Real Options in Equity Partnership

Timothy B. Folta and Kent D.MillerSMJ,23; 77 - 88 ( 2002)

Introduction

O To maintain efficiency and speed, companies join partner firms having expertise in R& D.

O Simultaneously, scholar debate whether R&D - sourced though collaborative or acquisition.

O Partnership transition toward acquisition – lack theoretical and empirical attention.

O Partnership termination ignore partnership acquisitions or combine buyouts (CB).

O This study examines CB by developing literature using real options theory (Kogut, 1991 etc.)

Continue:

O Extend the real option theory to strategy in two ways.

O Focus on Joint venture acquisition – examine buyout and equity purchase of partner firms subsequent to initial minority equity stakes.

O Examine the effects of external uncertainty - both directly and combination with other variables – on equity purchases.

OUncertainty refers to the unpredictability of the internal and external environment and risk refers to performance volatility.

Theory and Hypothesis

O In the line with Kogut ( 1991), the current paper also focuses on joint ventures – Investment with partner firm as two stage compound options.

O 1st stage – the buyout option,occuer when the firm makes further equity purchases granting a controlling interest in the partner.

O 2nd stage – the growth option – involve one or more likely several discretionary investment to expand the business.

O Black – Scholes ( 1973) models provide starting point about key variable relevant to valuing partner buyout.

O C = f ( S,X,sigma,T,r)

Hypotheses

O H1: Increased partner valuations makes buyout more likely.

O H2:High Uncertainty makes partner buyout less likely.

O H3: When low uncertainty is combined with high valuation, partner buyouts are more likely.

O H4:When buyout options are more proprietary ( i.e., there are fewer equity partners associated with the target firms),partners buyout is more likely.

O H5: Under high uncertainty, the less proprietary a buyout option the more likely is partner buyout.

O H6:When growth options are more unique (i.e., fewer rivals in product market) partner buyout is more likely.

Model and Method

O North Carolina Biotechnology Center Action Data based and Bioscan.

O Restricted sample to four sub fields (Names)O 337 equity collaboration between 1978 and

1999,Identified.O Two buyout events.

ODV – hazard rate of acquiring a majority stake coded “1”. Raise ownership level at 50%.

O2nd set …….additional stake “1”. Raise beyond 50%.

OIndependent VariablesOFirm valuating, exogenous uncertainty

and option is proprietary.

Pairwise correlation coefficient

Results

Graph 1 & 2

Results explanation

O Acquisition of majority stakesO Model 1 and 2 have hypothesized

independent variable without Interaction terms.

O Main conclusion is that we do not have an overall significant effect associated with our theory driven relations for acquisition of majority stakes b/cO Theory does not explain majority stake

buyoutO Our measure or specification is

inadequate O Out sample size is insufficient.

Results explanation

O Acquisition of additional stakesOModel 3 & 4 is baseline and includes

main effect respectively. Model 5 introduced hypothesized interaction involving uncertainty.

OH1&3: received support using subfield value valuation measure but not using number of public offering s valuation measures.

OH2: expected acquisitions of additional equity stakes to be more likely in the present of low uncertainty.

OH4&5: corroboratedOOnly H6 is not corroborated.

Graph explanation

O Figure 1(a) illustrates the effects of subfield value over the variable’s range at three levels of uncertainty:

O The mean of uncertainty for the entire sample, the mean uncertainty plus a standard deviation, and the mean uncertainty minus a standard deviation.

O Also increases in subfield value had a greater impact on the rate of additional equity purchases for low levels of uncertainty.

O Figure 1(b), shows effect of number of equity partners at different levels of uncertainty.

O Means number of equity partners has an overall negative effect on acquiring additional equity.

Conclusion & Discussion

O Buyouts of research partners occur frequently, but have not been explained by previous research.

O At conceptual level, minority investment in partner firms do not provide investing firms propriety options.

O In the empirical portion, we tested several relations not previously examined in the real option literature.

O Future research to address real option theory aids in explaining partner buyouts in other industry contexts, or other types of collaborations, such as nonequity collaboration (Folta & Leiblein, 1994).