Real Options and Investment Mode: Evidence from Corporate Venture Capital and Acqusition

Real Options and Investment Mode: Evidence from Corporate Venture Capital and Acqusition

Tony W. Tong, Yong Li

Presenter: Wen ZHENG

Tony W. Tong is an assistant professor of management of the Leeds School of Business at the University of Colorado. He received his Ph.D. from The Ohio State University. His current research applies real options theory to study firms’ corporate development activities such as alliances, acquisitions, and corporate venture capital.

Yong Li is an assistant professor of the School of Management at the State University of New York at Buffalo. He received his Ph.D. from the University of Illinois at Urbana–Champaign. His current research applies real options theory to study investment under uncertainty and venture capital.

Authors

Contents

Discussion

Empirical

Theory and Hypothesis

Introduction

Problem Statement

• The paper draws from real options theory to compare CVC and acquisition empirically

Introduction

Theory

Empirical

Discussion

Problem Statement

• The paper draws from real options theory to compare CVC and acquisition empirically

Investment modes that are important tools that firms can employ to further their external business development and corporate growth initiatives.

Introduction

Theory

Empirical

Discussion

Problem Statement

• The paper draws from real options theory to compare CVC and acquisition empirically

CVC is the investment of corporate funds directly in external start-up companies.

It involves an investing firm taking a minority equity stake in a private entrepreneurial company (Gompers and Lerner, 1998).

Introduction

Theory

Empirical

Discussion

Introduction

Theory

Empirical

Discussion

Real Option View

CVC Acquisition

Expand Flexible to make sequence investment

One-time deal and few sequential investment

possibility

Abandon Flexible to liquidate its investment

Difficult to divest a company

DeferFlexible to defer

deciding to expand or abandon

High commitment and little deferral option

Option

Mode

Real options become more salient in CVC investments compared to acquisitions under conditions of uncertainty

Uncertainty

Hypothesis 1 (H1). The greater the level of uncertainty, the more CVC is preferred over time.

An increase in the exogenous uncertainty enhance the value of all types of real options.

Option to expand and abandon adjust and reverse active reduce downside risk and capture upside should the environment develop favorably.

Option to defer Limit exposure to market uncertainty

Introduction

Theory

Empirical

Discussion

Contingent Effect of Uncertainty

Irreversibility

Growth Opportunity

Competition

Positive relationship between uncertainty and preference for

CVC over acquisition

Introduction

Theory

Empirical

Discussion

Contingent Effect of Uncertainty

Hypothesis 2 (H2). The greater the level of irreversibility, the stronger the positive relationship between uncertainty and the preference for CVC over acquisition.

Irreversible: resale value < cost

Irreversible resale value sensitive to uncertainty Value of Option

Acquisition is harder to reverse than CVC

Introduction

Theory

Empirical

Discussion

Contingent Effect of Uncertainty

Hypothesis 3 (H3). The greater the level of growth opportunities, the weaker the positive relationship between uncertainty and the preference for CVC over acquisition

Growth opportunity Opportunity cost of waiting

Indecision loss of profit streams in the present or future periods

Downside loss can be less valuable when there is significant upside potential

Introduction

Theory

Empirical

Discussion

Contingent Effect of Uncertainty

Hypothesis 4 (H4). The greater the level of competition, the weaker the positive relationship between uncertainty and the preference for CVC over acquisition

Extent that growth opportunities shared Strategic value of commitment

Competitive investment Strategic value of commitment >flexibility value of deferring

CVC provides flexibility to defer, while acquisitions signal commitment to potential rivals.

Introduction

Theory

Empirical

Discussion

Sample• Sample: Public firms (Compustat) • Year: 2003-2005

– Coverage of private acquisitions would become more accurate and extensive since 2003

• CVC: First-round CVC investments– Valuable real options– On a similar footing with acquisitions

• Acquisition: Acquisition of private targets• Acquisition started as CVC

– Exercise of the options that are embedded in the initial CVC investment

Introduction

Theory

Empirical

Discussion

Variables and Measures

Introduction

Theory

Empirical

Discussion

Dependent Variable CVC vs. Acquisition

1 if investment is structured as CVC investment, 0 if structured as an acquisition.

Explanatory Variables Exogenous uncertainty

Volatility of industry stock market indices Irreversibility

Asset intangibility Growth Opportunities

Market-to-book ratio Level of competition

One-minus-industry concentration ratio

Variables and Measures

Introduction

Theory

Empirical

Discussion

Control Variables (Investment Firms) Size

Nature log of the firm’s total assets in million dollars. R&D intensity

R&D expenditure as a percentage of sales. Profitability

Return on sales: income before extraordinary items as a percentage to sales

Firm’s experience in CVC versus acquisition Logged the ratio of one plus the number of CVC

investments to one plus the number of CVC acquisition.

Variables and Measures

Introduction

Theory

Empirical

Discussion

Control Variables (Investee’s industry) Industry profitability

Sum of the income before extraordinary items for all of the firms in the industry in which the investee resides as a percentage of industry sales

Industry R&D intensity information asymmetry The amount of R&D expenditures for all of the business

in the industry as a percentage of industry sales IP regime

Carnegie Mellon Survey of Research and Development

Variables and Measures

Introduction

Theory

Empirical

Discussion

Control Variables (Investor investee dynamic level) Inter-industry investment

1 when the investor and the investee operate in two different three-digit SIC industries, and 0 otherwise.

Different State geographic location 1 when the investor and the investee are located in two

different state, 0 otherwise. Control Variables (Investee characteristics)

Investee age Take log of subtract value between the founding year

from the current year Investee size

Take the log of the number of employees.

Methodology

Introduction

Theory

Empirical

Discussion

Two Stage Probit model First Stage Sample selection model

Distinguish firms that undertook CVC investments or acquisitions from firms that undertook neither investment

P( Undertake CVC or acquisition)= f ( size, profitability, R&D intensity, capital intensity , financial leverage)

Second Stage The choice of CVC versus acquisition

P(Undertake CVC)= f ( Uncertainty, Uncertainty* irreversibility, Uncertainty*Growth opportunities, Uncertainty* competition, Control Variable)

ResultsDescriptive Statistics and Correlation Matrix

Introduction

Theory

Empirical

Discussion

ResultsHeckman Regression Results

Introduction

Theory

Empirical

Discussion H1

ResultsHeckman Regression Results

Introduction

Theory

Empirical

DiscussionH2

ResultsHeckman Regression Results

Introduction

Theory

Empirical

DiscussionH3

ResultsHeckman Regression Results

Introduction

Theory

Empirical

Discussion

H4

ResultsHeckman Regression Results

Introduction

Theory

Empirical

Discussion

ResultsHeckman Regression Results

Introduction

Theory

Empirical

Discussion

ResultsHeckman Regression Results

Introduction

Theory

Empirical

Discussion

ResultsHeckman Regression Results

Introduction

Theory

Empirical

Discussion

ResultsHeckman Regression Results

Introduction

Theory

Empirical

Discussion

ResultsHeckman Regression Results

Introduction

Theory

Empirical

Discussion

ResultsResults including investee age and investee

sizeIntroduction

Theory

Empirical

Discussion

ResultsRobustness check

Another measure of uncertainty Regress industry sales over five years against time and

then used the standard error of the regression coefficient divided by the mean of industry sales to develop a standardized proxy of uncertainty for each industry and year.

Another measure of irreversibility Industry inverse leverage

Explore the sensitivity of the findings to alternative models Technological innovation Companies outside

of the high-tech realm Minority acquisition

Introduction

Theory

Empirical

Discussion

Conclusion

• When an investment is surrounded by high levels of market uncertainty, maintaining flexibility becomes more important, and firms attach greater value to the real options embed in initial CVC investments vis-à-vis acquisition.

• The value of real options under uncertainty is contingent upon several factors that may either increase or decrease such value and therefore my shape firms’ choice between CVC and acquisition. (Irreversibility and Growth opportunity)

Introduction

Theory

Empirical

Discussion

Future Research Plan• Focus on only two investment mode

Other investment mode like alliance, joint ventures

• Take the investing firm’s perspective to examine investment mode choice From the perspective of both the investor and the investee

• Focus on creation of option Option creation + option implementation

Introduction

Theory

Empirical

Discussion