Exercising The Option

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Exercising The Option A Reflection on Real Options in R&DbyAnders HemreinterKnowledge Technologies

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What’s an Option? The Option Value of (an) Innovation An Option is the right, but not the obligation, to buy or sell an asset in the future at a fixed (pre-negotiated) price. Options are financial derivatives traded in (financial) markets.

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The Option Value of (an) Innovation The value of an option depends on The time before exercising the option The value of the underlying asset The volatility of the asset The strike price The interest rate What’s the Value of an Option?

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What’s a Real Option? The Option Value of (an) Innovation A Real Option is the right, but not the obligation, to invest in a business opportunity or chose a particular course of action for developing, growing or abandoning an opportunity. In R&D, the (real) option is to develop a new technology or product, the investment is the project and the (underlying) asset is the future cash flows from product sales. Real options are not traded in a market.

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Suggested Vocabulary Technology development involves real options (management flexibility) watch & wait engage & learn commit & commercialize staged development invest & proceed scale up/down abandon abandon abandon abandon opportunity

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Suggested Vocabulary Investing in Developing Product XX A Staging Option combined with Phased Development earned value?proceed? initial investment additional investment final investment earned value?proceed? product launch abandon abandon

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Suggested Vocabulary Investing in Developing Product XX A Delay Option combined with a Prediction Market “stock” = prod xx will become a killer app 100 0 “Stock” Trading Price develop watch & wait

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Suggested Vocabulary What’s Wrong With Net Present Value? Traditional NPV may undervalue innovation by assuming that not investing results in flat line business performance not accounting for management flexibility not accounting for potential growth options not valuing delay and uncertainty

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What about Black-Scholes? C = S x N(d ) – Ke x N(d – σ ) -rT Black-Scholes options pricing assumes that the underlying asset (e.g. stock price) behaves statistically as a Brownian motion. In R&D this may not be the case and the standard deviation (σ) of cash flows may be difficult to determine. Therefore Black-Scholes should be applied with considerable caution in R&D valuations. T

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Suggested Vocabulary Innovation Valuation NPV + Investment Bonus + Options Premium Total Innovation Value = The value of having or creating real options The value of avoiding a decline in business performance from not making the investment

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Suggested Vocabulary Exercising The Option Managing innovation and technology development can be seen as the exercising of a series of real options. By exercising or abandoning these options, management can charter a course that maximizes the return (or minimizes the loss) on innovation. Applying real options thinking is particularly useful when traditional NPV is not strongly positive or when considerable uncertainty is present.

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Suggested Vocabulary Contact: Anders Hemre interKnowledge Technologies ahemre@interknowledgetech.com www.interknowledgetech.com