Lecture 6:

Strategic Alliances & Joint

Ventures
Corporate Finance
Professor Joseph McCahery
Road Map
• Background: Vertical Integration
• Contractual Form
• Contracting for Innovation
• Ally or Acquire?
• Joint Ventures
• Governance
• Conflict Resolution

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Background: Vertical Integration
§ Vertical integration was at the core of 20th century business
organization
§ Standard story
• Growth in efficient scale required specific investment
• But specific investment by two parties presented risk of hold up
• Vertical integration eliminated hold up risk (Chandler, Williamson)

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Road Map
• Background: Vertical Integration
• Contractual Form
• Contracting for Innovation
• Ally or Acquire?
• Joint Ventures
• Governance
• Conflict Resolution

4
Contracting in the Face of Uncertainty
§ How contract across firm borders when “deal” has three
characteristics?
• Output is innovative
• Uncertainty prevents ex ante specification of product characteristics,
costs and method of production
• Neither party alone has the capacity to specify these elements
• Success requires collaboration among firms with different capabilities
• The process of specification and performance will be iterative

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Contract Theory Has No Solution
§ How do parties deal with opportunism and holdup?
• How do parties divide gains when:
• Uncertainty precludes specifying division ex ante, and
• Need for specific investment makes ex post allocation subject to
holdup
• Commitment necessary to encourage specific investments conflicts
with the flexibility necessary to adjust terms when uncertainty
resolved

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Contract Theory Has No Solution
§ Project is non-contractible ex ante
§ Continuous uncertainty precludes ex post renegotiation and ex ante
assignment of rights (Grossman & Hart 1986; Hart & Moore 1990)
§ Continuous adjustment precludes ex ante manipulation of relational
contracting (Baker et al 2006)
§ Both formal enforcement and reputation and/or retaliation seem
infeasible

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Road Map
• Background: Vertical Integration
• Contractual Form
• Contracting for Innovation
• Ally or Acquire?
• Joint Ventures
• Acquisition v. Joint Venture
• Governance
• Conflict Resolution

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Three Contract Exemplars
§ Long-term supply contract

§ Sale of Plant & Laptop

Manufacturing

§ Pharmaceutical development

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A Theory of Contracting for Innovation
§ Problem to solve
• Create a structure that
• Induces efficient transaction-specific investment
• Establishes a framework for iterative collaboration and adjustment
under continuous uncertainty
• Limits the risk of opportunism that discourages specific investment

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Contracting for Innovation
§ Contract structure depends on whether the collaboration is long
term or directed at discrete product
• In long term setting, where uncertainty is continually recreated,
barrier to opportunism arises from the collaboration process itself
• Result is braiding: formal contract governing process and informal
contracts covering actual purchases/sales
• Level of trust is endogenous: formal contract does not force out trust;
it is designed to develop it

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Contracting for Innovation: Long Term Setting
§ Process-oriented governance supports rapid learning about
product innovation and reciprocal cooperation

§ Iterative collaboration raises switching costs -screening for

capability and character

§ Referee mechanism clarifies behavior and disciplines defection

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Contracting for Innovation: Discrete Setting
§ In discrete setting, ultimate resolution of uncertainty requires
formal barriers to opportunism that address final period
• Value creation stage of the relationship
• Braiding of formal and informal contracts to support collaboration
and trust in the innovative
• Value division stage of the relationship
• Formal contract that defines how the value created is divided after
the collaboration is completed

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The Three Contract Exemplars Again
§ Deere-Standyne supply relationship illustrates long-term
collaboration setting:
• Entire arrangement focuses on building knowledge of Standyne’s
capabilities
• No formal commitment to buy or sell anything
• 5 year master contract for supply of precision parts; no required
output or quantity (“no minimum quantities are implied herein”);
no pricing

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Building Knowledge: Raising Switching Costs
§ Achieving Excellence program
• Transaction specific knowledge about the other party’s capabilities
– trust – creates switching cost barrier to opportunism
• Endogenous verification: a) monitor performance; b) exchange
information; c) learn about product development and each other
(“wavelength”)
• Levels of confidence: up to partnership

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The Three Contract Exemplars Again
§ Warner Lambert-Ligand
• Collaborative project with discrete product
• Collaboration in development stage – braded formal and
informal contracts builds trust and switching costs
• Once product developed, Warner Lambert is in a position to
behave opportunistically
• No switching cost barriers
• Formal barriers to opportunism through careful assignment of
decision rights through nested options
Like venture capital and movie deals

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Contracting for Innovation and the Theory of the Firm
§ Contracts for innovation challenge the premises of the “make or
buy” dichotomy.

§ Holmstrom & Roberts (1998): many problems solved in many

ways

§ Contracting for innovation is a further example: elements of

contract, bi-lateral governance and hierarchical management.

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Summary: Alliances vs. Vertical Integration
§ Industries driven by innovation have pushed practice ahead of
current contract theory and the theory of the firm.

§ In lieu of vertical integration, parties use explicit and implicit

terms in unique ways to contract across organizational
boundaries.

§ Next step: alliances

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Road Map
• Background: Vertical Integration
• Contractual Form
• Contracting for Innovation
• Ally or Acquire?
• Joint Ventures
• Governance
• Conflict Resolution

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Alliances
§ Strategic Alliances
— A compromise between short-term, pure market transactions
(e.g., spot transactions) and long-term, pure organizational
solutions (e.g., mergers and acquisitions)

§ A firm creating new products, skills, resources and new

competences are best served by:
§ Gaining competitive capabilities through co-option of
partners
§ Leveraging each other’s co-specialized resources
§ Gaining competence through internalized learning 20
Alliances
§ Types of Alliances
• Strategic alliances assume a variety of legal forms:
• Supply or purchase agreements
• Marketing or distribution agreements
• Agreements that provide technical services
• Management contracts
• Licensing of know-how, technology, design, or patent
• Franchising
• Joint venture

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Alliances
§ Cooperative arrangements differ in following respects:
• Strategic objectives
• Logic of value creation
• Scope of joint decision-making
• Capital commitment
• Sharing of risks and rewards
• Organizational structure
• Evolutionary trajectory

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Ford and DaimlerChrylser search for fuel and a cell

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Ford and DaimlerChrylser search for fuel and a cell

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Alliances
§ Classification by economic substance of alliance
• Objectives differ in importance across four alliance types:
• Pre-competitive, e.g., between unrelated firms
• Competitive, e.g., between companies in competitive markets
• Pro-competitive, e.g., vertical value chain relationships
• Non-competitive, e.g., between non-competing firms in same industry
but different markets

• Motivation: exploitative and exploratory

• Learning alliances, strong exploration but limited exploitation
• Business alliances, link between companies with strong exploitation but
limited exploration
• Hybrid alliances, join companies with strategic intents that incorporate
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both exploitation and exploration objectives
Ally or Acquire?
§ Build new businesses
§ Access new markets
§ Access skills and learning
§ Gain scale
§ Improve supplier effectiveness
§ Create advantaged networks

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Ally or Acquire? That is the question

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Ally or Acquire?
§ Questions?
• How do firms choose between the two?
• Do firms systematically evaluate the two alternatives?
• What factors determine the preference of an alliance over an acquisition
and vice versa?
• Which growth strategy (and factors) are likely to suit either an acquisition
or alliance?

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A Three-Stage Decision Model of Strategic Alliance and Network Formation

Choice 1

Choice 2
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Choice 1: The Hold-up Problem

Incomplete Contracts
Specific Investments
Hold-up
Problem

Attempt to capitalize on the SUNK NATURE

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Choice 2: Acquisitions or Joint Ventures?

Seller

Asymmetric Information
“Lemons”
Adverse Stock Purchase
Screening

Signaling
selection Agreement Incur extra transaction
costs:
•Due diligence
•Reps & Warranties
Buyer

Contract Negotiation

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Choice 2: Acquisitions or Joint Ventures?

Seller

Asymmetric Information
Agreement often defective
and lack total binding Moral
Stock Purchase

Monitoring

Incentives
power to guarantee hazard
Agreement
complete transfer of
intangible assets
Non-competition clauses
Non-solicitation clauses
Buyer

Contract Enforcement

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Choice 2: Acquisitions or Joint Ventures?

Seller Seller

Adverse selection Joint Venture Moral hazard

Incentives
Signaling
Agreement

Buyer Buyer

Involvement signals quality ex Remaining equity posts bond = less ex

ante post opportunism

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Creating Value Through Alliances

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Alliances

§ The Variety of Strategic Alliances: short to long term

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Acquisitions or Alliances?
Factor Strategy

Types of Synergies

Modular Nonequity alliances

Sequential Equity alliances
Reciprocal Acquisitions

Nature of Resources (Relative value of soft to hard resources)

Low Nonequity alliances

Low/Medium Acquisitions
High Equity Alliances
Extent of Redundant Resources

Low Nonequity alliances

Medium Equity alliances
High Acquisitions

Degree of Market Uncertainty

Low Nonequity alliances

Low/Medium Acquisitions
High Equity Alliances

Level of Competition

Low Nonequity alliances

Low/Medium Equity alliances
High Acquisition

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Alliance
Pros Cons
• Often Fastest Time to Market • Not Truly Independent
• Less Expensive • Upside / Liquidity Path Unclear
• Easier Process • Joint Control Often Unworkable
• Less Dependence on Third Party • Risks of Disputes or “Divorce”
Risk of Termination • Risks of Giving JV Exclusive Rights
• Improved Ability to Address New
Marke Technologies
• Pooling of Resources
• Time to Market Advantages
• Sharing of Profits and Risks
• Unlike Acquisitions, Can
“Unscramble”
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Road Map
• Background: Vertical Integration
• Contractual Form
• Contracting for Innovation
• Ally or Acquire?
• Joint Ventures
• Acquisition v. Joint Venture
• Governance
• Conflict Resolution

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Joint Ventures—Key issues
§ Structure – Choice of Entity
§ Ex Ante Planning: Core Economic Problems (adverse selection,
oral hazard, specific investments, and exogenous risk)
§ Ownership and Control – Management Fiduciary Duties and
Restrictions on Competition
§ Remedies – Mutual Reliance Provisions

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JV: Essential Characteristics
• Profit withdrawals
• Formalities of formation and reporting requirements
• Management structure
• Tax Limited liability (or not) for owner
• Financial engineering flexibility
• Effect on private agreement of form chosen
• How ownership interests are represent and transferred
• Restriction on sale of ownership interests
• Duration of form
• Monitoring the Investment

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Model JV Agreements
§ Traditional Model: Multinational finds local partner and negotiates SH
agreement
§ Hub & Spoke: core business relationship identified and company organized
pursuant to JV agreement
§ Network of Contracts: used when 3rd parties will supply good nd services to JV
§ Joint Bid: acquisition identified, but parnter added to help buy nd operate
company
§ Break up venture: parts of target venture sold off; partners the form company
and run other units
§ Building blocks model: business relationship identified (copackaging agreement)
and company makes investment of 5% 10% in partner or option to take up to 51%
of newly formed firm
§ Management agreement: business relationship identified; company supplies
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management assistance to existing firm
Adverse Selection, Moral Hazard, and Hold-up in JVs
§ The Role of the Contract
Seller Seller

Joint Venture
Screening

Monitoring
Adverse selection Moral hazard

Incentives
Signaling Agreement

Buyer Buyer

Confidentiality and Nondisclosure Agreements

Term Sheets and Letter of Intent
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Initial Steps in Evaluating A Possible Joint Venture (Ex Ante)

Confidentiality and
Nondisclosure Agreements

Confidentiality Agreements
•Definition of “confidential information”
•Nonsolicitation provisions
Ex Ante Contractual
Mechanisms •Persons
•Remedies

Term Sheets and Letter of Intent

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Trust your partner but don’t forget the pre-nuptial

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Parties
§ Shareholders: meetings, notice provisions, voting кequirements;
list of items that require vote (amending articles, merger, sale,
major transaction, etc.)
§ Directors and officers: provisions related to each parties right to
appoint number of directors (2 to 3 for each party); chair could be
given tie-breaker vote Officers: specify senior officers, party
responsible for nomination
§ Money control mechanism: list of matters to be approved
majority vote of directors; some items may require unanimity, but
this is difficult achieve in most JVs

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Common Joint Venture Agreement Provisions (Ex Post)

Contribution of Assets

Intellectual Property and

Confidential Information

Joint Venture Agreement

Financing Rights and Obligations

Profits

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Capital Contributions: Key issues
§ Parties’ contributions or reference to a funding agreement the parties
will enter into as to future funding contributions in kind (valuation
method is needed), contributions list along with values provision
needed to require parties to maintain their investment in JV
§ JV stock: covers classes of stock, common usually sufficient but could
have two classes to differentiated: 1) voting rights; 2) dividend rights
and 3) responsbilities to JV
§ Right of first refusal: parties grant with respect to sale of their interests
provides for exemptions (ie, transfers to affiliated companies within
group of companies can not be made without consent)

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Transfer of Assets to JVC: Key Issues
• Valuation — which assets, formula and when should it take place
• Warranties — nature of seller’s warranties based on subject matter of transfer (actions
rare in practice)
• List: capacity, regulatory approvals, title, no material litigation, audited accounts, MAC,
business being contributed, no material undisclosed liabilities, valid IPR, warranties on
land contributed
• Enforcement of warranties — given directly to JVC; another approach is to give
warranties to other JV party and in case of breach to have the right to direct that
financial compensation to be paid by defaulting party to the JVC
• Non-financial contribution — independent valuation needed
• IP — identify IPR being transferred to JVC and classify rights and obligations of parties
• Employees — transfer of a business will trigger rights and obligations of employees
• Enforcement by JVC — rights to be exercised under agreement
• Taxation — cost-effective measns of transferring assets to JVC (problem of stamp duty
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and other taxes)
GE ring-fences its core technology

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Common Joint Venture Agreement Provisions (Ex Post)

Control and Management

Exclusivity and Restrictions on Competition

Joint Venture Agreement

Reporting Obligation

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Operating Procedures
• Agreement will typically state accounting standards used
• More sophisticated systems will make reference to complete
accounting system used
• Independent audit requirement
• Auditing statements:
• First year statement (if losses expected early on, then only to take
full advantage of long first year of tax loss carry forward)
• Standards for approving debt finance will be included in this section:
permit local management to enter into deb finance in ordinary
course; secured or substanital debt raising will require partner
approval
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Real Options
§ Joint ventures: platforms on which to build resources,
capabilities and market position to give sustainable advantage
• When growth opportunities evolve, each partner can make
follow on investment
Follow on option exercised when value of growth opportunity exceeds the follow
on investment (real option)

• Joint Ventures as real options:

Exercised through divestment (put option) and acquisition decisions (call option)
To enter joint venture, firms choose between flexibility and commitment
For non-core product market IJVs, large number and greater spread (between
emerging markets and others) of IJVs in the firms’ portfolios generate more
valuable growth options
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Value Gains from a Joint Venture
§ Value issues for Joint Ventures
• They bring together non-traded assets difficult to value
• Relative contribution of each partner are hard to assess
• Value from the alliance may arise outside the relationship
Parties may be indirect rather than direct beneficiaries

• Relative value of the partners’ contribution may shift over time in

ways that are difficult to anticipate and recognize
Consequently, partners may conceal the real benefits they expect to receive or
have received

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Real Options

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Ally or Acquire: How Technology Leaders Decide?

Fluid phase Transitional phase Mature phase Phase of

technological
discontinuities

• Marketing • Acquisition • Technology • Acquisitions

alliances of alliances of
• Licensing competitors • Acquire technologies
strategies technology
• Standards • Marketing
alliances alliances to
expand to
new markets

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Case Study

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Case Study
Fluid and Transitional Phase Mature Phase Discontinuities Phase

Dynamics of the Phase • 160% growth rate • 100% growth rate • 44% growth rate
• Competition very low • Continued rapid growth as • Intense competition
• Niche market PC market took off
• Increased competition

Priorities • Establish itself as the • Keep up with the new • Provide end-to-end
quality producer technologies solutions to companies
• Gain quick market • Pursue a growth strategy • Keep up with the
recognition technological innovations
• Develop technologies that
can’t be licensed in

Alliances and Joint Ventures • Pursued a strategy of • Active; participated in 27 • Very active; participated in
licensing in alliances 71 alliances
• 47% included joint • 35% involved joint R&D,
marketing, 27% licensing 55% joint marketing
agreements, 40% joint • 10 minority investments
R&D, 27% supply
agreements
• 12 equity investments

Mergers and Acquisitions None 14 technology acquisitions Very active, 42 acquisitions

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Reasons for Failure

Overly optimistic

Poor communications

Lack of shared benefits

Slow results or payback

Lack of (financial) commitment

Misunderstood operating principles

Cultural mismatch

Lack of experience

0 20 40 60 80

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Large Tom and Little Jerry switch roles

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Joint Ventures
§ Questions: Performance assessment of joint venture
• How should the performance of a joint venture be assessed?
• How do businesses currently evaluate the performance of joint ventures?
• How could they do it better?
• What factors should be considered in assessing performance?
• What benchmark or benchmarks work best, e.g., market reaction, long-
term share price performance

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Road Map
• Background: Vertical Integration
• Contractual Form
• Contracting for Innovation
• Ally or Acquire?
• Joint Ventures
• Acquisition v. Joint Venture
• Governance
• Conflict Resolution

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Alliance = governance of open-ended agreement

Open-ended
agreement

Unforseen External Events

? Unforseen Internal Events

Structure Scope Governance

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Scope
• Create Room for Growth
• Select Partners That Are Not Competitors
• Establish Exclusive Arrangements Only When Necessary
• Anticipate and Negotiate Changes in Scope in Advance
• Define How Parents Will Use Technology Created by the Alliance

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Building a Governance Structure for a non-equity alliance

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Strategic Alliance and Joint Venture Agreement Provisions

• Contribution of assets • Control and • Defaults and remedies

• Intellectual property Management • Deadlock and dispute
and confidential • Restrictions on resolution
information competition mechanisms
• Financing rights and • Reporting obligations • Term and termination
obligations • Miscellaneous
• Profits

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Strategic Alliance and Joint Venture Agreement Provisions
Joint Ventures with even ownership Majority-Minority Joint Ventures

100
90
80
70
60
50
40
30
20
10
0
1 Year 3 Years 5 Years 7 Years 10 Years 15 Years

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Common Joint Venture Agreement Provisions (Ex Post)
Defaults and Remedies

Deadlock and Dispute

Resolution Mechanisms

Joint Venture Agreement

Term and Termination

Miscellaneous
• Assignability
• Reps and Warranties
• Publicity

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Allocating Decision Rights

Separate
Economic
Control from
Decision-
Making Control

Seek the
Create Conflict Casting Vote or
Resolution Veto Power on
Mechanisms Certain
Decisions

Agree in
Develop a
Advance on
Decision-
Ten to Fifteen
Making Map
Key Decisions

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Incentive Schemes

Reciprocal
penalties

Rewards
= Mutual Hostage
for
altruism

Bundling of
commitments

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Rewards for Altruism
• Extending licensing privileges for the joint venture’s product to a
parent who makes a critical contribution
• Providing a parent with preferential access to a joint venture’s
output when it has made critical contributions to the development
of those outputs
• Increasing a parent’s share of a joint venture’s profits or equity to
reflect a substantial asymmetrical escalation in contributions to
the joint venture beyond planned levels
• Accepting restrictions on the scope of a joint venture’s activities
that disproportionately favour one parent when it has made
exceptional contributions to the venture 70
Road Map
• Background: Vertical Integration
• Contractual Form
• Contracting for Innovation
• Ally or Acquire?
• Joint Ventures
• Acquisition v. Joint Venture
• Governance
• Conflict Resolution

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Dispute Resolution

Escalation Clause

Mediation / Arbitration

Buy-Sell Provision

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Termination – Russian Roulette

If B rejects
• A offers to sell
shares at €X • B has the right
to sell its shares
to A for €X
B accepts or
rejects

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Termination – Texas shoot-out

B rejects
• A offers to buy • A and B make
B’s shares for • And states it sealed bids
€X wishes to buy
A’s shares at a
B accepts or higher price The highest
rejects bidder wins

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Rates of Termination of Joint Ventures

35

30

25

20

15

10

0
1 2 3 4 5 6 7 >7
Dissolved Acquired
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Exit - Recommendations
§ Address Exit Up Front

§ Be Careful with “Buy-Sell” Provisions

§ Assess Who Is Likely to Be Buyer or Seller

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Problems of Dissension, Deadlock and Dissolution

Buy-out
arrangements

Special
dissolutions

Voting trusts

Arbitration
Trust/
Contractual
negotiation Arbitration
Ex-ante
Conflict provisions
Rules Dissolution
Courts
Statutory Withdrawal/
Ex-post redemption
Standards
gap-filling
Expulsion

Fiduciary
duties

Reasonableness/
fairness

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