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

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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

Start-Up

Enter and Compete

Competitive commercialisation

Start-Up

Enter and Compete

Profit > entry costs

Competitive commercialisation

Start-Up

Enter and 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 Compete

Sell or license

Start-Up

Compete and/or cooperate?
Enter and Compete

Sell or license

Start-Up

π−f

Compete and/or cooperate?
Enter and Compete

Sell or license

Start-Up

π−f

t

Compete and/or cooperate?
Enter and Compete

Sell or license

Start-Up

π−f

t

Incumbent

Compete and/or cooperate?
Enter and Compete

Sell or license

Start-Up

π−f

t

Incumbent

π

Compete and/or cooperate?
Enter and Compete

Sell or license

Start-Up

π−f

t
Π−t

Incumbent

π

Compete and/or cooperate?
Enter and Compete

Sell or license

Total Surplus

Compete and/or cooperate?
Enter and Compete

Sell or license

Total Surplus

2π − f

Π

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?

Firm Start-Up Incumbent

Willingness to Pay Comp π-f ΔΠ Coop t ΔΠ

Preemption Comp π-f
Π(1+Δ) - π

Coop t 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 noncontractible)

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 noncontractible) • 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 noncontractible) • 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 noncontractible) • 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 noncontractible) • 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

∂F ∂s

Π′(d) −


<0

∂2 F ∂d∂s

Π(d) > 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 -- ongoing change

Starting point
• Segal & Whinston (2007) model of dynamic technological competition • SW apply to antitrust practices • SW consider entrants as competing and displacing incumbents -- ongoing 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
Innovation leader chosen

Production

Innovation

Negotiations

Timeline

t-1

t

t+1

Selection
Innovation leader chosen

Production

Innovation

Negotiations

Capabilities Acquired

Timeline

t-1

t

t+1

Selection
Innovation leader chosen

Production

Innovation

Negotiations
Commercialisation choice

Capabilities Acquired

Negotiations

Negotiations

Entrant Innovates

Negotiations

Competition

Entrant Innovates

Negotiations

Competition

I loses monopoly profits

Entrant Innovates

Negotiations

Competition

I loses monopoly profits

E becomes I (earns Π)

Entrant Innovates

Negotiations

Competition

I loses monopoly profits

E becomes I (earns Π)

Entrant Innovates

Cooperation

Negotiations

Competition

I loses monopoly profits

E becomes I (earns Π)

Entrant Innovates
I retains monopoly profits

Cooperation

Negotiations

Competition

I loses monopoly profits

E becomes I (earns Π)

Entrant Innovates
I retains monopoly profits

Cooperation

E remains E (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
Production Only Innovation Only Production & Innovation

Example

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader E as innovation leader

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader E as innovation leader Merger or I as innovation leader

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader E as innovation leader Merger or I as innovation leader

Probability of becoming Leader

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader E as innovation leader Merger or I as innovation leader

Probability of becoming Leader

σ p ∈[0,1]

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader E as innovation leader Merger or I as innovation leader

Probability of becoming Leader

σ p ∈[0,1]

σ i ∈[0,1]

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader E as innovation leader Merger or I as innovation leader

Probability of becoming Leader

σ p ∈[0,1]

σ i ∈[0,1]
σ ip ≥ max{σ p , σ i }

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 NonInnovator

Continuation payoffs
I Innovation Leader

E Innovation Leader

I NonInnovator

Continuation payoffs
I Innovation Leader

E Innovation Leader

I NonInnovator

Continuation payoffs
I Innovation Leader

E Innovation Leader

I NonInnovator

Cooperation

Continuation payoffs
I Innovation Leader

E Innovation Leader

I NonInnovator

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
σi

VI ≥ v I + v E

σ ip

Licensing Equilibrium Outcomes
σ ip
Competition
VI < v I + v E

σp

Licensing

Licensing

Does high σi drive competition?

Competition
σi

VI ≥ v I + v E

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 i I

≥ σ pδVE + Π + σ iδV + (1 − σ i )δVI    
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

Competition
σp

VIi < v II + v EE V +V

Acquisition
Does high σi drive competition?
VIi ≥ v II + v EE V +V

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

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