Compensation Options in Joint Ventures. A Real Options Approach

Abstract

This research focuses on a cluster of dynamic reallocation and restatement of ownership clauses contained in joint venture agreements. These clauses, with potentially significant financial implications, govern the transfer of rights between the parties on two key financial issues: the allocation of profits and losses and the ownership interests in the joint venture. The central contribution of this research is to consider these clauses themselves as non-standard real options and to propose a methodology for assessing their values. Determination of such values will be essential throughout the joint venture negotiation process. In addition, we provide valuable information on another key question of managerial importance: estimating the downside risk of a clause so that the affected party can design a hedging strategy. Two actual case studies extracted from recent joint ventures have been used to stress the importance of these concepts and to develop suitable valuation techniques. The theoretical framework is based on real options methodologies. However, the clauses studied involve real options with non-standard features (compensation options and options with uncertain initial date). Therefore, we have developed ad hoc valuation models with user-friendly numerical examples in spreadsheet format.