Venture Capital and the Finance of Innovation, Second Edition

348 CHAPTER 19 R&D FINANCE
Business risks can take many forms. In general, a business risk relates to changes
in consumer preferences. For example, the demand for Newdrug would be affected by
the performance of the overall economy, because the availability of health insurance
and consumers’ willingness to pay out of pocket would both be affected by the strength
of the labor market. Also, because diabetes strikes disproportionately among older
patients, it is likely that Medicare—government-run health insurance for citizens over
the age of 65—would be a major customer. Thus, Drugco needs to worry about the
pressure of federal budgets. These types of risks would certainly have positive market
betas and would require risk-adjusted discount rates. The computation of these discount
rates requires careful modeling for the timing of various investment decisions. These
models often use decision trees and real-options analysis (to be studied in Chapter 21),
sometimes aided by the use of binomial trees (to be studied in Chapter 22).
Competitive risks relate to the behavior of other companies. For the development
of Newdrug, Drugco needs to worry about the competitive responses of
other drug companies in the diabetes business. In response to Newdrug, competitors
may accelerate (or decelerate) their own diabetes drug projects. Even if these
competitors do not develop new drugs, they may alter the pricing of existing drugs,
file lawsuits claiming the infringement of some intellectual property, or increase
their sales efforts on existing drugs. Some of these activities depend on the state of
the economy and hence would carry positive betas and require the calculation
of risk-adjusted discount rates. In any case, competitive risks require careful
modeling using game theory, a topic covered in Chapter 23.
19.2.2 Energy Innovation
Fuelco is considering several development projects using its patented Newcell
technology. Project A is a government contract that requires competitive bidding
against other companies. Project B is a product to be sold to automotive manufacturers
for eventual resale in consumer projects. Project C is product to be sold
directly to consumers. The technology for Project C requires a successful completion
of Projects A and B as inputs. Exhibit 19-8 sketches the timeline and risks
for these projects.
In the shorthand representation of Exhibit 19-8, we see that each of the three
projects has technical risks, with Project C effectively incorporating technical risks
from Projects A and B in addition to direct risks from Project C. All three projects
may have competitive risks. These risks are clearest for Project A, which must
compete for a government contract against other companies. Business risks may be
largely absent from Project A (if we are willing to believe that the government will
follow through on the contract regardless of economic conditions), but these
business risks are present for Projects B and C. In some cases, long-term contracts
with potential customers can alleviate business risk in the short run (particularly for
Project B), but in the long run it is difficult for energy projects to completely
eliminate business risks. For Fuelco, the main business risk is the price of crude oil.