1. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Technical Due Diligence & Monte Carlo Risk Analysis n James F. Wright (Ph.D. in Physical and Nuclear Chemistry) n http://www.drjfwright.com n http://www.montecarloriskanalysis.com

2. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Technical Due Diligence and Monte Carlo Risk Analysis Outline n Technical Due Diligence & Quality Audits n Applicable Projects (Type & Size) n The Technical Due Diligence Team n Technical Systems Analysis n Technical (Monte Carlo) Risk Analysis

3. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Two-Cow Feudalism n You own and care for the cows n You & your cows live on your lord’s estate n Your lord takes some of your milk

4. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Two-Cow Fascism n The government confiscates your cows n You are hired to care for the cows n The government sells you milk

5. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Two-Cow Communism n You “donate” both cows to the community n The community cares for the cows n The milk is made available to the community as needed

6. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Two-Cow Totalitarianism n The government confiscates both of your cows n The government denies they ever existed n You are drafted as an Army Private n Only 50 most powerful in government get milk

7. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Two-Cow Traditional Capitalism n You own two cows n You sell one cow & buy a bull n You establish Dairy Farm n You establish Beef Cattle Operation n Your business prospers and you retire on the income.

8. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Two-Cow “Dot Com” Capitalism n You own two cows n $500 million IPO (your two cows, 500 PC’s & associated facilities) n Company sells milk over the internet n Company has no profit but sales grow

9. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Two-Cow “Dot Com” Capitalism (cont.) n You pump Company’s stock n You exercise $15 million golden parachute n The company files for Chapter 11 n You have local grocery store deliver milk to your house

10. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Two-Cow Ethereal Capitalism n You have two real cows n You sell all three of them to your publicly listed company using a letter of credit opened by your brother-in-law at the bank n You initiate a debt/equity swap with an associated general offer and get all four cows back with a tax exemption for five cows

11. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Two-Cow Ethereal Capitalism (cont.) n Milk rights for six cows transferred (via an intermediary) to Cayman Island company you secretly own n Cayman Island company sells the rights to all seven cows back to your publicly listed company n The publicly listed company’s Annual Report states it owns eight cows with an option for another.

12. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Quality Audit A systematic, independent examination of the quality system to determine: whether both the quality system activities, and the results of such activities, comply with quality system procedures; that these procedures are implemented effectively; and that these procedures are suitable to achieve quality system objectives.

13. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference ISO 9001 2000 The required business practices in this “Quality Management Standard” are sound operating principles that should maximize efficiency (and profits!)

14. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Why Evaluate Projects? n Investor Due Diligence – to Protect Investors n Compliance Audits – To Verify Quality Management System (ISO 9001 2000)

15. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference What is Due Diligence? According to Webster: The care that a reasonable person exercises under the circumstances to avoid harm to other persons or property.

16. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference What is Due Diligence? According to me: The act of protecting entities from harm caused by a process or event.

17. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference What is Technical Due Diligence? According to me: The act of protecting entities, that utilize new or emerging technologies (i.e., risky projects!), from harm caused by a process or event.

18. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference What is Due Diligence My QA Definition: The act of protecting entities from harm caused by a process or event by verifying the existence of a comprehensive Quality Management System.

19. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Types of Projects n Conventional Projects - Success determined by conventional business parameters n High-Tech Projects - Success determined by above plus Internet-related factors n Technical Projects - Success determined by above plus ability to develop new or emerging technologies

20. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Sources of Technical Projects n New or emerging technologies (Risky Projects are both the Best and the Worst) n Big national science n Successful technical companies

21. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference TABU (Technical Axiom of Business Uncertainty) The less you know about a project, the higher your uncertainty regarding the project!

22. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Some Corollaries of TABU n Those that treat a pro forma as fact are showing you how little they know about the project n Surprises will usually adversely effect the project n Cost estimates will usually be underestimated n Income estimates will usually be overestimated

23. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference More Corollaries of TABU n Uncertainties increase as estimations are moved farther into the future n The added cost of technologies must usually be repaid at the end of the project n New technologies seldom lower up-front expenses n Expected savings from operating in less- developed countries are usually fiction

24. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference The Thesis n Projects with high risk need a more sophisticated method of due diligence n The uncertainty in high-risk projects should be quantified

25. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Elements of the Technical Due Diligence Process n Form a Technical Due Diligence Team – Qualifications determined by Project’s Character and Relative Risk n Technical Systems Analysis - Will technology work as advertised? n Technical Risk Analysis - Quantify the risk!

26. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Technical Due Diligence Team n Project Manager - Expert, confidence of client, no conflict of interest, focused, manager n Marketing, Technical, Legal, Finance, etc. Team Members - Qualified experts, no conflicts of interest, “loose lips sink ships”

27. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Basis of Technical Systems Analysis A technology is unproven until it has been demonstrated to work at the required scale as planned!

28. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference The Process of Technical Systems Analysis n Define Technical Scope n Technology & Scaling n Operational Process n Marketing & Sales Methodology n Legal & Regulatory Issues n Operational Model (with quantified uncertainty!)

29. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Technical Risk Analysis n Define a Scenario - Business Model n Evaluate the Consequences of the Scenario - determined by the investor-selected metric and analysis methodology (Monte Carlo)

30. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference The Metric n Process Metrics – Percent Idle Time, Manufacturing Time n Economic Metrics – Net Discounted Cash Flow, Profitability Index

31. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Accuracy & Precision n Precise Accurate

32. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Sources of Error n Random Error - caused by chance, not reducible, no effect on accuracy (most likely value), effects precision n Uncertainty - determined by assessor and their (lack of) knowledge, effects most likely value, accuracy and precision

33. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Different Analyses Single Valued Analysis A = 1023 ft x 753 ft A = 770,319 ft 2

34. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Different Analyses Standard Error Propagation A = 1023 ft x 753 ft A = 770,319 ft 2  = 74,096 ft 2 (symmetric  )

35. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Different Analyses Monte Carlo Simulation n Took 20 measurements of each side n Created a distribution function for each side n Used 50,000 iterations n A = 771,897 ft 2 n  = 6,508 ft 2 (from FWHM of distribution function)

36. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Monte Carlo Risk Analysis n Use metric that client understands n Monte Carlo calculates answer to metric that reflects the uncertainties of each of the input parameters

37. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Gaussian Frequency Distribution

38. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Gaussian Cumulative Distribution

39. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference The Monte Carlo Process n Determine metric (A = p + xy/z) n Determine distribution function for p, x, y, & z n Start Iterative Process - Use PRNG to get values for p, x, y, & z to be used in this iteration - Calculate A for this iteration n Continue Iteration until OK

40. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference Gaussangular Distribution

41. AUDIT QUALITY DIVISION 14 - 15 February 200211 th Annual QAD Conference The Book! “Monte Carlo Risk Analysis and Due Diligence of New Business Ventures” by James F. Wright n Publisher - AMACOM (August, 2002, release) n Monte Carlo software included on CD n Two detailed examples in book that use software n 30 Tables, 49 Figures/Screens, 480 Equations