Compensation measures for alliance formation: A real options analysis

This paper presents a real options model of alliance formation between two firms for entry into a new market. We analyze how different compensation measures affect the alliance timing and option values. Generally, when profit structures of the two firms before and after an alliance are different, their individually optimal alliance timings do not coincide. Therefore, achieving an agreement on a common alliance timing becomes an important issue. To promote alliance formation, we examine two feasible compensation measures provided by one firm to the other: share adjustment (flow compensation) and subsidy (lump-sum compensation). We find that subsidy induces an earlier alliance, although share adjustment is Pareto optimal in terms of the joint option value.