Strategic Luck Investing in longshot opportunities 112812 Please

Strategic Luck: Investing in long-shot opportunities 11/28/12 ( Please be sure to take a penny ; -) 1 Strategic Management

Today’s Agenda § Generating your own luck: The problem of strategic investments under uncertainty § Modeling investment decisions § Staging of investment decisions to mitigate downside risk § Moving from staging to real option analysis § Managing portfolios of real options § Organizational dilemmas from portfolios of strategic investments § Managing change § Escalation of commitment 2 Strategic Management

Exercise: Heads Up! § Initially, everybody stands. § Flip coins when told, all at the same time. § Do not look at the coin until told. § If you flip a head, remain standing. § If you flip a tail, sit down. § Winner (last one standing) gets all the $ 3 Strategic Management

Proposition: Success in technological innovation is all luck. § Realistic simulation? Does the exercise simulate the innovation process for organizations & industries? § Selection bias. We often only study “winners. ” § § In search of excellence… Stock scam… § Few repeat innovators. Most major innovations come from outsiders. 4 Strategic Management

50/50 is better than one can expect for many innovations: How do most analytical tools handle this? 19% Chance of Phase III success & FDA approval 5 Strategic Management

Hit, Miss, Error: Investing in Uncertain Technologies Actual Outcome Success II False I False+ Failure Pursue Drop Judgment 6 Adapted from Zur Shapira (1995) Risk Taking: A managerial perspective Predicted Strategic Management

Investment Decisions as Pure Luck Actual Outcome Success Failure Predicted Drop Pursue Judgment 8 Adapted from Zur Shapira (1995) Risk Taking: A managerial perspective Strategic Management

A Highly Predictive Model or Just Avoiding Risky Decisions? Actual Outcome Success Failure Predicted Drop Pursue Judgment 9 Adapted from Zur Shapira (1995) Risk Taking: A managerial perspective Strategic Management

Wish you could get a brief glimpse of the future? 10 Strategic Management

Today’s Agenda § Generating your own luck: The problem of strategic investments under uncertainty § Modeling investment decisions § Staging of investment decisions to mitigate downside risk § Moving from staging to real option analysis § Managing portfolios of real options § Organizational dilemmas from portfolios of strategic investments § Managing change § Escalation of commitment 12 Strategic Management

NPV & Investment Under Uncertainty Traditional NPV Approach Should we invest in commercializing a new but uncertain technology? Assume: * $100 M technology investment * 50% probability of $200 M NPV return Analysis: -100 +. 5(200) = 0 Rule: No reason to take on the risk! Question: Will we know more in 1 yr? 13 Strategic Management

Uncertainty Clarifies Over Time… Profit/Loss Profile Greater Profits X X X Worse Losses 14 Most likely Value (NPV) X Time Strategic Management

Assessing Real Option Value. 8 $36 M $17 M . 5 ($182 M) Commercialize (-$91 M) Pilot Capability (-$10 M) . 5 $0 M Commercialize Tech (-$100 M) Decision Abandon Project . 2 . 5 15 Failure ($0 M) Success ($200 M) . 5 Abandon Project Success Failure ($0 M) Option price==$10 M Option value=$27 M value=$46 M Strategic Management

Types of Real Options Option Type Abandon/put Important in, e. g. , Cash out startups; Capitalintensive industries Switch outputs Consumer electronics, or inputs Electric power Defer Natural-resources; R&D commitment (pharma, etc. ), patents Expand scale Venture capital; Fashion or scope apparel; JV M&A Growth Technology platforms; core competencies 16 Trigger Respond to bad news Respond to good news Strategic Management

Dell’s Switching Option § Dell faced uncertainty over which type of battery to use in its laptops (Ni. Hi or the new Li. On). 1. If Li. On works (p=60%), NPV = $600 Million 2. If Li. On fails (but they commit), NPV = $250 Million 3. If they stick with Ni. Hi, NPV = $500 Million § Two ways to defer commitment (retain flexibility): 1. Dual development: Cost = $3 Million 2. Overdesign (either battery works): Cost = $10 Million § Is it worth the added cost to be able to switch battery technologies later? 17 Strategic Management

Black-Scholes Option Valuation 18 Strategic Management

Calculating Option Parameters t X S = $81 M § § 19 r NPV (@10%) = ($12 M); Risk free rate = 5. 5% Luehrman approach parameters S = Current value of a project’s underlying assets X = Expenditure required to acquire project assets t = Time before the exercise decision is made r = Risk free rate σ = Standard deviation on project returns (? ) Strategic Management

Some Volatility Reference Points 1928 1988 20 1933 1993 1938 1999 1943 1948 1953 1958 1963 1968 1973 1978 1983 Forward looking/Implied volatility estimates: § Genzyme: 32% § Alexza Pharmaceuticals: 110% § Crucell NV: 156% Strategic Management

Today’s Agenda § Generating your own luck: The problem of strategic investments under uncertainty § Modeling investment decisions § Staging of investment decisions to mitigate downside risk § Moving from staging to real option analysis § Managing portfolios of real options § Organizational dilemmas from portfolios of strategic investments § Managing change § Escalation of commitment 21 Strategic Management

Real Options in Real Organizations: Predicting outcomes Time Frame Ambiguity Persistent Uncertainty Outcomes § Escalation § Kill golden goose § Pressure to delay decision § Social capital/ reputation is key Org Form Integrate/ Isolate § Integrated: Champion w/strong ties Escalation 3 M § Isolated: Champion w/weak ties Kill good projects 22 *Adapted from Coff & Laverty, 2001, 2007 Strategic Management

Bottom line on Real Options § Does an option make sense? What can you learn by delaying full commitment? At what cost? § Methods. Choose one that fits w/available info, culture, and decision-makers’ styles. Tool Decision Tree Black Scholes Strengths Intuitive & Superior to DCF Rigorous & intuitive for some… Limitations • May not account for risk properly • Some option value missed • Hard to measure parameters (e. g. σ) • Ignores some information § Management challenges. Must tailor org systems (structure, incentives, etc. ) to make it work. 24 Strategic Management