Strategic planning is about choosing a course of action designed to achieve a particular objective.

1. Vladimir Tingue
NEW VENTURE STRATEGY AND
REAL OPTIONS

2. Learning Objectives
• Understand what makes a decision strategic
• Understand the interrelationships between financing
decisions and other aspects of new venture strategy
• Be able to explain how strategic decisions are related to the
entrepreneur’s objective of value- maximization
• Recognize the real options reflected in strategic alternatives
• Understand how to use decision trees to identify and evaluate
real options
• Understand how to use game trees when strategic choices
depend on rival reactions
• Understand how the business plan is related to strategic
planning and strategy implementation

3. Strategic Planning
• Strategic planning is about choosing a course
of action designed to achieve a particular
objective
• Strategic plans offer the opportunity to
change course (real options)
• The ability to pursue a strategy may depend
on the availability of financing

4. Framework of Strategic Planning
• Describe real options as decision trees (or
game trees)
• Identify the objective and the strategic
alternative for achieving it
• Use investment valuation to compare
alternative strategies

5. Product-Market, Financial, and
Organizational Strategy
• Financial strategy: defines the type and timing of
financing.
• Product-market strategy: involves targeted sales
growth rate, product price, product quality.
• Organizational strategy: concerns the horizontal
and vertical boundaries of the firm
• Product-market, organizational, and financial
decisions need to be viewed simultaneously.

6. The Interactive Components of Strategy
Financial
Strategy
Product
Market
Strategy
Organizational
Strategy
 Type of financing
 Outside versus entrepreneur
 Debt versus equity
 Financial contracts
 Loan covenants
 Options
 Staging
 Vertical boundaries
 Horizontal boundaries
 Scale and scope
 Product
 Price
 Margin
 Quality
 Differentiation
 Targeted sales growth
The more vertical
and horizontal
integration, the
greater the financial
needs.
Outside investment
is more likely the
larger the firm.
Rapid growth
reduces
financial
flexibility and
requires
sacrificing
control to
attract outside
financing.
Rapid growth
requires a larger
organization.
Economies-of-scope
imply more product
lines.
Figure 4.1

7. What Makes a Plan or Decision Strategic?
• Strategic decisions are consequential
• Strategic decisions are both active and reactive
• Strategic decisions are not costless to reverse

8. Financial Strategy
• Financial strategic choices have the same
three characteristics:
– consequential
– active and reactive
– costly to reverse
• Competitive interdependencies also are
present
• The scope of financial strategy is quite broad
– type of financing
– amount of financing
– financial contracting

9. Deciding on the Objective
• Assumed objective in this text is to maximize the
entrepreneur’s return
• A three-step process:
1. Estimate the entrepreneur’s NPV for each alternative
2. Adjust the NPV by assigning values to qualitative
considerations important to the entrepreneur
3. Select the strategy that yields the highest adjusted
NPV to the entrepreneur
• Decision will be rational, i.e., the expected right
choice given the information known at the time

10. Strategic Planning for New Ventures
• Plans of new ventures are unconstrained by
prior decisions
– In contrast to plans of established businesses
• Strategic planning for new ventures should
simultaneously consider
– product-market strategy
– organizational strategy
– financial strategy

11. Strategic Planning for New Ventures
Example: calorie-free ice cream technology
• Product market strategy
– high-margin/slow growth or low-margin/high
growth
• Organizational strategy
– manufacture only (one-level) or manufacture and
market (integrated)
• Both have implications for financial strategy

12. Financial Implications of Product-Market and
Organizational Strategic Choices
Product Market Choice
Slow growth Rapid growth
Organizational
Choice
One-level
entry
Initially financed by
entrepreneur, growth
financed with
operating cash flows
NPV = $40
Initially financed by
entrepreneur, growth
financed with
operating cash flows
and outside financing
NPV = $120
Integrated
entry
Initial financing
includes outside
equity, growth
financed with
operating cash flows
NPV = ($20)
Initial financing
includes outside
equity, growth
financed with
operating cash flows
and outside financing
NPV = $70
Table 4.1

13. Recognizing Real Options
• Strategic planning is not a one-shot exercise
• Passage of time brings deviation from
forecasts and new information
• Opportunities to abandon, expand, or redirect
the venture (real options)
• Select the strategy that offers the highest
expected value in light of the venture’s real
options

14. Option Basics
• An option is the right, but not the obligation,
to make a decision and take an action in the
future
• The value of an option depends on
– market price of the underlying asset
– volatility of the price of the underlying asset
– time to option expiration
– time value of money
• The cost to acquire an option is called the
“premium”

15. Call Option on a Share of Amazon Stock
Figure 4-3
Gives the holder the right to buy the underlying stock
at a predetermined (exercise) price

16. Figure 4-3
Put Option on a Share of Amazon Stock
Gives the holder the right to sell the underlying stock
at a predetermined (exercise) price

17. Comparisons Between Real and
Financial Options
• Real options are similar to financial options
• Yet differ in important ways
– real option markets are not complete
– real options often are interdependent
• The real option premium
– may bear little relation to the value of the option
– for example, the value of an abandonment option
depends on the next highest alternative use of the
asset

18. Some Common Types of Real Options
• Wait/Learn
• Expand or contract
• Switch inputs or outputs
• Abandon

19. The Real Option Premium
• May bear little relation to the value of the
option
• For example, the value of an abandonment
option depends on the next highest
alternative use of the asset

20. Strategic Planning and Decision Trees
• Decision trees
– are a good way to conceptualize strategic
alternatives that involve real options
– impose discipline on the evaluation process
– are used to evaluate connections between decisions
today and the future value of the venture
– incorporate both decisions and uncertain events
– use probabilities to estimate conditional NPVs

21. Decision Tree Techniques
1. Focus on the most important choices
2. Reason forward to construct the tree
3. Keep track of what is known and unknown at
each node
4. Evaluate choices recursively, starting at the
last decision point
5. Prune the tree
6. Select the branch of the tree with the highest
expected NPV

22. An Illustration
• Entrepreneur is considering investing in a new
restaurant
• Uncertain demand can be high, moderate, or low
• The decision:
– build a large restaurant ($750,000)
– build a small restaurant ($600,000)
– don’t build
• Entrepreneur invests $400,000
• Outside investor provides the balance and gets one
percent of the equity for each $10,000 invested
– large restaurant  investor gets 35% equity
– small restaurant  investor gets 20% equity
– entrepreneur retains balance of the equity

23. Total restaurant PV conditional on size and
demand:
An Illustration (cont’d.)
Demand
Size Low
(prob. = 20%)
Moderate
(prob. = 50%)
High
(prob. = 30%)
Large $300,000 $800,000 $1,500,000
Small $400,000 $800,000 $800,000

24. Evaluating the Venture As an
Accept-Reject Decision
• Consider the project as a simple accept-reject
decision with mutually exclusive alternatives
• Invest in large restaurant
• Invest in small restaurant
• Don’t invest
• Decision tree notation:
• Squares represent decision points
• Circles represent uncertainty
• Each state has an associated probability
• Triangles in the figure are terminal nodes

25. 30.0% 30.0%
$975,000 $575,000 = -$400,000 + 0.65 x $1,500,000
TRUE Chance
-$400,000 $191,500
50.0% 50.0%
$520,000 $120,000 = -$400,000 + 0.65 x $800,000
20.0% 20.0%
$195,000 -$205,000 = -$400,000 + 0.65 x $300,000
30.0% 0.0%
$640,000 $240,000 = -$400,000 + 0.80 x $800,000
FALSE Chance
-$400,000 $176,000
50.0% 0.0%
$640,000 $240,000 = -$400,000 + 0.80 x $800,000
20.0% 0.0%
$320,000 -$80,000 = -$400,000 + 0.80 x $400,000
Decision
$191,500
30.0% 0.0%
$0 $0
FALSE Chance
$0 $0
50.0% 0.0%
$0 $0
20.0% 0.0%
$0 $0
Prepared using PrecisionTree ®, Palisade Corporation.
Accept-Reject
High Demand
Moderate Demand
Low Demand
Large Restaurant
High Demand
Moderate Demand
Low Demand
Small Restaurant
Do Not Enter
High Demand
Moderate Demand
Low Demand
Figure 4.3

26. Conditional PVs of entrepreneur
PVEntrep. (Large/High) = 65% X $1,500,000 = $975,000
PVEntrep. (Large/Moderate) = 65% X $800,000 = $520,000
PVEntrep. (Large/Low) = 65% X $300,000 = $195,000
Expected PV of entrepreneur
E(PVEntrep. |Large) =
= 30% X $975,000 + 50% X $520,000 + 20% X $195,000
= $591,500
Expected NPV of entrepreneur
E(NPVEntrep. |Large) = -$400,000 + $591,500 = $191,500
Entrepreneur’s NPV – Large Restaurant

27. Conditional PVs of entrepreneur
PVEntrep. (Small/High) = 80% X $800,000 = $640,000
PVEntrep. (Small/Moderate) = 80% X $800,000 = $640,000
PVEntrep. (Small/Low) = 80% X $400,000 = $320,000
Expected PV of entrepreneur
E(PVEntrep. |Small) =
= 30% X $640,000 + 50% X $640,000 + 20% X $320,000
= $576,000
Expected NPV of entrepreneur
E(NPVEntrep. |Small) = -$400,000 + $576,00 = $176,000
Entrepreneur’s NPV – Small Restaurant

28. E(NPVEntrep. |Build Large) = $191,500
E(NPVEntrep. |Build Small) = $176,000
E(NPVEntrep. |Don’t Built) = $0
 Build Large
Base Case Decision

29. The Wait/Learn Option
• Suppose the entrepreneur can wait to learn
more about demand
• Waiting is a call option on building the optimal
size restaurant
• BUT waiting increases likelihood of competitor
entry
– reduces large restaurant PV to $1,300,000
– reduces small restaurant PV to $700,000

30. Conditional NPV of entrepreneur with waiting
NPVEntrep. (Wait/High/Build Large) = $445,000
NPVEntrep. (Wait/Moderate/Build Small) = $160,000
NPVEntrep. (Wait/Low/Don’t Build) = $0
Expected NPV of entrepreneur with waiting
E(NPVEntrep. |Wait) =
= 30% X $445,000 + 50% X $160,000 + 20% X $0
= $213,500
Compare to base case (accept/reject) NPV = $191,500
 Option value = $213,500 - $191,500 = $22,000
Wait/Learn Option

31. • Entrepreneur can build small now, learn about
demand, and then decide whether to expand
– PV of large restaurant is $1.4 million if demand is high
• Expansion costs $200,000 (total cost is $800,000)
• $200,000 for expansion comes from investor
– less uncertainty means better terms for entrepreneur
– one percent equity for each $20,000 invested (10%)
for expansion
– total investor share is 30% with expansion
Expansion Option

32. FALSE Chance
-$400,000 $191,500
TRUE 30.0%
$980,000 $580,000 = -$400,000 + 0.70 x $1,400,000
30.0% Decision
$0 $580,000
FALSE 0.0%
$640,000 $240,000 = -$400,000 + 0.80 x $800,000
TRUE Chance
-$400,000 $278,000
FALSE 0.0%
$560,000 $160,000 = -$400,000 + 0.70 x $800,000
50.0% Decision
$0 $240,000
TRUE 50.0%
$640,000 $240,000 = -$400,000 + 0.80 x $800,000
FALSE 0.0%
$210,000 -$190,000 = -$400,000 + 0.70 x $300,000
20.0% Decision
-$80,000
TRUE 20.0%
$320,000 -$80,000 = -$400,000 + 0.80 x $400,000
Decision
$278,000
FALSE Chance
$0 $0
Prepared using PrecisionTree ®, Palisade Corporation.
Initial Choice
Large Restaurant
Small Restaurant
Do Not Enter
Expand
Do Not Expand
High Demand
Moderate Demand
Expand
Do Not Expand
Low Demand
Expand
Do Not Expand
+
+
Figure 4.5

33. NPVEntrep. (Small/High/Expand) = $580,000
NPVEntrep. (Small/Moderate/Don’t Expand) = $240,000
NPVEntrep. (Small/Low/Don’t Expand) = -$80,000
E(NPVEntrep. |Small) = 30% X $580,000 + 50% X $240,000 + 20% X -$80,000
E(NPVEntrep. |Small/Expansion Option) = $278,000
Base case NPV = $191,500
Value of expansion option = $278,000 - $191,500
= $86,500
Expansion vs. Wait/Learn = $278,000 - $213,500
= $64,500
Expansion Option

34. • Restaurant can be converted to office space
– PV of large restaurant as office $600,000
– PV of small restaurant as office $300,000
• No value for small restaurant
– lowest PV as restaurant is $400,000
NPVEntrep. (Large/Low/Abandon) = -$400,000 + (65% X $600,000)
= -$10,000
E(NPVEntrep. |Large/Abandon Option) =
= 30% X $575,000 + 50% X $120,000 + 20% X -$10,000 = $230,500
Abandonment Option

35. • Value of the abandonment option if we build the large
restaurant
NPVEntrep. (Large/Low/Abandon) = -$400,000 + (65% X $600,000)
= -$10,000
E(NPVEntrep. |Large/Abandon Option) =
30% X $575,000 + 50% X $120,000 + 20% X -$10,000 = $230,500
E(NPVEntrep. |Small/Expansion Option) = $278,000
Best choice: build small with expansion option
Abandonment Option

36. Rival Reactions and Game Trees
• Decision-trees do not explicitly incorporate
the reactions of rivals
• Not an issue if a venture offers a unique
product or service
• Not an issue in markets with many
competitors because other firms will not react
specifically to the entry of a new rival

37. Game Theory
• A game consists of
– a set of players,
– an order of play,
– the information set available to the players,
– the set of actions available to each player,
– the payoff schedule that results from the outcome
of the actions of the players.
 A sequential-move game can be analyzed with
a game tree

38. Nash Equilibrium
• In a non-cooperative game, the players cannot
enter into binding, enforceable agreements
with each other
• A Nash equilibrium is a set of strategies, one
for each player, such that each player’s
strategy is optimal given the strategy of the
other player(s)

39. Game Tree Illustration
• Kelly is considering opening a bar
• Three options
– enter with a large bar
– enter with a small bar
– wait to see if the economy warrants another bar
• Erin’s Pub, a national chain, is considering
entering the market
• Kelly has the first mover advantage, but she
needs to consider how Erin might respond to
her choice of options

40. Game Tree Illustration – Nash Equilibrium
• If Kelly enters with a large bar, Erin’s best option is don’t
enter
• If Kelly enters with a small bar, Erin’s best option is to also
enter
• If Kelly waits, Erin’s will enter since all payoffs are > $0
– if Kelly then enters with large bar, Kelly’s payoff = $300,000
– if Kelly then enters with small bar, Kelly’s payoff = $190,000
– both are positive, but are also less than Kelly’s payoff s from
immediately entering with a large bar ($425,000/no Erin;
$380,000/Erin enters)
• Nash Equilibrium: Kelly enters with a large bar and Erin
does not enter

41. Games Entrepreneurs Play
• Strategic games commonly played by
entrepreneurs include the following:
– the business plan
– strategic partnering
– control
– information disclosure

42. Strategic Flexibility vs. Strategic Commitment
• Decision trees and game trees are useful for
assessing tradeoffs between the value of
maintaining flexibility (real options) and the value of
committing to a more limited course of action
• Maintaining flexibility can create value if valuable
information will be revealed with time (Figure 4.5)
• Early commitment can create value by precluding
competitive entry (Figure 4.6)
• Important to consider the values of the various
types of imbedded real options in any venture

43. Strategic Planning and the Business Plan
• Entrepreneur may default into a course of action
less valuable than a foregone alternative
• A well-structured plan enables the entrepreneur
to identify and react to problems
• Not a one-shot exercise
• Projections have to be modified in light of actual
experience, and to reassess overall strategy

44. New Venture Strategy and Real Options -
Summary
• Product-market, organizational, and financial
strategies need to be considered simultaneously
• New ventures can be viewed as portfolios of real
options
• Real options can enhance value by adding
flexibility
• Decision trees and game trees are useful tools for
analyzing real options and new venture strategy