Technical Due Diligence & Monte Carlo Risk Analysis

1. Technical Due Diligence & Monte Carlo Risk Analysis • James F. Wright (Ph.D. in Physical and Nuclear Chemistry) • http://www.drjfwright.com • http://www.montecarloriskanalysis.com 11th Annual QAD Conference

2. Technical Due Diligence and Monte Carlo Risk Analysis Outline • Technical Due Diligence & Quality Audits • Applicable Projects (Type & Size) • The Technical Due Diligence Team • Technical Systems Analysis • Technical (Monte Carlo) Risk Analysis 11th Annual QAD Conference

3. Two-Cow Feudalism • You own and care for the cows • You & your cows live on your lord’s estate • Your lord takes some of your milk 11th Annual QAD Conference

4. Two-Cow Fascism • The government confiscates your cows • You are hired to care for the cows • The government sells you milk 11th Annual QAD Conference

5. Two-Cow Communism • You “donate” both cows to the community • The community cares for the cows • The milk is made available to the community as needed 11th Annual QAD Conference

6. Two-Cow Totalitarianism • The government confiscates both of your cows • The government denies they ever existed • You are drafted as an Army Private • Only 50 most powerful in government get milk 11th Annual QAD Conference

7. Two-Cow Traditional Capitalism • You own two cows • You sell one cow & buy a bull • You establish Dairy Farm • You establish Beef Cattle Operation • Your business prospers and you retire on the income. 11th Annual QAD Conference

8. Two-Cow “Dot Com” Capitalism • You own two cows • $500 million IPO (your two cows, 500 PC’s & associated facilities) • Company sells milk over the internet • Company has no profit but sales grow 11th Annual QAD Conference

9. Two-Cow “Dot Com” Capitalism (cont.) • You pump Company’s stock • You exercise $15 million golden parachute • The company files for Chapter 11 • You have local grocery store deliver milk to your house 11th Annual QAD Conference

10. Two-Cow Ethereal Capitalism • You have two real cows • You sell all three of them to your publicly listed company using a letter of credit opened by your brother-in-law at the bank • You initiate a debt/equity swap with an associated general offer and get all four cows back with a tax exemption for five cows 11th Annual QAD Conference

11. Two-Cow Ethereal Capitalism (cont.) • Milk rights for six cows transferred (via an intermediary) to Cayman Island company you secretly own • Cayman Island company sells the rights to all seven cows back to your publicly listed company • The publicly listed company’s Annual Report states it owns eight cows with an option for another. 11th Annual QAD Conference

12. Quality Audit A systematic, independent examination of the quality system to determine: whether both the quality system activities, and the results of such activities, comply with quality system procedures; that these procedures are implemented effectively; and that these procedures are suitable to achieve quality system objectives. 11th Annual QAD Conference

13. ISO 9001 2000 The required business practices in this “Quality Management Standard” are sound operating principles that should maximize efficiency (and profits!) 11th Annual QAD Conference

14. Why Evaluate Projects? • Investor Due Diligence – to Protect Investors • Compliance Audits – To Verify Quality Management System (ISO 9001 2000) 11th Annual QAD Conference

15. What is Due Diligence? According to Webster: The care that a reasonable person exercises under the circumstances to avoid harm to other persons or property. 11th Annual QAD Conference

16. What is Due Diligence? According to me: The act of protecting entities from harm caused by a process or event. 11th Annual QAD Conference

17. What is Technical Due Diligence? According to me: The act of protecting entities, that utilize new or emerging technologies (i.e., risky projects!), from harm caused by a process or event. 11th Annual QAD Conference

18. What is Due Diligence My QA Definition: The act of protecting entities from harm caused by a process or event by verifying the existence of a comprehensive Quality Management System. 11th Annual QAD Conference

19. Types of Projects • Conventional Projects - Success determined by conventional business parameters • High-Tech Projects - Success determined by above plus Internet-related factors • Technical Projects - Success determined by above plus ability to develop new or emerging technologies 11th Annual QAD Conference

20. Sources of Technical Projects • New or emerging technologies (Risky Projects are both the Best and the Worst) • Big national science • Successful technical companies 11th Annual QAD Conference

21. TABU (Technical Axiom of Business Uncertainty) The less you know about a project, the higher your uncertainty regarding the project! 11th Annual QAD Conference

22. Some Corollaries of TABU • Those that treat a pro forma as fact are showing you how little they know about the project • Surprises will usually adversely effect the project • Cost estimates will usually be underestimated • Income estimates will usually be overestimated 11th Annual QAD Conference

23. More Corollaries of TABU • Uncertainties increase as estimations are moved farther into the future • The added cost of technologies must usually be repaid at the end of the project • New technologies seldom lower up-front expenses • Expected savings from operating in less-developed countries are usually fiction 11th Annual QAD Conference

24. The Thesis • Projects with high risk need a more sophisticated method of due diligence • The uncertainty in high-risk projects should be quantified 11th Annual QAD Conference

25. Elements of the Technical Due Diligence Process • Form a Technical Due Diligence Team – Qualifications determined by Project’s Character and Relative Risk • Technical Systems Analysis - Will technology work as advertised? • Technical Risk Analysis - Quantify the risk! 11th Annual QAD Conference

26. Technical Due Diligence Team • Project Manager - Expert, confidence of client, no conflict of interest, focused, manager • Marketing, Technical, Legal, Finance, etc. Team Members - Qualified experts, no conflicts of interest, “loose lips sink ships” 11th Annual QAD Conference

27. Basis of Technical Systems Analysis A technology is unproven until it has been demonstrated to work at the required scale as planned! 11th Annual QAD Conference

28. The Process of Technical Systems Analysis • Define Technical Scope • Technology & Scaling • Operational Process • Marketing & Sales Methodology • Legal & Regulatory Issues • Operational Model (with quantified uncertainty!) 11th Annual QAD Conference

29. Technical Risk Analysis • Define a Scenario - Business Model • Evaluate the Consequences of the Scenario - determined by the investor-selected metric and analysis methodology (Monte Carlo) 11th Annual QAD Conference

30. The Metric • Process Metrics – Percent Idle Time, Manufacturing Time • Economic Metrics – Net Discounted Cash Flow, Profitability Index 11th Annual QAD Conference

31. Accuracy & Precision Precise Accurate 11th Annual QAD Conference

32. Sources of Error • Random Error - caused by chance, not reducible, no effect on accuracy (most likely value), effects precision • Uncertainty - determined by assessor and their (lack of) knowledge, effects most likely value, accuracy and precision 11th Annual QAD Conference

33. Different Analyses Single Valued Analysis A = 1023 ft x 753 ft A = 770,319 ft2 11th Annual QAD Conference

34. Different Analyses Standard Error Propagation A = 1023 ft x 753 ft A = 770,319 ft2  = 74,096 ft2 (symmetric ) 11th Annual QAD Conference

35. Different Analyses Monte Carlo Simulation • Took 20 measurements of each side • Created a distribution function for each side • Used 50,000 iterations • A = 771,897 ft2 •  = 6,508 ft2 (from FWHM of distribution function) 11th Annual QAD Conference

36. Monte Carlo Risk Analysis • Use metric that client understands • Monte Carlo calculates answer to metric that reflects the uncertainties of each of the input parameters 11th Annual QAD Conference

37. Gaussian Frequency Distribution 11th Annual QAD Conference

38. Gaussian Cumulative Distribution 11th Annual QAD Conference

39. The Monte Carlo Process • Determine metric (A = p + xy/z) • Determine distribution function for p, x, y, & z • Start Iterative Process - Use PRNG to get values for p, x, y, & z to be used in this iteration - Calculate A for this iteration • Continue Iteration until OK 11th Annual QAD Conference

40. Gaussangular Distribution 11th Annual QAD Conference

41. The Book! “Monte Carlo Risk Analysis and Due Diligence of New Business Ventures” by James F. Wright • Publisher - AMACOM (August, 2002, release) • Monte Carlo software included on CD • Two detailed examples in book that use software • 30 Tables, 49 Figures/Screens, 480 Equations 11th Annual QAD Conference