Evaluation of International Joint Venture Agreements: Real Options in Practice

ABSTRACT The main goal of this study is to develop practitioner-friendly methodologies, in a real options framework, for evaluating joint venture (JV) agreements. Avoiding the general issue of JVs' design, we illustrate the application of real options methodology by valuing specific clauses extracted from actual JV agreements. Additionally, we have tried to contribute to the real options field by designing valuation methodologies to capture the value of more complex embedded options ("Compensation Options" and "Options with Uncertain Initial Date") in JV agreements with certain nonstandard features, due to contractual requirements. JEL Classification: G13 Keywords: Real options; International joint ventures; Valuation of contract clauses I. INTRODUCTION Joint venture (JV) agreements are widely studied; however, the application of real options to assess joint venture agreements is not extensive in the literature. The main goal of this study is to develop practitioner-friendly methodologies, in a real options framework, for evaluating joint venture agreements. The design of a JV is the result of a negotiation process. Although there is no standard negotiation, we could draft a sequence from the key economic and legal terms to the detailed statement of clauses governing specific features of the business operations of the new venture. In order to fit the present research into the JV field and stress its main contributions, Figure 1 describes how the key issues and additional clauses important for our research are interconnected. [FIGURE 1 OMITTED] In the early steps of the negotiation, the parties agree on two main issues: their contributions to the JV and their percentages of ownership in the JV. The extent of linkage among these issues depends upon particular aspects of the legal and economic framework where the JV is meant to operate. Situations where the percentages of ownership cannot be negotiated (and, therefore, cannot be linked with the partners' contributions) often arise, especially in international joint ventures (IJV), due to legal restrictions on the percentage of foreign ownership. (A limit of 49% foreign equity interests in an IJV is not unusual in certain countries and sectors.) On the other hand, with no restrictions, the partners may wish to accomplish an ownership distribution that would reflect, as precisely as possible, the value of each partners' contributions. Between these two scenarios many other intermediate situations could be envisioned. The question of ownership in JVs has been broadly studied. An interesting recent survey on ownership patterns can be found in Hausbald and Hege (2003), where the authors found that "Joint ventures exhibit the following intriguing ownership pattern: the vast majority allocate equal or almost equal equity stakes to the parent firms. Large sample data indicate that about two thirds of two-parent joint ventures have 50%-50% equity allocations, while up to 12% show 50.1% or 51% majority stakes". Valuing each party's contribution in a JV entails the same difficulties as valuation of any other assets but often involves additional difficulty concerning the valuation of intangible assets (e.g., licenses, intellectual property rights, technology, know-how, human skills). Ground-floor type (see Seth and Kim, 2001) or transfer pricing valuation of intangibles using real options (see Faiferlick et al., 2004) are just a couple of references in recent research literature. Intangible assets will play an important role in the real options approach that will be developed later on in this paper. Once an agreement on the two previous issues (parties' contributions and percentage of ownership) is reached, the negotiation will come to the point of deciding the allocation of profits and losses from the JV (the third issue). The interests of the parties in profits and losses and their initial contributions, as well as such interests and their percentages of ownership, may not be the same. …