Real Options and Investment Mode: Evidence from Corporate Venture Capital and Acquisition BA549A Session 7: Real Options Tony W. Tong Yong Li Organization Science (2011) presented by Eunkwang Seo

AGENDA Phenomenon to Study Corporate Venture Capital (CVC) Recently, corporate venture capital has emerged as an important means for achieving growth and expansion. CVS involves an investing firm taking a minority equity stake in a private entrepreneurial company.

AGENDA Research Question Q. Why and when do firms choose CVC investments over acquisitions? CVC investments and acquisitions can be viewed as alternative governance modes for external business development activities (Schildt et al., 2005; Keil et al., 2008). The determinants to the choice between CVC and acquisition have not been examined yet, as compared to the choice between acquisition and alliances. The purpose of this study is to explore the determinants in the view of real option theory.

Real Option View of CVC and Acquisition THEORY & HYPOTHESES Real Option View of CVC and Acquisition CVC investments as real options The option to grow: The CVC firm has the right but not the obligation to make a subsequent investment and increase the level of resource commitment. The option to abandon: The CVC firm also has the right to liquidate its investment. The option to defer: The CVC firm can defer making any definite decision concerning whether to expand or abandon. Acquisitions are typically one-time deals and provide few sequential investment possibilities. Although acquisitions can offer an abandonment option, the option is difficult and less likely to exercise.

Uncertainty and Choice between CVC and acquisition THEORY & HYPOTHESES Uncertainty and Choice between CVC and acquisition Uncertainty favors Flexibility In the presence of the options to grow, abandon, and defer, a CVC investment not only helps the firm to reduce downside risk but also position the firm to capitalize on the upside potential when the environment develops favorably. Compared to CVC investments, acquisitions give the firm less flexibility to adjust or reverse its actions. Therefore, under exogenous market uncertainty, firms will prefer CVC over acquisition. Hypothesis 1. The greater the level of uncertainty, the more CVC is preferred over acquisition.

Contingent Effects of Uncertainty THEORY & HYPOTHESES Contingent Effects of Uncertainty Irreversibility Investments are irreversible when their resale value is less than their costs. As irreversibility increases, the resale value decreases, and investment decision will become more sensitive to conditions of uncertainty (Dixit, 1989; Pindyck, 1991). Thus, when an investment project involves high levels of irreversibility, the impact of uncertainty on the choice is strengthened. Hypothesis 2. The greater the level of irreversibility, the stronger the positive relationship between uncertainty and the preference for CVC over acquisition.

Contingent Effects of Uncertainty THEORY & HYPOTHESES Contingent Effects of Uncertainty Growth opportunities and competition Delaying or staging investments may incur opportunity costs of waiting. The value of real options is partially offset by growth opportunities and level of competition. In these cases, speedy and timely commitments through acquisitions can provide strategic advantages. Hypothesis 3. The greater the level of growth opportunities, the weaker the positive relationship between uncertainty and the preference for CVC over acquisition. Hypothesis 4. The greater the level of competition, the weaker the positive relationship between uncertainty and the preference for CVC over acquisition.

METHODS Sample CVC investments Acquisitions Using Venture Economics’ VentureXpert database Focusing on first-round investments The CVC sub-sample includes 546 investment deals by 99 investing firms during 2003-2005. Acquisitions Using SDC database Excluding buyouts, divestitures, restructuring, carveouts … The sample includes 2,237 investment deals by 1,193 acquirers during 2003-2005. 8 cases in which acquisitions are considered exercise of the options are excluded. The acquisition sub-sample includes 2,229 M&A deals during the period. Therefore, the final sample includes 2,775 investment deals.

RESULTS Measurement Dependent Variables Explanatory Variables Binary choice variable: CVC vs. Acquisition Heckman model to address potential sample selection bias: CVC or acquisitions vs. neither investment. Explanatory Variables Uncertainty: the volatility of industry stock market Irreversibility: asset intangibility Growth opportunities: the market-to-book ratio Competition: one-minus-industry concentration ratio Controls: various firm/industry-level controls.

RESULTS H1 supported H2 supported H3 supported H4 not supported

METHODS and CONCLUSION Robustness Check Alternative measures Uncertainty: regression residuals of industry sales Irreversibility: the industry inverse leverage, the liquidity index Alternative models Focusing on companies outside of high-tech realm Multinomial regression with minority acquisitions Conclusion CVC investments as an alternative means for growth CVC investments as a real option Uncertainty is a key determinant to CVC investments over acquisition (flexibility). Irreversibility and growth opportunities are boundary conditions.