Real options in equity partnership Timothy B. Folta and Kent D. Miller Presenter: Wen ZHENG 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 Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 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 Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 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 Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 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) ▫ 𝐶 = 𝑓(𝑆, 𝑋, σ, 𝑇, 𝑟)  𝑆: partner value future cash flow + option value for future growth opportunities  𝑋: exercise price organizational expenditure + monetary expenditure  σ: uncertainty of the partner’s value  𝑇: duration length of time the buyout decision may be deferred  𝑟: risk-free interest rate (not include in the study) Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 Introduction Theory and Hypothesis Research Design Result Discussion Buyout Options • Exercise Condition ▫ 𝑆 − 𝑋 > 𝐶 𝑆, 𝑋, σ, 𝑇 ; 𝑆 − 𝑋 > 0 ▫ Early Exercise decisions may be warranted if deferring buyout results in  Cash flow or learning sacrifice  Diminished opportunities to preempt rivals Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 Introduction Theory and Hypothesis Research Design Result Discussion Hypothesis • 𝑆 − 𝑋 > 𝐶(𝑆, 𝑋, σ, 𝑇) ; 𝑆 − 𝑋 > 0 ▫ H1: 𝑆  buyout ▫ H2: σ  buyout ▫ H3: σ × 𝑆  buyout ▫ H4: proprietary  buyout ▫ H5: σ × proprietary  buyout ▫ H6: unique  buyout Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 Introduction Theory and Hypothesis Research Design Result Discussion Data • 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 Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 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 𝑞 𝑡+Δ𝑡 Δ𝑡 Δ𝑡→0  λ 𝑡 = lim [ ]  λ 𝑡 = exp α′ 𝑋𝑡 ▫ Maximum Likelihood  There is independence of failure times  Not true  “cluster” option (Lin and Wei (1989)) Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 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 Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 Introduction Theory and Hypothesis Folta and Kim (2002) Research Design Result Real Options in Equity Partnerships Discussion 10/9/2013 Introduction Theory and Hypothesis Folta and Kim (2002) Research Design Result Real Options in Equity Partnerships Discussion 10/9/2013 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 Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 Introduction Theory and Hypothesis Folta and Kim (2002) Research Design Result Real Options in Equity Partnerships Discussion 10/9/2013 Introduction Theory and Hypothesis Folta and Kim (2002) Research Design Result Real Options in Equity Partnerships Discussion 10/9/2013 Introduction Theory and Hypothesis Research Design Result Discussion H1& H3 are supported using subfield value measure Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 Introduction Theory and Hypothesis Research Design Result Discussion H1 & H3 Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 Introduction Theory and Hypothesis Research Design Result Discussion H2 is corroborated Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 Introduction Theory and Hypothesis Research Design Result Discussion H4& H5 are corroborated Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 Introduction Theory and Hypothesis Research Design Result Discussion H4 & H5 Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 Introduction Theory and Hypothesis Research Design Result Discussion H6 is not corroborated Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013 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 Folta and Kim (2002) Real Options in Equity Partnerships 10/9/2013