Real Options in Equity Partnerships

Real Options in Equity Partn erships Timothy Folta and Kent Miller (2002) Strategic Management Journal Presented by Der-Ting Huang Main Purposes Extend a developing literature using option theory to diagnose the mo tives for incrementally committing to strategies through sequential inv estment processes Buyouts and equity purchases of partner firms subsequent to initial m

inority equity stakes Consider unexplored relations that are illuminated by a careful and rig orous application of option theory Theory and Hypotheses Kogut (1991): Joint ventures Investments in partner firms as two-stage compound options Two stages First stage: buyout option Second stage: growth option focus on first-stage buyout option

Theory and Hypotheses Black-Scholes (1973) model Identifies key variables relevant to valuing the partner buyout option S: partner value C: call option X: exercise price : uncertainty of parent value T: length of time the buyout decision may be deferred r: risk-free rate of return (not included in this study)

Prior to expiration, the option will only be exercised when Theory and Hypotheses Hypothesis 1: Increased partner valuation makes buyouts more likely. Hypothesis 2: High uncertainty makes partner buyouts less likely. Hypothesis 3: When low uncertainty is combined with high valuation, partner buyouts are m ore likely. Hypothesis 4: When buyout options are more proprietary (i.e., there are fewer equity partne rs associated with the target firm), partner buyout is more likely Hypothesis 5: Under high uncertainty, the less proprietary a buyout option the more likely is partner buyout.

Hypothesis 6: When growth options are more unique (i.e., there are fewer rivals in the produ ct market) partner buyout is more likely. Research Design Sample The North Carolina Biotechnology Center (NCBC) Actions Database and Bioscan 4 subfields: therapeutics, diagnostics, agriculture, and supplier/specialty chemical 285 minority equity partnerships (22 terminated by purchases the ownership level to 50% 87 dissolved, 35 acquired by 3rd parties, 141 still in effect at the end of 1999 ) Method

1. Hazard rate of acquiring a majority stake 2. Hazard rate of acquiring an additional stake Research Design Variables Firm valuation Difference in the number of public offerings since the initiation of the equity partnership Uncertainty 26-week standard deviation of weekly returns for each of the four biotechnology subfield indices Proprietary

Number of equity partners Number of rivals Control variables License (1,0) Option (1,0) The number of commercial alliances The number of private equity placements The number of biotechnology sectors Firm age Alliance experience of the established firm

Results H1: partner value (+) H2: High uncertainty (-) H3: low uncertainty + high partner value (+) H4: More proprietary (+) H5: High uncertainty + less proprietary (-) H6: Growth options more unique (fewer rivals) (+)

Buyout Results H2 H4 H3 H5 Results low

uncertainty H1 and H3 H4 High uncertainty Sample mean Sample mean

High uncertainty low uncertainty Conclusion Although delaying commitment is optimal for financial options, there may be opportunity costs to waiting to exercise real options Tests several relations not previously examined