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The Governance Structure of International Joint Ventures

Property Rights and Transaction Cost Explanations

Sonja Horvath (Remetic)

Doctorate candidate

Center for Business Studies

University of Vienna

Brünner Str. 72

A-1210 Vienna, Austria

Sonja.Remetic@gmail.com

November, 2011

Abstract

This paper explores the determinants of ownership and residual decision rights in international joint

ventures (IJVs) by developing a theoretical framework based on the property right and transaction cost

theory. According to the transaction cost theory, environmental uncertainty (consisting of market,

legal and political as well as cultural uncertainty) impacts the allocation of decision and ownership

rights between the joint venture partners. Using the property rights theory we operationalize control by

differentiating between residual decision and ownership rights (e.g. Grossmann, Hart 1986; Baker et

al. 2008). The thesis of the paper is: The more important the JV-partner‘s intangible knowledge assets

relative to the other partner for the generation of residual income and the higher the environmental

uncertainty, the more residual decision and ownership rights should be assigned to her. Specifically,

we focus on three environmental determinants under the transaction cost perspective: cultural distance,

political and legal uncertainty and market uncertainty. Empirical results from joint ventures in the

CEE provide some support of the hypotheses.

KEY Words:

Joint ventures, intangible knowledge assets, residual decision rights, ownership rights

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1. Problem

This paper explores the relationship between ownership and the allocation of residual decision

rights in international joint ventures by applying the theoretical framework of property rights

and transaction cost theories. The balance of ownership that leads to improved performance

is likely to depend on the resources each partner contributes into the joint venture and the

resources of the nation in which the venture is established. In other words, the criticality of

the resources committed to a JV affords a parent some control independent of its equity share.

In addition, equity ownership levels may actually be related to the bargaining power secured

to partners by the resources they possess. The question of ownership and residual decision

rights is extremely important for the organization, operation and performance of international

joint ventures.

Neither the property rights theory, nor the transaction cost theory can explain this

problem alone. The theoretical grounds of transaction cost theory view the allocation of

decision rights as firm’s attempt to reduce the risk-associated transaction costs.

By using the property rights theory we operationalize control by residual decision and

ownership rights (e.g. Grossmann, Hart 1986; Baker et al. 2008). The thesis of the paper is:

The more important the JV-partner‘s intangible knowledge assets relative to the other for the

generation of residual income, the more residual decision rights should be assigned to her. We

focus on three determinants of the transaction cost perspective: cultural distance, political and

legal uncertainty and market uncertainty.

Globalization, increasing challenges in inter-firm competition and technology

advancements require more flexible organization forms, which give rise to partnerships

between firms (Webster 1992).

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It has become difficult to stay competitive without joining forces with other companies

(Ohmae 1989, Webster 1992). Firms in a weaker position may leverage themselves against

dominant players through alliances (Child & Faulkner, 1998).

In last couple of decades, International Joint Ventures (IJVs) have become a favourite

component of corporate strategy to support firm’s appetite for growth in international markets

(Ding, 1997; Duan, 2007; Dunning, 1995; Li, 2003; Meschi & Riccio, 2008; Luo & Park,

2004). However, despite their popularity IJVs often experience managerial difficulties and

often fail to achieve the goals their founding members aimed for (Park & Ungson, 2001). As a

direct outcome, it is said that joint ventures in particular undergo high failure rates (Harrigan,

1988; Kogut, 1989; Inkpen & Beamish, 1997; Reuer, Zollo, & Singh, 2002; Luo & Park,

2004; Mohr & Spekman, 1994). IJVs eventually break up at a rate of between 30% and 70%

of their total formation (Geringer & Hebert, 1991; Yeheskel, Newburry & Zeira, 2004;

Hennart et al., 1998). This effect is especially seen when IJV managing partners follow

different objectives for their newly started endeavour (Pearce, 1997; Shenkar, 1990). Official

reasons for IJV failure are manifold. The available literature is abundant with firm grounds

why failure rates may be high (e.g. Franko 1971; Gomes-Casseres 1987; Pearce 1997), one of

these reasons being the control problems between IJV management, and the grounding

partners (Groot & Merchant 2000; Sherman 1992; Groot and Merchant 2000; Chalos and

O’Connor 2004; Porporato 2006). Besides the new operating environment in a foreign

market, carrying high degrees of uncertainty and risk the parent firms in IJV may well have

differing interests when it comes to their goal realization and management. Lacking the

possibility to exercise sufficient control over the IJV can limit the capacity of the parent to

effectively coordinate his activities, make the most of their resources and effectively

implement its strategy. Control is an effective way to tackle the risk of opportunism, IJV

foreign parent firms are faced with (Zhang & Li, 2001).

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Such considerations and other governance decisions become particularly relevant as

the terms of a joint venture are negotiated. Decisions made during this period are critical for

the future and success of the entity, as it is usually more difficult to make major governance

changes after the JV has been established. Partners have a number of issues to consider,

including the level of equity ownership of each and the division of management

responsibility. What takes place in the stage of IJV governance structure negotiation is not

final governance structure we will see all throughout the lifetime of the IJV – it is more a

dynamic process which will keep occurring throughout the IJV activity. Or as Kogut (2002)

puts it so well: “no matter what the initial agreement on control and ownership may have been

at the start of a venture, environmental change over time may shift the relative bargaining

power among partners”. These changes, which may result in a shift of partners’ bargaining

power, have their root in inter-partner learning, changes in resource allocations, industry

structure, and volatility in host government’s regulations on foreign investments.

Organizations will continuously keep changing their structure (Nielsen, 2007). On the one

front IJVs will embrace these dynamics and on the other they will strive towards (especially

inner) stability. Environmental factors are crucial for the stability of IJV’s (Harrigan, 1985)

and therefore it is of no surprise, that IJVs will reconfigure their control designs in order to

keep apace with these changes. In more detail, Yan and Zeng (1999) and Zhang and Li (2001)

argue that evolution of control design is dependent on extraneous variables such as changes in

government policies and competitive environment.

Luckily, the advantages still overcome the disadvantages for IJV formation and the

reasons foreign parent firms enter joint ventures take many shapes and forms. Kogut (1988)

summarizes three main motives for IJV formation to be cost reduction, strategic behaviour,

and learning. Makino suggests the following classification of motives for entering IJVs

(Makino 1995): accessing the partners’ proprietary resources, and achieving economies of

scale and scope. However, the most comprehensive motive behind IJV formations of foreign

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parent firms is to gain access to local firm’s proprietary resources such as firm-specific

knowledge and most of all country specific knowledge. In that sense, local firms may not

have the state of art management know-how and technology (Luo et al., 2001), but they can

often contribute their country specific knowledge, land, and manufacturing facilities (Killing,

1983) to the newly formed legal entity. Motives behind IJV formation are especially

important, as previous literature concludes when the strategic motives of parent firms

determine their control in IJVs (e.g. Calantone & Zhao, 2001). Could it be that the primary

problem in managing IJVs stem from this one single nuisance: There is more than one parent

in IJVs (Killing 1982)? Thus, the ability of the owners to exercise control over the joint

venture is a function not only of its influence over its joint venture managers, but also of the

influence over the other parent (Child et al. 1997). Lorange et al. (1986) maintain that through

exercising a proper IJV control structure, foreign parent firms can make sure that their

strategies are effectively implemented, and their resources are efficiently utilized in order to

maximize IJV’s performance.

In order to add some colour to the governance structure considerations we will apply

two different perspectives, which help explain the choice for IJV ownership and decision

rights structures: transaction cost and property rights perspective.

With the property rights perspective, we look at the IJV governance structure as a product of

parent’s resources utilization in the alliance. These resources may be implicit (contractible)

such as equity, machinery etc. and tacit (or non-contractible) in form of know-how such as

production skills, efficient management, knowledge of local markets etc. The property rights

perspective will help to understand this relationship between the equity (ownership) and

decisions the parent is entitled to make based not only on his stake in equity but also on

know-how which cannot be contracted for in the joint venture contract. The application of the

property rights theory allows us to argue that the arrangement of residual decision rights and

ownership stake in joint ventures will depend on the allocation of intangible knowledge assets

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between the joint venture partners. Based on that notion we can go ahead and argue that the

more significant the joint venture partner's knowledge assets are for the generation of residual

surplus, the more residual decision rights will be assigned to her. But the property rights

theory cannot explain the structure of decision rights and ownership stake alone, and in

addition we apply the transaction cost theory. The transaction cost theory (TCT) is one of the

driving perspectives in the theory of the firm, and the main idea behind this view is that firms

are created in order to reduce the costs which accrue when performing transactions in the

market such as the costs of mal-adaptation, haggling, setup and running and bonding (Coase,

1937). The TCT rests of a few assumptions, namely that all contracts are considered

incomplete, and under the assumption of bounded rationality (individuals are not able to see

all of the possible outcomes before they take place) and uncertainty influences the optimal

institutional arrangement. Following this logic, the relationship between residual decision

rights and ownership rights in joint ventures can be summarized as follows: The institutional

arrangement will be effected by host country uncertainty (market uncertainty, cultural

uncertainty, and political and legal uncertainty) in such a way that the foreign parent will

forego a certain portion of ownership and residual decision rights for the benefit of the local

parent. As Campbell and Reuer (2001) put it so nicely: it may even be in the partners' best

interest to leave contracts incomplete. If the contracts are too detailed on the account of the

partners' responsibilities, this may limit the joint venture's operational flexibility and could be

interpreted as too meticulous in court, nevertheless complicating management and conflict

resolution. Instead, the joint venture partners will often remain on general terms of agreement,

installing less detailed areas of influence in order to remain flexible and uncomplicated. And

as praxis has it, many firms enter joint ventures as an in-between stage towards acquisitions

(Balakrishnan and Koza, 1993). Kogut (1991) sees joint ventures as call options, or options to

buy (outright acquisitions) at some future point in time.

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In general, many other theories have been applied in the research of joint ventures.

These theories can broadly be classified into economic theories and managerial or

organizational theories, and the aspects being investigated can be divided into organization,

operation and performance of JVs (Child et al. 2005; Robson et al. 2002). The most

reoccurring topics have been studied in great depths and so for example, Taco and William

(2004) conduct a major study on international joint ventures by reviewing ten major journals

for the period of 15 years between 1988 and 2003, and identify 388 different studies dealing

with IJVs among which control in international joint ventures was subject of 15 studies, while

most IJV studies focused on the entry mode strategy (57/388), the partner learning (39/388),

and the partner selection (28/388). However, research on uncertainties facing IJV remains

scant.

In addition, what remains unexplored is the application of the property rights theory to

the research of IJV. There are many empirical and theoretical study focusing on the

distribution of residual decision rights in organizational economics (Aghion, Tirole 1997;

Christie et al. 2003; Baiman, Larcker, Rajan 1995; Nagar 2002; Arrunada et al. 2001; Lerner,

Merger 1998; Desai, Foley, Hines 2004; Kaplan, Stromberg 2003; Elfenbein, Lerner 2003;

Gil 2005; Hendrikse 2005; Vázquez 2005), but due to the complexity of data extraction

methods, particularly when it comes down to gathering information on intangible knowledge

assets and decision rights between partners, the property rights perspective applied to IJVs has

diligently been avoided in the past. Control considerations have also been a subject in the

international management literature (Killing 1983; Schaan 1988; Geringer, Hebert 1989;

Mjoen, Tallmann 1997; Chalos, O’Connor 1998; Calantone, Zhao 2000; Pangarka, Klein

2004; Choi, Beamish 2004). Unfortunately, control is still a very heterogeneous concept in the

international management literature and only partly related to decision rights. In a number of

studies control has been modelled by relative degree of ownership and/or a high level of

management control and/or a high level of control of specific activities (Blodgetts 1991a,

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1991b; Gray, Yann 1992; Mjoen, Tallman 1997; Yan, Gray 2001), making the comparison

more difficult and generalization of results next to impossible.

In order to overcome these issues we consider the necessity of a standardized measure

of control in IJVs and define it as the allocation of residual decision rights (Hansmann 1996;

Nagar 2002; Elfenbein, Lerner 2003; Windsperger 2004) along the lines of contribution of

critical resources. This approach rests on Rajan and Zingales’ concept of access to critical

resources (Rajan, Zingales 1998; 2001) under which they show that power in an organization

is a direct product of control over critical assets that generate the residual income stream. In

other words, the partner who has the best access to assets critical for network surplus

generation will have a higher degree of control.

Our main contribution to the joint venture literature is the following: First, we present

a property rights and transaction cost view on the allocation of residual decision and

ownership rights in joint ventures, and second we empirically investigate the structure of

decision and ownership rights in Austrian joint ventures with Central and Eastern European

partners. As a result of our study the available data confirms the hypothesis that the joint

venture partner’s intangible assets positively influence the proportion of residual decision

rights which will be allocated to that partner.

2. Theory Development

For the purposes of this paper we analyse the following situation: An Austrian-based

Company (JVP-1), on pursuit of international experience decides to enter into an IJV with a

local partner (JVP-2) in one of the countries in Central and Eastern European economic area.

The Austrian partner dedicates a certain volume of financial assets in order to formally

purchase a stake in the new entity. International Joint venture means that the parent

companies simply originate from different countries and a certain degree of cross-border

transaction is necessary. The newly formed, separate legal entity, strives towards maximizing

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financial returns both utilizing tacit and implicit factors of production and partner’s

investments in these assets. Now, two possible scenarios arise:

Figure 1. Structure of an international joint venture

The partner companies creating a joint venture firm face the problem of maximizing the

returns to the intangible knowledge assets committed to the new venture, while both being

dependent on individual contributions of each parent.

We assume in this case that the intangible knowledge assets of the Austrian parent company

comprise of, in the first line knowledge and skills (organizational capabilities) in product

development, procurement, production and branding. The local partner exhibits significant

non-contractible knowledge on the local market, cultural and institutional know-how and

human resource capabilities (Lecraw 1984; Fagre, Wells 1982; Hennart 1988; Nakamura

2005).

In our first scenario, the Austrian parent company has a large volume of intangible

knowledge assets in managerial and product know-how, whereas the local partner is better

equipped with knowledge on local market movements and has a better approach to local

human resource management. This know-how is less intangible and can be better integrated

into a contract. Austrian parent’s know-how assets are determinant for network surplus and

more difficult to make a subject of a contract. Due to this disparity a large fraction of residual

Joint Venture Partner 1

(JVP1) – Austrian company

investing in foreign country

Joint Venture Partner 2

(JVP2) – local partner

Joint Venture (JV) – equity

joint venture

Joint Venture Partner 1

(JVP1) – Austrian company

investing in foreign country

Joint Venture Partner 2

(JVP2) – local partner

Joint Venture (JV) – equity

joint venture

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decision rights should be allocated to him in order to maximize the joint venture’s residual

income stream. In a different scenario, it is the local partner who is in possession of surplus

determinant intangible knowledge assets such as local market knowledge and cultural know-

how. The foreign joint venture partner is entering the alliances by bringing in assets which are

easier to contract in for. During the governance structure considerations the allocation of

residual decision and ownership rights should take place based on the assessment of both

partners’ know-how assets. This scenario shows that the local partner is in a stronger

bargaining position and as a general rule of thumb more residual decision rights should be

transferred to him.

There are several implications to be drawn from these two different scenarios.

Inefficiencies arise when the conditions are not fulfilled with the following effects for both

partners and the joint venture: in the first case inefficiencies will arise because residual

decision rights are allocated to JVP-2, although the JVP-1 is in possession of intangible

knowledge assets critical for generating a large portion of the total residual income stream of

the operation. In the second case inefficiencies arise because a small portion of residual

decision rights is transferred to JVP-2, even though it is the JVP-2 who possess a large

portion of intangible knowledge assets. An unsatisfactory condition is created because the

joint venture decisions are made and influenced by the partner, who even though he does not

have the residual income generation-relevant knowledge assets to do so. The more important

problem arising out of this scenario is that the residual surplus of a joint venture cannot be

maximized if there is a disparity between the distribution of intangible knowledge assets and

the allocation of decision rights.

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2.1. Property Rights Theory

The property rights theory explains the allocation of residual decision rights in

organizations by using the notion that the allocation of ownership and residual decision rights

depends on the distribution of intangible knowledge assets that generate the firm’s residual

surplus (Baker et al. 2004; Baker, Hubbard 2003, 2004; Windsperger, Yurdakul 2007). One

of the most significant contributions to the property rights view is the well known GHM

Model (Grossman, Hart 1986; Hart, Moore 1990). The literature distinguishes between the

“classical” and the “modern” GHM Model. The ‘classical’ form of property rights theory

gives more consideration to the historical and institutional context that shapes and changes

property rights (and therefore led to ‘getting the incentives right’). The ‘modern’ version of

property rights theory, uses advanced mathematical tools and stylized modelling of ownership

and incentive structures. We conduct this study using the additions from the latter model.

The initial streams of property rights research highlight the view of shared ownership

and provide multi-dimensional definitions of property rights and ownership that can help us in

our intention to explain business trends that are neither market nor hierarchy, such as joint

ventures (Hennart, 1993). We draw on this assumptions and suggest that the more important

the joint venture partner‘s intangible assets relative to the other partner for the creation of

residual income of the joint venture, the more residual rights of control (decision and

ownership rights) are transferred to her/him. But which intangible assets do partners invest in

and bring into the joint venture? International business literature identifies knowledge assets

(know-how) and distinguishes between (organizational capabilities) in product development,

procurement, production and branding, and on the other hand the know-how on local market

access, cultural and institutional know-how and human resource capabilities (Lecraw 1984;

Fagre, Wells 1982; Hennart 1988; Nakamura 2005). Following Baruch Lev there are three

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main “nexuses” of sources of intangibles (often a particular intangible asset is created by a

combination of these sources): discovery (innovation), organizational practices, and human

resources.

In our study, and based on the views presented here we distinguish between two types

of intangible knowledge assets: strategic and operative intangible knowledge assets. Strategic

intangible knowledge assets (see appendix) include know-how on corporate planning,

controlling, financing, organization, and strategy formation and fall under organizational

practices. Operative intangible knowledge assets include know-how on all activities requiring

human contact such as marketing, human resources, sales, services. We state the following

hypothesis:

H1a: The higher the strategic intangible knowledge assets of JVP-1, the higher is

JVP-1’s portion of residual decision rights.

The more know-how the Austrian partner has on corporate activities such as strategy

formation and other organizational practices which establish a degree of efficiency in the

organization the more residual decision rights should be allocated to him. On the other hand

the more know-how the foreign partner has in the host-country on activities such as marketing

to potential customers, hiring and firing, sale and post-sale services the more impact he will

have on the generation of network income, and the more residual decision rights should be

allocated to him.

H1b: The higher the operational intangible knowledge assets of JVP-1, the higher is

JVP-1’s portion of residual decision rights.

According to the property rights view the allocation of ownership rights depends on the

distribution of intangible (non-contractible) assets: The more important a person’s intangible

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knowledge assets for the generation of the residual income relative to another person, the

more ownership rights should be assigned to that person. Starting with this assumption we

draw the following hypothesis:

H2a: The higher the intangible strategic knowledge assets of JVP-1, the higher is

JVP-1’s portion of ownership rights.

Analogous hypothesis are to be drawn for the relationship between intangible operational

knowledge assets and ownership rights:

H2b: The higher the intangible operational knowledge assets of JVP-1, the higher is

JVP-1’s portion of ownership rights.

Empirical literature on the determinants of ownership and decision rights choice structures

has often delivered inconsistent findings. We have already mentioned the lack of rigour in the

use of different theoretical perspectives (and therefore different definitions of the same

concept which we are not standardized and comparable) but some of the inconsistencies may

be caused by the existence of unrecognized moderating effects and differences in research-

design methods. The mixed findings regarding the relationship between the bargaining power

and allocation of ownership and decision rights may also be due to the fact that the experience

of joint ventures (time) moderates this relationship. We will offer an alternative way to deal

with this issue, irrelevant of the predicted sign of this relationship:

H2c: The influence of intangible knowledge on decision and ownership rights allocation will

vary with the time as the bargaining power shifts (Moderating Effect).

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2.2. Transaction Cost Theory

In the transaction cost literature, external uncertainty is described as the degree of inability to

predict the firm’s future environment. In highly uncertain situations TCT predicts firms to

avoid ownership (Williamson, 1979). He recommends measures for firms to maintain their

flexibility and transfer the risk to outside parties. In a fast changing environment committing

resources to one operation proves inadequate for a degree of control over the operation is lost,

when the firms are not able to reallocate their resources ahead of negative externalities. The

uncertainty of the new, external environment is better known as “country risk”, which appears

in different shapes and sizes. Herring (1983) defines “country risk” as a combination of

political instability, economic fluctuations and currency changes. Kumar and Seth (1998), see

host country uncertainty as the complexity and volatility of environmental factors. This

uncertainty can be high due to physical and cultural distance, volatile host-government

political and legal framework, and other specific factors (Pangarkar & Klein, 2004).

Firms act in response to unpredictability by making use of control in order to administer their

volatile dwellings and solve disagreements (Killing 1982; Bivens and Lovell, 1966). The

design of control dimensions in IJVs is highly dependent on the level of uncertainty (Johnson

et al., 2002) which in turn affects management control systems. Govindarajan and Shank

(1992) note that different units of the same country, based in countries of different levels of

uncertainty will require systematically different management control systems. The

environmental uncertainty is defined as the complexity and volatility of the environmental

factors (Duncan 1972; Dess & Beard 1984), these factors being further described as

unexpected changes in regulation, legislation, judicial decisions, interest rates, or changes in

demand (Kumar & Seth, 1998).

Further on, the transaction cost perspective focuses on exploiting existing capabilities

and dealing with external uncertainty, the property rights theory focuses on enhancement of

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capabilities, in particular intangible resources and assets of the firm (Brouthers and Brouthers,

2000). What is particularly relevant for our study is the host-country uncertainty. Uncertainty

refers to the difficulty or inability to predict the environment (Miller, 1992), or to the

unpredictability of changes of some factors (Brouthers, Brouther, & Werner (2003). Host

country uncertainty in this academic enterprise refers to the following factors: cultural

uncertainty, competitive uncertainty, and environmental uncertainty (Gatignon and Anderson,

1988:315).

Speaking of flexibility, foreign markets are often plagued by the increasing amount of

new competitors. In order to stay competitive, the IJVs need to react fast to changing

environment. Sanchez-Peinado & Pla-Barber (2006) argue that when international joint

ventures partners are faced with unexpected changes in demand, they tend to adopt looser

control structures allowing the IJVs to enjoy greater flexibility in handling these changes.

Therefore, as the environmental uncertainty rises, the need for flexibility increases which

opposes the TCT assumptions. Williamson (1979) hypothesizes that firms should react to

volatility by avoiding ownership, since it commits them to one operation that may not be

appropriate when the next environmental shift occurs. Rather, firms should retain flexibility

and shift risk to outsiders. Opposing this view, we expect that:

H3a: The higher the political/legal stability in the host country, the higher is JVP-1’s

portion of residual decision rights.

Shan (1991) researched the relationship between the foreign firms’ stake in IJVs and

the political risk of the host country. Brouthers and Bamossy (1997), while studying the role

of key stakeholders in the IJV negotiation process, also focused on the influence of the host

country government on IJVs. Pan and Tse (1996), when discussing the cooperative strategies

between foreign firms in China, suggested that the foreign firms involved in IJVs tend to

cooperate with one another when the level of risk in the country increases. For example

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Hennart (1988) sees international joint ventures may sometimes as powerful vehicles to

overcome local country hostilities towards wholly owned subsidiaries. So far scholars have

either focused on single determinants, such as political risks (Clark & Tunaru 2001), cultural

distance (Kogut & Singh 1988) or sovereign risks (Cantor & Packer 1996) or when applying a

more sophisticated approach – a bundle of factors known as country risk (Hoti & McAleer

2004; Krayenbuehl 1985; Erb, Harvey & Viskanta 1996). Drawing on the TCT we argue that:

H3b: The higher the political/legal stability in the host country, the higher is JVP-1’s

portion of ownership rights.

A particularly compelling form of host-country uncertainty is created by perceived cultural

distance between the partners involved. Gert Hofstede pioneered research on this topic often

stating that, "Culture is more often a source of conflict than of synergy. Cultural differences

are a nuisance at best and often a disaster”. Naturally, may recommendations have been made

on how to capture cultural distance. Kogut and Singh's (1988) cultural index is clearly the

most popular approach to measure cultural distance. The difference between home and host

cultures is extremely difficult to measure, but has never the less managed to capture the

attention across disciplines. So how does cultural distance impact the allocation of ownership

and decision rights across joint ventures? Well, it has often been stated that the greater the

cultural difference between the partners from different companies, the lesser degree of control

should be demanded by the foreign partner (Buckley et al. 1999). When firms enter foreign

countries, they first need to transfer their business methods to a new setting, train their agents

accordingly, making sunk-investments in the new operation. These investments become

transaction-specific and are of little use to other firms in that country. The literature agrees on

the notion that the higher the socio-cultural distance between home and host countries, the

lower the degree of control which will be demanded by foreign investors (Davidson, 1982;

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Anderson and Gatignon, 1986; Kogut and Singh, 1988; Gomes-Casseres, 1989; Agarwal and

Ramaswami, 1992; Larimo, 1993, 1994; Benito, 1996). Therefore the TCT states:

H4a: The higher the cultural uncertainty in the host country, the higher is JVP-2’s

portion of residual decision rights.

The greater the cultural distance between two countries, the greater the risk perceived by the

entrant and the perceived degree of difficulty persists when transferring values, management

practices and operational systems, therefore the need for host-country knowledge will

increase. Firms form joint ventures as an effective way to gain access to such knowledge and

accumulate market-specific know-how, as anything else such as actual operational experience

would take a considerable amount of time (Hennart, 1988; Kogut, 1988).

H4b: The higher the cultural uncertainty in the host country, the higher is JVP-2’s

portion of ownership rights.

When IJVs are facing a higher degree of host country uncertainty, compared to the home

country, the foreign parent firms may need to provide the IJVs with more self-government in

decision making, and to allow them to be more flexible in order to deal with uncertainty in an

appropriate and competent way. Peng and Health (1996) suggested that when operating in an

unknown environment such as China, the foreign parent firms may need to rely on the local

parent firms to obtain the needed resources, therefore willingly transferring a significant

portion of control to the local parents. Calantone and Zhao (2001) add that for the parent firms

that are unfamiliar with new markets, acquiring local knowledge about customs and processes

in the new environment should be of major concern rather than the control issues. This

situation arises because of the IJVs proximity with the changing environment and their first

hand knowledge of these particular situations (Lewis, 1990). Furthermore, Kumar and Seth

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(1998) deliver arguments that complex control is not efficient when managing the relationship

between the IJV and its parents in circumstances of high environmental uncertainty.

H5a: The higher the market uncertainty in the host country, the higher is JVP-2’s

portion of residual decision rights.

H5b: The higher the market uncertainty in the host country, the higher is JVP-2’s

portion of ownership rights.

3. Empirical Analysis

3.1. Data and Measurement

The empirical settings for testing these hypotheses are the parent Austrian joint ventures

formed with partner companies in Central and Eastern Europe. We used a questionnaire to

collect the data from a sample of 450 Austrian companies maintaining foreign direct

investments in one of the Central and Eastern European countries. The questionnaire took

approximately 15 minutes to complete. We received 60 responses, which brings us to a

response rate of 13.3%. To trace non-response bias, we investigated whether the results

obtained from analysis are driven by differences between the group of respondents and the

group of non-respondents. Non-response bias was measured by comparing two groups of

responders between March 2005 and October 2005 (Amstrong & Overton 1977). No

significant differences emerged between the two groups of respondents.

To test the property rights and transaction cost hypothesis the following variables are included

in the regression analysis: intangible knowledge assets – operational (JVP-1 and JVP-2),

intangible knowledge assets – strategic (JVP-1 and JVP-2), residual decision rights (strategic

and operative for both JVP-1 and JVP-2), ownership stake, uncertainty (market, culture,

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political & legal), as well as firm size (JVP-1 and JVP-2) and age, as control variables (see

appendix).

Intangible Knowledge Assets (KNOW): The joint venture partner’s intangible assets

refer to the specific knowledge of local markets, distribution channel, procurement, human

resource management, technological know how, organizational capabilities, and knowledge of

cultural and the institutional environment. In the questionnaire the general managers of the

CEE JV-companies were asked to rate on a seven-point scale (1- no extent; 7 – to a very large

extent) their contribution to the intangible assets of the joint ventures in different functions of

the value chain. The know-how contributions of each partner where asked for 12 different

functions, which they bring into the joint venture (see appendix). The indicator of knowledge

assets addresses the extent to which JV-partner 1 adds new knowledge in each of the twelve-

items.

For each partner we ran a factor analysis on the intangible knowledge assets, which in

turn extracted two distinct factors which we name strategic and operational intangible

knowledge assets. We state that the intangible knowledge assets of each partner consist of

both strategic management and day to day operative business activities. Thus, the joint

venture partner’s intangible assets refer to the specific knowledge of strategic factors

(corporate planning, controlling, financing, organization, strategy) and operational factors

(marketing, human resources, sales and services). For the further regression analysis two

variables are formed using the above items computed by applying means.

All variables loading on the same factors had a loading in excess of 0.7. For the total

amount of variance explained by the factor solution and individual Cronbach Alpha values see

Table 1.

20

Cronbach’s Alpha JV-Partner1 JV-Partner2

Intangible Knowledge

Assets Strategic .856 .981

Intangible Knowledge

Assets Operational .823 .806

Total Variance Explained 65.431% 68.836%

Table 1. The reliability of Intangible Knowledge Assets was assessed by Cronbach’s

alpha.

Residual Decision Rights (DR): The item of decision rights (DR) measures the allocation of

decision making authority among the joint venture partners. The residual decision rights in

our data set gather information on the influence of JV partners over the following decision

making activities: strategic decisions, organizational decisions, product decisions, price

decisions, hiring, wages, training, production decisions, marketing measures, advertising

decisions, suppliers, investment projects, lenders, financing, accounting, and cooperation

partners. The measure of decision rights addresses the degree to which residual decisions are

influenced by JVP-1 compared to JVP-2. We again take the average of the items loading on

the two factors, as reported by the factor analysis. The average of these rating is a measure for

distribution of the decision making power in the joint venture company and was previously

used in retail banking as Nagar’s measure of decision rights (Nagar, 2002;) and

Windsperger’s measure of decision rights in franchising networks (Windsperger, 2004). The

executive managers of the joint venture companies were asked to rate the joint venture

partner's influence on these decisions on a seven-point scale.

21

Ownership Rights (OR): The joint venture partner’s ownership rights (OR) are measured by

the percentage of asset ownership of the joint venture partners in the joint venture company (=

equity ratio).

Uncertainty (UNCERT): The Austrian joint venture partners (JVP-1) were asked to rate the

different sources of uncertainty in the host country market on a five-item scale (see

Appendix). The factor analysis resulted in three factors which we identified as follows:

cultural distance, market uncertainty, and political & legal stability (will be included in the

regression equation with an opposite sign due to the wording in the questionnaire).

We further control for additional variables which may have an influence over the allocation of

decision and ownership rights in joint ventures such as the size of the JVP-1 and the

experience of the IJV measured in years.

Firm Size (SIZE): We include both the log value of the number of employees for the Austrian

partner in his home country, and the log value of the number of employees of the JVP-2 in the

host country (country of the IJV). Organization size is a powerful explanatory variable

regarding organization performance (Weinar and Mahoney, 1981; Wernerfelt and

Montgomery, 1988. In addition, Blau (1970) finds that organization size plays an important

role in organization information processing. Larger companies simply have more resources to

monitor IJV activities, whereas smaller companies may react to changes faster in pursuit of

their interests, and their agility may spur issues with their partners. The amount and quality of

information and knowledge being exchanged between top and middle management may also

be directly influenced by firm size. Larger organizations tend to keep an entire portfolio of

culturally diverse border-crossing operations, whereas smaller firms absorb cultural

differences more slowly, as a result of their relatively scarce portfolio of foreign operations

22

(Erramilli et al., 1997; Gomez-Mejia and Palich, 1997). In our case the parent size is modelled

after the global number of parent firm employees (Hennart and Park, 1993; Hennart et al.,

1996; Larimo, 1997; Hartzing, 1998). Drawing on this research we state that the larger the

size of the parent firm, the larger its coordination and monitoring capacity, the more easily the

parent firm can control the joint venture company, and hence the lower the propensity to

transfer residual decision rights to the other partner.

Joint Venture Experience (AGE): Age is a frequently used operational measure determining

stability in terms of prolonged existence of the joint venture. Age of the joint venture (tsurvey

– tIJV formation) is an important determinant of the success and growth for international joint

venture (Sapienza, Almeida and Autio, 2000). For example, studies report that the longevity

of equity the joint venture contract has the influence over the degree of foreign ownership in

Chinese joint ventures (Pan, 1996; Shan, 1991; Chadee and Qiu, 2001). Projects of longer

duration give foreign firms time to familiarize themselves with the business environment

without being under time pressure to conduct business. Thus, the foreign partner (in our case

JVP-1) is more likely to seek a higher level of equity ownership as the duration of the JV

contract becomes more mature. The older the joint venture company, the more time the

foreign joint venture partner has to learn and recode the tacit (non-contractible) component of

know-how to more explicit (contractible) knowledge as a natural consequence of inter-

organizational learning (Inkpen 2000; Nonaka, Takeuchi 1995). In this way more control can

be exercised. We use a log measure in terms of number of employees for both JVP-1 and

JVP-2 separately.

23

3.2. Regression Results

In our sample of 60 Austrian joint ventures, most partners come from the Czech Republic and

Hungary, followed by Poland, Slovenia and Slovakia. A typical equity joint venture in the

sample has two partners, and the parent company has been operating internationally for more

than 4.5 years, which at the same time is equivalent to the number of years the company spent

in the host-country. We can assume that the entire international experience of the Austrian

joint venture partner in one of the CEE countries is based on his experience in the IJV.

To test our hypothesis (H1) we carry out ordinal regression analysis with the index of decision

rights (DR) as dependent variable (Chu, Anderson 1992) (see appendix): The explanatory

variables refer to joint venture partner’s advantage in operative and strategic knowledge

factors (operative KNOW_JVP-1; strategic KNOW_JVP-1; operative KNOW_JVP-2;

strategic KNOW_JVP-2), and all three variables measuring uncertainty (market UNCERT;

political and legal UNCERT (opposite sign); cultural UNCERT). Political and Legal

Uncertainty as unit was measured in the questionnaire as Political & Legal Stability, hence the

opposite sign from the other two sources of uncertainty. The control variables of size (SIZE)

and age (AGE) were added in a separate model for decision rights and ownership rights

regressions. We estimate the following regression equation:

DR = αααα + ß1 KNOW_JVP-1_Operative+ ß2 KNOW_JVP-1_Strategic – ß3

KNOW_JVP-2_Operative – ß4 KNOW_JVP-2_Strategic + ß5 SIZE_JVP-1 + ß6

AGE- ß7 UNCERT (Cultural Distance; Market) + ß8 UNCERT (Political &

Legal)*1 + ß9 SIZE_JVP-2

1 *, ** Measured in the Questionnaire as Political & Legal Stability, hence the opposite

sign from the other two sources of uncertainty.

24

Based on our property rights hypothesis, decision rights (DR) and ownership rights (OR) vary

positively with the JVP-1’s know-how advantage (KNOW) in operative and strategic

functions over the other IJV partner. In the model accompanying the main setting, we control

for two additional variables and assume that residual decision rights will vary positively with

the SIZE of JVP-1 due to economics of scale in coordination and monitoring activities, and

IJV experience (AGE) due to organizational learning, and different sources of uncertainty

(UNCERT) due to increased risk. Hence β 1, β 2, β 5, β 6, β 8 and β 9 have a positive

sign, whereas β 3, β 4 and β 7 carry a negative relationship.

Results of the ordinal regressions are provided in the Appendix. The fit of the model was

estimated by using the Cauchit method due to the distribution of the data.

The Chi-Square values for Models 1 and 2 of are 35,088 and 45,225; they are significant at p<

0.001 level. For the Models 3 and 4 the Chi-Square values are 10,810 and 19,439, significant

at p<0.5 and P<0.05 thus rejecting the null hypothesis that the estimated coefficients are zero.

The overall fit of the ordinal regression model point to the appropriateness of the set of

variables in predicting the distribution of residual decision rights in joint ventures.

Testing our property rights hypothesis (H1a; H1b), examining the relationship between

residual decision rights and intangible knowledge assets of JVP-1 and JVP-2 we find that the

coefficients of intangible knowledge for operational and strategic assets (KNOW) for JVP-1

are highly significant and consistent with our property rights hypothesis: The more intangible

knowledge assets the foreign partner has in forms of day to day operations and/or strategic

direction, the more residual decision rights, in praxis, are allocated to him, whereas the impact

of operative knowledge assets exceeds that of strategic assets. The more in tune the foreign

25

partner is with the day to day operations the more residual decision rights will be assigned to

him. The portion of strategic intangible knowledge assets of the local partner had a negative

impact on the allocation of residual decision rights to the foreign partner. That means the

more knowledge the local partner has of the strategic management of the joint venture, the

less residual decisions rights will be distributed to JVP-1 and the more will be attributed to

JVP-2.

With the impact of SIZE and AGE this effect is somewhat changed. The intangible

knowledge assets of the JVP-1 on both operative and strategic management dwellings remain

to be significant determinants of the residual decision rights. And the more the JVP-1 knows

about both operative and strategic functions the more residual decision rights will be assigned

to him. However, under the influence of size of both JVP-1 and JVP-2 and the experience of

the IJV, the strategic knowledge assets of JVP-2 become insignificant and the role is taken

over by the operative knowledge assets preserving the negative sign in the relationship with

the JVP-1 residual decision rights. That means, under the influence of partner size and

experience of the IJV, the more intangible knowledge assets the JVP-2 has on operative, day

to day business, the less residual decision rights will be assigned to JVP-1.

In support of our hypothesis (H4a; H4b) the effect of cultural distance is significant and

negative, meaning the more socio-cultural distance the foreign partner perceives on his

relationship with the local partner, the more residual decision rights will be allocated to the

local partner.

As assumed, IJV experience (AGE) is a significant determinant of the distribution of residual

decision rights in IJVs from the perspective of the Austrian partner JVP-1. The older and

more experienced the IJV, the more residual decision rights will be assigned to the local

partner JVP-2. Size also showed to have a significant and negative influence on the

26

distribution of residual decision rights from the Austrian perspective. The larger the JVP-1 is

the more residual decision rights will be assigned to the local country partner JVP-2. This can

be explained by the fact that larger firms seeking international experience will be more likely

to invest into IJVs in order to learn from their local partners on host country business

environment.

In order to estimate these relationships for the allocation of ownership rights between the two

IJV partners we estimate the following regression:

OR = αααα + ß1 KNOW_JVP-1_Operative+ ß2 KNOW_JVP-1_Strategic – ß3

KNOW_JVP-2_Operative – ß4 KNOW_JVP-2_Strategic + ß5 SIZE_JVP-1 + ß6

AGE – ß7 UNCERT (Cultural Distance; Market) + ß8 UNCERT (Political &

Legal)**+ β 9 SIZE_JVP-2

Testing our property rights hypothesis (H2a; H2b; H2c), examining the relationship between

ownership rights and intangible knowledge assets we find that the coefficient of intangible

knowledge operational assets (KNOW) for JVP-1 as the only significant coefficients

consistent with our property rights hypothesis. The more operative intangible knowledge

assets the foreign partner has about the business daily activity the larger ownership stake he is

able to assume in the IJV.

A very significant measure influencing the size of equity ownership of the foreign

partner is the market uncertainty in the host country supporting our hypothesis (H5b),

carrying a positive effect. That means that the higher the market uncertainty in the host

country, the larger ownership stake will be assumed by the foreign partner. We may see this

result as a risk minimizing tool, foreign firms use when they are being active in the CEE

27

economic area. This effect may be overshadowing the other sources of uncertainties, due to

the fact that some of the countries in the sample at the time of data collection were in the

process of starting their European Union (EU) membership, which was a milestone for better

overall business conditions and a movement of conversion with the rest of the EU members.

The market uncertainty (UNCERT), having a positive and significant (however lesser) impact

on the allocation of ownership rights to the JVP-1, is in contradiction with our hypothesis

predicting exactly the opposite for this relationship. The higher the market uncertainty, the

more ownership rights are transferred to the JVP-1. Another predictor of ownership in

international joint ventures is the intangible operational knowledge assets of the foreign (JVP-

1) with a positive and significant effect. And this is a good sign, because the more know-how

the foreign partner has on how to handle market uncertainty, his risk-averseness will not stop

him from owning a larger share in the joint venture. The more foreign partner feels

comfortable with the knowledge he has in Marketing, Human Resources, Sales and Service

and their application in the host country, the more ownership rights he is willing to assume.

That can also be explained by the high interest of foreign companies to apply their selling and

customer service solutions in these near markets, and the expansion policies to cover

consumer needs in CEE.

Both AGE of IJV and SIZE of JVP-1 are significant predictors of the JVP-1 ownership stake.

And while AGE carries a positive effect SIZE of JVP-1 has a negative impact on the

ownership of JVP-1 of joint venture equity. Our model predicted a positive relationship for

both values. Joint venture experience can be explained by the fact that the older the joint

venture gets, the more comfortable the foreign partner will become of doing business in the

host country and the more likely ownership will be increased by the foreign joint venture

partner (JVP-1). As the initial risks are tackled and the joint venture becomes more

established, the foreign partner learns more about the host country and is more willing to

28

assume a higher equity stake in the undertaking. The negative impact of JVP-1 size on the

size of ownership can really be explained by the phenomenon that larger, international

companies hold smaller stakes across a larger number of projects.

3.3. Discussion

The main goal of the paper is to present an explanation of distribution of residual decision and

ownership rights in international joint ventures, by applying the property rights and

transaction cost. First, we test the hypothesis that the joint venture partners’ residual decision

rights go hand in hand with the significance of his intangible knowledge assets, for the

generation of network surplus of the joint venture. We find that the allocation of residual

decision rights of the foreign partner will depend both on strategic and operative intangible

knowledge assets.

We test the hypothesis on the joint venture partner’s ownership rights stating that they

will vary directly with the importance of parent intangible knowledge assets to generate

residual of the joint venture. The data from 60 joint ventures between an Austrian and CEE

partners confirms the hypothesis that the joint venture partner’s intangible assets, both

operative and strategic will positively influence the likelihood to assign a higher share of

residual decision rights to the partner having those intangible assets. Secondly, we look into

the relationship between time and residual decision distributed between joint venture partners.

No moderating effect could be established. The reason for this could be the small sample set.

Despite this drawback, compared to previous research and building on the work of Yan and

Gray (2001), we operationalize a measure for control consisting of strategic and operational

residual decisions. In that way our study makes a considerable contribution to the

measurement on how to measure the distribution of residual decision rights between joint

venture partners.

29

In addition, this study also has several managerial implications. First, in conformity

with Windsperger and Kocsis (2005) this study finds that the distribution of residual decision

rights in joint ventures are based on the allocation of the IJV-partners’ intangible knowledge

assets which are necessary for the generation of residual surplus. Drawing on this conclusion,

this study encourages firms to establish their governance structures after assessing their

knowledge assets and residual decision rights they wish to allow in their joint venture. A high

portion of the residual surplus in a joint venture may be generated by applying highly non-

contractible know-how. If this joint venture partner indeed possesses the residual decision

rights to efficiently utilize her intangible knowledge assets for the creation of the total income

stream then the situation will exhibit efficiency. Know-how which is less intangible and

therefore more contractible does not influence the residual income stream of the joint venture

even if this joint venture partner has a high proportion of residual decision rights. If joint

venture partners match residual decision rights with ownership rights – they will improve the

conditions for knowledge creation which is particularly important for laying out the

foundation for innovation (Grandori, Furlotti 2006; 2008). When partners are motivated to

efficiently use their know-how, a joint venture partner with a higher portion of residual

decision and ownership rights will more likely generate a higher residual surplus. The

opposite can take place too – partners with a small portion of residual decision rights are less

likely to reach an increase of the residual income stream to maximum levels, due to the

inability of partners to influence the use of innovation assets even when he does have a large

portion of ownership rights. Such situations, where there are discrepancies between the

allocation of decision rights and ownership rights (high/low) are unfavourable, and the

incentive for partners is missing to efficiently apply their know-how due to inappropriate

portion of ownership assets.

Our empirical study has some limitations: although the database sample used in the

survey is diverse, it is still far from a large and statistically solid random sample. Second,

30

while the empirical results deliver support for the property rights and transaction cost

hypotheses, we recommend collecting additional empirical evidence in order to increase the

solidity of results. Furthermore, future research has to investigate the relationship between the

allocation of decision and ownership rights; as well as how these two measures impact the

performance of the joint venture. The moderating effect has to be addressed by using a larger

sample.

31

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Appendix A: Regression Results

Table 1. Model 1; H1

Table 2. Model 2;H2

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Table 3. Model 3; H3

40

Table 4. Model 4;H4

Table 5. Correlations Independent Variables

41

Appendix B: Description of Dependent and Independent Variables

Decision Rights DR To which extent does the JV-partner 1 (JVP1) influence the following

decisions compared to JV-partner 2(JVP2)? (1=no extent, 7=to a very

large extent)

Sixteen items, Average is used for JVP1; ordinal variable

(Strategy, Organisational form, Product sorting, hiring, wages,

training, production, product pricing, marketing measures,

advertising, suppliers, investment projects, lenders, financing,

accounting, cooperation partners)

Ownership Percentage of asset ownership of JVP1

1=0-20%

2=21-40%

3=41%-60%

4=61%-80%

5=81%-100%

KNOW Strategic To which extent does JVP1/JVP2 add new knowledge in each of the

following value chain activities (1=no extent, 7=to a very large

extent): corporate planning, controlling, financing, organization,

strategy.

Strategic Cronbach´s Alpha JVP1=.856 and JVP2=.891

KNOW Operative To which extent does JVP1/JVP2 add new knowledge in each of the

following value chain activities (1=no extent, 7=to a very large

extent):marketing, human resources, sales, service

Operative Cronbach´s Alpha JVP1=.823 and JVP2=.806

Size Log(Number of employees of JVP1)

Age Joint venture (JV) companies´years of existence (Tsurvey-

Tformation)

Uncertainty The general manager was asked to evaluate uncertainty on a 5 point

scale. Result of Factor Analysis: Cultural, Political & Legal and

Market. Averages are used in further calculations.

Cultural

Uncertainty

The perceived cultural distance between JVP1 country and JV

country is high.

(1=not at all; 5=to a very large extent)

Political & Legal

Uncertainty

Stability of political situation in JV country is high.

(1=not at all; 5=to a very large extent)

Stability of legal situation in JV country is high.

(1=not at all; 5=to a very large extent)

(Cronbach´s Alpha=.704)

Market

Uncertainty

Demand uncertainty is high.

(1=not at all; 5=to a very large extent)

New competitors enter the market often.

(1=not at all; 5=to a very large extent)

Market prices are highly volatile.

(1=not at all; 5=to a very large extent)

Competition is very fierce.

(1=not at all; 5=to a very large extent)

Cronbach´s Alpha=.683