real options and investment mode: evidence from corporate venture capital and acquisition

Real Options and Investment Mode: Evidence from Corporate Venture

Capital and Acquisition

Tony W. Tong & Yong Li (2011)Organization Scienc, 22(3): 659-674.

Jae Kyun Yoo

BADM 549: Strategy Research Seminar (Fall 2014)

Authors

Tong, T. W., & Li, Y. 2011.Real Options and Investment Mode: Evidence from Corporate Venture Capital and Acquisi-tion, Organization Science, 22(3): 659-674.

• Associate Professor (Leeds School of Business, University of Colorado)

• Ph.D. from Fisher College of Business (Ohio State University)

• M.A. from Fisher College of Business (Ohio State University)

• M.Sc. From NUS Business School• B.A. from Shanghai Institute of Foreign Trade

Yong Li

Tony W. Tong

• Associate Professor (University at Buffalo, SUNY)• Ph.D. from University of Illinois at Urbana-Cham-

paign• M.B.A. from University of Queensland

Introduction


Research on examining firms’ CVC investments in com-parison with acquisitions has been much less worked on compared to independent studies of each.

The paper aims to fill this gap by empirically comparing CVC and acquisition as two investment modes and by investigating when firms prefer to undertake CVC in-vestments versus acquisitions.

The paper draws from real options theory to develop hy-potheses on the determinants of the choice between CVC and acquisition.

A Real Options View of CVC Investments and Acquisitions

These differences suggest that CVC investments are embedded with greater real options and of-fer more flexibility than acquisitions.


CVC Investment Acquisition

Expand The right but not the obli-gation to make a subse-quent investment.

Typically one-time deals and provide few sequen-tial investment possibili-ties.

Abandon Option to liquidate its in-vestment.

Difficult to divest a com-pany.

Defer Option to defer making any definitive decision concerning whether to expand or abandon.

Represent high commit-ment and provide little de-ferral option.

Uncertainty and the Choice Between CVC and Acquisition

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

Uncertainty creates a disincentive for firms to make one-time and hard-to-reverse commitment that is often required in acquisitions.

By contrast, the various real options obtained from initial CVC investments will become more valuable under conditions of uncertainty.


The Contingent Effects 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 Investments: Resale Value < Cost

Irreversibility ↑ Resale Value ↓ Sensitive to Uncertainty Value of Option ↑


The Contingent Effects of Uncertainty (cont.)

Hypothesis 3 (H3). The greater the level of growth opportu-nities, the weaker the positive relationship between uncer-tainty and the preference for CVC over acquisition.

Delaying or staging investments in the presence of growth opportunities may incur opportunity costs of wait-ing.

Whereas CVC investments allow the firm to defer com-mitments and adopt a wait-and-see strategy, acquisi-tions enable the firm to commit resources in a speedy way to capitalize on the growth opportunities.


The Contingent Effects of Uncertainty (cont.)

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

To the extent that growth opportunities are shared, speedy investments can help the firm avoid missing out the opportunities, and timely commitment can also gain the firm strategic advantages.


Data

Sample• Public firms between 2003-2005.• CVC: First-round CVC investments.• Acquisition: Acquisition of private targets.• Acquisitions started as CVC (exercise vs purchase).

Variables• Dependent Variable: CVC vs. Acquisition• Explanatory Variables:

Exogenous uncertainty (volatility of industry stock market in-dices)

Irreversibility (asset intangibility) Growth Opportunities (market-to-book ratio) Level of Competition (One-minus-industry concentration ratio)

• Control Variables: size, R&D intensity, profitability, firm’s experi-ence in CVC vs. acquisition, industry profitability, industry R&D in-tensity, IP regime, interindustry investment, different state, in-vestee age, investee size, two year dummy variables


Results


Hypothesis 1 supportedHypothesis 2 supportedHypothesis 3 supported

Hypothesis 4 not supported

Conclusions


When an investment is surrounded by high levels of mar-ket uncertainty, maintaining flexibility becomes more impor-tant, and firms attach greater value to the real options em-bedded in initial CVC investments vis-à-vis acquisition.

The findings show that investment irreversibility will further increase firms’ propensity toward CVC, whereas growth opportunities facing the investment will weaken the pref-erence for CVC under uncertainty.

Future Research


Consider other activities, such as alliances and joint ven-tures, which can also be used to further firms’ external corporate development initiatives.

Investigate investment mode choice from the perspectives of both the investor and the investee.

Extend our focus on option creation at the initial invest-ment stage to option implementation at the postinvestment stage.

real options and investment mode: evidence from corporate venture capital and acquisition

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