eCommerce—The investment: Get real! By Kathleen Dahlberg and Benjamin
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PDF Help Traditional corporate finance techniques are not up to
evaluating the new risk/reward dynamics of investing in eCommerce. So what are
you supposed to do with all those proposals sitting on your desk? Begin
thinking about these investments in an entirely different way by using real
options theory. It can take much of the guesswork out of eVenture
opportunities.
Recently BP Amoco evaluated a business opportunity
that would save the company money. Managers understood the risks and rewards
associated with the project—which involved creating a new service—and believed
they had the necessary analytical tools to make an informed decision.Using
discounted cash-flow analysis, they determined the project would produce a
savings of $20 million per year.
Managers also suspected that the service could be sold externally, but
they did not know how to evaluate this added benefit. The eCommerce-related
project had no fixed assets. Like so many ventures in the fast-changing
Internet space, there was a great deal of uncertainty about it.
If management had used only discounted cash-flow analysis to evaluate the
eCommerce opportunity, the project would have been penalized for the
uncertainty, and the valuation would have been so low that the company probably
would not have chosen to invest in selling the service.
Instead, managers supplemented the analysis by using real options theory
to value the investment. The value of the option turned out to be several
hundred million dollars. So BP Amoco decided to invest in the eCommerce aspect
of the project.
Culture clash
What managers at BP Amoco used
was a way of making investment decisions more appropriate to eCommerce ventures
than discounted cash-flow analysis, the tried-and-true measuring stick that is
as much a part of most corporate cultures as blue suits and wing-tip shoes used
to be.
Indeed, the rise of eCommerce
poses a serious challenge for "old economy" corporations faced with myriad
investment opportunities in an arena they are struggling to understand. The
very nature of the new economy—its dynamic, ever-changing complexion and high
degree of risk—requires a different way of analyzing potential eCommerce
ventures. It also calls for new tools and techniques with which a company can
create new business models in response to ever-changing opportunities.
A new and effective approach does, in fact, exist: Use real options
theory, which was first introduced by former Thunderbird professor Timothy
Luehrman as a tool for valuing corporate investments, as a starting point for
changing the mind-set.
The risk penalty
The traditional approach to
corporate investments could be described as Think Big, Act Big and Don't Fail.
Think Big means finding the big idea that defines a number of
projects or programs. Act Big means taking on a large project
or program that usually has a multimillion-dollar price tag. Don't
Fail means eliminating the project's risk.
Discounted cash-flow analysis has a built-in bias for large,
capital-intensive projects for which the risks are predictable and manageable,
and the nature of the venture will not change during its life. However, for
high-risk eCommerce ventures, there is a higher discount rate and,
consequently, a lower projected value of the project.
An example of a typical old economy venture is a large offshore drilling
platform, where the anticipated benefits can be reasonably quantified through a
rigorous budgeting process, and where the expected risks are already known and
have been factored into the company's analysis. This is Think Big and Act Big,
with a risk profile that the company can become very good at managing.
The dilemma facing many managers confronted with an eCommerce opportunity
is the necessity of making an all-or-nothing decision: Either commit
substantial funds to a highly speculative venture where many of the risks are
unknown, or forgo the project altogether. There appears to be no middle ground.
That's where the options pricing approach comes in.
As Luehrman pointed out in a Harvard Business Review
article ("Investment Opportunities as Real Options: Getting Started on the
Numbers," May/June 1997), a prospective corporate investment is like a call
option in that a company has the right, but not the obligation, to purchase the
operating assets of a new venture.
The options pricing approach does a better job than discounted cash-flow
analysis of valuing possible eVentures because it is more accommodating of the
new economy's volatility. Many Internet companies are in a constant state of
refining or modifying their business plans in response to new competitive
thrusts.
Uncertainty versus risk
In such an
environment, of course, much of the risk of a new eVenture is not known ahead
of time. Discounted cash-flow analysis penalizes dot-com companies for this
volatility far more than it does traditional ventures, in which the anticipated
benefit might be smaller but is easier to predict.
The options pricing method
considers uncertainty rather than just risk. This uncertainty is expressed in
the variability of the project's anticipated benefits rather than, say, the
risk that the project may blow up.
The greater the potential payoff, the higher the value of the option.
That is because with real options, the downside risk is minimized by having the
ability to exit while the upside can still be exercised. eVentures are
therefore not improperly penalized for their uncertainty, and the options
pricing approach can enable managers to make informed decisions about whether
to proceed with—or discontinue—a project.
BP Amoco is pioneering the use of options pricing theory to make these
kinds of informed decisions. Indeed, the company is beginning to embrace the
technique as one of the tools to change the mind-set that has grown up around
the exclusive use of discounted cash-flow analysis and the way in which
eBusiness opportunities are not only valued but managed and measured as well.
BP Amoco is working on several such opportunities, including initiatives
in the human resources and new business areas. It also has created an
eLaboratory, where its members work with the company's line managers on
developing these projects.
The computations derived from the basic options pricing model are not
intended to yield a definitive answer but rather to provide BP's decision
makers with the basis for an ongoing dialogue about the company's various
eCommerce ventures.
Allowing for judgment
The key is not to get
too caught up in the numbers, and instead to allow judgment to play an
important role in these investment decisions. Many of the risks are still
unknown, and the financial projections are too fluid for any computation to be
definitive.
Not that computations are irrelevant. They remain as important in
considering the new opportunities as they do in more traditional business
ventures. But their unique value lies in helping managers to think about
potential projects as staged investment opportunities and to evaluate these
projects using a variety of assumptions.
BP Amoco is essentially beginning to create a new language in which
managers at the giant oil company can have meaningful dialogues about their
eInvestments. Throughout a project's execution, managers make a series of
scale-up-or-out evaluations not unlike the multiphase reviews at most venture
capital firms.
With a more traditional project, reviews would be conducted to make sure
it stayed on time and on budget. No one would anticipate that the essential
nature of the project would change. Any actions taken would be to keep the
project on track.
The kinetic nature of the new economy makes this
fire-your-missile-and-forget-it approach impractical. Instead, managers need to
adopt a project review process in which the ongoing evaluation is structured
around key decision points. Each decision is fundamentally different and may,
for example, provide more funding, completely modify the project or kill it
altogether.
This evaluation approach is quite similar to the way in which venture
capital firms manage their investments, where the initial funding might be just
enough to help a new company flesh out its business plan. A second level of
funding would allow the company to develop an important technology. A third
might enable it to respond to a new opportunity in a highly dynamic
marketplace.
At each decision point, corporate managers at BP Amoco are beginning to
apply the options pricing model to a project under review to provide a measure
of valuation guidance. In this sense, the company has the option of continuing
the venture or killing it. This new approach to eVentures might be described as
Think Big, Act Small—but Scale Fast, Learn and Adapt.
Finding your prince
Traditional companies that
are moving into eCommerce also need to think differently about success and
failure. With a more traditional project, the determination of success is
pretty straightforward: Was it completed on time? Did it meet its revenue
projections?
But in the eCommerce arena,
with its dynamic character, success might be defined as gaining a better
understanding of customer behavior or developing a new technology for
application elsewhere in the company.
As with more traditional ventures, the ultimate objective is still to
build significant businesses that will augment the corporation's profitability
and create shareholder value. But if the traditional metrics for valuing
corporate investments are inappropriate for most eVentures, so, too, is the
traditional yardstick for measuring their success.
Indeed, a small "failure" might actually be a success if it prevents a
larger failure later on, or if it creates knowledge that can be applied in an
emerging sector where much is still unknown.
For example, authentication—the ability to positively identify the
individual performing an eCommerce transaction—is a critical technology in the
eEconomy. A new venture may not meet its business objective but may gain some
key insight into how to authenticate customers.
Again, there may be something to be learned from venture capitalists.
According to conventional wisdom, six out of 10 venture capital investments
will break even, and three will be failures. But one investment in 10—the
so-called prince—will more than pay for the other nine combined.
Venture capitalists like to say that you have to kiss a lot of frogs to
find a prince. Clearly, traditional corporations need a more effective approach
to building lasting relationships with the princes of the new economy.
The writers would like to thank Shashank Tripathi, a
London-based senior manager in the Accenture Strategic Services practice, for
his help with this article. Kathleen Dahlberg is vice president for eBusiness at
BP Amoco. For 20 years Ms. Dahlberg has specialized in enhancing business
performance through leading-edge technology; she is currently working on the
implementation of the eStrategy BP Amoco developed last year. Ms. Dahlberg is a
regular speaker at Forrester, Cisco and IBM conferences in the United States
and Europe.
Benjamin Porter is a Boston-based
associate partner in the Accenture Strategic Information Technology
Effectiveness practice. He has more than 20 years' experience working with
large organizations in the management and strategic use of technology. His
current client focus is on the consumer-products industry.
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