1.
The Impact of Technological Risk on the Likelihood of Investment
1.1
Big risk -- small chance of investment
During the start-up phase of corporate life cycles, there are frequently concurrent activities in R&D and activities directed towards generating funds necessary to sustain operations and in acquiring private equity investment. In more mature enterprises, new projects may still be in the R&D phase while planners are seeking resource commitments for commercial exploitation. In both cases, there is a problem that is the result of trying to obtain “investment” when there is a perceived technological risk, the kinds of risk associated with R&D efforts. This perceived risk is an important determinate in the investment decision-making process.
1.2 But not all investors are the same
For set of investment opportunities having essentially equivalent projected commercial potentials, when the risk is known to be high, the likelihood of securing funds is relatively small. Conversely, when the risk is low, the likelihood of securing funds is greater. For a given project, say one in the R&D phase such that there is a known level of risk to successful commercialization, the likelihood of investment is also markedly influenced by the degree to which the investor or the financial decision-maker is conservative or risk-adverse. This tendency is qualitatively represented in Figure 1.
Figure 1: For any degree of risk, the likelihood of investment depends markedly on the degree to which the investor is conservative.
2.
Differing Perceptions of the Likelihood of Technological (and Business) Success
2.1 Investors are conservative and risk-adverse
Conservatism is natural in the investment and financial management community. It follows from the nature of the responsibilities placed on decision-makers in that community. (Reference:
Chambers & Lacey,
1994) The degree to which these decision-makers accommodate risk depends on numerous factors, but clearly their understanding or perception of the likelihood of an investment leading to a successful conclusion is a dominant consideration. In enterprises with substantive technology components, business success may be a function of technological success. Unfortunately, understanding of the likelihood of technological success is usually difficult for the investment and financial management community.
2.2 Proponents of new technology tend to be both optimistic and adventuresome
Contrasted to members of the investment and financial management community, proponents of new or evolving technologies tend to be both optimistic and adventuresome. Virtually a prerequisite for entrepreneurship in technology areas is the attribute of being willing to assume and accommodate a large measure of risk.
Fundamental differences in how the desirability of an investment in a technology-based or technology-dependent enterprise development is viewed may lead to misunderstandings. These can be a result of the failure of each party to fully appreciate how the other views the same investment “opportunity.” Such differences, over a range of perceived degrees of the likelihood of “success,” are represented schematically in Figure 2.
Figure 2: The desirability of an investment varies with the perceived likelihood of success and technology proponents and investors typically diverge in their perception of the likelihood of success.
When the parties to an investment negotiation do not appreciate or fully understand the differences in their understanding or perception of the same “opportunity,” much less the reasons for their being differences, the negotiations can become stalled, even acrimonious. Hopefully this brief will shed some light on situations of this ilk and, in proposing and exploring how independent technology assessments brings a new resource into the process, will facilitate sound investment decision-making.
3. Uncertainties in the Level of Risk
3.1 The less certainly investors know the risk, the more conservatively they tend to act
Differences in how the two principal parties to enterprise development view investment opportunities make matters complicated but, unfortunately, they are complicated even more by an uncertainty in knowing the level of risk associated with a given technology. Some level of uncertainty is always part of the process.
3.2 But not all investors are the
same
For any given level of risk (although what that risk may be in an absolute sense is unknowable), Figure 3 depicts an overlying uncertainty. For any level of such uncertainty, there is likely to be a range of views about making an investment. In Figure 3, a band of uncertainty associated with the degree of technology-related risk is depicted. Rarely will all investors arrive at the same evaluation for a given investment situation if it has any degree of uncertainty at all.
Figure 3: Knowing with certainty the level of risk improves the likelihood of securing an investment.
4. Technology Assessment Changes the Decision Paradigm
Such factors as those noted above will continue to cascade and multiply unless a new tool is introduced into the investment decision-making process. To provide a context for such a tool and how it might be used, the following section describes briefly current mainstream practices.
4.1 Due diligence
Due diligence is an in-depth analysis of the financial and operational conditions of a company targeted for investment, merger, or acquisition. It may be as detailed as an accounting audit but is typically much broader in scope because the operational condition and efficiency of the target’s assets are investigated as well. Due diligence is to ascertain the economic values and results of operations and express them in financial terms. The objective is to find, identify, and estimate the impact of purchase price or investment conditions. (Reference:
McLaughlin, 1998) Due diligence may also be described in terms of investigation of investment potential by consideration of six major areas of concern including market structure, competition, and marketing strategy; management team assessment; operating plan (development, operations, marketing, support systems); financial review; legal review; and technology assessment. (Reference:
Keely,
et.al.,
1998):
4.2 Technology Assessment
“Assessing Technology Risks” was the topic of the September 1999 Beta-Rubicon Technology Assessment Brief. The following paragraph is from that brief and is repeated here so that this paper will be complete as a standalone document.
“Technology Assessment includes a detailed review and analysis of the technology development proposal documentation and literature, verification of the representations made by the proponent, and a reviewer’s conference. There must be a review of the technology plan; an evaluation of the depth of proponent’s in-house expertise, and a search and analysis of state of the art in the proponent’s area of technology. Additionally there should be a search and analysis of related and competitive technologies, a detailed analysis of the technology and development plans, schedules, budget, and its management capabilities to respond to the opportunity; and structured interviews with key personnel. Conclusions and recommendations must be formulated, and full details of methodology, sources, and references documented.”
4.3 Technology Assessment complements Due Diligence and promotes a new paradigm
Technology assessment may be integrated with classical due diligence providing a new focus on opportunities that are primarily technology-based or technology-driven or both. Technology assessment augmenting due diligence requires an intimate knowledge of the state-of-the-art in technology, as well as of technology trends, R&D management, and management technology. Further, it requires a high degree of research and scientific sophistication, a well-developed analytical methodology to provide accurate evaluations of the relative risks and potential rewards of the acquisition of, merger with, or investment in technology-based enterprises. It requires extensive data gathering and information extraction capabilities and the ability to translate technical detail into terms that make relative potential risks and rewards meaningful to the investment community. When these conditions are met, a new paradigm emerges. A paradigm shift is needed to respond to the increasingly frequent appearance of complex technology components in new or upgrading enterprises.
Figure 4: Adding technology assessment to conventional due diligence changes the investment decision-making paradigm.
5. Improving the Knowledge of the Level of Risk and Facilitating Investments
In situations where differences are at play in both the risks perceived to be associated with technology deployment and where there exists a substantial degree of uncertainty with which that risk is known, the likelihood of investment is almost certain to be smaller than it would be otherwise. How would this situation be improved by using the new investment decision-making paradigm described above? How can the new paradigm facilitate more sound technology investment decisions?
5.1 In-depth Technology Assessments improve confidence
While any objective assessment of the technology component of a new or evolving enterprise is better than none, it should be intuitively obvious that more in-depth assessments provide more information and greater certainty than lesser ones. There are also diminishing returns if such analyses are excessive. A S-shaped curve results if measures of the thoroughness of the technology assessment are presented in relationship to the resulting confidence in the certainty of the assessed risk. This is shown in Figure 5.
Figure 5: The degree of certainty in risk improves with the thoroughness of the assessment of the technology.
5.2 Confidence in likelihood of success promotes investment
The overall resultant of the above considerations is represented in Figure 6. That the high and low certainty lines cross reveals a serious weakness in depending on poorly quantified (low certainty) determinations of the likelihood of success in technology based or technology dependent enterprises for investment decisions. Indeed, where the uncertainty is large, it is foreseeable that investments could be made where more certain information would clearly preclude them (at the end of the curve where the likelihood of success in below the mid-point. On a more positive note, the likelihood of investment should be substantially better where the certainty in the determination is good and where the likelihood of success is above the mid-point.
Figure 6: The likelihood of success and the certain knowledge of risk positively correlate with the likelihood of securing investment.
5.3 Knowledge of risk may allow greater management flexibility
There are numerous management concerns related to the development of new products and processes. Several are associated primarily with risk management. Cooper, for example, notes that one should err on the side of thoroughness in designing new products. He goes on to say that, “Flexibility and short-cuts can be built in, especially for lower-risk projects when the risks of omission are understood.” For higher-risk projects, he recommends the adoption and adherence to disciplined and thorough new product processes. (Reference:
Cooper, 1998). These ideas presume a good knowledge of the level and nature of the risks involved and constitute another important reason for undertaking detailed technology assessments.
6. Concluding Comments
Technology assessment is not easy. It requires special skills and aptitudes. (Reference:
Kahaner, 1996) However, general agreement with the arguments presented above leads naturally to consideration of the necessary characteristics of an investment-facilitating technology assessment to be used in complement to conventional due diligence. We would suggest that those characteristics include, as a minimum, the following:
1. Competence: in-depth knowledge of the technology.
2. Competence: in-breadth knowledge of technology management, implementation, and deployment.
3. Objectivity and independence with no vested interest in specific outcomes.
4. Communications skills to provide meaningful, well organized, complete, and clear results.
5. Responsiveness to client needs relative to scope, timing, and presentation.
Such characteristics are well understood by Beta-Rubicon, Inc. and, indeed, are fundamental in our approach to technology assessment.
6.1 Allied situations that merit consideration
This brief has not explicitly considered venture capital (VC) funds or angel investors. VC funds invest in only 2% to 4% of the “opportunities” that they review and angel investors only slightly more. Further, the rate of return on they expect on their investment is 10 to 15% higher than the S&P return on equity and, for early stage enterprises typically exceeds 60%. These expectations of high returns are in large part the result of the level of risk being assumed (Keely, et. al., 1998). If the level of risk is reduced through technology assessment, the gap between the expectations of these investors and what is acceptable to entrepreneurial enterprises should be narrowed and more investments successfully negotiated.
6.2 Prepared by:
R. R. (Ron) Goforth, Ph.D., General Manager of Beta-Rubicon, Inc., prepared
"Independent Technology Assessments Facilitate Sound Investment
Decisions."
6.3 Contact Information:
To request further information, offer comments, or express interest in securing the
services of Beta-Rubicon, Inc., please contact:
| Dr. R. R. (Ron) Goforth, General Manager |
Voice: (479)444-8118 |
| Beta-Rubicon, Inc. |
FAX: (479)575-7446 |
| 21 West Mountain, Suite 123 |
e-mail: email@beta-rubicon.com |
| Fayetteville, AR 72701 |
|
Alternatively, if you prefer to contact us directly from this site, you may use
our "Request for Additional Information."
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References
Chambers, Donald R., & Lacey, Nelson
J., Modern Corporate Finance: Theory and
Practice, Harper Collins Publishers, New York, 1994. pp-205-219.
Cooper, Robert G., Product Leadership: Creating and Launching Superior New
Products, Perseus Books, Reading, MA., 1998. pp. 55.
Kahaner, Larry, Competitive Intelligence, Simon & Schuster, 1996. pp. 95-100.
Keeley, Robert H., Jeffrey M. Cooper, Gary D.
Bloomer, Business Angels: A Guide to Private
Investing, Colorado Capital Alliance, Inc., Boulder, CO, 1998.
McLaughlin, Joseph, Chair, Conducting Due Diligence 1998, Practising Law Institute, New York, 1998.
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