Real options in equity partnership

1. Real options in equity partnership Timothy B. Folta and Kent D. Miller Presenter: Wen ZHENG

2. Introduction Theory and Hypothesis Research Design Result Discussion Research Question • Extends a developing literature using option theory to diagnose the motives for incrementally committing to strategies through sequential investment purchase • Examine acquisitions and equity purchases in existing biotechnology partners by established firms from outside of biotechnology

3. Introduction Theory and Hypothesis Research Design Result Discussion Options • Characterize minority investments in partner firms as two-stage compound options (Kogut, 1991) • First stage • Purchase an option buying an initial equity stake • Exercise the option buyout option • Second stage • Purchase an option further equity purchases • Exercise the option growth option

4. Introduction Theory and Hypothesis Research Design Result Discussion Options • Characterize minority investments in partner firms as two-stage compound options (Kogut, 1991) • First stage • Purchase an option buying an initial equity stake • Exercise the option buyout option • Second stage • Purchase an option further equity purchases • Exercise the option growth option

5. Introduction Theory and Hypothesis Research Design Result Discussion Buyout Options • Options • Holding the option maintain flexibility • Exercise the option  increase commitment • Control: acquire a major stake • Partial: incremental investment • Value (Black-Scholes model) • : partner value future cash flow + option value for future growth opportunities • : exercise price organizational expenditure + monetary expenditure • : uncertainty of the partner’s value • : duration length of time the buyout decision may be deferred • : risk-free interest rate (not include in the study)

6. Introduction Theory and Hypothesis Research Design Result Discussion Buyout Options • Exercise Condition • Early Exercise decisions may be warranted if deferring buyout results in • Cash flow or learning sacrifice • Diminished opportunities to preempt rivals

7. Introduction Theory and Hypothesis Research Design Result Discussion Hypothesis • ; • H1:  buyout • H2:  buyout • H3:  buyout • H4: proprietary  buyout • H5: proprietary  buyout • H6: unique  buyout

8. Introduction Theory and Hypothesis Research Design Result Discussion • Dataset • NCBC Actions Database • Bioscan • Sample • 285 minority equity partnership (1978-1999) • 22 were buyout in a majority purchase • 122 were terminated by other means (dissolution, etc.) • 141 were still in operation at the end of the study’s time period • 120 instance of incremental increases in equity • Subfield • Therapeutics; diagnostics; agriculture; supplier/specialty chemical Data

9. Introduction Theory and Hypothesis Research Design Result Discussion Model and Method • Event history techniques • Buyout events • Acquiring a majority stake • Acquiring an additional stake • Hazard rate • Maximum Likelihood • There is independence of failure times  Not true • “cluster” option (Lin and Wei (1989))

10. Introduction Theory and Hypothesis Research Design Result Discussion Variables • Firm Valuation • A stock market index of public firms active in the firm’s technological subfield • A proxy for the ability to attract capital from public markets • Uncertainty • 26-week standard deviation of weekly returns for each of the four biotechnology subfield indices • Proprietary • The log of the number of established firms with equity partnerships outstanding in the target firms in the previous month • Control Variables • Nature of option • Nature of the target firms • Nature of the established firms

11. Introduction Theory and Hypothesis Research Design Result Discussion

12. Introduction Theory and Hypothesis Research Design Result Discussion

13. Introduction Theory and Hypothesis Research Design Result Discussion • Lack of overall explanatory power • The theory doesn’t explain majority-stake buyout • Inadequate measurement and specification • Sample size is insufficient • Uncertainty is significantly negative correlated with the buyout likelihood

14. Introduction Theory and Hypothesis Research Design Result Discussion

15. Introduction Theory and Hypothesis Research Design Result Discussion

16. Introduction Theory and Hypothesis Research Design Result Discussion H1& H3 are supported using subfield value measure

17. Introduction Theory and Hypothesis Research Design Result Discussion H1 & H3

18. Introduction Theory and Hypothesis Research Design Result Discussion H2 is corroborated

19. Introduction Theory and Hypothesis Research Design Result Discussion H4& H5 are corroborated

20. Introduction Theory and Hypothesis Research Design Result Discussion H4 & H5

21. Introduction Theory and Hypothesis Research Design Result Discussion H6 is not corroborated

22. Introduction Theory and Hypothesis Research Design Result Discussion • This paper explores how option theory illustrate the buyout of research partners • H1-H5 are corroborated, but H6 is not • This paper recognize the difference between real and financial option • Financial option: delaying commitment is always optimal • Real option: opportunity cost to wait • Future Research • Address the extent to which real option theory aids in explaining partner buyouts in other industry contexts, or other types of collaborations, such as non-equity collaboration • Carefully examine the assumption underlying real option pricing models