Trial Balloon

Based on research by Prashant Kale and Phanish Puranam

• Managers are more likely to seek equity in a partner firm when they think the firm’s resources offer a competitive advantage.
• Managers are also more likely to seek equity in a partner firm when they think the partnership will lower their transaction hazard. 
• Contrary to existing theory, uncertainty in the market makes managers less likely to seek equity ownership in a partner firm.

When it comes to a company’s equity ownership structure, the decisions that managers make are important and long-lived. So naturally, years of study have been devoted to describing — in theory, at least — what managers should consider as they navigate these intricate choices.

But what role do these theories play in a real life test?

For answers, Rice Business professor Prashant Kale joined INSEAD professor Phanish Puranam in a study of 66 managers and their decision process. The study was designed to measure how the factors cited in two widely held theories of equity ownership — the “resource-based view” and the “transaction-cost economics view” — impact managers when they’re making choices about equity ownership.

The resource-based view (RBV) maintains that managers seek equity in another firm to get access to that firm’s resources and sharpen their own firm’s competitive edge. A company that sells athletic shoes, for example, may find it worthwhile to partner with a manufacturing plant in order to add its capabilities to its own. Equity ownership in a factory could give the shoe company access to manufacturing resources, to decision-making power over the plant and to seamless coordination between manufacturing and other operations.

The transaction-cost economics (TCE) view, in contrast, emphasizes how equity lowers the transaction hazards in business dealings between firms. The sports shoe company, for example, may sell a high-profile sneaker that requires a special shoelace developed by another firm. In that case, the shoe company might pursue equity ownership in the shoelace company in order to gain some control over the firm. This, in turn, would accomplish two things: lower the risk of self-interested behavior from the shoelace company and spark greater cooperation between the firms in their business dealings.

Past studies have measured how much managers consider the factors cited in these two theories when they make decisions about ownership structures. These studies, however, depended mainly on archival data, and many didn’t control for other variables that might influence managerial decisions. Ultimately, Kale and Puranam write, this previous research didn’t connect the dots between theory and real life business practice.

To establish a clear link between theory and actual managerial decision-making, Kale and Puranam asked respondents to imagine that they were seeking an inter-firm partnership in order to secure another firm’s technological resources. At the same time, the researchers controlled for non-RBV and non-TCE based factors that might influence managerial choices.

Using a methodology called policy capture, Kale and Puranam came up with 30 different scenarios that required respondents to consider various decision-making criteria. For each scenario, the respondents were asked whether they’d choose:

1. a contractual relationship
2. a minority equity stake in the firm
3. a non-majority equity stake in the firm, or
4. majority equity stake/acquisition.

The researchers took care to design some of the decision-making criteria using RBV or TCE factors, and other criteria based on control factors. This allowed them to measure exactly how much the theoretical criteria influenced managers’ choices.

What they found was that resource-based and transaction-cost factors did indeed influence the managers’ choices. Most influential were factors related to gaining a competitive edge, as proposed by RBV theory. The greater the apparent value of the RBV factors, the higher the level of ownership the managers wanted in the new partner firm.

Transaction-cost factors also shaped managers’ equity ownership choices, but not as much as the prospect of honing competitiveness. Transaction-cost advantages influenced managers’ decisions to seek an equity stake in the firm. But when those advantages grew, it didn’t increase managers’ interest in raising their levels of ownership of the partnering firm.

What about the role of demand uncertainty in these decisions? Contrary to the tenets of transaction-cost theory, Kale and Puranam discovered, uncertain demand conditions actually made respondents less interested in an equity stake in the partner firm.

In short, and just as RBV- and TCE-based theories suggest, the resources and relationships offered by inter-firm partnerships strongly swayed managers’ decisions about the kind of equity ownership agreements they wanted. In practice as in theory, these key assets are deemed worth the investment — if the market is stable. When market demand is uncertain, however, real life managers don’t react as transaction-cost theory prophesies they will. Instead, uncertain demand conditions make respondents less keen for an equity stake in a new partner firm.

Human nature, in other words, is highly predictable. But there’s still no substitute for watching what happens in the open air of real business.

Prashant Kale is an associate professor of strategic management at Jones Graduate School of Business at Rice University.

To learn more, please see: Kale, P. & Puranam, P. (2013). The design of equity ownership structure in inter-firm relationships: Do managers choose according to theory? Journal of Organization Design, 2(2), 15-30.