the assignment of call option rights between partners in international joint ventures

Strategic Management JournalStrat. Mgmt. J., 34: 1232–1243 (2013)

Published online EarlyView 6 June 2013 in Wiley Online Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2061

Received 25 August 2010 ; Final revision received 12 September 2011

THE ASSIGNMENT OF CALL OPTION RIGHTSBETWEEN PARTNERS IN INTERNATIONAL JOINTVENTURES

TONY W. TONG1 and SALI LI2*1 Leeds School of Business, University of Colorado, Boulder, Colorado, U.S.A.2 Darla Moore School of Business, University of South Carolina, Columbia, SouthCarolina, U.S.A.

We examine call option rights as a contractual clause in international joint ventures (IJVs) andpropose that the assignment of the call option right in an IJV is determined by certain ex anteasymmetries between the partners. Results show that between the two partners in an IJV, the firmwith greater complementarity with the venture and greater prior IJV experience is more likelyto hold the call option right; in addition, the firm’s contractual choice on the call option rightand its ownership choice on a greater initial equity stake are substitutive. Our focus on explicitcall options advances the real options theory of collaborative agreements, and our results alsohighlight that option rights be considered an important part of alliance design. Copyright 2013 John Wiley & Sons, Ltd.

INTRODUCTION

How firms structure their collaborative agree-ments is a central concern of strategy researchers.Since Kogut’s (1991) seminal application ofoption theory to the domain of joint ventures(JVs), subsequent research has generated manyimportant insights into this question. For example,theoretical research suggests that real optionstheory offers a dynamic view of using JVs tosequentially enter into new markets (Bowmanand Hurry, 1993; Chi and McGuire, 1996; Millerand Folta, 2002). Empirical evidence on firms’entry modes is consistent with the view that JVsand minority investments enable firms to pursuestrategies through incremental investment (Folta,1998; Folta and Miller, 2002; Tong, Reuer, and

Keywords: Real options; call option rights; internationaljoint ventures; equity ownership; alliance design*Correspondence to: Sali Li, Darla Moore School of Business,University of South Carolina, 1705 College Street, Columbia,SC 29208, U.S.A. E-mail: [email protected]

Copyright 2013 John Wiley & Sons, Ltd.

Peng, 2008). Research has further shown thatreal options are reflected in firms’ JV governancedecisions, such as how to structure a JV by choos-ing appropriate ownership levels and specifyingparticular call option clauses (Cuypers and Martin,2010; Reuer and Tong, 2005; Seth and Chi, 2005).

While this stream of research often invokes theview that JVs provide partners with options toexpand, researchers also call for a more carefulexamination of the conditions under which suchoptions are valuable to the firm (Chi, 2000; Kogut,1991). In particular, research has emphasizedthat real options studies on JVs would need toaccount for whether there is a call option rightin the JV agreement (Chi and McGuire, 1996) andwhich partner holds the call option (Miller andFolta, 2002), rather than assuming that JVs conferembedded call options in rather universalisticterms (c.f. Reuer and Tong, 2005). In this paper,we respond to calls for more research on calloption rights in JVs to better understand howfirms structure their collaborative ventures. Alsoknown as explicit call options, call option rights

Assignment of Call Option Rights in IJVs 1233

are contractual clauses conferring a firm in a JV thelegal right to acquire equity stake from its partners(Kogut, 1991). Specifically, we investigate howcall option rights are assigned between partners ininternational joint ventures (IJVs), and we proposeand test several factors determining which partnerin an IJV will hold the call option right. Ourempirical focus on IJVs is attractive not onlybecause IJVs tend to face high levels of uncertaintythat make a real options study relevant, but moreimportantly prior conceptual and empirical workon call option rights has also focused on IJVsspecifically (Chi and McGuire, 1996; Reuer andTong, 2005).

Our focus on the assignment of call option rightsbetween IJV partners is important for severaltheoretical and empirical reasons. First, becausea call option right confers a partner the securedright to acquire the other party’s equity stake, itclearly specifies the holder of the call option. Animproved understanding of the allocation of calloption rights between partners can therefore helpscholars better understand the question of whoacquires whom that is core to the real optionstheory of JVs (Chi, 2000; Kogut, 1991). By con-trast, without an explicit call option in place, bothparties in a JV share the implicit option to expand;in this case, any party’s claim to such options isnot secured and nonproprietary (Chi and McGuire,1996; Miller and Folta, 2002). Second, the ex anteassignment of the call option right in a JV to apartner is important because it can affect the gainsthe firm potentially attains from exercising the callex post . Because an explicit call option assignsthe legal right to acquire to a particular party,who will exercise the option only if it is favorableto do so, the party holding the call option rightshould expect to gain from exercising the option.By contrast, an implicit call option is less likely togenerate significant value for a firm that exercisesit in part because of the ex post bargaining over theconditions for option exercise (Chi and McGuire,1996; Reuer and Tong, 2005). These theoreticalconsiderations also carry important implicationsfor empirical real options studies on JVs. Consid-ering the role of explicit call options, for example,may help to reconcile some of the mixed findingson the performance or risk implications of JVsreported in prior research (Kumar, 2005; Reuerand Leiblein, 2000; Tong et al., 2008).

Beyond its contributions to the real optionsliterature, our study also contributes to the

broader alliance literature by improving existingunderstanding of alliance design. Specifically, calloption rights represent contingent control rightsallowing the firm holding the right to gain greatercontrol as the IJV evolves from its formation andsuch a need arises subsequently (Noldeke andSchmidt, 1998). Absent option rights to acquireequity and increase control ex post , however, afirm may obtain greater control over the IJV bynegotiating for a greater initial equity positionex ante. We provide the first empirical evidenceon the interdependent relationship between firms’decisions on a greater initial ownership positionand their decisions on the option right to acquireequity stake subsequent to the initial investment.Our study therefore joins a growing stream ofalliance research suggesting that firms considercontractual provisions and ownership structuressimultaneously as they design their collaborativerelationships (Luo, 2002; Poppo and Zenger,2002).

THEORY AND HYPOTHESES

The option right to acquire partners’ equity stake isvaluable for firms investing in an IJV (Chi, 2000;Kogut, 1991), but both partners in the IJV mustfind the option right clause mutually beneficial sothat it may become part of the IJV agreement. The-ory of option pricing and trading has established anecessary condition under which exchange of anoption can provide a positive economic value tothe exchange partners (e.g., Hull, 2006); namely,the partners must have divergent valuations of theoption’s underlying asset ex ante or anticipate adivergence between their valuations ex post . Insuch cases, by giving the option to the party witha higher valuation of the asset, option trading cancreate value for both exchange partners. Followingthis logic, in the case of a call option right inan IJV, the party with a greater valuation of theventure is more likely to hold the option right,since assigning the right to this party will creategains to both partners. Divergent valuations area result of certain ex ante or ex post asymmetriesbetween the partners. Ex ante asymmetry providesthe basis for the allocation of the option right atthe IJV contract design stage, whereas ex postasymmetry pertains to the IJV operation andcontract implementation stage and is the basis forthe decision to exercise the option (Chi, 2000;

Copyright 2013 John Wiley & Sons, Ltd. Strat. Mgmt. J., 34: 1232–1243 (2013)DOI: 10.1002/smj

1234 T. W. Tong and S. Li

Chi and McGuire, 1996; Kogut, 1991). Our studyfocuses on ex ante asymmetry. Specifically, wedraw from existing literatures on real options andalliances to focus on two ex ante asymmetries thatmay lead the partners to have divergent valuationsof the IJV ex ante or to anticipate a divergencebetween their valuations ex post , thus shaping theallocation of the call option right in the venture.

Relative complementarity

Our first hypothesis focuses on the difference incomplementarity between the partner firms withthe IJV, and complementarity difference likelyleads to potential ex ante divergence between thepartners’ valuations of the IJV in particular. It isuseful to start by noting that firms participating inan IJV often possess different resource bases, andthe IJV provides a means for the firms to com-bine their complementary assets. Kogut (1991) firstargues that because partner firms tend to bring dif-ferent capabilities to a JV, their valuations of theventure will likely differ. Core to Kogut’s argu-ment is the notion that partner firms tend to haveasymmetric complementarity with their joint ven-ture. As one example, an IJV may be formed tosupply key inputs to the partners (Hennart, 1988),yet the venture might supply a greater amount ofits output to one partner, which may therefore ben-efit more from the venture than the other party,leading to potential divergent valuations of theventure between the two firms. An IJV can alsobe used to develop new products or enter intonew markets by pooling together resources andsharing the investment cost between partners (Bal-akrishnan and Koza, 1993; Chi and Seth, 2009).However, because the firms may operate in differ-ent businesses and possess different resources, thespillover effect of the venture’s product offeringsor technologies might be greater for one partnerthan the other. This situation also creates asym-metric complementarity between the firms withthe IJV, leading to differences in their valuationsof the venture. As another example, Nanda andWilliamson (1995) have observed that firms mayconvert an underperforming business into an IJVby partnering with another firm that possessesgreater synergy with that business and also givingthe firm an option to acquire the venture sub-sequently, because the partner firm may place ahigher value on the venture, compared to the orig-inal owner of the venture’s assets.

To summarize, asymmetry in the firms’ com-plementarity with the IJV likely causes divergentvaluations of the venture, leading one firm to valuethe venture more than the other does. In this sit-uation, it is mutually beneficial for the partnersto trade call option rights; more specifically, giv-ing the call option right to the partner that has agreater complementarity with and thus a greatervaluation of the venture will provide a positiveeconomic value for both of the partners. Therefore,we hypothesize:

Hypothesis 1 (H1): The greater a firm’s comple-mentarity with the IJV compared to its partner,the more likely it will hold the call option right .

Relative IJV experience

We argue that ex ante asymmetry in the partners’amount of prior IJV experience may also shapethe assignment of call option rights between IJVpartners for several reasons. First, research hassuggested that the potential of learning and res-olution of behavioral uncertainty in an IJV playsan important role in affecting the trading of realoptions between the partners (Chi and McGuire,1996; Kogut, 1991). Specifically, collaborationand a period of joint operation in a JV providesopportunities for interpartner learning (Chi, 2000),allowing firms to better understand the partner’sresource contributions, capabilities, and its behav-ioral orientations (Balakrishnan and Koza, 1993;Hennart, 1988). However, firms in alliances learnat different rates (Hamel, 1991). Specifically, firmsthat learn faster may be better able to exploit thelearning potential in an IJV to their advantage, andtherefore are more likely to place a higher valueon the option to acquire the partner’s equity stake.Given that a firm’s learning capabilities developfrom its prior IJV experience (Barkema et al.,1997), the partner with greater prior IJV experi-ence is more likely to value the call option righthighly and hold the option right. This view is con-sistent with prior real options research suggestingthat asymmetric learning can create gains to bothpartners by allowing an efficient transfer of equitystake from the slow learner to the fast learner whoplaces a relatively higher value on the venture(Seth and Chi, 2005).

Second, while market uncertainty is largelyexogenous to the firms participating in an IJV, theirabilities to detect and interpret such uncertainty



can often differ. Kogut’s (1991) original workemphasizes the importance of recognizing andinterpreting environmental cues for option exercisein a JV. Specifically, firms’ option exercise deci-sions are cued by certain signals in the environ-ment, which indicate varying levels of uncertaintyand changing values of the venture. Firms use dif-ferent rules and policies to recognize cues andinterpret signals, however, due to particular admin-istrative heritages and previous experiences (seeKogut and Kulatilaka, 1994). As a result, howthe cues and signals are recognized and inter-preted can differ among firms that confront thesame environmental uncertainty. We suggest thatfirms with greater IJV experience will be betterable to recognize and interpret cues of environmen-tal change, since such firms may have developedgreater capabilities or certain routines for moni-toring the environment and analyzing the impactof environmental changes on the IJV. In addition,firms with greater IJV experience are also likelyto react more quickly to environmental changes byadapting the IJV subsequently after the venture isformed. Research on the dynamics of alliance man-agement has suggested that firms with greater prioralliance experience are more capable of adaptingthe alliance in the postformation stage. Such adap-tation capabilities can serve as a link connectingthe firm’s cue recognition to subsequent optionexercise, such that the firm is able to obtain theeconomic value of the call option right. Thus, wehypothesize:

Hypothesis 2 (H2): The more prior IJV expe-rience a firm has compared to its partner, themore likely it will hold the call option right .

Call option rights and initial equity stakes

While the assignment of the call option right in anIJV can be affected by certain ex ante asymmetriesbetween the partner firms, we suggest that thiscontractual decision is also related to the alloca-tion of initial equity share in the venture. Thevalue of a call option right is linked to the initialequity stake a firm holds for several reasons. First,Kogut’s (1991) conceptual model suggests that thevalue of having a call option in an IJV is inverselyrelated to a firm’s ownership level, everythingelse constant. Specifically, by holding less equityas well as the call option right, the firm puts lessinvestment capital at risk up front, incurs less

carrying cost during the option holding period,and is positioned to capture greater value if theenvironment proves to be favorable ex post (Tonget al., 2008). By contrast, a higher initial stake inan IJV involves greater initial commitment, and theterminal value of the call option is lower, every-thing else constant. This reasoning suggests thatfirms holding the call option right in an IJV willprefer a more modest initial equity stake upfront.

Second, holding the call option right in an IJVcan help the option holder mitigate uncertaintyabout the other partner’s behavior in several ways,and this has implications for the relationshipbetween call option rights and initial equitystakes. To begin with, firms often enter into JVsunder asymmetric information, and a period ofjoint operation can help firms gather informationto ascertain the quality of the assets contributedby the partner as well as the capabilities of thepartner (Balakrishnan and Koza, 1993; Chi, 2000).The firm can reduce adverse selection problemsand moral hazard by taking a smaller initialequity stake and holding the call option right inthe IJV. A smaller initial equity share limits thefirm’s exposure to the risk of adverse selectionand increases the incentives of the partner (withthe higher initial equity share) to transfer itsproductive assets to the venture. Further, becausethe call option does not obligate the firm toacquire under unfavorable conditions, the firm’soverpayment risk is also reduced in a future period(Chi and McGuire, 1996). Call option rights mayalso help to reduce the risk of misappropriation byIJV partners (Reuer and Tong, 2005). Consider afirm that holds a minority equity ownership in anIJV with a partner and holds a call option right.When the firm finds out the partner’s opportunisticinclination to misappropriate its knowledge for useoutside the scope of the IJV, it can exercise thecall to increase control over the venture (e.g., cer-tain key functions in the venture) to limit furtherknowledge leakage. While the firm may also justexit the IJV ex post in this case, there is still valuein negotiating for a call option right ex ante, sincethe option right does not oblige the firm to acquire.Having the option right to increase control mightalso dampen the partner’s incentive to abuse thefirm’s proprietary knowledge, therefore reducingthe likelihood of knowledge abuse in the firstplace. For this reason, call control rights will beless valuable for a firm that has already obtaineda large or dominant ownership position in an IJV,



because such firms have already had significantinfluences over the venture’s daily operations anddecision making. In this case, the marginal valueof additional control available from the exerciseof the call option is lower, compared to the casewhen the firm has a smaller initial equity stake.

Third, call option rights are contingent controlrights that allow the firm to increase its equitystake and thus obtain greater control over the ven-ture at its discretion in the future (Kogut, 1991;Noldeke and Schmidt, 1998). A firm lacking calloption rights can have other means available toobtain greater control over the IJV, however, if itbelieves greater control is desirable. One meansoften referred to in the literature is that the firmcan negotiate for a larger share of equity owner-ship at the IJV formation stage (Hennart, 1988;Li, Zhou, and Zajac, 2009). Based on transactioncost economics (Williamson, 1985), prior researchon alliance governance suggests that firms holdinga majority ownership position can obtain greatercontrol over the venture’s businesses and oper-ations and guard against potential opportunism.Thus, lacking the option right to acquire additionalinterest and increase its equity stake in an IJV expost , a firm can obtain greater control over theventure by negotiating for a larger initial equityownership ex ante. On the other hand, firms thathold a larger initial equity stake may also find thecall option right less valuable, as discussed earlier,and thus may be more willing to give the optionright to the partner.

The discussions suggest an interdependent rela-tionship between the holding of a call option rightand the ownership of a larger equity stake in anIJV: the two means are potential substitutes incurbing exchange hazards, and the value of onemeans is inversely related to the simultaneous useof the other. We expect that firms investing in IJVswill consider the two means at the same time, sug-gesting that ownership structures and contractualprovisions are key dimensions of alliance design.Accordingly, we hypothesize:

Hypothesis 3a (H3a): When a firm’s initialequity stake in the IJV is greater compared toits partner, there is a lower likelihood that itwill hold the call option right .

Hypothesis 3b (H3b): When a firm holds thecall option right in the IJV, there is a lower

likelihood that its initial equity stake will begreater compared to its partner .

METHODS

Sample and data sources

The IJV sample for analysis was obtained fromthe Joint Venture/Alliance module in the SecuritiesData Company (SDC) database. Our study of IJVsfacilitates comparison with prior studies on calloption rights that have focused on IJVs specifically(Chi and McGuire, 1996; Reuer and Tong, 2005).For the purpose of this study, an IJV is defined asa two-partner equity joint venture that was basedoutside the United States and involved one U.S.firm and one local firm from the host country. Afocus on two-partner IJVs facilitates our analysis,given our focus on the assignment of call optionrights and initial equity ownership between thepartners. A search of the SDC database for theperiod 1989–2008 generated a base sample of4,955 IJVs that met our definition of IJV andhad full data available for the variables describedbelow.

Within this base sample, the researchers thensought to identify the assignment of call optionrights between IJV partners by searching throughthe activity synopsis text provided by the SDC.This activity synopsis serves as an importantsource of information for alliance research, andit has been used widely by prior alliance scholars(e.g., Li et al., 2008; Oxley and Sampson, 2004).For our research in particular, such activitysynopsis provided detailed information allowingresearchers to determine whether an IJV agreementcontained a call option right and which IJV partnerheld the option right. We used the following keywords to perform the search: option, right, choice,opportunity; then we extracted all of the IJVswhose synopses contained one or more of thesekey words. We read each of these synopses to codewhether or not the IJV contained a call option rightto acquire as defined in our study and, if so, whichpartner held the option right. At the end of theprocess, we were able to code these variables for135 IJVs located in 32 host countries that reportedclear call option right information. Though thepercentage of IJVs with call option rights is higherthan that reported in prior research (Reuer andTong, 2005), it is still relatively low at about 2.7



percent. For these IJVs, the agreement containedone call option right that was either assigned to theU.S. firm or the local partner in the venture, andnone of the ventures contained a put option at thesame time. Note that our research question requiresus to incorporate both IJV partners’ perspectivesinto our analysis (both the U.S. firm and the localfirm), as we explain in detail below.

Variables and measurement

One novel feature of our hypotheses is that theyare developed taking both partners in an IJV intoconsideration, and therefore the hypotheses applyto both the U.S. firm and the host country firm par-ticipating in the venture. For ease of explanation,however, we treat the U.S. firm as the focal firm inthe empirical analyses below and code all partner-related variables from the U.S. firm’s perspective.

Dependent variables

The first dependent variable in our analysis isa binary variable, U.S. Partner Call Option ,indicating whether or not the U.S. parent firm inthe IJV holds the call option right. The variable iscoded 1 if the call option right is assigned to theU.S. firm (i.e., the option right is not assigned tothe local firm), and 0 otherwise (i.e., the optionright is assigned to the local firm). In addition,as discussed in Hypotheses 3a and 3b, we alsomodeled firms’ holding of call option right simul-taneously with their initial ownership position inan IJV to examine the interdependence betweenfirms’ contractual and ownership decisions. Inthese models, there is a second binary dependentvariable, U.S. Partner Majority Equity Ownership,which is coded 1 if the U.S. firm has a majorityequity position—defined as greater than 50 per-cent of the ownership—in the IJV (i.e., the localfirm holds an ownership of less than 50%), and 0otherwise (i.e., the local firm holds an ownershipof 50% or higher). Twenty-seven IJVs in oursample had a 50-50 ownership structure; separatetests excluding these observations produced simi-lar and somewhat stronger results. To examine theinterdependent relationship between call optionrights and initial ownership positions, U.S. PartnerMajority Equity Ownership and U.S. Partner CallOption Right also serve as an explanatory variablein our simultaneous test of H3a and H3b. Data forfirms’ ownership positions were from the SDC.

Explanatory variables

The first explanatory variable is Relative Comple-mentarity . We used the input–output (IO) tablesfrom the Bureau of Economic Analysis to firstmeasure the degree of complementarity betweenan IJV and each of its two parent firms (e.g.,Fan and Lang, 2000); the variable relative com-plementarity was then calculated as the differencebetween the complementarity index of the U.S.parent and the IJV and that of the host countryparent and the IJV. This approach is widely usedin extant research, although it comes with the lim-itation associated with the industry codes in theIO tables and the SIC (standard industrial classifi-cation) system (Robins and Wiersema, 1995). Thesecond explanatory variable is Relative IJV Expe-rience. We first measured each parent firm’s IJVexperience by counting the number of IJVs formedin all foreign countries (Barkema et al., 1997) dur-ing the five years prior to, but not including, thefocal year in which the focal IJV was formed.IJV experience was then defined as the log of oneplus the number of IJVs. Given that our analysistreats the U.S. parent as the focal firm, relative IJVexperience was calculated by subtracting the localpartner’s IJV experience from the U.S. partner’sIJV experience. Results were qualitatively identi-cal when we used other measures of relative IJVexperience as well as a measure of relative inter-national alliance experience.

Control variables

At the dyadic level, we first controlled for RelativeSize; this variable was measured as the differencebetween the U.S. parent firm’s employee numberand the host country parent firm’s employeenumber. We also controlled for Relative DomesticJV Experience, measured in the same way asthe variable Relative IJV Experience earlier, butbased on the number of domestic JVs formedinstead. We further included a dummy variableRepeat Alliance measuring whether or not thepartners in an IJV had formed any prior alliancesbetween them before the focal venture (Gulati,1995). Results were the same when we used acount of prior alliances between the partners. Atthe IJV level, we controlled for R&D IJV , definedas IJVs that report performing R&D activities intheir activity synopsis (Li et al., 2008). At theIJV’s host country level, we first controlled for



the host country’s GDP Growth . This variable wasmeasured by the percentage growth rate in realgross domestic product (GDP) of the host country,averaged across the five years before the focalIJV was established. In addition, we controlled forthe host country’s intellectual property protectionand used an indicator Rule of Law developed byresearchers at the World Bank (Kaufmann, Kraay,and Mastruzzi, 2009) as a measure of intellectualproperty protection. Results were qualitativelysimilar when we used Ginarte and Park’s (1997)patent protection index. A third host-country levelvariable is Political Uncertainty , which is specificto the political environment in the host country andwas measured by the Political Constraint Indexdeveloped by Henisz (2000). We followed priorresearch and measured Political Uncertainty bysubtracting the Political Constraint index from one,such that the greater the score is, the greater thepolitical hazards are for doing business in thatcountry. At the home country–host country dyadiclevel, we controlled for Cultural Distance betweenthe U.S. and the IJV’s host country (Kogut andSingh, 1988). Finally, we included the inverseMills ratio derived from a first-stage model usingthe base sample of 4,955 IJVs, which estimated thelikelihood of an IJV having a call option right tocontrol for potential endogeneity (results availableupon request). We also included year fixed effectsand industry sector fixed effects.

Statistical approach

To examine the interdependence between calloption rights and initial ownership positions, i.e.,to test H3a and H3b simultaneously, we used thebivariate probit model to jointly estimate the twoprobit equations with the dependent variables U.S.Partner Call Option and U.S. Partner MajorityEquity Ownership, respectively. The bivariate pro-bit model, with two equations of probit models, hasa structure similar to that of a seemingly unrelatedregression model, except that the dependent vari-ables are binary indicators (Maddala, 1983). Weused Stata’s command biprobit for estimation ofour bivariate probit models.

RESULTS

Table 1 reports descriptive statistics and a correla-tion matrix for the variables used in our hypotheses Ta

ble

1.D

escr

iptiv

est

atis

tics

and

corr

elat

ion

mat

rix

Var

iabl

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ean

S.D

.(1

)(2

)(3

)(4

)(5

)(6

)(7

)(8

)(9

)(1

0)(1

1)

1.U

.S.

part

ner

call

optio

n0.

700.

462.

U.S

.pa

rtne

rm

ajor

ityeq

uity

owne

rshi

p0.

270.

44−0

.18*

3.R

elat

ive

com

plem

enta

rity

0.07

0.45

0.25

**−0

.12

4.R

elat

ive

IJV

expe

rien

ce0.

200.

750.

25**

0.15

†0.

125.

Rel

ativ

esi

ze11

.34

83.3

3−0

.04

0.04

0.08

0.11

6.R

elat

ive

dom

estic

JVex

peri

ence

5.67

40.5

80.

07−0

.14†

0.16

†0.

15†

0.09

7.R

epea

tal

lianc

e0.

070.

020.

00−0

.11

−0.0

90.

03−0

.03

−0.0

38.

R&

DIJ

V0.

100.

30−0

.20*

0.23

**−0

.06

−0.1

1−0

.06

−0.0

4−0

.10

9.G

DP

grow

th2.

434.

120.

06−0

.22*

0.22

*0.

00−0

.03

−0.0

40.

01−0

.10

10.

Rul

eof

law

0.97

1.08

−0.1

6†−0

.05

−0.0

8−0

.24*

*−0

.00

−0.2

1*0.

080.

01−0

.18*

11.

Polit

ical

unce

rtai

nty

0.62

0.30

−0.2

0*−0

.08

−0.0

80.

19*

−0.0

40.

030.

100.

110.

43**

*−0

.62*

**12

.C

ultu

ral

dist

ance

1.91

1.55

0.14

†0.

21∗

0.07

0.11

−0.0

7−0

.02

−0.0

5−0

.01

0.07

−0.6

1***

0.56

***

Two-

taile

dte

st.

N=

135.

†p<

0.10

;*p

<0.

05;

**p

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01;

***p

<0.

001.



tests. As the table shows, the U.S. partner holds thecall option right in about 70 percent of the IJVs,suggesting that in a significant portion of the IJVs(i.e., 30%), the call option right is assigned to thelocal partner. This finding is consistent with reportsby practitioners that local partners often receive thecall option right in their IJVs with multinationalinvestors (e.g., Businessweek , 2003). The tablealso indicates that the U.S. partner holds the major-ity equity position in about 27 percent of the IJVs.We note that Relative Size is not significantly cor-related with U.S. Partner Call Option; thus, largerU.S. firms with greater bargaining power are notsystematically more likely to hold the call optionright as conventional wisdom might suggest.

Model 1 of Table 2 presents the regressionresults for the factors affecting the likelihood ofthe U.S. firm (the focal firm in our analysis) hold-ing the call option right in the IJVs. In Hypothesis1, we argued that the greater the firm’s comple-mentarity with the IJV compared to its partner,the more likely the firm will hold the call optionright. The positive and significant coefficient onthe variable Relative Complementarity providesempirical support for H1 (p < 0.05). Hypothesis 2proposed that the more prior IJV experience a firmhas compared to its partner, the more likely thefirm will hold the call option right. The result forthe variable Relative IJV Experience is consistentwith this prediction (p < 0.05), supporting H2. Wealso argued that when a firm has a greater shareof initial equity stake compared to its partner (i.e.,when the firm takes a majority equity ownership),then it is less likely that the firm will hold thecall option right (i.e., H3a). The coefficient on thevariable U.S. Partner Majority Equity Ownershipis negative and significant (p < 0.05), providingsupport for our hypothesis. Among the controlvariables, GDP Growth and Rule of Law have anegative and significant coefficient (p < 0.05 andp < 0.10, respectively). The variable inverse Millsratio is insignificant, suggesting that self-selectionbias is not a concern.

In Hypothesis 3b, we predicted that the firmthat holds the call option right in an IJV is lesslikely to have an initial equity stake greaterthan its partner. To test this hypothesis, we rana separate probit regression using U.S. PartnerMajority Equity Ownership as the dependentvariable, and the results are reported in Model 2.The coefficient on the variable U.S. Partner CallOption is negative and significant (p < 0.01),

suggesting that when the U.S. firm holds the calloption right, it is less likely to have a majorityequity ownership in the IJV. H3b is thereforesupported. Results for the control variables areconsistent with reports in the literature: a U.S. firmis more likely to hold the majority equity positionin an IJV when the firm has greater relative IJVexperience (p < 0.01), when the venture performsR&D activities (p < 0.10), when the host countryhas a smaller GDP growth (p < 0.05), offersgreater intellectual property protection (p < 0.01),and presents less political uncertainty (p < 0.01),and when the cultural distance between the U.S.and the host country is greater (p < 0.01).

Models 3–8 display results from three bivari-ate probit models that we estimated: Models3 and 4 report results from a bivariate probitmodel with the two dependent variables U.S.Partner Call Option and U.S. Partner MajorityEquity Ownership; Models 5 and 6 report resultsfrom a recursive bivariate probit model (Maddala,1983), where the dependent variable U.S. Part-ner Majority Equity Ownership is also added asan explanatory variable to the U.S. Partner CallOption equation; Models 7 and 8 report resultsfrom another recursive bivariate probit model,where the dependent variable U.S. Partner CallOption is added as an explanatory variable to theU.S. Partner Majority Equity Ownership equation.Likelihood ratio tests show that ρ, the correla-tion between the error terms in the two probitequations, is negative and significant in all models,suggesting that firms’ decisions concerning calloption rights and majority equity ownerships areinterdependent. Note that the variable U.S. Part-ner Majority Equity Ownership has a negativelysignificant coefficient in Model 5 (p < 0.05), andso does the variable U.S. Partner Majority EquityOwnership in Model 8 (p < 0.05). Taken together,the set of results provide strong support for H3aand H3b collectively. In addition, we note that theresults for the other two explanatory variables (rel-ative complementarity, relative IJV experience) arequalitatively similar across the models in this table.

DISCUSSION

Our study makes three contributions to researchon real options and alliances. First, we developseveral conditions shaping the assignment of calloption rights between IJV partners and conduct



Tabl

e2.

Reg

ress

ion

resu

ltsfo

rca

llop

tion

righ

tan

dm

ajor

ityeq

uity

owne

rshi

p

Prob

itm

odel

Biv

aria

tepr

obit

mod

elR

ecur

sive

biva

riat

epr

obit

mod

el

Var

iabl

eU

.S.

call

optio

n(1

)U

.S.

maj

ority

equi

ty(2

)U

.S.

call

optio

n(3

)U

.S.

maj

ority

equi

ty(4

)U

.S.

call

optio

n(5

)U

.S.

maj

ority

equi

ty(6

)U

.S.

call

optio

n(7

)U

.S.

maj

ority

equi

ty(8

)

Con

stan

t1.

83(1

.02)

−1.7

0(1

.52)

1.24

*(0

.55)

−0.8

5†(0

.51)

1.36

*(0

.55)

−0.8

7†(0

.51)

1.27

*(0

.54)

−0.1

6(0

.56)

Rel

ativ

esi

ze0.

01(0

.07)

0.05

(0.0

9)0.

02(0

.06)

0.02

(0.0

7)0.

06(0

.07)

0.02

(0.0

7)0.

02(0

.06)

0.03

(0.0

6)R

elat

ive

dom

estic

JVex

peri

ence

0.02

(0.3

0)−0

.52

(0.3

6)−0

.31

(0.2

5)−0

.23

(0.2

4)−0

.34

(0.2

6)−0

.22

(0.2

3)−0

.30

(0.2

5)−0

.21

(0.2

6)R

epea

tal

lianc

e−0

.17

(0.5

5)−0

.73

(0.8

8)0.

04(0

.51)

−0.7

9(0

.66)

−0.0

5(0

.51)

−0.7

7(0

.65)

0.03

(0.5

0)−0

.63

(0.6

2)R

&D

IJV

0.20

(0.6

5)1.

04†

(0.6

5)−0

.02

(0.6

6)0.

85(0

.59)

−0.0

1(0

.65)

0.88

*(0

.39)

−0.0

7(0

.66)

1.10

*(0

.49)

GD

Pgr

owth

−0.0

5*(0

.02)

−0.1

0*(0

.04)

−0.0

2(0

.03)

−0.0

8†(0

.04)

−0.0

2(0

.04)

−0.0

8†(0

.04)

−0.0

2(0

.03)

−0.0

9*(0

.04)

Rul

eof

law

−0.3

1†(0

.20)

0.72

**(0

.22)

−0.3

9†(0

.23)

0.39

*(0

.17)

−0.3

8†(0

.22)

0.39

*(0

.17)

−0.3

9†(0

.23)

0.45

*(0

.18)

Polit

ical

unce

rtai

nty

−0.7

5(0

.65)

−1.9

1**

(0.5

6)−0

.46

(0.6

8)−0

.62

(0.5

1)−0

.40

(0.6

8)−0

.63

(0.5

1)−0

.48

(0.6

8)−0

.80

(0.5

4)C

ultu

ral

dist

ance

−0.0

4(0

.09)

0.58

**(0

.18)

−0.0

9(0

.10)

0.33

**(0

.10)

−0.0

9(0

.10)

0.33

**(0

.10)

−0.0

9(0

.10)

0.38

**(0

.12)

Rel

ativ

eco

mpl

emen

tari

ty0.

88*

(0.4

3)−0

.10

(0.7

5)0.

74**

(0.2

3)−0

.47

(0.3

0)0.

80**

*(0

.23)

−0.4

8(0

.30)

0.74

**(0

.23)

0.43

(0.2

9)R

elat

ive

IJV

expe

rien

ce0.

62*

(0.2

9)0.

58**

(0.2

1)0.

60*

(0.2

5)0.

40*

(0.1

9)0.

61**

(0.2

4)0.

40*

(0.1

9)0.

59*

(0.2

4)0.

43*

(0.1

9)In

vers

eM

ills

ratio

−0.0

4(0

.24)

−0.2

2(1

.09)

——

——

——

U.S

.pa

rtne

rca

llop

tion

—−0

.98*

*(0

.37)

——

——

—−0

.91*

(0.4

3)U

.S.

part

ner

maj

ority

equi

tyow

ners

hip

−0.7

7*(0

.36)

——

—−0

.64*

(0.3

0)—

——

Mod

elχ

237

1.68

***

180.

33**

*12

90.2

5***

1610

.11*

**16

45.9

4***

Log

pseu

dolik

elih

ood

−59.

35−4

8.32

−125

.60

−124

.40

−122

.89

LR

test

ofρ

=0

——

−0.4

9*−0

.49*

−0.5

4**

Two-

taile

dte

st.

N=

135.

Stan

dard

erro

rsar

ecl

uste

red

byth

eIJ

V’s

host

coun

try.

Yea

ran

din

dust

ryfix

edef

fect

sar

ein

clud

edan

dar

ejo

intly

sign

ifica

nt.

†p<

0.10

;*p

<0.

05;

**p

<0.

01;

***p

<0.

001.



the first empirical test of the determinants ofsuch option right assignment. We show that inour sample of IJVs between U.S. multinationalfirms and local partners, the local firm on averageholds the option right to purchase the U.S. firm’sequity stake about 30 percent of the time. Thoughpractitioners report that local partners in IJVsare often assigned the call option right (e.g.,Businessweek , 2003), extant research appears togive much more attention to cases where themultinational firm holds the call option. Our theoryand findings challenge the assumption often madein prior IJV research that the multinational firmholds the call option right to expand in its foreignIJVs by demonstrating that the local partner mayalso hold the option right under certain specifiedconditions (Chi and McGuire, 1996; Reuer andTong, 2005).

Second, our study moves existing real optionsresearch beyond its current focus on embeddedoptions to give specific attention to option rightclauses actually incorporated in investment design,thus allowing a more direct investigation of therole of real options in firms’ strategic decisions.Given that call option rights confer a secured rightto expand and that firms holding such options willexercise them only if it is favorable for them to doso (Reuer and Tong, 2005), a study of such optionrights holds the promise to improve our knowledgeof when firms can derive option value from JVsand alliances (Chi and McGuire, 1996; Miller andFolta, 2002). Our study also suggests that payingdue attention to option rights may help scholarsbetter understand the conditions under which firmsare able to appropriate value in other strategicinvestments such as R&D, M&As, and venturecapital (e.g., Bloom and Van Reneen, 2002; Tongand Li, 2011).

Finally, our study contributes to the broaderalliance literature by integrating two key dimen-sions of alliance design (i.e., contractual and own-ership choices). A large body of alliance researchhas studied the allocation of initial equity stakebetween partners and has suggested that choos-ing appropriate ownership positions is a key aspectof alliance design with important implications forfirms’ control of the alliance. By contrast, lessresearch has been devoted to another critical aspectof alliance design, namely, the contractual rightsthat firms incorporate into the collaborative agree-ment (Luo, 2002; Poppo and Zenger, 2002). Ourstudy focuses on the use of call option rights

in IJV agreements, and we specifically examinehow partners decide on the assignment of suchrights and the allocation of initial equity stakessimultaneously. The findings we presented demon-strate that firms’ contractual choices on call optionrights and their ownership choices on greater initialequity stakes are substitutive in nature. Our studyjoins a growing stream of alliance research thatexamines the interdependent relationship betweenmultiple dimensions of alliance design (Li et al.,2008; Oxley and Sampson, 2004). In addition,our findings are consistent with prior research byhighlighting that real options theory and transac-tion cost economics are complementary in explain-ing the structuring of JVs (Chi, 2000; Chi andMcGuire, 1996; Chi and Seth, 2009; Folta, 1998;Reuer and Tong, 2005; Tong and Li, 2011).

We would like to note several directions forfuture research. Our sample was developed fromthe IJVs tracked by the SDC database; despitethe comprehensiveness of its coverage, the SDCis not likely to cover the whole IJV population.Future research can test the generalizability of ourfindings by investigating IJVs drawn from otherdata sources or other types of IJVs. In addition,although our sampling of IJVs facilitates compar-ison with prior studies on call option rights thathave similarly focused on IJVs (Chi and McGuire,1996; Reuer and Tong, 2005), the theories we aretesting are not limited to such international ven-tures. Future work can therefore extend our study’sfocus to domestic joint ventures and other alliancecontexts such as minority investments (Folta andMiller, 2002). Ample opportunities exist to extendthis study’s focus on call option rights at the IJVformation stage by investigating how firms man-age and implement such rights during the stage ofdeal execution and IJV operation. For example, itwould be interesting to examine some of the spe-cific ex post conditions that trigger the call option-holding firm’s subsequent exercise of the optionright, and compare these conditions with those thatlead the firm to decide to continue holding onto theoption. Studies can also investigate the conditionsunder which the firm that holds a minority equityposition and a call option right in the joint venturemay exit the venture ex post , and the specific fac-tors affecting such exit. Future research can alsoexamine the use of put options by studying whyfirms would choose to have put option rights inplace ex ante rather than negotiate IJV sale expost . Finally, future research can enhance extant



knowledge of alliance design by examining howfirms can use call or put option rights in combina-tion with particular organizational mechanisms andmanagement practices to facilitate contingent con-trol. As applications of real options theory growin strategic management, we believe that stud-ies on the role explicit options play in shapingthe design of alliances and other corporate invest-ments will be an important complement to priorresearch focusing on the embedded options in suchinvestments.

ACKNOWLEDGEMENTS

For their valuable comments, we are grateful toLung-fei Lee, Ed Levitas, Margarethe Wiersema,anonymous reviewers, and participants at theconferences and seminars where an earlier versionof this paper was presented.

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