Cobalt Systems and SilverLight Electronics Role of Cobalt Systems

By Catherine Tinsley

2002-2008 Dispute Resolution Research Center, Northwestern University. All rights reserved. The Dispute Resolution Research Center (DRRC) requires a $3.50 per person usage fee for each of its exercises, including this exercise. Payment should be made to the DRRC in U.S. dollars. Any use of this exercise without this required payment is unauthorized and in violation of copyright law, which imposes statutory and other damages on infringers. DRRC, Kellogg School of Management, Northwestern University, 2001 Sheridan Road, Evanston, Illinois 60208-2001 Tel: 847-491-8068, Fax: 847-467-5700, drrc@kellogg.northwestern.edu, www.kellogg.northwestern.edu/drrc

You represent Cobalt Americas and Far East (CAFE). You would like to develop a joint venture with a Korean company, as consumer tastes and government tax policies favor locally made products. However, you wonder whether SilverLight Electronics is the right partner for Cobalt. Cobalt is eager to increase its market share in Korea because the PC market is projected to grow by 50% over the next five years. SilverLight is a logical choice, given that you began negotiations with them a few years ago. However, the 1995-1996 negotiations precipitously ended when SilverLight declared 'irreconcilable cultural differences.' You are wary of SilverLight, since you do not want to negotiate another sudden termination. On the other hand, other Korean computer companies do not seem interested in a joint venture at this time. Preliminary negotiations with SilverLight have already produced seven issues, as well as three options on each of the seven issues. You may think of other options, but if you do, you must communicate those options to the other party prior to the negotiation. The issues and options are summarized below. Access to Korean markets One reason for establishing a joint venture is access to sales, distribution, and after-sales service networks. In Korea there are no independent distributors to channel your product to retail outlets. All distributors are linked to their own manufacturers. There are also no local companies to provide independent customer support. The margins on PCs are simply too low to support this service, thus all customer support companies are also linked to the manufacturer. Usually the manufacturer, distributor, and support company are all part of one Chaebol. You may be able to buy an equity share in both a distributor and after-sales servicer, but these firms may not give you the same attention they give the electronics firm that is part of their same Chaebol. It is probably better in the long run to form a joint

venture with a Chaebol firm, and use its distributors and after-sales servicers. Thus, if you form a joint venture, it is only right that this venture would have full access to SilverLights sales, distribution, customer support, and PC servicing organizations. As well, it would be nice if you could have access to SilverLights networks for other Cobalt computer products. Your options here are:

a. Neither the JV nor other Cobalt products have access to SilverLights networks.

b. The JV has access to all SilverLights networks.

c. Both the JV and other Cobalt products have access to SilverLights networks.

Protection for your Technology You worry about sharing technology with your Korean counterparts for fear that it might be leaked to the industry as a whole. There are two particular concerns: 1) your notebook technology, which is state of the art, and 2) your multimedia PC technology, which is still in development. Most companies already have good desktop technology, so you are less concerned about sharing this technology. Typically, when one company shares a U.S. patented technology with another, there is a 7% royalty fee (that SilverLight would pay Cobalt), although some companies waive this fee. You already have U.S. patents for your desktop and notebook technology. The desktop patent expires in 10 years; the notebook patent expires in 14 years. You are nervous about sharing your notebook and multimedia technology with SilverLight because of the loose patent laws in Korea. As in many Asian countries, in Korea, patent systems are designed to encourage industry cooperation, and offer little protection for individual inventors. It is common for a product to be modified only slightly and then submitted as a new technology for Korean patent

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and production rights, which last 15 years. Of course, you could always reverse engineer any competitors new product, modify it slightly, and then apply for your own Korean patent and production rights. The Korean government does little to discourage this reverse engineering and modification process, claiming it results in product improvement and industry development. Your real concern here is how this might threaten any future U.S. patent of the multimedia technology (because your hope is to market multimedia products worldwide). It is a real possibility that if your technology is made public in any way then another Korean firm can reverse engineer and export the product back to the U.S., before U.S. patent protection comes through. Thus, your options are:

a. Share both your notebook and multimedia technology with SilverLight.

b. Share your notebook technology with SilverLight, negotiating a royalty fee.

c. Share neither your notebook nor your multimedia technology

Financial Accounting Practices It is essential that Cobalt understand the true financial condition of this joint venture, at any given point in time. The joint venture will have to follow the U.S. based General Accounting Accepted Practices (GAAP) when calculating its quarterly returns. Despite the fact that the JV will be based in Korea and subject to Korean laws which allow companies to use standards issued by the International Accounting Standards Committee (IASC), Cobalt joint ventures have always used GAAP. Otherwise, the burden of evaluating the performance of Cobalt's enterprises worldwide is too great. IASC standards permit choices that are prohibited under GAAP, such as revaluation of assets and capitalization of development costs. There are some formulas for converting IASC-based reports to GAAP reports, but these are imperfect because less detail is required by IASC standards. Thus, unless the JV uses GAAP standards, it will be hard for Cobalt to assess the JV's performance, incorporate this JV into its reported earnings to the Securities and Exchange Commission (SEC), and difficult to compare the JVs performance to that of other Cobalt businesses. Finally, because Cobalt is a publicly traded company, it may face discrimination in U.S. capital markets if American investors find it difficult to appraise some of Cobalt's joint ventures. You could elect to keep two sets of books (one using GAAP standards and the other using those of IASC),

however, paying for two quarterly performance reports is obviously more costly than paying for one. Moreover, keeping two sets of books (for whatever reason) raises concerns at the SEC and may provoke the SEC to put a firm under stricter supervision than otherwise. Thus, your options are:

a. Use IASC standards. b. Use both IASC and GAAP standards (two

sets of books). c. Use GAAP standards for the JV.

Equity Ownership You realize that Cobalt's general policy of 100% ownership will not be successful in Korea because such a firm would lack an independent distribution and service network. In order to raise your 1% market share, you need to form a joint venture. Cobalt's JV policy is to retain control of at least half the ownership to give you majority control over operations. However, you do want SilverLight to be committed to the joint venture, so they should have some sizable equity stake, below 51%. A minority share may also be in SilverLights interests, since Korean companies have not had much available equity capital since the economic collapse. You will try for as large an equity share as possible. If you accept less than 51% ownership, you know eyebrows will be raised back at Cobalt. Your options are:

a. Above 51% equity ownership for SilverLight

b. 51% equity ownership for SilverLight c. Below 51% equity ownership for

SilverLight Top Management Team Another way to maintain control over technology and operations is through top management placement. Although Cobalt generally hires some local management, these locals must undergo extensive training and socialization into the 'Cobalt way of doing business'. You would like to see most of the top management committee (CEO, CFO, Director Marketing, Director Sales, Director Personnel, Director Operations, Director of R&D, and Director of External Relations) from Cobalt. You are willing to hire local middle managers with the expectation that some of them would move up to top management positions eventually. At a minimum the CEO and Director of Operations (to help ensure operational control) and R&D (to help ensure technology

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security) must be from Cobalt. You would also like the CFO to be from Cobalt (to help with the accounting standards issue). Thus, your options are:

a. CEO, Operations, and R&D from Cobalt; all others, SilverLight

b. CEO, Operations, R&D, and Finance from Cobalt; all others, SilverLight.

c. All top management from Cobalt, with local middle management hires expected to move to upper management eventually.

Joint Venture Name Brand identity is important to Cobalt. You have worked hard to establish a worldwide identity that means high quality and high service. Thus, you would like the joint venture, which will be producing high-end technological products, to carry the Cobalt name. Cobalt, in building its worldwide family of companies, has never before been partner to a JV that did not have the Cobalt name, thus it is sort of an informal corporate norm or standard. Thus, your options are:

a. Only SilverLight identity in the JV name. b. Cobalt identity as well as SilverLight

identity in the JV name. c. No SilverLight identity in the JV name.

Access to U.S. markets SilverLight wants access to the U.S. market. This could be access for the PCs made by the joint venture, meaning they would be marketed and sold through Cobalts existing marketing and distribution channels. Of course you do not want these PCs to cut into your already existing U.S. market share. And you want to maintain your strong brand identity in the U.S.you are the largest PC maker, when people think of PCs they think of Cobalt. Cobalt could also open their existing marketing and distribution channels to other SilverLight products for a fee (typically 5% of revenues). Thus, your options are:

a. Access to Cobalts marketing and distribution channels for JV products and other SilverLight products.

b. JV access to Cobalts marketing and distribution channels.

c. No access to Cobalts channels for either the JV or for other SilverLight products.

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Cobalt Systems and SilverLight Electronics Planning Document for Cobalt Systems

Assume that you have 100 percentage points to allocate to the 7 issues. Please distribute the 100 percentage points, according to the importance of the issues for you. For example, if the first issue (Access to Korean Markets) was extremely important to you, and all the other issues were equally less important, you might allocate your 100 percentage points as follows:

Example: 40% Access to Korean Markets 10% Protection for your Technology 10% Financial Accounting Practices 10% Equity Ownership 10% Top Management Team 10% Joint Venture Name 10% SilverLights access to U.S. Markets 100% TOTAL

Your Allocation Access to Korean Markets Protection for your Technology Financial Accounting Practices Equity Ownership Top Management Team Joint Venture Name SilverLights access to U.S. Markets 100% TOTAL

Now assign a value of 1 to 100 points to each option. The only requirement is that the points for option a must be the smallest and the points for option c the largest, since option c is always the best choice for Cobalt and option a always the worst. For example, you may decide that below 51% equity ownership for SilverLight is worth 100 points, that 51% equity ownership is worth 30 points, and above 51% equity ownership is worth 10 points. _______% Equity Ownership (percentage from your answer to Question #1) Assign from 1 to 100 points to each option: ______ a. Above 51% equity ownership for SilverLight ______ b. 51% equity ownership for SilverLight ______ c. Below 51% equity ownership for SilverLight _______% Top Management Team (percentage from your answer to Question #1) Assign from 1 to 100 points to each option: ______ a. CEO, Operations, & R&D from Cobalt, all others, SilverLight ______ b. CEO, Operations, R&D, and Finance from Cobalt, all others, SilverLight ______ c. All top management from Cobalt _______% Financial Accounting Practices (percentage from your answer to Question #1) Assign from 1 to 100 points to each option: ______ a. Use IASC standards for the JV ______ b. Use both IASC and GAAP standards (2 sets of books) ______ c. Use GAAP standards for the JV

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Cobalt Systems and SilverLight Electronics Planning Document for Cobalt Systems (Contd)

_______% Access to Technology (percentage from your answer to Question #1)

Assign from 1 to 100 points to each option: ______ a. Share both your notebook and multimedia technology ______ b. Share your notebook technology ______ c. Share neither your notebook nor your multimedia technology

_______% Access to U.S. Markets (percentage from your answer to Question #1)

Assign from 1 to 100 points to each option: ______a. Access to Cobalts marketing and distribution channels for JV and other SilverLight

products ______ b. JV products have access to Cobalts marketing and distribution channels ______ c. No access to Cobalts channels

_______% Joint Venture Name (percentage from your answer to Question #1)

Assign from 1 to 100 points to each option: ______ a. Only SilverLight identity in the JV name ______ b. SilverLight identity as well as Cobalt identity in JV name ______ c. No SilverLight identity in JV name

_______% Cobalts access to Korean Markets (percentage from your answer to Question #1)

Assign from 1 to 100 points to each option: ______ a. Neither JV nor other Cobalt products have access to SilverLight networks ______ b. JV has access to all SilverLights networks ______ c. Both the JV and other Cobalt products have access to SilverLights networks

In order to analyze the value to you of a potential agreement with SilverLight, multiply the percentage weight from Question #1 times the value of the option chosen from Questions #2 and sum across issues. FINAL NOTE: Assume for this negotiation that if you cannot get an agreement with SilverLight, your going it alone strategy would be worth 30 points.