Contractual incompleteness and the optimality of equity joint ventures
Introduction
When two firms possessing complementary capabilities for developing new technologies or new products initiate joint projects, the choice of the organizational form is an issue. One of the most commonly observed forms is an Equity Joint Venture (EJV).1 In this paper, we ask the following question: what are the circumstances under which firms engaged in developing new technologies or processes would choose an EJV over a simple contractual arrangement, whereby one of the firms could hire the other to perform the same tasks that the latter would perform if it were a partner in an EJV?
As an example of the type of contractual arrangement that could be possible, one can imagine one of the firms (say Firm 1) setting up a wholly-owned subsidiary (WS) and offering an incentive contract (a profit-sharing scheme) to the other party (the `agent') that would relate the latter's compensation to the profits of the subsidiary. To all intents and purposes, setting up an EJV instead would seem to do essentially the same thing: it would allow the partners to share the profits of the separate entity through ownership of equity shares. Thus, the basic question is: why are equity shares different from simple profit shares?
We argue that the difference stems from the fact that a joint venture partner enjoys somewhat different rights over future profit streams than an agent of a WS. The most important difference here is that equity is marketable,2 whereas profit shares promised as part of an incentive scheme typically are not. The agent of a WS is promised profit shares as part of a document that represents an agreement between the two parties. It is difficult, if not impossible, to separate the profit claims from the rest of the agreement and market them. Equity shares afford a simple way to implement this separation. We show that this distinction is in fact crucial for understanding the difference between an EJV and a WS, and why the former may do better than the latter under some circumstances. We argue that the marketability of equity can mitigate ex post opportunism by the other partner that may otherwise arise and lead to inefficient outcomes.3
From Grossman and Hart (1986), we know that the allocation of rights matters in the presence of contractual incompleteness.4 In the context of projects involving the development of new technologies or innovations, contractual incompleteness arises for a very natural reason: not all the future products (innovations) can be foreseen ex ante. Typically, such projects have certain well-defined technological milestones or objectives, but often there are spin-offs that were not anticipated ex ante. These unforeseen applications could be in market segments in which one of the partners is a dominant player and has an incumbency advantage – essentially precluding entry by the other.5 The inability to specify precisely ex ante the full range of future applications makes it impossible to write contracts based on the sharing of the profits from these applications, which accrue to the partners in their existing lines of business and thus cannot automatically be shared. We show how the rights associated with equity matter in the presence of contractual incompleteness of this nature. The optimality of EJVs under certain conditions thus provides a rationale for partial ownership, an element that is missing in Grossman and Hart's analysis.
Our paper is related to a growing literature on the organizational form for R&D cooperation, which will be discussed in the conclusion. In terms of research methodology, our paper is related to Aghion and Tirole (1994) as both papers analyze partial ownership in settings of incomplete contracts. In Aghion and Tirole's model, a research unit makes an innovation that is specific to its customer. If the customer has to make a cash injection into the project, it may be in the interest of the customer to demand that the research unit raise cash from third parties by selling equity shares before its research effort is made (i.e., ex ante marketability of equity). In contrast, our paper elucidates how the rights associated with equity including ex post marketability can bring about the right alignment of incentives and hence alleviate the ex post hold-up problem. Thus, while Aghion and Tirole consider only ex ante marketability of equity shares, we stress the role of ex post marketability of equity.
The rest of the paper is organized as follows. Section 2outlines the model and derives the second-best solution to a double-sided moral hazard problem. In Section 3, the optimality of equity joint ventures over alternative contractual forms is established, and the prevalence of the 51–49 (or 50–50) joint venture is explained as well. In Section 4, certain generalizations are considered. The paper concludes with Section 5.
Section snippets
Technology
We label the two partners Firm 1 and Firm 2. Both firms are assumed to be risk neutral. The firms need to provide costly effort for the success of the joint R&D project. The `state' of the project could be either `success', with probability ρ(e1, e2), or `failure', with probability 1 − ρ(e1, e2), where e1 denotes the unverifiable effort of Firm 1 and e2 that of Firm 2. For simplicity of analysis, ρ is assumed to be ρ = e1e2, where e1, e2 ∈ [0, 1]. The cost for firm i of effort ei is
Alternative contractual/organizational forms
In this section, we examine the relative merit of two alternative contractual/organizational forms in implementing the efficient outcome identified in the previous section, given the limitations on the contractual capabilities discussed previously. The alternatives are (a) either firm can set up a WS and employ the other firm as an `agent' whose compensation is linked to the subsidiary's profits, and (b) the two firms set up an equity joint venture where each has equity shares.
A more general bargaining framework
Our analysis so far has been based on some strong assumptions about relative bargaining power. It may be asked to what extent the results are driven by the particular assumptions about ex post bargaining that have been made. It turns out that the results are not very sensitive to the assumptions at all. We consider an extension of the basic model to show this.
We make the same assumptions about the information structure, project payoffs and contractual capabilities as in Section 2. However, we
Conclusion
We address in this paper two empirical issues noted by existing studies (see Footnotes): the importance of equity joint ventures as an organizational form for cooperative R&D activity, and the prevalence of the so-called 50–50 or 51–49 joint venture arrangements. There is a growing literature on the organizational structure for R&D cooperation. In recent years, R&D cooperation has become an increasingly important business strategy. The rationales for R&D cooperation vary from coordination of
Acknowledgements
We thank Yuk-Shee Chan, Leonard K. Cheng, Gregory Chow, Vidhan Goyal, Oliver Hart, Jean-Jacques Laffont, Ivan Png and Kunal Sengupta for helpful discussions. We also thank editor Richard H. Day and two anonymous referees whose comments have significantly improved the paper.
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