I will try to provide several examples of a real option analysis in contractual relationships between two parties: a delivery contract for a service product with uncertain development time; a supplier contract for assets with short lead times such as fashion goods with market uncertainty; and a joint venture agreement to co-develop a new original drug with significant technical and market payoff uncertainty.
For instance, a joint venture on a product Research & Development program can be viewed as a sequential compound option whereby after the initial learning experience one of the partners makes an equity investment in the other partner.
Successful product development during the joint venture creates the option to expand the agreement to include sales or distribution rights and may ultimately create the incentive—and real option—to acquire the joint venture partner. These types of agreements are frequent in high-tech industries such as semiconductors, software development or biotechnology, which feature high R&D intensity and high levels of technical uncertainty.
A recent article in Financial Times alludes to Pfizer’s changing drug strategy to restructure R&D, which now involves a series of investments in start-up BioTech companies in exchange for equity. The size and research budget from Pfizer’s approximately $7bn in annual R&D spending and to be corrected later.
These examples also extend to other industries. Anheuser-Busch, the global brewery, within the past few years has initiated a novel strategy of growth option acquisitions by making small equity investments in local breweries in foreign markets. These investments given Anheuser both growth options as well as learning options: By participating in the small breweries, Anheuser learns quickly about the market structure, demand, and growth potential of these markets, thereby reducing much of the noise that would otherwise cloud assumptions about the attractiveness of these markets. This, in turn, facilitates informed decisions as to which of those growth options should be exercised by acquiring target firms in proliferating markets.
A joint venture creates the option to learn about technical and market uncertainty by preserving a stake in the development program. It provides the opportunity to participate in the upside potential while also sustaining enough flexibility to exit at low costs if the project fails. Those partner strategies that build on sequential investments constitute an important part of corporate strategies. They avoid the risk inherent in premature acquisition of some technology firm prior to obtaining a good understanding of the feasibility of the emerging technology and its market acceptance.
An agreement between two partners, be it to jointly develop a new product or to provide for product or service supply, should allow for sufficient embedded options and flexibility to sustain a fair and just allocation of obligations and rewards to each party for both the current conditions, under which the agreement is closed, and a set of future uncertainties. In other words, the agreement should create a Pareto optimal allocation of risks and reward in the face of uncertainty: there is no other allocation in which some other individual is better off and no individual is worse off. It implies that both parties can benefit equally from future upsides and are equally protected against downside risks. Contract embedded options that permit fair risk and reward sharing during the presumed lifetime of the agreement under a set of future uncertainties are likely to stabilize and sustain the relationship between the two parties.
One solution to the problem of future uncertainties is contingent contracts.
In a contingent contract, some of the deal terms are not finalized but are left open for future events, that is, the contingencies, to occur. Those contingencies may relate to uncertain market payoffs, the success of a joint project, or the costs it may take to complete a task. Real options are a great analytical tool to reconcile disparate assumptions and expectations in the structure of a contingent contract.
In other words, contract embedded options are constructed to make behavioral motives or penalize unwanted actions. These include delivery contracts with penalty clauses for delays or employment contracts that entail incentive options.
Please, read related posts in my blog:
The contingent contract is of special interest to me. If an outcome = x then a deal term = y. For example, market success might lead to a higher commission. So there’s protection of a JV partner in the case of an adverse outcome? Thanks, GD.
Also, for the small business, there’s increased certainty and less risk by banding together in joint ventures such as the ‘giveaways’ which are prevalent today, reducing market uncertainty for the small Internet startup operations. I’ve recently been involved in 7 of them. GD.
Yepp, thank you for this question. I just tried to show you through the real examples how to minimaze the risks and manage them to protect the investment and succeed in.
Yours,
Vladislav Gurin