Start-Up Commercialisation Strategy and the

Market for Ideas

Joshua Gans
Melbourne Business School

Entrepreneurship Boot Camp

30th July 2010
Sources of entrepreneurial rents

Source: Thomson Venture/NVCA

Sources of entrepreneurial rents

Competition with
established firms

Source: Thomson Venture/NVCA

Sources of entrepreneurial rents

Cooperation with
established firms

Competition with
established firms

Source: Thomson Venture/NVCA

Andrew Lacy
Andrew Lacy
Andrew Lacy
Andrew Lacy
Andrew Lacy
Andrew Lacy
Andrew Lacy
Andrew Lacy

$1 million per month

40 million users
Exclusive content deals
Understanding commercialisation decisions

• What determines what type of commercialisation strategy

that entrepreneurs choose?
• How does commercialisation choice impact on incentives
to innovate?
• How does intellectual property protection impact on
commercialisation strategy?
Competitive commercialisation
Competitive commercialisation

Start-Up
Competitive commercialisation

Enter and
Start-Up
Compete
Competitive commercialisation

Enter and
Start-Up
Compete

Profit > entry costs

Competitive commercialisation

Enter and
Start-Up
Compete

π> f
Cooperative commercialisation

Start-Up

π< f
Cooperative commercialisation

Start-Up Sell or license

π< f
Cooperative commercialisation

Start-Up Sell or license

Earn payment, t
Compete or cooperate?
Compete or cooperate?

Simple analysis suggests that the main predictor of

commercialisation mode is ...
Compete or cooperate?

Simple analysis suggests that the main predictor of

commercialisation mode is ...
... start-up entry costs
Compete or cooperate?

Simple analysis suggests that the main predictor of

commercialisation mode is ...
... start-up entry costs
Complementary assets held by established firms; Teece
(1986)
Compete or cooperate?

Simple analysis suggests that the main predictor of

commercialisation mode is ...
... start-up entry costs
Complementary assets held by established firms; Teece
(1986)
If choose cooperation, start-up profits (t) depend upon
whether complementary assets are loosely or tightly held
Compete and/or cooperate?
Compete and/or cooperate?

Start-Up
Compete and/or cooperate?

Enter and
Compete

Start-Up

Sell or license
Compete and/or cooperate?

Enter and
Compete

Start-Up ?

Sell or license
Compete and/or cooperate?

Enter and
Sell or license
Compete

Start-Up
Compete and/or cooperate?

Enter and
Sell or license
Compete

Start-Up π−f
Compete and/or cooperate?

Enter and
Sell or license
Compete

Start-Up π−f t
Compete and/or cooperate?

Enter and
Sell or license
Compete

Start-Up π−f t

Incumbent
Compete and/or cooperate?

Enter and
Sell or license
Compete

Start-Up π−f t

Incumbent π
Compete and/or cooperate?

Enter and
Sell or license
Compete

Start-Up π−f t

Incumbent π Π−t
Compete and/or cooperate?

Enter and
Sell or license
Compete

Total
Surplus
Compete and/or cooperate?

Enter and
Sell or license
Compete

Total 2π − f Π
Surplus
Gains from Trade

2π − f Π
Gains from Trade

2π − f > Π
Gains from Trade

2π − f > Π

Competitive Commercialisation
Gains from Trade

Π > 2π − f

Cooperative Commercialisation
What if entry isn’t feasible?

π< f Threat of competition not credible

Still possible that t > 0

(i) multiple incumbents
(ii) innovation adds value to
monopoly profits (ΔΠ)
Drivers of start-up innovation incentives

• Innovation prize = t
• t will be higher if
• Innovation has higher value to a monopolist
• Innovation has higher value if exclusively held under competition
• Complementary assets are loosely held
• More established firms as potential partners
A little bargaining review

• What determines t?
• Incumbent power
• Start-up forced to accept take it or leave it offer from incumbent
• t = max{π - f, 0}
• Nash bargaining solution
• Each gets the same share of total surplus
• TS = (1+Δ)Π - (2π - f)
• If π > f, (1+Δ)Π - t - π = t - (π - f) or t = ((1+Δ)Π + f)/2
• If π < f, (1+Δ)Π - t - Π = t or t = ΔΠ/2
• Rubinstein bargaining
• t = max{ΔΠ/2, π - f}
• Wolinsky bargaining (Gans & Stern, 2000)
• Incumbent can continue to search through negotiations (e.g., find patent workaround)
• t < max{ΔΠ/2, π - f}
• Implication: broader patent protection increases t
Cooperate Ex Ante? Aghion & Tirole, 1994

• Suppose
• Innovation has value, V
• Innovation generated with probability, p(e, E)
• e: start-up’s (non-contractible) effort & effort cost
• E: incumbent’s effort & effort cost
• Incumbent employs entrepreneur
• e* = 0 while incumbent earns p(0,E*(V))V - E*(V)
• Independent entrepreneur with ex post licensing
• t = V/2 so both earn (net of effort costs) p(e*(V/2),E*(V/2))V/2
• Allocation of property rights determined by
• Which party’s effort is more important
• Ex ante bargaining power of both parties as entrepreneur is wealth constrained
(leads to too much incumbent ownership)
Patent races

• What drives innovation incentives when start-ups compete with

incumbents?
Willingness to Pay Preemption
Firm
Comp Coop Comp Coop
Start-Up π-f t π-f t
Incumbent ΔΠ ΔΠ Π(1+Δ) - π t
• Competitive commercialisation
• Incumbent has higher preemption incentives (Gilbert & Newbery, 1981)
• WTP depends on credibility of entry (Reinganum, 1982)
• Cooperative commercialisation
• Preemption incentives are equalised (Katz & Shapiro, 1985)
• t < ΔΠ; so in general incumbent has higher incentives unless start-up entry threat
credible
Impediments to Cooperative Commercialisation

• Static drivers suggest that start-ups will try to engage in

cooperative commercialisation but when will competition be
observed?
• Inefficiencies in bargaining
• Differences in perceptions (information asymmetries)
• Transaction costs and complexity
• Locating suitable partners (Hellmann, 2007; Hsu, 2007)
• Difficulties in transferring tacit knowledge (Arora, 1995)

• Non-monetary considerations
• Entrepreneur’s desire for control

• Avoiding bargaining altogether

Incentives to avoid bargaining
Incentives to avoid bargaining

• Arrow’s disclosure problem

• If want someone to buy an idea, need to disclose the idea to assess quality. Makes
you vulnerable to expropriation.
• Example: Bob Kearns and the intermittent windshield wiper
Incentives to avoid bargaining

• Arrow’s disclosure problem

• If want someone to buy an idea, need to disclose the idea to assess quality. Makes
you vulnerable to expropriation.
• Example: Bob Kearns and the intermittent windshield wiper
• Disclosures can reduce the licensing payment to start-ups
• Let d be the knowledge disclosed and F(d) the probability that the incumbent can
use the knowledge to adopt the innovation with F’(d) > 0
• t = (1 - F(d))ΔΠ/2
Incentives to avoid bargaining

• Arrow’s disclosure problem

• If want someone to buy an idea, need to disclose the idea to assess quality. Makes
you vulnerable to expropriation.
• Example: Bob Kearns and the intermittent windshield wiper
• Disclosures can reduce the licensing payment to start-ups
• Let d be the knowledge disclosed and F(d) the probability that the incumbent can
use the knowledge to adopt the innovation with F’(d) > 0
• t = (1 - F(d))ΔΠ/2
• Incumbent competition and the scorched earth threat
• Suppose that there are two (or more) potential buyers of an idea and they compete
with one another
• Threaten to give idea to rival firm if buyer does not pay (Anton & Yao, 1994)
• Very act of stealing an idea signals its value to others and creates competition
(Biais & Perotti, RJE, 2008)
Patents can facilitate disclosure & cooperation
Patents can facilitate disclosure & cooperation

• Suppose that disclosure requires effort and is also non-contractible (e.g., tacit
knowledge; Arora, 1995) but increases profits, Π’(d) > 0.
Patents can facilitate disclosure & cooperation

• Suppose that disclosure requires effort and is also non-contractible (e.g., tacit
knowledge; Arora, 1995) but increases profits, Π’(d) > 0.
• Will only choose to disclose prior to agreement (no profit sharing as it is non-
contractible)
Patents can facilitate disclosure & cooperation

• Suppose that disclosure requires effort and is also non-contractible (e.g., tacit
knowledge; Arora, 1995) but increases profits, Π’(d) > 0.
• Will only choose to disclose prior to agreement (no profit sharing as it is non-
contractible)
• Let s be the strength of patent protection (e.g., the probability that the
incumbent will be blocked). F is decreasing in s.
Patents can facilitate disclosure & cooperation

• Suppose that disclosure requires effort and is also non-contractible (e.g., tacit
knowledge; Arora, 1995) but increases profits, Π’(d) > 0.
• Will only choose to disclose prior to agreement (no profit sharing as it is non-
contractible)
• Let s be the strength of patent protection (e.g., the probability that the
incumbent will be blocked). F is decreasing in s.

t = Π(d) − F(d, s)Π(d)

Patents can facilitate disclosure & cooperation

• Suppose that disclosure requires effort and is also non-contractible (e.g., tacit
knowledge; Arora, 1995) but increases profits, Π’(d) > 0.
• Will only choose to disclose prior to agreement (no profit sharing as it is non-
contractible)
• Let s be the strength of patent protection (e.g., the probability that the
incumbent will be blocked). F is decreasing in s.

t = Π(d) − F(d, s)Π(d)

∂d *
∂s ≥0
Patents can facilitate disclosure & cooperation

• Suppose that disclosure requires effort and is also non-contractible (e.g., tacit
knowledge; Arora, 1995) but increases profits, Π’(d) > 0.
• Will only choose to disclose prior to agreement (no profit sharing as it is non-
contractible)
• Let s be the strength of patent protection (e.g., the probability that the
incumbent will be blocked). F is decreasing in s.

t = Π(d) − F(d, s)Π(d)

∂d
≥0 − ∂F
Π′(d) − ∂2 F
Π(d) > 0
*

∂s ∂s 
∂d∂s
<0
Dynamic drivers of commercialisation choice

• Cases of start-up choice over commercialisation suggest a dynamic concern

for creation and capture of future innovative rents
Dynamic drivers of commercialisation choice

• Cases of start-up choice over commercialisation suggest a dynamic concern

for creation and capture of future innovative rents

EMI and the CT Scanner

Powell claimed that the expertise developed by Hounsfield and his team, couple
with protection from patents, would give EMI three or four years, and maybe
many more, to establish a solid market position. He argued that investments
should be made quickly and boldly to maximize the market share of the EMI
scanner before competitors entered. Other options, such as licensing, would
impede the development of the scanner. If the licensees were the major X-ray
equipment suppliers, they might not promote the scanner aggressively since it
would cannibalize their sales of X-ray equipment and consumables. Smaller
companies would lack EMI’s sense of commitment and urgency. Besides,
licensing would not provide EMI with the major strategic diversification it was
seeking. It would be, in Powell’s words, “selling our birthright.”
Dynamic drivers of commercialisation choice

• Cases of start-up choice over commercialisation suggest a dynamic concern

for creation and capture of future innovative rents

Ecton
With such a clear focus and few distractions, the Ecton development
team had met most of their project milestones on schedule, at
significantly lower cost than they had planned, based upon their past
experience. The Ecton founders worried that if their company were
absorbed into a larger organization after acquisition, their development
efforts for next-generation products would get mired … in complexity …
Perhaps, they reasoned, their efforts would be more successful in the
long run if they remained independent until they had refined a
development process … that might survive acquisition and integration.
Dynamic drivers of commercialisation choice

• Cases of start-up choice over commercialisation suggest a dynamic concern

for creation and capture of future innovative rents

Palm

Dubinsky and Hawkins believed licensing the Palm OS right away would
only stifle Palm’s attempts to be the market leader. Furthermore, by having
more entrants manufacturing Palm OS devices, Palm’s income would be
reduced, thereby stripping away opportunities to invest in future
technologies. As far as Dubinsky was concerned, the timing of licensing
the platform was crucial. She stated, “Licensing will come later. Today it
certainly won’t add value. What will add value today is investing in product
development, getting the next generation and the next generation out,
advancing the category, and building intellectual property.”
Dynamic drivers of commercialisation choice

• Cases of start-up choice over commercialisation suggest a dynamic concern

for creation and capture of future innovative rents
Starting point
Starting point

• Segal & Whinston (2007) model of dynamic technological competition

• SW apply to antitrust practices
• SW consider entrants as competing and displacing incumbents -- on-
going change
Starting point

• Segal & Whinston (2007) model of dynamic technological competition

• SW apply to antitrust practices
• SW consider entrants as competing and displacing incumbents -- on-
going change

• Here, modifications
• Remove static competition effects to focus on dynamics in
Schumpeterian, ‘winner-take-all’ or ‘for the market’ competition.
• Incorporate ideas markets
• Model dynamic capabilities (firms may not be long-lived)
Firms & Innovations
Firms & Innovations

• Discrete time, infinite horizon with common discount factor, δ

Firms & Innovations

• Discrete time, infinite horizon with common discount factor, δ

• Innovations are sequential
• Innovation yields new product of higher quality than previous generation
Firms & Innovations

• Discrete time, infinite horizon with common discount factor, δ

• Innovations are sequential
• Innovation yields new product of higher quality than previous generation
• Incumbent (I)
• There is a single producer of the new product who can earn per period monopoly
rents, Π, until displaced.
Firms & Innovations

• Discrete time, infinite horizon with common discount factor, δ

• Innovations are sequential
• Innovation yields new product of higher quality than previous generation
• Incumbent (I)
• There is a single producer of the new product who can earn per period monopoly
rents, Π, until displaced.
• Ideas are scarce
• For each product generation only one firm conducts R&D
• Innovation leader drawn from pool of firms including the current incumbent
(O’Donoghue, Scotchmer and Thisse, 1998)
• I can be the innovation leader and prolong incumbency
• Otherwise, label leader as ‘entrant’ or E.
Firms & Innovations

• Discrete time, infinite horizon with common discount factor, δ

• Innovations are sequential
• Innovation yields new product of higher quality than previous generation
• Incumbent (I)
• There is a single producer of the new product who can earn per period monopoly
rents, Π, until displaced.
• Ideas are scarce
• For each product generation only one firm conducts R&D
• Innovation leader drawn from pool of firms including the current incumbent
(O’Donoghue, Scotchmer and Thisse, 1998)
• I can be the innovation leader and prolong incumbency
• Otherwise, label leader as ‘entrant’ or E.
• Innovation rate:
• Innovation leader generates an innovation immediately
Timeline

t-1 t t+1
Timeline

t-1 t t+1

Selection
Timeline

t-1 t t+1

Selection Production
Timeline

t-1 t t+1

Selection Production Innovation

Timeline

t-1 t t+1

Selection Production Innovation Negotiations

Timeline

t-1 t t+1

Selection Production Innovation Negotiations

Innovation
leader
chosen
Timeline

t-1 t t+1

Selection Production Innovation Negotiations

Innovation
leader Capabilities Acquired
chosen
Timeline

t-1 t t+1

Selection Production Innovation Negotiations

Innovation
Commercialisation
leader Capabilities Acquired
choice
chosen
Negotiations
Negotiations

Entrant
Innovates
Negotiations

Competition

Entrant
Innovates
Negotiations

I loses
Competition
monopoly
profits
Entrant
Innovates
Negotiations

I loses E
Competition
monopoly becomes I
profits (earns Π)
Entrant
Innovates
Negotiations

I loses E
Competition
monopoly becomes I
profits (earns Π)
Entrant
Innovates

Cooperation
Negotiations

I loses E
Competition
monopoly becomes I
profits (earns Π)
Entrant
Innovates

I retains
Cooperation monopoly
profits
Negotiations

I loses E
Competition
monopoly becomes I
profits (earns Π)
Entrant
Innovates

I retains E remains
Cooperation monopoly E
profits (earns τ)
Selection: Dynamic Capabilities
Selection: Dynamic Capabilities

Prior Activity
Selection: Dynamic Capabilities

Prior Activity

Production
Only
Selection: Dynamic Capabilities

Prior Activity

Production
Only

Innovation
Only
Selection: Dynamic Capabilities

Prior Activity

Production
Only

Innovation
Only

Production &
Innovation
Selection: Dynamic Capabilities

Prior Activity Example

Production
Only

Innovation
Only

Production &
Innovation
Selection: Dynamic Capabilities

Prior Activity Example

Production I not an
Only innovation leader

Innovation
Only

Production &
Innovation
Selection: Dynamic Capabilities

Prior Activity Example

Production I not an
Only innovation leader

Innovation E as innovation
Only leader

Production &
Innovation
Selection: Dynamic Capabilities

Prior Activity Example

Production I not an
Only innovation leader

Innovation E as innovation
Only leader

Production & Merger or I as

Innovation innovation leader
Selection: Dynamic Capabilities

Probability of
Prior Activity Example becoming Leader
Production I not an
Only innovation leader

Innovation E as innovation
Only leader

Production & Merger or I as

Innovation innovation leader
Selection: Dynamic Capabilities

Probability of
Prior Activity Example becoming Leader
Production I not an
σ p ∈[0,1]
Only innovation leader

Innovation E as innovation
Only leader

Production & Merger or I as

Innovation innovation leader
Selection: Dynamic Capabilities

Probability of
Prior Activity Example becoming Leader
Production I not an
σ p ∈[0,1]
Only innovation leader

Innovation E as innovation
leader
σ i ∈[0,1]
Only

Production & Merger or I as

Innovation innovation leader
Selection: Dynamic Capabilities

Probability of
Prior Activity Example becoming Leader
Production I not an
σ p ∈[0,1]
Only innovation leader

Innovation E as innovation
leader
σ i ∈[0,1]
Only

Production & Merger or I as

σ ip ≥ max{σ p , σ i }
Innovation innovation leader
Continuation payoffs
Continuation payoffs

I Innovation Leader
Continuation payoffs

I Innovation Leader
 Continuation payoffs

I Innovation Leader

E Innovation Leader
 Continuation payoffs

I Innovation Leader

E Innovation Leader
 Continuation payoffs

I Innovation Leader

E Innovation Leader
 Continuation payoffs

I Innovation Leader

E Innovation Leader

I Non-
Innovator
 Continuation payoffs

I Innovation Leader

E Innovation Leader

I Non-
Innovator
 Continuation payoffs

I Innovation Leader

E Innovation Leader

I Non-
Innovator
 Continuation payoffs

I Innovation Leader

E Innovation Leader

I Non-
Innovator

Cooperation
 Continuation payoffs

I Innovation Leader

E Innovation Leader

I Non-
Innovator

Cooperation Competition
Gains from Trade (Licensing)

Cooperation Competition
Gains from Trade (Licensing)

Cooperation Competition
Gains from Trade (Licensing)

+ +

Cooperation Competition
Gains from Trade (Licensing)

+ > +

Cooperation Competition
Gains from Trade (Licensing)

Π − τ + δσ pVI + δ (1 − σ p )v I + τ + δσ i v E
≥ Π + δσ p v E + δσ iVI + δ (1 − σ i )v I
Gains from Trade (Licensing)

( )
(σ p − σ i ) VI − v E − v I ≥ 0
Gains from Trade (Licensing)

(σ p − σ i )(σ ip − σ i − σ p ) ≥ 0
Gains from Trade (Licensing)

(σ p − σ i )(σ ip − σ i − σ p ) ≥ 0

Caveat: if incumbents innovate at a slower rate, both will have an interest

in choosing a commercialisation mode that maximises the probability that
the incumbent is the innovation leader
Licensing Equilibrium Outcomes
σ ip

Competition VI < v I + v E

σp Licensing Licensing

Competition
VI ≥ v I + v E

σi σ ip
Licensing Equilibrium Outcomes
σ ip

Competition VI < v I + v E

σp Licensing Licensing

Does high σi Competition

drive VI ≥ v I + v E
competition?
σi σ ip
Gains from Trade (Acquisition)
Gains from Trade (Acquisition)

Π − τ + σ ipδV + (1 − σ ip )δVI + τ
I
i

  
Joint Payoff from Cooperation

≥ σ pδVE + Π + σ iδV + (1 − σ i )δVI

I
i

  
Joint Payoff from Competition
Gains from Trade (Acquisition)

(σ ip − σ i )δ (VI − v I ) ≥ σ pδ v E
Gains from Trade (Acquisition)

(σ ip − σ i )δ (VI − v I ) ≥ σ pδ v E

1 − σ ip > 1 − σ i − σ p
Gains from Trade (Acquisition)

(σ ip − σ i )δ (VI − v I ) ≥ σ pδ v E

1 − σ ip > 1 − σ i − σ p implies positive externality

on potential entrants
Acquisition Equilibrium Outcomes
σ ip

VIi < vVII ++ vVEE

Competition

σp

Acquisition
Does high σi
drive VIi ≥ vVII ++ vVEE
competition?
σi σ ip
Conclusions

• Even in the absence of static rationales, dynamic

considerations can drive commercialisation choices
• Need to look at relative capabilities
• Capabilities here are based on experience
• Empirically, examine commercialisation choice based on start-up
experience in R&D variables and incumbent experience in
products and production