Professional Documents
Culture Documents
:
Evidence from the SBIR Program*
by
COMMENTS WELCOME!
*
The cooperation and assistance of the firms that contributed data used in this study is greatly appreciated.
Josh Lerner, Scott Wallsten, Scott Shane, seminar participants at MIT, the FTC and the NBER, and
especially Iain Cockburn, provided thoughtful suggestions and advice. David Hsu provided outstanding
research assistance. We also gratefully acknowledge funding for this research by the MIT Center for
Innovation in Product Development under NSF Cooperative Agreement # EEC-9529140. Any remaining
errors or omissions are our responsibility.
**
Melbourne Business School, University of Melbourne, and MIT Sloan School & NBER, respectively.
All correspondence to Scott Stern, Sloan School of Management, MIT, Cambridge (MA), 02142;
mailto:sstern@mit.edu. The latest version of this paper is available at
http://www.mbs.unimelb.edu.au/jgans/research.htm.
When Does Funding Research in Smaller Firms Bear Fruit?:
Evidence from the SBIR Program
Abstract
This paper evaluates whether the relative concentration of funding for small, research-
oriented firms in some important high-tech industries is related to the differences across
industries in the appropriability regime facing small firms. We explore this hypothesis by
analyzing the performance of projects funded by the Small Business Innovation Research
(SBIR) program, a Federal subsidy that provides R&D funds for small businesses. By
design, the cost of R&D capital is (approximately) equalized for firms funded by the
SBIR. As a result, we neutralize capital market imperfections as a direct source of
variation in our sample. In contrast, the SBIR does not affect sector-level differences in
the appropriability regime or in the underlying level of technological opportunity. The
main contribution of this paper results from exploiting this difference to evaluate the
salience of capital market imperfections, the appropriability regime facing small firms,
and the overall level of technology opportunity. Specifically, if the SBIR fund projects on
the margin (as it should under an optimal subsidy regime), then a cross-sectional
comparison identifies the relative importance of capital versus product market
imperfections across markets. Our principal empirical result is that project-level
performance is highest for those technologies that are in industrial segments that attract
high rates of venture capital investment. As well, there is weak but positive evidence that
performance is related to the overall level of scientific opportunity. We interpret these
findings as suggesting that an important difference between industrial sectors is the
degree of appropriability for research-oriented small businesses; variation in the
appropriability regime helps explain the concentrated nature of venture capital activity in
the economy.
I. Introduction
Since Arrow (1962), economists have been aware that competitive markets may
fail to provide the socially optimal level of R&D investment. Innovation is beset by
uncertainty, imperfect monitoring and imperfect property rights; the combination of these
factors leads many to conclude that the realized level of R&D investment by private firms
is too low (Bush, 1945; Griliches, 1992; Romer, 1990). In this context, special attention
is paid to the role of the small, research-oriented firm. While many suggest that these
1934; Foster, 1986; Acs and Audretsch, 1996), others highlight that smaller, start-up
1989; Teece, 1986; Kamien and Schwartz, 1982; Himmelberg and Petersen, 1994).
Specifically, smaller firms may both have difficulty raising capital for R&D projects and
be less well positioned to extract the social value of their innovations in the marketplace.
sectors experience high rates of innovation, the composition of funding and performance
venture financiers have somehow overcome the capital market imperfections and
environments. Put another way, understanding why small firm research is financed in
only a few sectors involves discerning how the funded sectors differ in terms of the
as well as providing policy guidance in terms of how to better encourage small firm
The paper evaluates the variation across sectors in the performance of projects
funded by the Small Business Innovation Research (SBIR) program, a Federal subsidy
that provides R&D funds for small businesses. By design, the SBIR program effectively
equalizes the type of capital market imperfections that theoretically raise the costs of
capital to small firm R&D. As a result, the salience of capital market imperfections is
(roughly) equalized across our sample. In contrast, the SBIR does not affect sector-level
opportunity. The main contribution of this paper arises from exploiting this difference to
evaluate how sectors differ in terms of capital market imperfections, the appropriability
regime facing small firms, and the overall level of technological opportunity.
that would not have been funded in the absence of a subsidy, then a cross-sectional
deterred from funding innovations with relatively high ex post returns in those industries
where capital market imperfections are particularly binding. If projects are funded on the
margin, then one would expect that grants provided to firms in capital-constrained
3
industries would tend to perform most highly. On the other hand, grantee performance
will be highest in those sectors that have the ability to earn the highest returns even in the
absence of the subsidy. If differences across sectors are driven by differences in the
performance and the stock of private venture capital fundraising, conditional on the level
and technological opportunity itself, this may suggest that the critical differences in
Using a novel dataset constructed from a survey by the authors of SBIR funded
projects, our principal empirical finding is that project-level performance is highest for
those technologies that are in industrial segments that attract high rates of venture capital
investment. As well, there is weak, but positive, evidence that performance is related to
the overall level of scientific opportunity. We interpret these findings as suggesting that
research-oriented small businesses, and this variation helps explain the relative
differs from most prior treatments that have attempted to evaluate intersectoral
differences in the environment for small-firm R&D. By and large, such studies have
analyzed samples that are subject to an important selectivity – they have indeed been
funded by the private sector (Mansfield, 1995; Griliches, 1998; Hall, 1988; 1993;
capital market imperfections from more downstream issues such as the appropriablity
4
regime. As well, our approach differs from prior work on the SBIR (in particular Lerner
(1996) and Wallsten (1997)). Both of these prior studies seek to identify the incremental
the differences across funded firms in order to understand how different segments differ
The rest of the paper proceeds as follows. In the next section, we review the
theoretical and empirical literature on the constraints facing small research-oriented firms
in capital and product markets. Section III then describes the SBIR program and the
features that allow it to provide an experiment to control for capital market imperfections
across sectors. Section IV presents a model that captures the essence of capital and
product market imperfections and we use this as a basis to formulate testable hypotheses
about the determinants of venture capital funding levels across industries. Section V
presents an overview of our dataset while in Section VI we present our main empirical
results and tests for the robustness of these. A final section concludes.
Among the most distinctive facts about the innovative process is the concentrated
nature of formal R&D investment across the economy and the even further concentrated
nature of venture capital finance or small-firm R&D financing. Consider first the
distribution of R&D funding relative to value added across the manufacturing sector of
5
the U.S. economy. 1 Relative to the distribution of aggregate economic activity (even
when one examines the venture capital financing or the financing of R&D in small and
medium-sized firms. Using data drawn from Kortum and Lerner (1999), Figure 1B
the (already concentrated) privately financed R&D investment. Though there are
SIC-oriented sectors (a concern which we address directly in our empirical work), Figure
1B suggests that, even among R&D-intensive sectors, a very small number receive a very
high share of the overall funds from venture capital sources.3 This latter finding about the
concentrated nature of investment by small firms suggests that differences across sectors
are not merely driven by difference in raw technological opportunity (which would be
reflected in the aggregate R&D distribution) but depend on the ability of small firms to
both finance risky but potentially valuable innovation investments and their ability to
1
All data are drawn from the 1992 NSF Science and Engineering Indicators and are presented in terms of
R & Dj
their rank of .
VALUE ADDED j
2
Indeed, the Gini coefficient of inequality is over .6, a relatively high rate of inequality across sectors in
terms of their R&D expenditures.
3
Indeed, while economists have relatively ignored the consequences of this observation, its validity is a
widely accepted and well-documented feature of the venture finance industry (REFS,
www.ventureone.com). As well, one could replicate our result by shifting the analysis away from venture
capital in particular and towards the somewhat more comparable concept of small-to-medium sized R&D
investment (tabulations available from the authors).
6
Although prior research has acknowledged that these distributions are in fact
skewed (Griliches, 1986; Hall, 1992; Kortum and Lerner, 1999), few attempts have been
made to distinguish the different potential drivers of the heterogeneity across sectors.
Specifically, while there exist studies which examine a single hypothesis and exploit
variation across sectors to evaluate its relative importance (e.g., Cockburn and Griliches,
1988; Himmelstein, 1993), there has been little systematic analysis of the full set of
potential drivers of this observed heterogeneity across sectors in terms of the intensity of
the innovative or entrepreneurial process. In particular, our analysis will consider three
contribute to differences in terms of their R&D investment levels: the salience of capital
opportunity. Each of these potential sources has the potential to create variance in the
environment across different industrial sectors that manifests itself in terms of differences
turning to an equilibrium analysis of how each shapes industry-level R&D funding and
how evaluation of government-subsidized research may provide insight into the relative
(Schmookler, 1967; Rosenberg, 1974). Indeed, to the extent that most studies of the
asymmetries between financier and research firm and the consequential incompleteness
of financial contracts (Kamien and Schwartz, 198*). One strand of this literature focuses
on the potential conflict between equity or debt finance and the incentives of small
Holmstrom (1989) notes the difficulty in measuring either the inputs or outputs of
research firms while Aghion and Tirole (1994) extend this to demonstrate the adverse
Related to this are concerns that innovators themselves may be able to hold-up
financiers. Anand and Galetovic (1999) examine the potential concerns of corporate and
venture capitalists in having multi-project research firms realize the returns from financed
innovations in opportunistic ways. Hellmann (1998a) notes that innovators may have
incentives that are not purely commercial and hence, may not act in ways that maximize
investor returns. These effects can make finance contracts infeasible or require excessive
control and monitoring by financiers thereby diluting the innovation incentives of small
firms.
8
potentially successful projects ex ante. The adverse selection literature goes all the way
back to Stiglitz and Weiss (1981) and their analysis of the difficulties of using debt
contracts to identify good projects. Ownership arrangements and other forms of corporate
governance can mitigate these issues. However, the potential for small firm
Hubbard, 1998).
Degree of Appropriability
innovators to appropriate the economic returns from the innovative process. Innovation
involves spillovers (Bush, 1949; Nelson, 1959) and the pricing of indivisibilities is
imperfect (Arrow, 1962; Romer, 1990) so that private investors can never appropriate the
full social returns on any sunk R&D costs. These challenges face all private research
commercialization and the incentives for R&D investment is the central focus of the
Schumpeter (1942) noted that the competitive process dissipates innovative rents
favoring monopoly over entry (see also Gilbert and Newbery, 1982). However, even
when these firms are looking to license or otherwise sell their innovations to product
market incumbents, there are important challenges. As noted earlier, such licensing
contracts can rarely be agreed upon ex ante. Either the output of innovative activity is
9
hard to specify (Aghion and Tirole, 1994) or it is difficult to identify good projects ex
ante (Anton and Yao, 1994). The result of this is that, even when intellectual property
rights are relatively secure, small firms may only appropriate a fraction of the private
returns from innovation. Only when they pose a sufficient competitive threat to existing
incumbents or play multiple incumbents off against on another, can they improve their
Furthermore, there are transactions costs associated with the exchange of ideas ex
post. Potential purchasers of tacit knowledge or innovations with weak property rights
can expropriate small firm innovators deterring them from seeking profitable partnerships
(Anton and Yao, 1994). This is fundamental because it is rarely the case the innovations
can be sold without revealing their nature to potential buyers (Arrow, 1962).4 This means
that small research firms may face costly product market entry as the only feasible
commercialization route, thereby, reducing their returns further (Gans and Stern, 1998).
In this section, we integrate the insights of the previous two sections and develop
a simple model of the impact of an R&D subsidy focused on small mostly research-
constraints on small firm research financing, the average performance of SBIR grantees
is likely to be negatively associated with observed levels of venture capital funding. This
4
Anton and Yao (1994) demonstrate that the presence of multiple incumbents or low entry barriers can
mitigate this exp ropriation problem. In these cases, the small research firm can credibly threaten to destroy
the potential for an exclusive licensing arrangement in order to avoid expropriation and improve their
potential license fee (see also Rasmusen, 1988).
10
is because the funding mechanism identifies high potential performers only in industries
where those are not otherwise likely to be funded. Alternatively, a positive association
between average performance and venture capital funding will be indicative of the
Either way, this discussion will highlight the fact that we need to control for
Our focus here is on the provision of capital to a research unit (RU) that engages
in innovative activity. That capital is considered a critical input for innovative activity.
We suppose that a project requires a unit of capital. 5 This capital may be provided by a
venture capitalist (VC) or by a subsidy from the government. The primary difference
between the two sources is that the former requires, while the latter does not strictly use,
potential private returns in selecting projects to fund. We will consider the VC capital
source first and discuss the role of a government subsidy later. It is assumed that the
Having received the requisite capital for the project, the probability that a
5
This unit is the minimum level of capital required for a project. The unit assumption is a normalization;
essentially all our return variables are in per unit of capital terms for notational ease.
11
equity partners) can only appropriate a fraction, γ (< 1). We denote the RU’s returns by v
= γV. As discussed earlier (in Section II), previous research has identified many potential
determinants of γ including the degree of product market competition and the ease of
entry to it, the strength of intellectual property rights, and transactions costs involved in
selling ideas. Each of these represents a potential imperfection at the product, rather than
While our discussion of the model here will focus on an individual project with
social return, V, we expect that these returns will vary among projects. For our exposition
here we will assume that a given project is drawn from an industry-level distribution that
is uniform over the space [ 0,V ] . The parameter, V , is, therefore, a measure of the level
Determining VC Funding
that is, it is increasingly difficult to attract capital. For a given project, the marginal
private cost of capital is F + θ, where θ is the difference between the private and social
marginal cost of capital. We assume that θ > 0 capturing the potential for capital market
imperfections. This marginal cost determines the supply of industry funding for small
firm research. This model is admittedly a reduced form. In the appendix, we provide
three alternative models of why, in this context, the private cost of capital may be greater
On the demand-side, the expected private return from a project is pv. The total
industry demand for these projects – that is, the number of projects funded, F – is
determined by the distribution of project value in the industry. That is, if for F projects
are funded, the marginal project has social value V determined by F = V − V . The
expected marginal private return when F projects are funded is, therefore,
F= 1
2 ( pγ V −θ ) (1)
shifts the demand and hence F, upwards, while an increase in θ, shifts supply upwards
and lower capital costs, will see more funding than other industries. However, other
things being equal, the marginal project funded will have a higher expected value in
industries that have higher capital costs as well as greater degrees of appropriability and
technological opportunity.
13
pγ V F+θ
Expected
Project
Value
pγ (V − F )
0 Total Funding
F
Notice that a project will be undertaken only if pv ≥ F + θ . This differs from the
investment in R&D may be less than the socially desirable level both because of
difficulties in appropriability through the product market (γ < 1) and a greater private cost
of capital.
Fi = f (Vi ,γ i ,θ i ) . That is the random variable, Fi, is a function of the industry levels of
Each of these variables determines either the demand or supply of funds to the industry.
The key issue with this empirical exercise is that, while the quantity variable (F)
is readily observable, there are difficulties in determining the price variable (the expected
propose that SBIR program recipients provide a means of identifying the marginal
project. The SBIR program provides capital grants that effectively equalize the type of
capital market imperfections modeled here. Specifically, these grants do not require
equity participation by third parties or any reference to the private returns from capital
investment. As such, the effect of the SBIR program is to (roughly) equalize any
private cost of capital is simply irrelevant in terms of the direct objectives of the subsidy
program. Hence, SBIR recipients include those that would not otherwise meet private
funding criteria.
where it does not currently exist. For the financing of small firm investment, this goal
could be realised if the projects that were selected were the most promising projects that
missed out on private funding. In our model, these projects would be those that just failed
to attract funding. For industry i, the marginal project would be characterized by the
condition:
pγ iVi + θ i
vi = .
2p
15
If this project is granted a subsidy, this condition characterizes the private return it would
realize. Observe that this private return is increasing in the degree of capital market
appropriability (γi). Importantly, given its role in determining the supply of funds,
industries.
Proposition 1. cov[vi ,Fi ] < 0 if and only if the variance of θi exceeds the variance of
pγ iVi .
pγ V + θ i pγ iVi +θ i
cov[ F , vi ] = E 12 ( pγ iVi − θ i ) i i − E 2 ( pγ iVi −θ i ) E
1
<0
2p 2p
⇒
1
4p
(
2
) (
p2 E (γ iVi ) − E θi2 <
1
4p
p2 E γ iVi − E [θi ]
2
) 2
Intuitively, variations in θi move the supply curve while variations pγ iVi move the
demand curve. Thus if the variance of θi exceeded that for pγ iVi , one would observe
‘price’ and ‘quantity’ variables across industries tracking the demand curve. As this is
downward sloping those variables would be negatively correlated. On the other hand, if
the opposite were true and θi varied relatively little across industries, observed pairs
would track the supply curve that is upward sloping. Hence, the variables would be
positively correlated.
16
returns of marginal projects (v i), we can use the correlation between this and observed
VC funding (Fi) to determine the relative strengths of capital market imperfections and
industries.
Funding Mechanism
In proposing the above empirical test of the relative salience of capital and
a marginal funding mechanism for selecting SBIR recipients. It may be objected that the
SBIR could use other mechanisms for allocating funds. In particular, projects may be
selected to ensure political success of the program. Consequently, the SBIR may cherry
pick the best possible project rather than projects that would otherwise not receive private
If cherry picking is the selection mechanism, then if the main source of variation
across industries is in the capital market imperfection (θi) then the level of industry VC
funding is unlikely to explain the average performance of grant recipients. While the
grant alleviates the capital market imperfection, it equalizes its expected effect on
individual grant recipients, as those recipients are not selected on the basis of V alone.
This is in contrast to the marginal rule that implicitly considers θ when it searchers for
projects that are not likely to be funded by the VC. Under cherry picking, projects that
might otherwise by funded, are selected for a government subsidy. Hence, the concerns
17
that subsidy programs, such as the SBIR, may not be allocating resources to where they
higher product market appropriability (γi), will perform better under a cherry picking rule.
Hence, if either of these were the main source of structural variation across industries,
performance and the level of industry VC funding. Otherwise that correlation would be
close to zero.
This paper uses Proposition One in order to evaluate how an evaluation of the
the relative salience of different forces which determine the funding and intensity of
do so, we exploit data about projects funded by the Federal government’s SBIR, the
largest individual source of R&D financing for small to medium-sized firms in the United
States. SBIR funding provides a unique and informative source of variation in the
firms, the SBIR program (roughly) equalizes the cost of capital for R&D regardless of
exploit this variation to evaluate the relative importance of capital market imperfections,
in the level and composition of R&D investment across industries and technological
sectors. Such a test depends, of course, on drawing a precise mapping between the
institutional details of the SBIR program and the assumed economic consequence of the
program. We, therefore, first briefly review the SBIR program, highlighting the potential
The SBIR Program, first authorized in 1982, requires that all Federal agencies
who support a minimal level of R&D activity are required to set aside a certain
percentage of their funds for extramural grants to fund R&D projects by small business.6
research,
industries; and
(c) enhance the participation of small firms as well as women and minority-
From a political perspective, the program’s support seems to derive in part from (ever-
economic growth (Cohen and Noll, 1993). Combined with political rhetoric which simply
assumes that research-oriented start-up firms are the engine of long-term economic
growth, and that such firms face a particularly severe “funding gap” arising from the
6
This percentage has varied over time starting at X in 1990 and reaching a stable level of Y in 1997. For
the purposes of the program, a small business is defined as an US-owned firm with less than 500
employees. Further details of the SBIR are discussed extensively in GAO (1995), Wallsten (1995, 1997),
and Lerner (1999).
19
unwillingness of investors to shoulder the risks of early-stage financing, the SBIR has
been a popular program whose scope has been consistently expanded since its inception
(REFS). Indeed, the SBIR is now the single largest source of early–stage R&D financing
for small firms in the United States with 1997 expenditures of over $1 billion.
Despite its political support, the program has been somewhat controversial. In
part, this is because neither the legislative nor regulatory rules governing the program
mandate the program fund projects on the margin (which would determine performance
Wallsten (1997), the program’s funding guidelines seem to focus on funding the most
(thus suggesting that performance may reflect the “cherry-picking” regime).7 Perhaps as a
consequence of this selectivity, there is some evidence that firms funded by the program
do tend to have an accelerated rate of growth compared to similar firms (Lerner, 1999).
However, Lerner emphasizes that this “boost” to firm-level growth seems to be localized
according to the location or technology focus of the firm, a contention which we explore
Indeed, the main focus of this prior research is on the assessment of the marginal
contribution of SBIR funding (and government venture capital more generally). Towards
this goal, each of these analyses is framed in terms of the counterfactual of the expected
behavior or performance of these firms, in the absence of the subsidy program. Indeed,
both Lerner (1999) and Wallsten (1997) focus their results around the comparison of a
7
An additional critique is that a small number of firms have been able to win a disproportionate share of
overall grants. While the absolute importance of these so-called “SBIR mills” is limited, the potential for
regulatory capture by these firms has led to interest in limits on the total number of grants for which a
20
group of SBIR-funded firms and a “matched sample” of firms who are observationally
similar ex ante but who do not receive SBIR funding. For example, Wallsten concludes
that SBIR award winners do not necessarily grow faster than other firms (in terms of
employment growth) by comparing a group of SBIR award winners with a group of firms
who had applied for but been rejected in the SBIR grant applications. Lerner also
examines both SBIR grantees and a comparison group in a regression analysis. Once
again his focus is on the incremental differences at the firm level associated with
receiving an SBIR award. He concludes that the awardees do tend to grow faster though
this effect is mostly localized around firms in locations that also fund venture capital.
This paper refocuses analysis of the program away from program assessment.
(1) the wide dispersion of these funds across industries and technology segments;
(2) the program’s ability to alleviate capital market imperfections in the funding
of research; and
We use these features together to pose and analyze our empirical test which compares the
behavior and performance of SBIR grantees across industrial areas and technology
segments.
(Agriculture, Defense, HHS, etc.) whose missions span the scope of the economy’s
activities, the expenditures of the SBIR program are much more widely dispersed (across
single firm might be eligible (GAO, 1995). While we do not specifically address mini-mills per se, we do
demonstrate that our results are robust to their inclusion or exclusion.
21
industries and technological areas) than privately funded R&D. This wedge between
SBIR expenditures and private funding is particularly salient if one focuses on investment
or R&D expenditures specifically for small (or venture-backed) firms. In other words, a
specific if unintended contribution of the SBIR program is to expand the supply of capital
to research-oriented, smaller firms to a set of industries and technologies which, for one
subsidy, the SBIR program substantially alleviates the salience of capital market
imperfections. In contrast to the tradeoff that emerges between the provision of incentives
organization, the SBIR does not extract equity (or debt) from the grantee. In fact, quite
the opposite. The incentives to perform the research are preserved and incentives to divert
the fruits of research away from equity holders are minimized. Of course, SBIR funds do
not completely alleviate capital market issues or incentive problems – we only claim (or
need to claim) that the SBIR program reduces the salience of capital market
property rights are weak in a given area prior to the SBIR grant, there is nothing in the
funding of that research which will overcome this general bias. Indeed, while venture
capitalist funding may provide non-pecuniary value to the firm through the experience of
the managers in translating research results or novel ideas into appropriable technologies
22
The remainder of this paper is devoted to exposing and exploring the economic
test embedded in these three features of the SBIR. By being more diverse than privately
funded investment, data from grantees provides information about the differences in the
returns structure across industries where there is currently venture capital funding and
also where such funding is more rare. Differences among SBIR grantees across industrial
areas may reflect the differential impact of reducing the salience of capital market
given industry, then the provision of public funds may hold particularly high marginal
similar across sectors, but sectors differ substantially in terms of their appropriability
regime (or overall technological opportunity). In this case, the subsidy will be most
productive (in terms of project performance) in those sectors that already offer a
to the earlier hypothesis, project performance should be highest in those sectors that
already are funded by venture capitalists. In evaluating the performance of the SBIR
equalizing shift in the capital constraint, holding the appropriability regime constant. We
can examine this more carefully by first describing the data we have gathered for this
8
In recent years, there has been legislation encouraging the funding of consultants for grantees to assist in
the commercialization process. By all accounts, such efforts or activities are very rare empirically and pale
compared to the involvement of venture capital management.
23
V. Data
This paper presents results from a novel dataset of 100 projects funded by the
SBIR since 1990. The data were gathered via a field-based proprietary survey conducted
by the authors. This project-level data was then supplemented with public data on each
firm’s patenting behavior, SBIR grant history, and covariates related to the industry,
business segment, and scientific underpinning associated with each project. In this
section, we first review our procedure and the elements of our survey (highlighting the
sample selection and data gathering process) and then review the summary statistics for
the sample (Table 1 includes the definitions of all the variables used in the analysis;
The data is drawn from several sources; most importantly a survey conducted
between December and February 1999 (see Appendix B for a copy). Along with a similar
survey of the commercialization histories of venture-backed firms, the data from this
survey are being used to study a variety of phenomena associated with the incentives,
The sample is drawn from a list (compiled by the Small Business Administration)
of the (approximately) 200 largest historical beneficiaries of SBIR grants. For survey
participants, we requested information about their most successful project funded by the
SBIR (for most firms, there was only one (or at most two) SBIR-funded projects which
the firm considered technologically successful). By focusing on the projects for each firm
24
that overcame the substantial technological hurdles associated with innovation, the data
provide information about the relative economic returns of projects in different industries
Approximately 50% of the surveys were conducted over the telephone. The
remainder was completed through fax and regular mail (many surveys required follow-up
overall response rate to the survey was approximately 50%. While sample selection was
not ideal, the degree of non-response seemed correlated with the level of effort devoted to
identifying the individual at the firm who could answer the questions on the survey. Only
secrecy or confidentiality (all respondents were ensured that their individual responses
The surveys provide information both about the company who received the SBIR
grant as well as the details of the SBIR-funded project. The first part of the survey
gathers information about the size and background of the workforce (e.g., share of
workforce with a Ph.D.) as well as some information about the criteria used to promote
scientists and engineers. Second, the survey asks about the financial structure of the firm
(e.g., share of the firm’s equity owned by venture capitalists or by top management) as
well as the rules used to fund research and development activities (as well as other
investment activities such as advertising). Data is also gathered about the internal
authority structure of the firm (the composition of the board of directors) and the firm’s
information about the nature of the technology and the underlying innovation (e.g.,
product or process innovation, development of novel system, the intellectual property and
strategy of the firm (e.g., time from conception of the new product to market
out the revenues associated with the project into several different categories,
distinguishing direct product market sales from licensing revenue and the sale of
intellectual property assets (e.g., patent exchanges and the like). For both product market
sales and licensing revenue, the survey gathers information about the current-year
revenue (which seemed to be much more reliable, consistent and complete for most
firms) and the total revenues accruing to this product since its commercial introduction.
Finally, the survey gathers information about the nature of the licensing (if it occurs) as
the technology.
(see Table 1 for definitions). First, we define the project-level variables. We define
performance in terms of the aggregate annual revenues from product sales, licensing, and
intellectual property exchanges (REVENUE 98).9 For each project, we identify the
number of PATENTS awarded since the grant as well as the project-level SBIR AWARD
SIZE (from the USPTO and the Small Business Administration, respectively). In
9
All of the qualitative results are robust to using the data on total project revenues (indeed, they are highly
correlated). However, this would further reduce the number of usable surveys by approximately one-third.
26
addition, we identify all firms who receive at least some of their overall revenues not
through direct product market sales but through licensing arrangements or intellectual
property sales. We denote these firms COOPERATORS insofar as nearly all of these
firms are involved in cooperative contracting with more established product market
with the same firms who have arranged to “buy out” the SBIR awardees’ product market
position (Anton and Yao, 1995; Gans and Stern, 1998). We also include several dummy
variables, which denote the technology, product and customer base types of each project
(TIME-TO-MARKET) that is simply the overall time from initial product conception to
the first sale of this product to any customer (either directly or through licensing).
As well, we include several firm-specific variables that describe the more general
firm size (EMPLOYMENT 98). We use the initial value of this measure as a key control
in most of our empirical analysis (BASELINE EMPLOYEES), in order to control for the
initial size of the firm. As well, the analysis examines variables related to financial
between these is while the first confirms the potential importance of the “certification”
hypothesis (SBIR grants lead to VC funding which leads to overall performance), the
latter allows us to capture the pure associated between performance and maintaining a
27
closely held organization. Similarly, FOUNDER CEO proxies for the overall
scientific areas associated with each project. Specifically, we want to distinguish three
R&D in the project’s industrial area, and the scientific and engineering opportunities
segments identified by Venture One (see Figure 3A). For each segment, we measure the
between 1985 – 1992. We also present results for the VC CAPITAL FLOW, which are
composed exclusively of the 1992 disbursements. We also assign each project (firm) to a
single three-digit SIC; the NSF Science and Engineering Indicators provides data for each
project. First, we assigned each project to one or more scientific and engineering fields
(out of a total of 14). In contrast to the mutually exclusive nature of the prior variables,
the science base of each project can be composed from multiple sources. For each area
stock in that area (equal to 1990 FUNDING + .8 1988 FUNDING + .6 1986 FUNDING).
Each project’s SCIENCE STOCK is simply the sum of the individual field-level stocks
heterogeneity among firms by including a number of variables from the survey that
capture, at least to some degree, the firm’s perception of the appropriability environment
relevant for the project under consideration. Specifically, we include several variables
Summary Statistics
Out of a total 100 responses, 74 were fully usable for the empirical work reported
here.10 However, for most of the analysis, we exclude the small number of observations
(3) that were clearly so-called SBIR “mills”; these organizations have a much more
diverse research portfolio from the rest of the sample and also have a different
relationship with funding agencies. This leaves us with 71 total observations for the
10
Most of the non-responses were because of non-reporting of all 1998 revenues (e.g., sales reported but
not licensing revenue. We have checked our results including all results, even those for whom the data was
incomplete; the qualitative results are unchanged.
29
Among these 71, the average project reports approximately 6.5 million dollars in
revenue, compared with an average award size of 1.5 million (but note the high standard
productive in a technical sense. On average, each has been issued over 9 patents that were
applied for since the first SBIR grant associated with the specific project here (all chosen
projects have their first funding date after 1990). In addition, almost a third of the sample
earns at least some its revenue through cooperative licensing or IP exchanges (most often
projects is a little over four years, though some outliers in part drive this (from
biotechnology and the like). Finally, at the firm level, while most of these organizations
are quite small at inception (35 employees on average), they tend to experience
substantial growth over time (the average firm has nearly 90 employees by 1998).11
As suggested earlier, the principal empirical exercise of this paper will be to relate
Figure 3 presents the distributions of the three principal measures we use to capture these
the level of technological opportunity and realized private investment activity. Whereas
11
As well, in terms of the internal organization and finance of the firms, over 50% of equity is retained by
insiders; perhaps surprisingly, while 25% of the sample had attracted some form of VC or “angel”
financing, the equity share of these investors is quite small (the average level of equity held by these
outside investors across the full sample is less than 7%). In addition, in nearly 60% of the firms, the CEO is
30
entrepreneurial activity and is divided into several segments which do not precisely map
investment in alternative scientific and engineering fields upon which many of these
innovations draw and differences across sectors ni terms of aggregate R&D expenditures,
FUNDING STOCK will be sensitive to the differences across sectors in terms of the
in Table II, Figure 3 highlights both the skewed nature of both venture financing and
R&D funding (e.g., telecommunications, medical care technologies, and software make
measured as the cumulative investment in given areas over 8 years, one can see that the
vraiables for the environment) are each Likert measures; not surprisingly, the mean of
each varies from a little above 3 to just over 4. With these summary statistics in mind, we
can turn the heart of our empirical analysis, to which we now turn.
one of the original founders of the firm. Finally, the firms are reasonably concentrated
geographically(nearly half the companies are located in either California or Massachusetts).
31
We now turn to our evaluation of the principal hypotheses of this paper (recall
Proposition 1). Specifically, we are concerned with the degree of variation across sectors
in technological opportunity (V(V )), the degree of appropriability (V(γ)), and the
relative salience of capital constraints (V(θ)). Our empirical test provides evidence about
the relative salience of these factors in explaining the large differences in R&D funding
for small firms across industries that we highlighted in Section II. Specifically, we test for
the relationship between project-level performance and the level of private investment in
specific factors that also may affect performance. In Tables 3-5, we present our main
finding from this analysis: controlling for project-level, firm-level and other
for small firms in a given technology segment and, more tentatively, in the science stock
overall R&D investment in a given area or the overall size of an industrial segment.
These basic findings are robust to several quite stringent tests of robustness, including the
well as variation in the measurement of the level of financing for small research-oriented
firms (some of these results are presented in Appendix C). As well, in Table 6, we show
the alternative measures of private investment and technological opportunity. The most
striking result is that, whereas SCIENCE STOCK, SIC R&D EXPENDITURES, and SIC
both statistically significant and quantitatively important: doubling the level of venture
revenue (see (3-1)). As well, in (3-5), we demonstrate that our principal result
lower in magnitude). When considering these results, it is useful to recall that, relative to
opportunity than the variation in the structural parameters associated with appropriability
or capital market imperfection impacting small, entrepreneurial firms. While we defer our
overall interpretation of this result until our conclusions, it is useful to note that, under the
logic of Proposition 1, this result suggests that there is a salient difference across
industrial segments in terms of their appropriability environment (i.e., V(γ) > 0), even
after incorporating some more direct measures which would capture variation in
the robustness of the VC FUNDING STOCK result to the inclusion of various project-
“control,” the level of initial employment at each firm. In some sense, this very simple
measure should capture some degree of the heterogeneity among firms in terms of their
revenue; however, its inclusion does not impact our main result at all. We then extend our
associated with the firm’s perception of the appropriability environment and project-level
controls, respectively. At one level, the results from this analysis are interesting in their
own right: while revenues are increasing in the technological quality and product
respectively) and whether firms “cooperate” with more established firms (note this could
be in part the result of the selectivity of projects which are attractive for licensing),
environment facing individual firms. However, the more important finding from Table 4
is that the coefficient associated with VC FUNDING STOCK remains roughly the same
magnitude and statistically significant, despite the large number of control variables
included and given the relatively small number of observations in the sample. Indeed, in
(4-4), we include all of the control measures simultaneously with no impact on the
underlying result regarding the VC FUNDING STOCK variable. Once again, given the
logic of Proposition 1, these results suggest that there exists an important source of
variation across sectors in terms of the degree of appropriability facing small firms, and
that such differences are reflected in the ability of subsidized firms to earn returns on
all of the controls considered in Table 4. Interestingly, with these controls in place, the
and is statistically significant (SIC R&D EXPENDITURES remains both relatively small
and statistically insignificant). However, when, in (5-3), we include all of these variables
together, the principal result associated with VC FUNDING STOCK remains robust, as
does the SCIENCE STOCK result. In other words, even after we control simultaneously
projects tend to be associated with those industrial segments with high rates of venture
capital funding.12 While such a result may be interesting in terms of SBIR evaluation per
se, perhaps its more important implication is that such covariation is only possible when
12
Appendix Tables A-1 and A-2 further establish the robustness of the VC FUNDING result. In A-1, we
include additional firm-level covariates, including measures of the financial organization of the firm, as
well as additional environmental covariates associated with the geographic location of the firm. As before,
while the SCIENCE STOCK variable is only significant in some specifications, the VC FUNDING
STOCK remains significant at a similar magnitude. Finally, in A-2, we consider alternative sample
selection schemes such as mandating that we only include projects whose 98 REVENUES are greater than
the size of their SBIR grant or including the SBIR “mills” in the analysis. As before, our main qualitative
result is confirmed: project-level revenues are strongly associated with segment-specific level of venture
financing.
35
(EMPLOYMENT 98). In some sense, this analysis is more directly comparable to the
analysis pursued by Lerner (1999), in that Table 6 focuses on the determinants of firm-
level performance among SBIR-funded firms. The analysis is straightforward and echoes
controlling for BASELINE EMPLOYMENT (as well, this result is relatively robust to
the inclusion of various controls, similar to the earlier analysis). In conjunction with our
earlier findings regarding REVENUE 98, Table 6 provides additional evidence that there
segment-specific levels of venture activity, a result which can be tied to the potential
research-oriented firms.
results. The sample is small and based on an imperfect survey. Even with this limitation,
however, several generalizations are possible. First and most importantly, our results
behavior seems to reflect that the economy offers small “pockets” where the
Understanding how such pockets emerge seems to be a promising area for further study.
More broadly, our results can be tied to policy. While recent policy activity has
focused on overcoming the “funding gap” for small, research-oriented firms, our results
suggest that benefits might arise from turning attention to strengthening the
Finally, we return to our contention that our results are suggestive but not the final
word. Beyond the small sample size, we can imagine that a more conclusive approach to
this type of research would be to more carefully integrate the earlier approaches of
Lerner, Wallsten and others (which compared the incremental benefits of SBIR grants)
with the intra-grantee analysis presented here. Such a dataset would allow for more
careful distinction between variation resulting from overall technological conditions, the
fact of being an SBIR grantee, and policy-sensitive issues such as the appropriability
Suppose that the RU employs effort in innovative activity and that this can
influence the likelihood of generating a successful innovation. We assume that this effort
has a contractible and a non-contractible component. Using only contractible effort, the
probability of generating a successful innovation is pL. We normalize the cost of this
effort to 0. However, by expending non-contractible effort for a marginal cost of 1, the
RU can raise this innovation probability to pH > pL.
We make two simplifying assumptions. First, we assume that research and capital
provision to the RU is socially desirable for some projects, i.e., p HV > F + 1 . Second, we
assume that there exists F beyond which it is never worthwhile providing capital to the
RU if it is not expected to expend a high level of effort in innovative activity, i.e.,
p Lγ V = F . The former assumption raises the possibility that some socially desirable
projects may go unfunded because of a lack of appropriability. The latter assumption,
however, means that the VC may not fund some privately profitable projects. This is
essentially because of a capital market imperfection that dilutes the role of VC-equity
when RU effort is non-contractible.
Turning to the determinants of VC funding let α denote the level of equity the RU
retains in its own firm. This level of equity (and any capital forthcoming from the VC) is
determined prior to the RU engaging in any innovative activity. The minimum level of
equity the RU can have and still expend a high level of effort ex post is given by the α
that just satisfies the RU’s incentive constraint:
1
pH αv − 1 ≥ pL v ⇒ α ≥ .
v ( pH − pL )
Given the competitive nature of VC capital markets, VC capital will be forthcoming for
the project so long as it is still profitable at this minimum RU-equity level.
p H (1 − α ) v ≥ F
38
Substituting for α, we can re-write the participation constraint for the VC as:
pH v −1 ≥ F +φ ,
where φ = pL /( pH − pL ) . Notice that, in this model, θ = φ ; meaning that the private cost
of capital exceeds the social cost of capital whenever, φ > 0.
In the previous model, the capital market imperfection arose because of the
detrimental effect of VC equity on the incentives of the RU to expend non-contractible
effort in innovative activity. Here we consider an alternative model where the probability
of a successful innovation depends on the RU’s ‘type’ that is private information to the
RU. We suppose that there are two types of RU’s. RU’s with high ability generate a
successful innovation with probability pH while for those with lower ability this
probability is reduced to pL. There is no non-contractible RU effort. It is assumed that a
given RU is a high type with probability 1-φ and this is commonly known. The potential
value of the project, v, is, however, known. Finally, we maintain the assumption of the
previous section that p HV > K and p Lγ V < K .
Recall that the VC market is competitive, so RUs can demand the maximum level
of equity for a given project, v. However, as they cannot signal their type, the maximum
RU equity that either the high or low type can demand is:
( (1 − φ ) pH + φ p L ) (1 − α ) v = F
F
⇒ α =1 −
( (1 − φ ) pH + φ p L ) v
This means that the lowest value project that can be funded in an industry is determined
by the v that results in α = 0; i.e., v = (1−φ ) pKH +φ pL . This implies that the total level of VC
funding in the industry will be:
F
F = V −
( pH − φ ( p H − p L ) ) γ
Notice that this is decreasing in φ implying that the inability of VCs to distinguish good
RUs from bad results in a lower level of VC funding in the industry. Thus, for this model,
θ = (1φ−(φp) HpH+ −pφL )pL . This equals 0 if φ = 0.
39
(c) Expropriation
Our final model of capital market perfections is based on the potential for
expropriation of ideas by a VC. When an RU approaches a given VC for funding they
must reveal their potential idea. In some situations an RU will provide inputs that are
required for that idea to become commercially viable. In other situations, however, the
RU does not add any value in this sense. If property rights over the idea are weak (as they
may be prior to any patents or copyright), then a VC may expropriate the idea and refuse
to let the RU share in any returns. This is a fundamental difficulty in any trade in ideas
(Arrow, 1962; and Anton and Yao, 1994) and it constrains RU appropriability in at every
stage of innovation.
We suppose that, provided a unit of capital is expended, the idea becomes
commercializable with probability, p, and the potential return, v, is common knowledge.
However, it is possible that the VC simply expropriate the full private return v if
approached by the RU. Anticipating this, the RU may not develop the idea of approach
the RU (although here there is no incentive for the RU not to bring the idea to a VC13 ).
However, as Anton and Yao (1994) demonstrate, a capital constrained RU may have
some alternative means of raising capital. This is certainly the case here given our
assumption of a competitive VC market. If one VC were to expropriate the idea, the idea
may be financed by another VC.
To see this, recall that product market appropriation (γ) depends in part on the
degree of competition an innovation faces. That is, are there products that are close
substitutes? If the RU were to turn to another VC, it may be able to reduce product
market appropriation to (1 − φ )γ ; even though it would not receive any ex post rents itself
in this eventuality. Fearing the RU’s competitive threat from disclosure to others, the
initial VC may not expropriate the RU; instead giving the RU some equity in the venture.
This means that RU-equity will be determined through a bilateral negotiation
between themselves and the first VC they approach. This equity is, therefore, not
determined competitively but through a bilateral monopoly (Williamson, 19??).
Essentially, both the RU and VC can use the threat of disclosure to others or
expropriation to bind themselves to reach agreement.
Following disclosure of the idea to the VC, the two parties negotiate over the
equity level given to the RU. Assuming Nash bargaining with equal bargaining power
this yields:
p (1 − α )γ V − F − ( p (1 − φ )γ V − F ) = pαγ V
⇒ α = 12 φ
A project with social value, V, will be funded if and only if the VC’s participation
constraints (expecting this level of equity) are satisfied. This participation constraint is
13
One could imagine that the RU has some sunk expenditures prior to bringing an idea to a VC that would
be lost in the face of expropriation. This could be added to the model here but it would not alter the basic
insight below about the high private cost of capital; it would merely complicated the cost of capital
function.
40
pγ V ≥ 2
2 −φ F . Consequently, the private cost of capital for this model is given by
φ
θ= 2 −φ F and it clearly exceeds 0 for φ ∈ (0,2] .
41
0.900
0.800
0.700
0.600
0.500
0.400
0.300
0.200
0.100
0.000
0.000 0.100 0.200 0.300 0.400 0.500 0.600 0.700 0.800 0.900 1.000
Cumulative % Value-added
42
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
14000
12000
10000
8000
6000
4000
2000
Industrial Segment
16000
14000
12000
10000
8000
6000
4000
2000
0
metal prod. industrial prod. electric. equip. instruments biotech transportation
Industrial Segment
(Note: R&D expenditures unreported for software & business services)
7000
6000
5000
4000
3000
2000
1000
Academic Discipline
44
16.00
12000
1992 VC Funding Stock ($M)
14.00
10000
6000 8.00
6.00
4000
4.00
2000
2.00
0 0.00
y
/IT
erg
gy
ter
s
tion
s
ts
En
tor
ice
olo
pu
s
uc
rta
ice
uc
ev
hn
m
rod
po
nd
erv
lD
Co
tec
ns
lP
ico
ica
sS
Bio
Tra
tria
ed
es
Se
us
M
sin
Ind
Bu
Industrial Segment
45
14000
1993 R&D Expenditures ($M) 10.00
12000
8000 6.00
6000
4.00
4000
2.00
2000
0 0.00
h
d.
ts
tec
n
pro
en
uip
tio
.
rod
bio
m
rta
eq
tal
lp
tru
po
me
tria
ic.
ins
ns
ctr
us
tra
ele
ind
Industrial Segment
(Note: R&D expenditures unreported for software & business services)
46
TABLE 1
VARIABLES * & DEFINITIONS
TABLE 2
MEANS & STANDARD DEVIATIONS
TABLE 3
PROJECT-LEVEL PERFORMANCE EQUATIONS
(NO PROJECT-LEVEL CONTROLS)
TABLE 4
PROJECT-LEVEL PERFORMANCE
AS A FUNCTION OF VC
TABLE 5
ALTERNATIVE INDUSTRY-LEVEL
CORRELATES OF SBIR PERFORMANCE
TABLE 6
FIRM EMPLOYMENT EQUATIONS
(NO PROJECT-LEVEL CONTROLS)
TABLE A-1
EQUITY & GEOGRAPHY CONTROLS
TABLE A-2
VARYING THE SAMPLE & THE VC MEASURE
sample
N=71
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