Real options in equity partnership

Timothy B. Folta and Kent D. Miller

Presenter: Wen ZHENG

Research Question

Folta and Kim (2002)

Real Options in Equity Partnerships 10/9/2013

Introduction Theory and Hypothesis Research Design Result Discussion

•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

Options

Folta and Kim (2002)

Real Options in Equity Partnerships 10/9/2013

Introduction Theory and Hypothesis Research Design Result Discussion

•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

Options

Folta and Kim (2002)

Real Options in Equity Partnerships 10/9/2013

Introduction Theory and Hypothesis Research Design Result Discussion

•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

Buyout Options

Folta and Kim (2002)

Real Options in Equity Partnerships 10/9/2013

Introduction Theory and Hypothesis Research Design Result Discussion

• 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)

Buyout Options

Folta and Kim (2002)

Real Options in Equity Partnerships 10/9/2013

Introduction Theory and Hypothesis Research Design Result Discussion

• Exercise Condition

▫Early Exercise decisions may be warranted if deferring buyout results in Cash flow or learning sacrifice

Diminished opportunities to preempt rivals

Hypothesis

Folta and Kim (2002)

Real Options in Equity Partnerships 10/9/2013

Introduction Theory and Hypothesis Research Design Result Discussion

• ;

▫H1: buyout

▫H2: buyout

▫H3: buyout

▫H4: proprietary buyout

▫H5: proprietary buyout

▫H6: unique buyout

Data

Folta and Kim (2002)

Real Options in Equity Partnerships 10/9/2013

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

Model and Method

Folta and Kim (2002)

Real Options in Equity Partnerships 10/9/2013

Introduction Theory and Hypothesis Research Design Result Discussion

• 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))

Variables

Folta and Kim (2002)

Real Options in Equity Partnerships 10/9/2013

Introduction Theory and Hypothesis Research Design Result Discussion

• 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 Research Design Result Discussion

Folta and Kim (2002)

Real Options in Equity Partnerships 10/9/2013

Introduction Theory and Hypothesis Research Design Result Discussion

Folta and Kim (2002)

Real Options in Equity Partnerships 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 Research Design Result Discussion

Folta and Kim (2002)

Real Options in Equity Partnerships 10/9/2013

Introduction Theory and Hypothesis Research Design Result Discussion

Folta and Kim (2002)

Real Options in Equity Partnerships 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