Contractual incompleteness and the optimality of equity joint ventures

Abstract

Firms engaged in the pooling of complementary skills often choose the Equity Joint Venture (EJV) over alternative profit-sharing arrangements. This paper addresses the issue of how equity shares are different from profit shares. It is shown that, in settings of contractual incompleteness, marketable equity ownership, when compared to non-transferable profit-sharing contracts, provides better ex ante incentives to the parties involved by mitigating ex post hold-up problems. Among other things, the prevalence of the 51–49 or 50–50 EJV in which one party has 51 percent (or 50 percent) equity shares is explained.

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.