Journal of Business Venturing
Volume 21, Issue 3, May 2006, Pages 265-285,
Cass Business School, City University
London EC2Y 8HB, England
Canterbury Business School, University of Kent,
University College Dublin,
UCD Business Schools, Department of Business Administration,
Belfield, Dublin 4, Ireland,
Sol C. Snider Entrepreneurial Research Center
Wharton School, University of Pennsylvania
We acknowledge valuable comments from the editor and two anonymous reviewers
of this journal, from Max Boisot, Phil Bromiley, Rudy Durand, Daniel Giamouridis,
Mike Lubatkin and Brian Wright and from seminar participants at the Wharton
School, Haas School, Cass Business School, Canterbury Business School, the
Academy of Management, Toronto. We also thank the Design Council of the UK for
their support in case writing, and the Haas Business School and Wharton Business
School, with special mention to “Mac” MacMillan for providing the right
intellectual climate for idea generation and his encouragement. The first author
is responsible for the core ideas and themes of the paper, the second and third
authors have contributed heavily to the paper development and finding examples
and the last author has contributed key insights into the legal position and the
role of venture funds.
© C. Baden-Fuller, May 2004
RAISING THE RETURNS TO VENTURE FINANCE
Investors in ventures that threaten to disrupt the markets of incumbents can
use the options markets to add value to their investments by purchasing put
options on the stock of the disrupted rivals on the basis of their asymmetric
knowledge. By making a profit on these derivative trades in the stock of the
disrupted firms, the investor innovator is able to recapture from the market
extra and immediate profits (equivalent to the value of the consumer surplus)
generated by the innovation. These additional profits increase the incentive of
investors to invest in disruptive technologies and so correct biases that have
been observed against disruptive innovation. Our paper provides guidance as to
how these effects arise and how valuable they are. It also explores the
regulatory and practical constraints on undertaking the trades, pointing out
that it is legal and effective provided certain conditions are met.
RAISING THE RETURNS TO VENTURE FINANCE
The returns to venture finance are skewed and uncertain. Research in this
journal suggests that most new ventures fail and overall less than one in ten
new ventures make a positive return (Mason and Harrison, 2002, Maingart et al.,
2002, Kleiman and Shulman, 1992, Bygrave 1989). Some of the most disappointing
returns occur when investors invest in companies that produce potentially
disruptive innovations, where disruption is defined as the case when the
innovation alters the dynamics of competition (see for instance Christensen,
1997). The gains from the effects of the disruption are often elusive whilst the
effect of the disruption are often more immediate. The ventures that cause the
disruption find that it takes time and effort to translate sales into profits,
but the firms that are threatened by the disruption find themselves facing a
very clear threat. Financial markets react quickly to threats, even when the
actual event is distant.
The central idea in the paper is that venture capital investors in pre-public
firms are often in possession of potentially valuable asymmetric information
about the actions of the firms in which they have invested (Aboody and Lev,
2000). This information relates to the timing and potential efficacy of the
effect of the invested firm’s actions on its rivals. For example, the firm may
be a new entrant that is about to launch a product that better satisfies market
requirements at a considerable discount to current market pricing. Such actions
have the potential to change the competitive landscape and so reduce the value
of the established rival firms. When those rival firms are quoted and traded,
the venture financier can capture additional value by trading in financial
options in the rivals’ stock.
The sequence of events is broadly as follows. Armed with the knowledge of the
situation of the disrupting firm in which it has a stake, the first step for the
investor is to establish the rights to trade. The investor does this by adding
to their investment “term sheets” explicit information rights permitting them to
utilize any information learned about unrelated third-parties as a result of
their investment in the firm. The investor then goes about exploiting the
information. It first identifies which third-party firms will be adversely
affected by the disruptive company’s innovation. Shortly before the disruptive
firm disrupts the markets for the identified third-party firm(s), the venture
financier purchases put options (or similar derivative instruments with
equivalent effects) on these rival firms whilst the knowledge of the disrupting
firm is not widely known or appreciated. In due course, the disrupting firm will
announce that its product-process and/or market penetration has progressed to
the point where its deleterious effects on the future profits of the rivals are
obvious to the investing public. As the financial markets integrate this
information, the rivals’ stock prices will fall speedily. The investor is then
able to exercise the options (cash-in the derivatives) at a profit.
The profits from the strategy proposed in this paper can be very attractive
and will be both additional and more immediate than the profits expected from
the investment in the company that is launching the disruptive innovation. We
will also produce evidence that suggests that the profits can be larger even
than those from the investment in the disrupting company. As the ability to
increase the returns to successful ventures is important, our strategy has a
potentially important effect on the overall returns of the investment portfolio.
The proposed strategy has some obvious limitations. We are only dealing with
innovations that are disruptive; that is, they are capable of influencing market
structures and stock prices of rivals. Although there is no requirement that the
firm that is causing the disruption is listed for the strategy to work, the
stock of the threatened firm (the “disrupted firm”) must be traded in
well-developed financial markets. Since, a large proportion of the US and
European economies are populated by quoted firms, and a significant goal of
venture financiers is to capture the maximum profit from the rights and
preferences negotiated into their investments, our paper has potentially a wide
Our analysis also discusses the transactions costs of the proposed
strategies, the impact of stock price volatility, and issues of timing. We also
discuss at some length the regulatory and ethical issues and we refer to legal
journals and US Supreme Court decisions to show that, in general, our strategies
do not fall foul of SEC and other regulatory rules. We begin the paper by
examining the ethical question of why the strategy has the potential to increase
public welfare as well as the purse of the investor.
There is a substantial literature on the use of asymmetric information
possessed by managers when they trade in the stock of their own firms for their
own personal gain: such activities are typically labeled insider trading or
trading on private information. The extensive discussion that appears in the
finance, economics and management journals generally concludes that the welfare
gains to such behavior are related to making information in markets more
efficient (see for instance Manne, 1966 and two excellent updates: Bebchuk and
Fershtman, 1994 and Hu and Noe, 2001). Recent papers have gone further and have
questioned whether there are any systematic losers from trading based on
asymmetric information because markets are friction-laden. The work has
typically used real data in real markets (e.g. Pagno and Roell, 1996, Jeng,
Metrick and Zeckhauser, 1999). This work in no way denies that there will be
specific losers in particular trades, but rather that writers of option
contracts do not lose overall in the long run. However, despite these papers,
the legal position is that insider trading is outlawed in most developed
Our case here is quite different: we are considering the use of what is
technically known as trading in stock substitutes, that is the use of
information that one investor possesses from his relationship with a firm in
which he/she has invested that affects the stock price of another legally and
institutionally unrelated firm. Diligent enquiry and a wide search have
indicated that this dimension has only rarely been discussed, and then only in
the law journals rather than those relating to finance and strategy (Ayres and
Bankman, 2002). This literature has stressed the cases where the information may
have been gained in dubious circumstances and has ignored the situation of
investors in disruptive innovations getting information legitimately through
their corporate governance exposure and diligence related to the firms in which
they have invested.
In this opening section, we wish to focus attention on the (economic) welfare
implications of investors in disruptively innovating firms trading in stock
substitutes? Because the proposed trading strategies might otherwise be
considered controversial, it is appropriate that this question be dealt with at
the very start of the paper and not consigned to a mere end-note. Because the
question is technical, we use the economists’ tool kit as a way of considering
questions of welfare and values.
Economists have often argued that investors in innovations need some
protection. The argument is usually portrayed in the context of defending patent
laws. Here we deploy the argument to defend our trading strategy. Our argument
also allows us to measure quite precisely the gains involved and connect these
gains to the welfare issues. We start with the famous discussion of the causes
of the poor returns to innovation set out by the Nobel Laureate Arrow (1962). He
pointed out the paradoxically destructive role played by competition. When a
firm introduces as disruptive innovation that threatens the survival of
competitors, subsequent competition can force down prices and reduce the profits
available to the innovator. The threat is greatest when the innovator has no
patents and cannot erect entry barriers. The competition can come from existing
firms or new firms that respond to the innovation. Competition, normally
considered to be a blessing, for consumer welfare can be adverse because the
investor may not be able to capture fully the returns to the innovation even
when the innovation is “socially desirable”. Arrow showed that this danger would
discourage investment in many radical innovations and consequently the
innovation may not be launched. The argument relied on a careful analysis of
The problem that Arrow identified can be overcome in part or in full if
inventors can make direct contracts with customers in advance. Customers can
promise to the inventor that s/he will receive his/her rewards either directly
through purchase contracts at a pre-determined price, or by side payments. Von
Hippel (1986) has pointed out that in many producer goods markets, such
contracting does occur on either a formal or an informal basis. Hirshleifer
(1961) has pointed to other ways of getting at the consumer benefit: the
innovator can make contracts with the suppliers of complementary goods to make
the gains. Thus he argued that Eli Witney, the inventor of the cotton gin, would
have made exceptional profits if he had abandoned his attempts to patent the
machine and instead focused attention on investment substitutes by buying up
land suitable for raising cotton; which, at the time, was trading at very low
Our proposed strategy for investors is another way around the problem
identified by Arrow (1962). The investors who hold stock in the disrupting firm
trade on the stock of the unrelated disrupted firms. Our strategy therefore
builds on a long line of discussion about how investors in innovations can
improve their returns with ingenious strategies.
Consumer surplus is a concept invented by Alfred Marshall that measures the
difference between the amount that consumers might be willing to pay (the value)
and the amount that they actually pay (the market price). To show simply how
this concept is used, let us go back to Arrow (1962). He explained that most
innovators see poor returns because they are unable to capture all of the
additional consumer-surplus (the consumer benefits) generated by their
innovations. The consumer surplus is lost to the investor because the innovating
firm has to lower prices to sell the product. This lost consumer surplus dulls
the returns from innovation. Furthermore, the innovator has to run the risk of
rivals copying the innovation when there are either no property rights in the
innovation, or the property rights are imperfect in their coverage.
We will build a simple model that examines how trading options on the stock
of rival firms can improve the welfare of society and the returns to investors
in the case of disruptive innovations. We begin with a very simple model (and we
later discuss how to generalise the results). We assume that there are only two
players, A and B. A is the innovating firm that plans to introduce a new
cost-reducing disruptive process to the market. B is the incumbent firm (or
group of firms). Since A’s innovation lowers costs, A anticipates that after
launch B’s product prices will fall. Such price behaviour is justified from
theory considerations (Arrow, 1962). This is reinforced by empirical studies
which have observed the negative impact upon an incumbent’s market value that an
announcement of disruptive innovations from rivals (Sundaram, John and John,
1996), or the actual launch of rival products that are strategic substitutes of
the incumbent’s products (Chen, Ho, Ik and Lee, 2002; Whinston and Collins,
1992). Figure One presents the standard micro-economic treatment of this
situation in graphical terms (with the standard assumption that A licences its
technology and shares the market with B).
FIGURE ONE ABOUT HERE
The diagram also allows us to track consumer surplus (which is the consumer’s
welfare not captured by either the producer’s costs or the producer’s profits).
The original consumer surplus before A’s arrival is represented by the area
between the upper part of the demand curve and the old price line. Following the
entry the consumer surplus has increased because the price has fallen, and the
sum of “B’s lost profits” and the area of the white triangle represents this.
(As is well known, the white triangle is small compared to “B’s lost profits”.)
We suppose A has a total monopoly on the innovation; that there is no
information leakage; and that B’s stock is traded. When A makes its discovery,
there is a time during which this knowledge is not widely disseminated or
appreciated. At that time, when financiers of A learn about the innovation (via
the investment-related contracts they have with A) they can place a bet on B’s
share price falling, buy a derivative instrument on B’s stock price, or sell the
stock of B short. They know that when knowledge of A’s project is widely
disseminated; B’s stock price will be adversely affected. The investor can then
realise profits from the arbitrage they have set up.
The instruments available to the investors in A to gather this benefit are
quite broad. They can sell stock short; they can make bets or they can purchase
a put option. We can be more precise. A short sale is exactly equivalent to (1)
purchasing a put option plus (2) selling a call option for the same maturity and
strike price less (3) the cash sum of the strike price discounted at the risk
free rate from the time of expiry of the options. This equivalence is determined
by the principles of arbitrage, and is independent of the assumptions of Black
and Scholes (1973).
We will explore later in the paper the various risks from selling short as
opposed to buying puts. Here we merely note that in practice, to limit risk, the
investors in A should purchase a put, a strategy that for a small fee (the loss
of the revenues from writing the call) eliminates the risk of being “wrong
footed” about price changes.
Proposition 1: Investors in companies creating disruptive innovations can
improve the returns to their investment by utilizing asymmetric information and
purchasing put options or similar contracts on the stock of rival firms before
knowledge about the success of the disruptive innovation is widely known.
Valuing the gains from a theory perspective
Using the concept of consumer surplus, we can quantify the gains. The profit
from the option trading for those investing in A depends on the significance of
A’s innovation. We assume that the innovation is disruptive; but even so, it is
unlikely to be so great as to force B out of business. In this case, the gains
in the option trading will closely reflect B’s lost profits. The more the
innovation affects B’s stock price, the greater the gain to A. In Figure One we
assumed for simplicity that B has a constant average-marginal cost curve. We
also assume that A’s project impinges exactly on B’s space (in economics terms
its technology is a perfect substitute). In this case the lost profits to B are
a significant part of the consumer welfare gain. As we show later, neither of
these two assumptions is necessary to obtain the key result.
It may be that A’s innovation is so significant that B is driven out of the
market. This case is shown in Figure Two, and the gains from the put option are
no longer equal to the change in the consumer surplus, because B’s stock cannot
be traded at a negative price. Therefore if the market price falls below the
point at which B is driven out A cannot re-capture that portion of the consumer
surplus generated below a zero price for B’s stock.
FIGURE TWO ABOUT HERE
Providing financial markets accurately gauge B’s losses following A’s entry,
then the gains from the put option to the investors in A represent a large part
of the change in consumer surplus following the disruption by A. This means that
the financial transaction “completes the market for knowledge” and so provides a
source of the lost profits identified by Arrow (1962). Even more significantly,
apart from the small white triangle of benefits, there are no other true gains
available, for all the consumer surplus is “used up”.
Proposition 1.a. The maximum gain to the investor from the exercise of the
put option on the rival firm is roughly equivalent to the un-appropriated
consumer surplus following the launch of the innovation minus the costs of
making the put option.
Generalising the results
Appeal to Coase’s theorem allows us to see the result in a different way and
to appreciate the generalisation of the result (and relaxation of the initial
assumptions) to cases where the innovation is not one of simple cost reduction
but includes product and market innovations. According to Coase (1960) market
forces ensure that the optimal allocation between producer and consumer will
occur provided information is perfect and transactions are costless. Where this
is not the case, incomplete contracts between producer and consumer will lead to
sub-optimal allocation. The problem facing A is that the value of the discounted
cash-flow of the project does not capture the value of the consumer surplus
resulting from the introduction of the innovation.
If A can obtain contracts from the customers of B in advance of its
innovation, it can capture the surplus. The extent to which such advance
contracts are possible depends on the extent to which customers believe that
innovations will occur without their having to engage in such contracts. In
practice, except where firms are vertically integrated with customers,
constructing contracts with users is very difficult. However, the capital market
has clear expectations about future customer behaviour. The market
capitalisation of B reflects the capital market’s assessment of the loyalty of
the customers via the discounted future earnings of B. In Coase’s terms,
purchasing a put option on B forms a contract with speculators about this
loyalty because B’s stockholders already have strong expectations about B’s
future profits from its customers. The put option is a surrogate contract with
B’s customers, overcoming the incomplete contract problem and enabling A to
extract the surplus.
Coase’s theorem allows us to appreciate that working the capital markets
allows A to capture the value of the consumer surplus in the more general case.
For example, if A’s innovation impacts many rivals, then buying a set of put
options on all of the rivals will allow A to capture the value of the lost
consumer surplus. More importantly, A cannot capture more consumer surplus than
exists, and it will capture (effectively) all there is to be had (less
Sometimes A will create an innovation that has complementary provider
benefits. For example, if A is innovating a new system for stock trading that
benefits the providers of complementary information such as Reuters, then A can
capture some of these gains by buying call options on the providers of the
complements. The stock prices of complementary providers will rise following the
announcement. Again, appeal to Coase’s theorem allows us to see, without complex
mathematics, that there is no double counting.
In general, where A’s innovation has both complementary and substitution
effects on a variety of other firms (i.e., on stock substitutes), the investors
in A can capture the value of the lost consumer surplus by buying a basket of
suitable call options on complementors and put options on rivals.
What the consumer surplus argument shows
Propositions 1a and 1b helps us measure the potential social benefits of the
trades that the investors undertake. From the investor’s perspective, the
financial trade captures most of the surplus (consumer benefit) that is not
captured by A when A sells its disruptive product in the market. In extreme
cases, the options trade makes an unprofitable, but socially-worthwhile,
investment realisable. In any case, the options trade yields a more immediate
cash benefit that is additional to the rather uncertain and more distant returns
otherwise inherent in such an investment. Thus there will be cases where the
options trade will allow projects to be financed that could not be financed
otherwise (except perhaps by government subsidy). As noted above, such cases
will improve society’s welfare (as seen by the economist’s measure of consumer
Who pays for the trades? The consumer does not pay directly; it is the
issuers of the instruments. But in most markets, the sellers of put options and
derivative instruments are pension funds, who undertake the positions in the
hope of increasing their returns. Where pension funds representing the same
class of consumers as the future users of B’s current products, the put option
is a surrogate contract with B’s customers. In other cases, pension funds or
speculators are merely standing in for the consumers. In Coase terms, we are
bridging the financial markets for B with the asset markets for A’s invention.
It must be stressed at this point that there is a big difference between
trading in derivatives on rival companies (stock substitutes) to help finance
innovations and the use of insider knowledge to reap personal gain. The societal
gains from insider trading are usually measured in terms of more efficient
trading on financial markets and more efficient signals. These gains are widely
disputed, have significant agency problems and create ethical concerns. In
contrast, trading by investors in stock substitutes to help finance disruptive
innovations is much more clearly socially beneficial in the sense that there are
no agency problems at all. The profits earned from these trades directly and
unambiguously benefit the financiers of the innovation process, thus solving the
dilemma pointed out by Arrow (1962). Moreover the economist’s metrics allowing
us to judge these benefits are rooted in a long tradition of welfare
calculations used by economists since Alfred Marshall.
In summary, the use of options augments value. Judging a venture investment
solely on the basis of its expected cash flows would be misleading if the gains
to be made from the exploitation of rivals’ losses were not taken into account.
Further, disregard of these gains can lead to sub-optimal returns to the
investor. In the final analysis it is the combination of the value of the
discounted cash-flow (DCF) of the investment and the gains from the paired
action in the financial markets which determines the true value of a potential
investment in the disruptive innovator, A.
THE IMPORTANCE OF THE PUT OPTION RELATIVE TO THE VALUE OF THE DCF
How important is the value of trading the financial options we propose
relative to the profits from the underlying disruptive investment? The answer to
this question is that the value could be very large. The profits from the option
trade could be many times the total future profits from the original investments
in the company undertaking the disruption. We begin by looking at four case
examples: airlines, computer peripherals, medical devices and drugs and then we
look at empirical papers that have observed the negative impact that
announcement of new potential or actual disruptions have upon the market
capitalisation of incumbent firms.
Whinston and Collins (1992) monitored the effect of 24 announcements by the
airline People Express. Each announcement was a stated intention to enter new US
domestic routes between two cities during 1984-85. They found that each
announcement had a significant negative effect on the market capitalization of
incumbents and a significant positive effect of the price of People Express’s
stock. The fall in any given incumbent’s stock price was about four times larger
than the gain in stock price experienced by People Express at the time of the
launch. This suggests that the potential gain from trading put options (or some
equivalent derivative) may be larger than the potential gains from the DCF of
the investment itself. Even more critically, the gains from the put arise
immediately, whereas the project gains (from the management perspective) are
spread over the life of the project. To reinforce the point; we know that the
investors in People Express ultimately lost money on their shares, but they
could still have made a profit if they had been able to undertake the financial
In the computer industry: in 1987, a venture capital-backed company named
Phoenix Technologies, then private, announced that it was planning to launch a
product that would disrupt Adobe’s postscript printer technology. On the
announcement, Adobe’s stock dropped over 36% over a two-month period. Investors
in Phoenix Technologies could have increased their return by purchasing at a
suitable time a put on Adobe’s stock (provided they did not have any other
relationship with Adobe, see the regulatory section below).
In the medical device industry, on September 17, 2003 it became clear that a
device called a “drug-eluting stent” from Boston Scientific would be a
disruptive technology to a division within the giant pharmaceutical company
Johnson and Johnson. The stock of J&J fell 1.4% in 15 minutes and 2.5% in that
day. Moreover, the stock price of the S&P 600 Smaller Cap SurModics (Nasdaq:
SRDX) dropped 13.7% that day; because, at the time, SurModics supplied the
technology to J&J that was used in its “drug-eluting stent”. (The stock in
Boston Scientific was suspended during the announcement period.) Investors in
Boston Scientific, after taking appropriate precautions, could have increased
their wealth by purchasing put options on either SurModics or on J&J at the
An example of complementary benefits can be seen in the pharmaceutical case
of Barr Laboratories. On July 12, 2001, Aai Pharma announced that it had
received a US patent for a form of fluoxetine, the active ingredient in Prozac.
Aai Pharma also announced that it had licensed fluoxetine to Eli Lilly for
marketing. Eli Lilly simultaneously announced its decision not to request FDA
(Federal Drug Agency) approval for the new form of Prozac thereby opening the
door for the production of generics to Prozac. The combined effect of the two
announcements was both complementary and threatening. Barr Laboratories found
themselves first-to-market in the US with a generic rival to Prozac. Barr’s
stock jumped 10% in the first day, and a further 24% during the following 42-day
period. Eli Lilly’s shares lost nearly 2% in the first day. Borrowing from data
supplied by John Graham (Fraser Forum: September, 23 2000) we can see that the
investors in Barr gained about $34 millions whereas the investors in Eli Lilly
lost more than $1 billions, once again showing that the wealth impact on the
disrupted firm can be much greater than that accruing to the disruptor.
In each of the above cases, the investors in the companies creating the
disruptive innovations potentially had early insights into the market dynamics.
These insights, whilst not absolutely guaranteed in their effect, provided solid
investment opportunities for the investors to increase their returns in the
Sundaram et al (1996) examined the impact that 106 announcements of changes
in R&D activities by firms from 18 industries had upon both the firm and its
rival. They found that were the R&D activity was characterized as generating
possible strategic substitutes to incumbent firms products that the incumbents
experienced negative and statistically significant reductions in stock market
value. The announcing firm experienced significant, positive rises in market
Building on the work of Sundaram et al (1996), Chen et al. (2002) provide
further support for the effect of announcements on the stock price of disrupted
firms. Employing a dataset of 384 new product announcements by firms from 39
industries, they found that where a new product launch announcement was viewed
as a strategic substitute for an incumbent product, then the incumbent
experienced negative and statistically significant reductions in its stock
market value within a narrow two-day window. The announcements studied by Chen
et al. (2002) were not just disruptive technologies but also non-disruptive ones
too, the competitors were defined by a wide industry definition rather than a
narrow product-based criterion, and the test of the price fall was restricted to
a narrow two day window in comparison to a 260 day benchmark which might be more
typical of an options contract. The test is therefore much more demanding than
that which our investors need.
Proposition 1c: Placing options contracts under conditions of asymmetric
market information has the potential to increase the returns to investors in
innovations many times, where the benchmark is the DCF of the investment solely
in the innovation itself without capitalizing on externalities.
This brings us to another point: investors in A may not be confident that
their firm A will succeed in disrupting B, but they can still benefit from the
asymmetric information if A has many close rivals also working on the same
challenge. Disruptive innovators come in packs; typically there are many firms
working on parallel tracks. Realization that a break-through is about to occur
may persuade the market that B’s value is under-threat even if the market may
not know which of the many firms in the pack will win. Studies of disruptive
innovations, such as Christensen (1997), give examples of these phenomena.
The returns are greatest when the rival incumbent has monopoly power
The above examples have several features that made the potential gains large.
The stock market clearly believed that the incumbents had some monopoly power
and were providing close substitutes. In addition, the incumbents had high costs
associated with exit in the sense that the assets they possessed were inflexible
and represented large sunk costs. For these reasons, entry obviously threatens
the incumbents’ stock prices.
From a theory perspective, it is obvious that the greatest gains to investors
in A will come when B is providing close substitutes. There is an additional
factor, when the incumbents have a large margin between price and marginal cost
and so a lot of profit to loose. One such case is where B holds a monopoly
position and faces high exit barriers due to sunk costs. As noted above, this
was the case for both People Express and Phoenix Technologies, where rivals were
often monopoly players with significant sunk costs. At the opposite extreme is
the case where the incumbents do not hold any monopoly position and where they
face no exit costs. This approximates to price equating to marginal costs. It
also corresponds to the case noted earlier when A’s entry induces B to quit.
Here there are little if any gains from buying the put, as B’s stock price will
not change. (B’s stock price could still be positive because the stock price
represents the value of flexible assets not committed to this market.)
Proposition 1d: The value of using the options contracts are likely to be
greatest where the rival incumbent firm or firms act as if they were a
monopolist and produce products that are close substitutes.
TIMING, INFORMATION LEAKAGE, TRANSACTIONS COSTS AND UNCERTAINTY
Until now we have ignored several important factors such as the carrying
costs of purchasing options, the danger of information leakage from the
disrupting company, the volatility of the stock price of the disrupted company
and uncertainty over the effects of the disclosure. These factors can interact
in a potentially damaging manner to affect both the size of the gains and the
timing of the investors moves. For example, if the rival firm B has a very
volatile stock price, perhaps because other factors such as raw material price
volatility, and if the time between buying the option and cashing in the bet is
long, there is a danger that the price of the stock will rise on account of
other factors even after the market has taken account of the bad news. We will
deal with the problem in several stages. First, what are the chances of making a
profit on the derivative trade for a given situation? Then, what factors
determine the timing of the buying, holding and selling of the derivative.
First, we note that we must consider the volatility of the stock price of the
rival firm on whose stock we place the trade. A higher volatility means a better
chance of the price rising in such as way that our announcement is nullified. We
also note that there is a volatility of the expected effect of the announcement.
If the information we release to the market is ambiguous, the market may not
react as much as we hoped and so the gains may be less. If E is the expected
value to be gained from depressing the stock price of B the disrupted firm, and
c the transactions cost of the put and T the time that the option is left open,
then the expected return is stated as below:
Gain is: E – c.T (1)
Let us first note that sophisticated investors who are rich (as is often the
case) will clearly take into account that any put option has a chance of making
a gain. Indeed, the typical sophisticated investor is likely to assume the
options are correctly priced by the market; and that the true transactions costs
are actually much less than the price of the put, even approaching zero. The
sophisticated investor (say a typical venture fund) is therefore unlikely to
perceive much downside risk from the speculative trade. Moreover, if the
investor acts like a venture fund the risk will be one that is well understood
and no more risky than many other investments that the fund makes. E may turn
out to be small, but if c is small there is nothing to be lost.
In contrast, the naïve risk-averse investor will not only be interested in
the expected gain, but also concerned with the likelihood of a loss and may take
a much more conservative view. To this investor, c.T may not be a trivial sum.
The likelihood of loss is dependent on the volatility of the stock price of the
rivals B and the volatility of the effectiveness of the announcement E as well
as the size of c.T. As a first order approximation, these risks work in an
additive manner (because they are independent events). Let us use a simple
example of the naïve risk-averse investor wishing to be 95% certain of making a
gain to see how the numbers work out. If SB is the standard deviation of the
variation of the price of B per period and if SA is the standard deviation of
the expected effect of the announcement (which is absolute) then the investor
wanting to limit risk to 5% should play as long as:
E > 2.SA + (2.SB + c).T (2)
Determinants of the Timing
The size of T is a critical factor in the potential profits of the trade and
the risk of the trade. A short T limits transactions costs and risk. A long T
has the opposite effect. What determines the value of T? The simple answer
detailed below is that T is determined by an interaction between the carrying
costs of the put and the rate at which information is leaked. And, as noted
above, the carrying costs for the put are comparatively less for the
sophisticated investor than the naïve one.
Figure Three shows the issues and solution to the effect of carrying costs
and information leakage diagrammatically. On the vertical axis we plot the
cumulative value of the information to the various parties and the cost of the
put, which we assume as constant over time. Time is shown horizontally. The
cumulative value of the information is measured as the total impact on the
market capitalization of the disrupted firm B. As noted, we assume that the true
impact of the information is clear to the investors of the innovating firm prior
to its becoming clear to the financial markets (in particular the stockholders
of B). Our diagram shows the typical S shaped information curve, but the curve
could have any shape. It also shows that the diffusion of (the significance of
the) information between A and B’s stockholders occurs at a constant rate; again
this is only for ease of exposition and does not affect the result. The
important point is that there is some time lag between the two curves.
INSERT FIGURE THREE ABOUT HERE
The vertical distance between the curve that depicts the information arrival
at investors in A and the curve that depicts its arrival to the general market
represents the difference between the value of the information held by investors
in the firm and that held by the market. The total value of asymmetric
information (the total value of the put) to the investors in A is represented by
the area under the asymmetric information curve. The net gain to the investors
in A is the difference between this area and the total cost of carrying the put,
the area under the horizontal cost-curve, i.e., the area between the asymmetric
information curve and the cost of carrying the put.
From the figure it is easy to see that gains are maximised by buying the put
at the earliest point in time where the value of asymmetric information is equal
to the cost of carrying the put. Likewise, the best moment to sell is when the
two are again equal. Optimal purchase of the put is not at the point at which
asymmetric information is at its greatest, as the casual observer may have
expected. We can generalise our result to the standard first order derivative
equation summarized in the proposition below.
Proposition 2: The optimal strategy for the investors in A is to purchase the
put when the value of the information asymmetry just rises above the carrying
cost of the put. Likewise, the investors in A should sell the put when the value
of the information asymmetry falls to just below the carrying cost.
Changes in the carrying costs of the put option and in the size of lag before
information is leaked have implications for the timing of option purchase, the
length of time for which the put is held and the size of the gain A can make.
These are readily seen by reference to the figure. The greater the carrying cost
of the put option, (i.e., the higher the cost-curve in the diagram) the later
the put is purchased, the shorter the length of time for which it is held, and
the less the gain from the option. Conversely, the lower the carrying cost of
the put: the earlier the put will be purchased; the later it will be sold and
the greater the gain to A. If we turn to information leakage, we see that a
shorter time-lag between the arrival of information at the firm and its
subsequent arrival at the market results in a shorter time-lag for which the put
is held, and again, a smaller gain from the option. The same holds if once
leakage begins, the rate of arrival of information at the market is faster than
that at the firm. If the time lag is long or the rate of information leakage
once it begins is slower than the rate of information arrival at the firm then
the put option is held longer and the total gain of the investors in A from the
option is greater.
In practice, knowledge of potentially disruptive innovations is often well
known before the market takes notice. There are many smaller companies
experimenting with innovations at any one time. Their investors attend board
meetings and conduct regular discussions with management. These sources of
information give company A’s investors regular feedback on the company’s
prospects relative to that of its competitors.
The moment when industry conferences give platform visibility to the
activities of these firms is when the knowledge becomes effective and is noticed
by the financial markets. Another way of gaining attention is to form an
alliance with credible partners. The stock market has been found to react
positively to announcements of alliance formation by small firms with larger
partners (Chan, Kensinger, Keown and Martin, 1997; Das, Sen and Sengupta 1998;
Koh and Venkatraman 1991; McConnell and Nantell 1985.) This means that in
practice there is a long time during which the investors in the disruptive
technology have a moment to place their bets.
What are the approximate transactions costs one might expect? To provide a
tangible example of a real venture situation, we give some data for investors in
a new book-selling business trading put options on a well traded stock
substitute that has a narrow portfolio – Barnes and Noble. We looked at Barnes
and Nobel (symbol: BKS) put options with various expiration dates on August
23rd, 1999, when BKS’s $25 stock price was equivalent to the strike price of the
options. BKS options with two-month, five-month and eight-month expirations
became profitable with only 2% stock-price drops. Indeed, suppose one was to
believe that the announcement could move the stock price of BKS by say 6% in 1-2
months, or 13% in 5-8 months, then this example indicates a potential to earn
greater than 30% cash-on-cash returns; and internal rates of return that are
very high (480% and 150% respectively). It is easy to see that a modest outlay
in this arena would greatly improve the return on the venture investment as a
REGULATORY AND LEGAL ISSUES
Some have expressed concern that our proposed strategies for the investors
are not legal. The concerns centre on the fact that investors in A are using
non-public information to make a gain on the change in the stock price of the
threatened firm B. In other words, the use of “material, non-public information”
gained through an investment in a “Disruptive private company A” would violate
insider trading laws related to trading publicly traded stock in “The disrupted
public company B.” We have carefully trawled the insider-trading statutes in the
US, and have discussed our example with lawyers and experts. Whilst we are not
legal scholars, there is clear U.S. Supreme Court case law and commentary to
support our position that the strategy we propose is legal. We particularly
refer to United States v. O’Hagan (1997) and to Ayres and Bankman (2002), who
explicitly discuss the legality of trading in stock substitutes. Neither the
Supreme Court case nor Ayres and Bankman discuss our example of venture
investors increasing their returns to help finance disruptive innovations, but
they both discuss the more general case of holders of material, non-public
information on a company with which they have no legal connection who choose to
trade on that information for personal benefit.
Because we are dealing with legal issues, it is necessary to use some legal
terminology that clarifies the situation more exactly and explains why the
legality is robust. The applicable United States Statute is Rule 10(b)-5 of the
Securities Exchange Act of 1934. This rule states that one cannot “engage in any
act, practice, or course of business which operates or would operate as a fraud
or deceit upon any person, in connection with the purchase or sale of any
security…” However, as far as our case is concerned, to infringe this law, one
must either be privy to material, non-public information known to insiders in
“Disrupted public company B” or one must have misappropriated material,
non-public information about “Disrupted public company B” (unknown to insiders)
from an “outsider” who is somehow the owner of such information.
Now our investors in the disruptive company A do not fall foul of any of the
SEC rules if they take care of the following: (i) they must owe no duty to B or
have any temporary or permanent relationship to B—this means that the investors
in A must take care not to be employed by B, or be directors or B, or to have
any trading arrangement with B; and (ii), they must likewise make sure that they
owe no temporary or permanent duty to any trading partner of B; such as being a
director of a major B supplier; and (iii), they must also be sure that company A
itself owes no duty to disrupted company B or has any temporary or permanent
trading relationship with company B (i.e., company B is an unrelated player in
the market competing directly or indirectly with company A). In other words, the
investor must not have any direct or indirect relationship with company B which
would, of course, subject the investor to insider trading restrictions when
trading on public company B’s stock.
The only other issue of concern, is that investors in A have a duty to
company A itself if these investors use A’s non-public information. This duty is
not necessarily broken just because the investors use this information for
personal gain. The key is to ensure that the investors do not misappropriate the
information about A.
When venture investors invest in a new company, it is typically the case that
they request many investor rights as part of their investment. These investor
rights are summarized in a document called a “terms sheet” for the investment
offer. The terms sheet becomes the basis for all final investment documents. To
make sure that the venture investors in A are not deemed to have misappropriated
information by later trading on such information learned through their company
A-related investment activities, venture investors should simply request
explicit permission to use such information as part of their investment term
US Supreme Court
The reader should note that it is not enough to read the SEC statutes, one
must also study how the courts interpret the law. Here we are fortunate to be
guided by a whole series of U.S. Supreme Court judgments that reinforce our
Cady, Roberts (1961) established the duty of an outsider, such as a brokerage
firm employee, to either disclose material, non-public information or abstain
from trading. It stated that outsiders “do not automatically have the special
obligation of corporate insiders, unless:…[F]irst, the existence of a
relationship giving access, directly or indirectly, to information intended to
be available only for a corporate purpose and not for the personal benefit of
anyone, and second, the inherent unfairness involved where a party takes
advantage of such information knowing it is unavailable to those with whom he is
dealing.” In the Cady, Roberts case, it was determined that there was a special
relationship between the trader and the corporation’s shareholders in which the
trade occurred, and that this special relationship applied to the tippee as
well. In Cady, Roberts, the defendants violated section 10(b) and Rule 10(b)-5
because they were under a fiduciary duty to the listed company’s shareholders.
But the case opened the door for people to trade on information where they had
no fiduciary duty. Two other cases: Investors Management Co (1971) and
Oppenheimer & Co (1976) gave further weight to this case and better defined the
types of insider information triggering the “disclose or abstain to trade”
In Chiarella (1980), and Dirks (1983), the Supreme Court reinforced the line
of reasoning, rejecting the contention that “mere possession of material
nonpublic information” imposes upon the possessor a fiduciary duty to disclose
or abstain from trading. In doing so, the Supreme Court reaffirmed that for a
Section 10(b) violation there must be a special relationship between the
corporation’s shareholders and the person trading on inside information.
“[T]here can be no duty to disclose where the person who has traded on inside
information ‘was not [the corporation’s] agent…was not a fiduciary, [or] was not
a person in whom the sellers [of the securities] had placed their trust and
confidence.’ ” Chiarella also defines “front-running” by indicating that certain
individuals such as lawyers, accountants and others may have limited but
special, confidential relationships with a corporation that gives them access to
information intended only for corporate purposes. These people must abstain from
trading because they are deemed to be “temporary insiders” until the
confidential information has been disclosed and absorbed by the market.
SEC v. Newman (1981) and SEC v. Materia (1985) established more clearly the
“misappropriation theory” (but see also the refinements below). These cases
changed the focus of Section 10(b) away from the defrauded purchaser or seller
of securities and instead focused on the trader’s relationship to the entity
from which the information was obtained. These cases determined that any breach
in duty to any person in obtaining the information—even if there is no breach of
duty to the purchasers or sellers of securities in the target companies—triggers
the “in connection with” requirement of Section 10(b). As such, if there is any
breach of duty to any party, then the breaching party is deemed to have
misappropriated information. In both these cases, each of the defendant’s
employers were temporary insiders of their clients, the acquiring companies, and
thus owed those companies a duty of loyalty and confidentiality. So, although
there was no fraud perpetrated by Messer’s Newman or Materia against the
buyers/sellers of any securities; those cases identified a duty running between
the defendants and the entities that were connected in some way to the
securities transaction from which the defendants wrongly profited. It should be
noted that in our proposed transaction, we stress that the investors in A must
take care (inter-alia) to have cleared their relationship with A and by
implication with the other investors in A about the use of the information.
Carpenter (1986) expanded on Newman and Materia in that there was no
confidential information breached related to the corporation’s securities when
certain trades took place. The only breach was that Mr. Winans, a writer for the
Wall Street Journal (and his tipee Carpenter), misappropriated for personal
profit the Wall Street Journal’s publishing schedule—which gave them market
information about the stocks that were to be covered in the Wall Street
Journal’s “Heard on the Street” column. The Second Circuit Court used Carpenter
to increase the scope of misappropriation theory related to securities fraud,
but the US Superior Court was split four to four and issued no opinion on the
securities fraud aspects of the case. Instead, Carpenter was convicted of mail
United States v. O’Hagan (1997) is the latest Supreme Court ruling and
defines current US law. It reaffirmed the misappropriation theory and “outlaws
trading on the basis of nonpublic information by a corporate ‘outsider’ in
breach of a duty owed not to a trading party, but to the source of the
information.” The majority of the Supreme Court justices conceded that “if Mr.
O’Hagan had informed his law firm of his intention to use the misappropriated
information to trade on the target stock, there would have been no section 10(b)
violation”. Justice Thomas pointed out that the fraud was to a third party—and
not to a party to the securities transaction. Thus the justices explicitly
discuss situations that encompass the strategies proposed in this paper.
In summary, the long line of judgments of the Supreme Court make it clear
that an investor in a disruptive innovating company can use “material, nonpublic
information” to trade in stock of rivals under section 10(b) of the Securities
Exchange Act of 1934, provided of course that the investor has no conflicting
fiduciary duty to either the disrupting firm A or the disrupted firm B.
According to March (1991) and Levinthal & March (1993), investors find it
hard to achieve satisfactory returns on projects that break new ground such as
new product development, new process development, new market development and/or
new organizational forms. Even though these investments may have significant
impacts in the markets where they appear, they carry high risk (Bebchuk and
Fershtman, 1994) and there are theory reasons to assume that the internal rates
of return may be poor (Teece, 1984; Leonard-Barton, 1992; Burgelman, 1994;
Barnett et al., 1994). The data cited in the opening paragraph of the paper
lends support to these theoretical views.
In the last decade capital markets have developed considerably and are more
willing to finance risky young ventures, and this has gone a long way to
righting this imbalance. The emergence of NASDAQ in the USA, AIM in London and
the Neuer Markt in Germany have provided a forum where owners of new firms can
capitalise on future uncertain profit streams and raise immediate capital on
their exploratory ideas. Whilst it is hard to link cause and effect, the
vibrancy of Silicon Valley is frequently ascribed to the existence of such
effective capital markets.
This paper goes one step further by explaining how vibrant capital markets
can provide another effective mechanism for assisting ventures in increasing
investment IRRs. When private investors fund a venture that poses a significant
entry threat, they may purchase a put option on its rival and so secure
additional returns to its as yet unannounced innovation. Upon announcement, the
reaction of the market in terms of the stock price generates an immediate gain
for the innovating firm. The investor does not have to wait for project
completion before reaping any reward. This added feedback is potentially short
and very powerful.
Linking our work to the work on real options
This paper has as its core the concept of options management. Our approach to
options is complementary but differs from the previous literature on real
options in the strategy field. We identify the availability of an embedded real
option that is present within investments made by early stage investors in
disruptive innovative companies. In our paper, this embedded real-option to
purchase a derivative in a stock-substitute bridges the financial and real asset
markets by enabling the investors in disruptive company A to create a contract,
effectively, with the customers of disrupted company B just prior to the point
in time when the disruption will occur.
Our suggested use of financial options instruments for bridging the financial
and real asset markets supports the real options approach to increasing value by
flexibility as noted by Leslie & Michaels (1997), Dixit & Pindyck (1994, 1997),
and Luerhman (1997, 1998). And our ideas are consistent with the logic of firms
developing a portfolio of new ideas (Bartlett & Ghoshal, 1993; Nonaka, 1994
1998; McGrath & MacMillan, 2000).
The idea that investors can use financial markets to increase value has a
parallel line of reasoning in the alliance literature. Writers such as Teece
(1996) have long stressed the importance of complementary assets and their role
in risky projects has been explored (Kogut, 1991; Bowman & Hurry, 1993; Sanchez,
1993; and most notably, McGrath, 1997, 1999). Yet partnerships have a downside.
They are notorious for their lack of clear governance mechanisms when compared
with ownership contracts. The success of alliances formed by firms is reported
by managers to be as low as 50% (Kale, Dyer and Singh, 2002). There is a chance
that the agreement will incur high costs if a party does not deliver. The
relatively high rate of failure of alliances can be associated with specific
relational risks that arise from risks of partner opportunism, conflicting
objectives, and misunderstandings that arise in addition to the standard
performance risks that all entrepreneurial business activities face (Das and
Teng, 2000). The need to create mechanisms such as trust to overcome these risks
has been stressed by Powell, 1990, and Ring & Van de Ven, 1992. Although
contracts can be written to try to prevent such events, the contracts are
typically incomplete and hard to enforce.
Our use of financial options markets to raise value does not go against any
of these moves, but has many intrinsic benefits that are not shown in alliance
contracts. Options contracts are simple, well regulated and have the merit that
there is a secure counter party that delivers the benefits.
In the context of the entrepreneurship literature we place our contribution
as a new strand of thinking that bridges entrepreneurial finance and strategy.
We argue that investors of ventures can use the financial markets to add value
to projects that threaten to disrupt incumbent firms by forward trading in the
stock of prospectively disrupted firms. This requires the use of asymmetric
knowledge. By making a profit on the trade in the disrupted firm’s stock the
investors are able to recapture from the market some extra profits (equivalent
to the value of the consumer surplus) generated by the innovation. Option
trading also gives exploration projects an immediate cash injection, reducing
Our paper provides guidance to how these effects arise, how valuable they
are, and some of the regulatory and practical issues. We suggest that direct
observation of these trades is likely to be difficult, but we provide
potentially testable propositions that can be used to identify if such trading
does occur. We believe that we have given a new dimension of financial strategy
for venture finance and a fruitful avenue for discussion and research.
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