First Tuesday’s ‘Next Big Thing’: Exploration vs Hunting

Those of us in attendance at the First Tuesday event held on the 11th of June had the opportunity to learn about fascinating developments in high-tech while being reminded of the gap in thinking between research engineering academia and the high-tech business community.

Prof. Joe McGeehan of the University of Bristol highlighted much of the fundamental research being performed in the South West of England in RF engineering, software development, and new fiber optic materials. Yet, when he proceeded to talk about the “Next Big Thing”, he spoke in the language of an explorer. In his viewpoint, killer applications can not be predicted. Researchers and business can explore possibilities and opportunities, yet their ability to predict killer applications is poor at best and somewhat futile.

Many people in the audience took issue with this viewpoint. Businesses investigate technology to hunt for the next big thing. While the tech business community strongly supports funding for fundamental science and engineering, we are also realistic about the economics of the situation. Even if our success rate is low, we should note that the financing of new developments may match the expected risk-adjusted return as determined by Real Options Analysis.

Real Options Analysis is an advanced finance method for pricing certain activities, such as business expansion and new product development. Pharmaceuticals, such as Merck, have been using Real Options Analysis to determine the value of exploring a new drug or therapeutic regimen for over a decade. Likewise, Royal Dutch Shell uses scenario planning to outline the value of new explorations and further exploitations.

The fundamental requirements of making a Real Options Analysis worthwhile is the ability to (1) stage or defer full investment and (2) postpone decision making until further information is gained. Using standard NPV techniques, the risk-adjusted rate-of-return demanded for a pharmaceutical, oil field, or technological investigation may indicate that the exploration is not worthwhile. Using Real Options pricing however, finance theory may indicate that initial funding is warranted and further funding would be contingent upon several factors, some of which are determined in the scenario planning while others are to be uncovered during the course of the first stage of investigation.

Many US technology firms are currently acquire funding through the Seed/Venture/Next Round/Public or Sell-Off funding method. In many ways, this financing method mirrors that used by pharmaceutical companies when they perform a Real Options Analysis. Both methods rely upon staged investment and the determination of risky variables after the initial investment is made.

While there are only a few specific cases of formal quantitative Real Options Analysis being applied to technology funding, it should be understood that efficient financial markets can make these calculations intuitively. One of the early cases of options trading was in 17th Century England, wherein people would trade options regarding the return of a shipping vessel and the value of its cargo. Historic financial research has indicated that the options prices used by these early traders closely match those which would be predicted by Black-Scholes equations. Also, Thales, a sophist philosopher who lived on the island of Milos in the Mediterranean, traded options on an olive oil crop long before many markets even existed.

Hence, in regards to the ability to predict “the next big thing,” entrepreneurs and venture capitalist may be less than perfect at predicting the outcomes, but financial theory takes this into account when determining the investment level for a particular activity. Moreover, we have made great strides in understanding what allows a new product or technology to take-off and what can kill it, and also in understanding the differences between having a great technology that everyone buys and having a killer application that draws a market to purchase all aspects of a new technology.

Business will continue to hunt for our next “killer-app”, but I also trust we continue funding explorers like Prof. McGeehan.

The May Report, TECH BUSINESS BRIEFS, June 19, 2002