Compensation Options in Joint Ventures. A Real Options Approach

Abstract

This research focuses on a cluster of dynamic reallocation and restatement of ownership clauses contained in joint venture agreements. These clauses, with potentially significant financial implications, govern the transfer of rights between the parties on two key financial issues: the allocation of profits and losses and the ownership interests in the joint venture. The central contribution of this research is to consider these clauses themselves as non-standard real options and to propose a methodology for assessing their values. Determination of such values will be essential throughout the joint venture negotiation process. In addition, we provide valuable information on another key question of managerial importance: estimating the downside risk of a clause so that the affected party can design a hedging strategy. Two actual case studies extracted from recent joint ventures have been used to stress the importance of these concepts and to develop suitable valuation techniques. The theoretical framework is based on real options methodologies. However, the clauses studied involve real options with non-standard features (compensation options and options with uncertain initial date). Therefore, we have developed ad hoc valuation models with user-friendly numerical examples in spreadsheet format.

Notes

¹The full text of the JV agreements used in the case studies was obtained from http://contracts.onecle.com

²Ω_t denotes IPO price in prior IPOs by TI in the United States and their financial results (if any) or IPO prices of competitors in the field (if any).

³Φ_t denotes factors such as stock prices of competitors at time t, the chance that a competitor issues an IPO at time t, or the financial results of TI parent company. Condition C₁(S_t,Φ_t) combines these quantitative and qualitative factors (such as U.S. legislation concerning foreign company IPOs).

⁴Ψ_t captures factors such as the financial situation of IDT at time t, IDT's financial policy, or information IDT has concerning the financial results of TI parent company. Condition C₂(P_t, S_t, Ψ_t) combines these factors to symbolize quantitative constrains that according to IDT's criteria would model its purchasing decision.

⁵Note that Date 1 is always prior to Date 2 as we have concluded in the previous section.