Innovation Process Management: Financial Pitfalls

1. Innovation Process Management: Financial Pitfalls Velko Tzolov, Ph.D., MBA May 15, 2009

2. Agenda • Motivation • Innovation Killers • Misusing Discounted Cash Flow and Net Present Value • Real Options Concept • Fixed and Sunk Cost Bias • Earning Per Share vs. Innovations: EVA Concept • Financial Pitfalls: Technology Start-ups • Conclusion

3. Motivation • Importance: direct link with the corporate strategy • Limitations of the traditional financial assessments • Common misunderstanding of critical assumptions & financial model limitations • Ever-changing business models & market opportunities “I’ll be happy to give you innovative thinking. What are the guidelines?”

4. Innovation Killers Objectives • Introduce key financial managerial tools and concepts • Discuss ideas and critics of financial managerial tools based on: “Innovation Killers – How Financial Tools Destroy Your Capacity to Do New Things”, by Clayton Christensen et al, HBR, Jan 2008 • Present my own interpretation and analysis of these tools’ applicability in the innovation financial management process

5. DCF & NPV: main concepts The Discounted Cash Flow (DCF) is a cash flow summary that has been adjusted to reflect the time value of money. It uses the Present Value concept and most commonly is confined in determining the Net Present Value number Present Value = (Future Value)/(1.0 + Interest Rate) # periods What is the present value of $100 at annual interest rate of 10% to be received in 3 years? Present Value = $100 / (1.0 +0.10)3 = $75.13 DCF isreturn on investment analysis tool

6. DCF & NPV: main concepts Net Present Value (NPV) is defined as the total present value of series of (negative or positive) cash flows Where, is the cash inflow (if positive) or outflow (if negative) in year t and i is the discount rate: The discount rate I & the total out years N are the key variable in the process!!

7. DCF & NPV: a graphic presentation There are plenty of commercial & in-house DCF & NPV software analysis tools

8. DCF & NPV: why using it? Rational behind using DCF for innovation project assessment • Determine profitability vs. loss: positive NPV means profitable project • Facilitate the evaluation of pessimistic, optimistic and realistic scenarios • Enable management decision making process • Help management to evaluate and select one project vs. other project • Determine investment decisions and estimate Return on Investment (ROI) figures DCF is not perfect, but still among the key tools used to support investment decisions

9. The DCF Trap • Wrong assumption that the present health of the company will persist indefinitely in the future even if the innovation investment is not made! • Do-nothing (or base scenario) will most likely lead to declining of the firm performance: losing competitiveness, market share, key customer accounts & future growth opportunities Would you approve negative NPV innovation project?! Projected cash flows from investing in innovations Expected real difference: innovation investment vs. doing nothing A B C Wrongly assumed cash Baseline if doing nothing More likely cash deterioration If doing nothing Executives should add the “do-nothing” analysis to their arsenal of DCF tools

10. The Terminal Value Trap • The number of “out years” can be a complete shot in the dark • To cope with it analysis use 3 to 5 year analysis and a fixed terminal value to account for all cash flows thereafter • Terminal value (TV) is estimated by the cash generated in the last year of DCF analysis divided by (i - g), where i is the discounted rate and g is projected growth rate in cash flows. Then the terminal value needs to be discounted to present value • “Terminal Value Trap” - TV often represents large (< 50%) of the NPV, it is based on estimates for preceding years and can lead to significant errors when evaluating innovation projects Terminal Value + Cash Flows Y0 Y1 Y2 Y3 Y4 Y5 Terminal Value could be an error magnifying factor in the DFC analysis

11. My five cents • When evaluating “do nothing” scenarios managers need to have a deep understanding: • Global and industry trends • Product/technology life cycles • Competitive landscape • Danger of substitutes that can very fast obsolete their product/service offering • In innovation accelerating environment very often estimates based on previous years don’t work

12. My five cents – cont. • Small scale/big scale innovation projects (relative to the company size) will always require different assessment tools and criteria (Intel vs. a small technology start up) • Discount rate – this is where all the “magic” is! • Most often it is set at Weighted Average Cost of Capital (WACC) • Sometimes it is higher to compensate for higher risk involved in technology innovation • Guess what is the WACC for many firms in the current deep recession?! WACC is the cost of capital for a firm to raise funds through equity and/or debt

13. Real Options in Innovation Process • A real option is the right, but not the obligation, to undertake a business decision. It is often referred as ROA – Real Option Analysis • In contrast to financial options in is not tradable, but can be financially assessed and priced • Complex stochastic method such as Monte-Carlo analysis or more traditional mathematical models such as Black-Scholes are being used to price the real options

14. Real Options in Innovation Process Real Option #2 Estimate $$ and bring to PV Estimate $$ and bring to PV + + Cash Flows Y0 Y1 Y2 Y3 Y4 Y5 ROA is often contrasted with NPV analysis, but other believe it’s a complementary tool

15. Real Option Analysis Samples • Option # 1: Cancel an innovation project, sell underlying assets, sell or license IP, re-assign staff to other projects and/or departments • Option # 2: Pursue different market (or segment), re-assess market share, revenues, margins and corresponding cash flows • Option # 3: Change business model: product vs. services, OEM vs. direct, product vs. license, etc, and reassess projected cash flows Drawbacks: • Accountants don’t understand and don’t like it!! • Underlying price assessment models could be pretty complex Can ROA analysis help a “NO GO” innovative NPV project to get green light ?! ROA accounts for changes in risk over a project's lifecycle and helps making risk adjustments

16. Fixed and Sunk Cost Analysis • Fixed Cost are expenses that do dot depend on the level of outputs (rent, fixed salaries, etc.) • Sunk Cost is cost that can not be recovered once they have been incurred (capital equipment, buildings, R&D cost) • Fixed & Sunk Cost Trap: Management bias toward leveraging assets and capabilities that are likely to become obsolete • It presents a great danger for incumbents because it slows the pace of innovations Firms have to wisely time their innovation investments

17. Fixed and Sunk Cost Analysis • Often it seems financially sound to use traditional technologies & assets that have access capacity & are substantially amortized thus offer low marginal cost of manufacturing • New (usually small) & old (usually large) firms often act differently, because of the different degree of leveraging existing brands and structures, as well as different corporate strategies • Capital asset usable lifetime vs. its competitive lifetime • Shortening the later is directly related to the accelerated pace of innovations and leads to completely new business environment Firms have to wisely time their innovation investments

18. Earnings per Share vs. Innovations The root of the problem • The never-ending lost of long-term (strategic) focus to meet short-term goals • Why: principal-agent theory – aligning shareholders with managers interests! • The mechanism of agent performance monitoring needs a tangible metric to measure success and determine compensation; EPS is being used as such a metric • It create a bias among executives against long-term investments. Instead they often buy back company stock and/or pay dividends

19. Earnings per Share vs. Innovations Is there way out? • Different mechanism of executive compensation (Verizon) • Using Economic Value Added (EVA) as a tangible metric • EVA is an estimate of true economic profit after making corrective adjustments including opportunity cost of equity capital • Shareholders of the company will receive a positive value added when the return from the capital employed in the business operations is greater than the cost of that capital EVA is a registered trademark of Stern Stewart & Co. Principal-agent theory has multiple facets including agent-agent problems

20. Business Processes & Innovations • Stage-gate innovation process: • Has been widely misused • Drawbacks include: decision criteria, significant degree of assumption tweaking, takes that correctness of the initially proposed strategy for given: lacks the Real Option aspect!!

21. Business Processes & Innovations • Discovery-driven planning • “Reverse Income Statement” – create assumption check list, rank order with deal killers and test assumptions • At a new stage, check against assumptions test if reasonable and reassess • If no plausible assumptions would support success, kill the project

22. Financial Pitfalls: Tech. Start-ups • Marginal vs. highly-differentiated businesses • Role and type of the entrepreneurs and investors • Current state of affairs: VC, angels, institutional, government, firms, entrepreneurs

23. Financial Pitfalls: Tech. Start-ups • Case study1 on successful technology businesses: • 100 most successful US start-up researched • Most successful businesses addressing markets with huge degree of ambiguity • Technology innovations less of a success factor vs. business model innovations • Generally no formal business & marketing plan • Entrepreneurs very agile in terms of business models, ideas, markets 1 “Origin and Evolution of New Businesses”, Oxford University Press, Jan 2000, Amar V Bhidé The best time to invest in technology start up is at the bottom of the recession

24. Financial Pitfalls: Tech. Start-ups cont. • VCs expect out of 10 investments in 3 to 5 year time horizon • 1 to be largely successful - returns >10 times • 2 to be OK, returns 2-5 times • 7 to be marginally successful to die • Investment decisions components • Huge discount rates (up to 40%) accounting for very high risk factors • Double and triple dips to factor in risk • Use simplified financial assessment tools and a lot of gut-feeling • Business valuations • DCF and Discounted Exit Valuation • Multiple of Revenues • Preceding Financing & “Divide the Pie” approach The VC industry in US is expected to have the worst year in two decades

25. Conclusion “…failure in innovation is rooted in not having asked an important question, rather the in having arrived at an incorrect answer”1 • The paradigms of financial analysis need to be challenged • Look beyond the financial tools: they are tools only that facilitate the decision making process and need to be used wisely • All decisions have to be taken based on long-term strategic objectives • Think about innovations outside of the box: a “cool” tech idea is a small fraction of the success, a “cool” business model is a bit more, but hard work + believe is all the rest 1“Innovation Killers–How Financial Tools Destroy Your Capacity to Do New Things”, Clayton Christensen et al, Harvard Business Review, Jan’08