Winner's Curse Applet
How much should you offer for a company of uncertain valuation?This applet demonstrates the winner's curse.
You are the Chief Financial Officer for your firm. Your firm is considering making a takeover offer for a small, privately-held Internet startup. The "true" value, V, of the shares of the startup are known with certainty only to its management. However, valuing Internet startups is quite challenging, and you only know that the shares are worth somewhere between $0 and $1000 per block of shares, and each possible value has equal probability. So, as far as you are concerned, someone has thrown a 1001 sided die, with each face having an integer between 0 and 1000, to determine the share value, V, and the outcome of this toss of the die was observed by the startup's management but not by you.
Because of corporate synergy, you know that the shares would be worth 50% more than their current value to your firm if you successfully acquire the startup. That is, after you acquire the startup, the value of each block of shares will increase 50% from V to 1.5 V.
You are required to recommend to your firm the amount that should be bid for the startup (per block of shares). The startup will agree to your offer if you bid more than V, and will turn you down if you bid less than V. This is your only chance - if your offer is rejected, there is no room for renegotiation.
How much do you bid per share?
Consider the expected value of the firm. Since any value between 0 and 1000 is equally likely, on average, the firm is worth 500. However, if you bid 500, notice that you will only win if V < 500. But, if the firm is worth at most 500, it is worth on average only 250, so you overpaid! Even with the synergies, 250x(1.5) = 375 is much less than you bid. This is the winner's curse! To be successful, you have to recognize that the expected value of the firm is irrelevant. All that should concern you is the expected value of the firm if you win, which depends on your bid.
This applet lets you try different bidding strategies. You will select the range of the firm's possible values (0 to 1000 in this example) and the extent of the synergies (50% in this example). Then, after entering a bid, the applet will simulate twenty firm values, and calculate your average profits.