1. Real Options in Equity Partnerships Author: Timothy B. Folta & Kent D. Miller Source: Strategic Management Journal (2002), Vol. 23, pp. 78-88 Presented by: Bradley Skousen

2. Purpose This paper argues that there is little theoretical and empirical studies on the determinants and timing of partner buyouts. The authors apply real options theory to extend the current understanding of a firm’s motives for incrementally committing to strategies through sequential investment processes. This is achieved in two ways: (1)The authors examine buyouts and equity purchases of partner firms subsequent to initial minority equity stakes. (2)The authors examine unexplored relations using real options theory (e.g.. external uncertainty on equity purchases).

3. Key Definitions Call Option: Is an initial equity stake conferring an inside position for subsequent equity purchases. Buyouts: Either a controlling or an incremental increase purchase in equity Two-stage compound options: The first stage, the buyout option, arises when the firm makes further equity purchases that result in a controlling interest in the partner (The focus of this paper). The second stage, the growth option, involves one or more discretionary investments to expand the business.

4. Theoretical Background The authors use the logic of the Black-Scholes model to identify key variables relevant to valuing the partner buyout option. Value of a call option C = f (S,X,σ,T, r) Where: C = Value of call option S = Partner value (including expected future cash flows and the option value of future growth opportunities) X = Exercise price to buy additional equity σ = Uncertainty of the partner’s value T = Length of time the buyout decision may be differed r = risk-free rate of return (Not included in the authors study) The option will only be exercised when the value of the underlying asset (S) exceeds the exercise price (X) by more than the value of holding the option (C): S −X > C(S,X,σ,T) In financial options this logic does not hold (Merton 1973) because the value of a call option always exceeds the value of exercising the option and holding the underlying asset. In this study, however, it is possible because real options considers the opportunity costs (e.g. learning sacrificed or diminished opportunities to preempt rivals.)

5. 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 more likely. Hypothesis 4: When buyout options are more proprietary (i.e. there are fewer equity partners 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 product market) partner buyout is more likely.

6. Model and Methods Two sets of Hazard Rate models were created. The first set of models defined the dependent variable as the hazard rate of acquiring a majority stake. The second set of models defined the dependent variable as the hazard rate of acquiring an additional stake. The study included 285 Minority Equity Partnerships in the Biotech Industry: 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

7. Variables Firm Valuation: Two measures were computed, (1) a stock market index of public firms active in the firm’s technological subfield (therapeutics, diagnostics, ag/bio, and supplier/specialty chemical), and (2) a proxy for the ability to attract capital from public markets. Target Firm Value: The difference in the number of public offerings since the initiation of the equity partnerships. Uncertainty: The 26-week standard deviation of weekly returns for each of the four biotechnology subfield indices. Proprietary: The number of equity partners was calculated as the log of the number of established firms with equity partnership outstanding in the target firm in the previous month. The number of rivals was calculated as the total number of firms having stated their involvement in any of Bioscan’s 123 biotechnology product areas.

8. Results – Majority Stake The main conclusion, is that the models do not have an overall significant effect associated with the authors theory-driven relations for acquisition of majority stakes. Potential Reasons: (1) The theory is wrong (2) Specification error (3) Sample size is insufficient Key Finding: The individual coefficient on uncertainty suggests that acquisition of majority stakes is more likely in the presence of lower uncertainty (Hypothesis 2).

9. Results – Minority Stake Hypothesis 1: Supported (only under subfield value valuation). Thus, higher partner valuation increases the likelihood of buyouts. Hypothesis 2: Supported. Thus, we expect acquisition of additional equity stakes to be more likely in the presence of low uncertainty. Hypothesis 3: Supported (only under subfield value valuation). Thus, higher valuation of growth opportunities coupled with lower uncertainty increases the likelihood of additional equity purchases. Hypothesis 4: Supported. Thus, if there are more equity partners a firm is less likely to acquire additional equity. Hypothesis 5: Supported. The results indicate that less proprietary (i.e. more equity partners) suggests that options are exercised at a faster rate in the presence of high uncertainty. Hypothesis 6: Not supported. Thus, no evidence for the influence of the number of rival firms on buyouts.

10. Conclusions Real Options Theory helps to explain why firms make additional equity purchases that do not result in a controlling position. Further research is needed to explain controlling purchases. This article expands previous work done on joint ventures (Kogut 1991) to a new context, equity purchases. Uncertainty, Price, Opportunity Costs, Proprietorship, Timing and Valuation are key concepts in Real Options Theory.