Finance implications of a patent race in a real options setting

This dissertation aims to integrate a finance perspective and an industrial organization (IO) perspective on a patent race by using a continuous-time real-options methodology.; In the first chapter, two start-up firms controlled by venture capitalists compete to invent a new technology. Only the winner can receive the patent and the loser will get nothing. Duopoly competition for the patent is modeled as a game in which there are three publicly observed stochastic state variables: the value of the patent and the expected cost-to-completion of each of the two firms. Using numerical approximations to this continuous-time game, we develop a discrete-time implementation on a 201 x 61 x 61 grid with 600 monthly decisions, through which we examine several financial properties of start-ups evolved in the patent race. Strikingly, the magnitude of each firm's return volatility can be in excess of 100%. The high return volatility mainly comes from these firms' technologic uncertainty. Each firm's CAPM beta is a complicated nonlinear function of its position in the race.; The second chapter extends the model in the first chapter to study a patent-race game in which a firm with larger research bandwidth competes with a firm with smaller bandwidth. The large firm is allowed to make strategic investments or acquisitions in the small firm subject to transactions costs. Although strategic investments and acquisitions prevent value-dissipating investments, the exogenously imposed transactions costs make such transactions costly. The large firm's optimal acquisition decisions strike a balance between these costs and the synergy value. We find that acquisitions occur in two conditions. One is when the small firm is about to make pre-emptive investments. The other is when the large firm has setbacks and the two firms are about to enter head-to- head competition. So acquisitions occur to change either the small firm or the large firm or both firms' incentive to enter competition. Strategic investments occur when the smaller leader has technological setbacks. In this situation, strategic investments mainly change the large firm's incentive to make inefficient investments. Our continuous-time approach shows that some intuitively rich strategic play can occur in equilibrium.