when the enterprises can not
achieve the desired economic benefit in the case of
high-risk project or the immature market. The steps of
method include: identify the real option type of high-risk
projects, design the incentive mechanism and design
specific exercise ways. In fact, real option presented in
this paper can be applied not only to high-risk project,
but also to other technical project. In addition, some
non-material incentives, such as honor or job promotion,
will bring more opportunities for R & D team, which
itself can be regarded as one of real options. How to
quantify the value of these non-material incentives ap-
proach and combine with other materials will be our next
research direction and focus.
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