SELECTION OF INNOVATION PROJECTS

Why do we care about selection decisions? Innovation can be described as an evolutionary search process:
variation, selection and retention  idea selection is as important as idea generation
Today’s question: how do individuals and firms select innovation projects using quantitative and qualitative
methods? Even in highly technical industries, around 50% of decisions on average are made following gut
feeling by managers. The more experience people have the more they rely on their feelings. Selection
decisions are hard to make
Type 1 error
False positive: an idea is selected and does not succeed; an error of commission;
we say something is there when it is not actually there

Type 2 error
False negative: we deny positive state and reject an idea that would have been
successful; an error of omission

Example of False positives: Apple’s Newton. Without this error there would
probably not be an iPad. The iPad comes from this error, Apple learn from it.
Example of False negatives: Beatles (1962), Telephone (1876), Cars (William II:
the car is only a temporary thing, I believe in horses)
Sometimes errors are important because you can later on build on them, or learn from them

If decisions are difficult to make firms might need some tools. Which tools can we use? Tools to support the
selection of innovation projects
Qualitative methods  Profile chart, Checklist, Scoring models and Q-sort
Quantitative methods  Discounted cash flow techniques and Option-based techniques

Which tool should be used when?

Initial research projects  non-financial techniques
Pre-development projects  option evaluation techniques
Development project  financial techniques

Profile chart
We have to think which are the criteria with which we are judging the idea (patentability, probability of
technical success, commercial success)  criteria reflect the key factors determining the success or failure
of a project. Then, for each criterion, we assign a qualitative judgment (for example high, medium, low) of
expected performance.
However, this method is very limited: the decision about the criteria is subjective and when you have
multiple projects it’s hard to decide with it. It is only useful if we have a core key factor that we want to use
to compare projects.
Checklists
Checklists are similar to the profile method. A set of criteria is fixed and projects are evaluated on the basis
of these criteria. The difference is that each project is assigned a yes / no evaluation according to the fact
that the project is satisfactory on the criterion or not (yes/no, 1/0)

Scoring models
The scoring models are based on the same principle of the previous two methods but add some other
information about the weight of each considered criterion. They provide a weighted evaluation of each
project, depending on the (strategic) importance of the criteria. This method solves the problem of weights
of criteria.

Q-sort analysis
Q-sort analysis is a cards-based selection process, declaring criteria and sorting cards representing projects
 comparison and debate  consensus on the best idea. We, as human beings, are unable to process big
data so, working on several projects evaluation in this way can be unproductive.

1. Each card represents a potential project

2. Selection criteria are declared
3. Individuals sort their cards in rank order
4. Comparisons and debate
5. Consensus on the best projects

Qualitative methods: Criteria to be considered

Market
Role of customer Use
Compatibility and ease of use
Distribution and pricing
Existing capabilities
Role of capabilities Competitors’ capabilities
Future capabilities
Timing
Project timing and costs Cost factors (now and future cost, learning
curves,...)
Quantitative methods
Quantitative methods are easy to be implemented, but once we are given the numbers. Problem with
quantitative methods is where do we get these number from? Once you have it it’s easy but having reliable
numbers is very hard. When we discuss the future income, that is how much value generate an idea, it’s
almost impossible to estimate.
The choice is between different futures. We use structured methods of selection:
• Probable costs of development, production, launch – usually based on engineering time
• Probable future income – estimates of future sales
• Probability of success, technical and commercial – expert judgement

Discounted cash flow methods

Most common techniques are:
Internal Rate of Returns  the discount rate that makes the net present value of investment zero
Net present value  expected cash inflows are discounted and compared to outlays

Strengths and weaknesses of discounted cash flow methods

Strengths  provide concrete financial estimates
explicitly consider timing of investment and time value of money
Weaknesses  may be deceptive; only as accurate as original estimates of cash flows
may fail to capture the strategic importance of a project

And if all this is so difficult, why then not relying on external ways which are gut-feeling methods of
selection?

Option based techniques

Options pricing theory can be applied to the evaluation of R&D investments as they are analogous to an
investment into a call option. Transferring this logic to R&D projects, the cost of R&D program can be
considered the price of a call option. The cost of future investment required to capitalize R&D results can
be considered the exercise price, and returns from it are analogous to stock returns on a successful stock
call option.
A firm can invest only in the first R&D expenses to obtain the possibility of choosing, at a certain future
date, to invest in the development phase of the project or reject it.
It can decide not to make the follow up investment necessary for an R&D program at a certain date, if the
investments results are no more profitable.

Problem though is that in innovation firm has positive influence on outcome of a project. It highly depends
on what firm does (in call options it’s not so). Also, sometimes you don’t have values all the time (while
market does give them all the time), and sometimes you need to get into project without knowing exercise
prices or have to pay them all at once without knowing future outcome.
What is a financial option?
An option is a contract which gives its holder the right, but not the obligation, to buy (or sell) an asset at
some predetermined price in the future.
• Call option: An option to buy a specified number of shares of a security within some future period.
• Put option: An option to sell a specified number of shares of a security within some future period.
Exercise (or strike) price: The price stated in the option contract at which the security can be bought or
sold.

Real options for choosing innovation projects

Real options: Applies stock option model to nonfinancial resource investments. E.g. with respect to R&D:
The cost of the R&D program can be considered the price of a call option.
The cost of future investment required to capitalize on the R&D program (such as the cost of
commercializing a new technology that is developed) can be considered the exercise price.
The returns to the R&D investment are analogous to the value of a stock purchased with a call option.

Example using an option-based technique

A pharmaceutical firm has to decide to invest 0,5 M$ in an R&D project in 2017. This may lead to a patent
of which the exploitation is estimated to start in 2020.
The production and commercialization of the new product requires an investment of 4 M$ at the year
2020.
The time in between is required to obtain the authorization from the regulatory body.
The value of the real options logic for selecting R&D projects
Option based techniques are valuable when there is uncertainty (as in innovation)
However, many innovation projects do not conform to the capital market assumptions underlying option
models.
• May not be able to acquire option at small price: may require full investment before its known whether
technology will be successful.
• Value of stock option is independent of call holder’s behavior, but value of R&D investment is shaped by
the firm’s capabilities, complementary assets, and strategies.