Comm Frame

The Product Market and the “Ideas” Market: Commercialization Strategies for Technology Entrepreneurs by Joshua S. Gans and Scott Stern* First Draft: 19th May, 2000

This paper develops a framework to explain observed patterns of start-up commercialization strategy across different industrial sectors. Our analysis focuses on two alternative start-up innovator commercialization strategies: (a) independent commercialization resulting in competition with more established firms (as observed in, say, the disk drive industry) and (b) cooperative commercialization through contracting with more established firms (perhaps through strategic alliances, licenses, or outright acquisition as observed in the pharmaceutical industry). These different paths have very different implications both in terms of the practical management issues associated with implementation and in terms of their predictions about the role of innovation in enhancing product market competition. While contracting in the market for ideas reinforces the market power of established firms, independent entry results in a more competitive product market environment. The analysis is organized around two fundamental environmental drivers of commercialization strategy: the strength of start-up knowledge assets (e.g., their intellectual property) and the scope of established-firm complementary assets. This allows us to characterize four distinct commercialization environments. For each of these environments, we are able to identify start-up strategy, incumbent strategy, the incentives to invest in a reputation, and, perhaps most importantly, the relationship between technological and market leadership.

DRAFT ONLY: PRELIMINARY AND VERY INCOMPLETE

*

Melbourne Business School, University of Melbourne, and NBER and Sloan School of Management, MIT, respectively. Contact author: Scott Stern, Sloan School of Management, MIT, Cambridge, MA, 02142. E-mail: [email protected]. The latest version of this paper is available at: www.mbs.unimelb.edu.au/jgans/research.htm.

1.

Introduction Over the past two decades, there has been a dramatic increase in the level of

investment in start-up innovation.

Start-up innovations are the technologies and

inventions with potential commercial application developed by small, young and/or entrepreneurial firms.

Because of their youth and small size, start-up innovators usually

have little experience in the markets for which their innovations are most appropriate, and they have at most two or three technologies that are at the stage of potential market introduction at any one time.

For many of these firms, their single most important

management challenge is how to translate these promising technologies into a stream of economic returns accruing to the firm=s investors and employees. In other words, the main problem is not so much invention but successful commercialization. In some cases, technologies that show themselves to be intrinsically superior at a technical level are, for one reason or another, unsuccessful in the marketplace.

For

example, in the development and marketing of typewriter keyboards, a number of designs (most notably the Dvorak keyboard design) have been promoted as being intrinsically superior to the so-called QWERTY keyboard (named after the first six letters on the top row of the typewriter) but have met very little success in the marketplace (David, 1986). From the perspective of inventors such as Dvorak, the advantages accruing to the established producers of typewriters using the QWERTY system swamped the benefits of

2

the proposed design and so precluded successful commercialization of this promising technology.1 In other cases, the start-up=s technology is successful in the marketplace but the lion=s share of the profits accrue to firms other than the start-up innovator.

Whether

through outright imitation or improvement upon the core ideas inherent in the start-up technology, the history of high-technology markets is littered with examples where initial start-up innovators are unable to successfully appropriate the returns on innovation (Teece, 1986). To take but one dramatic example, the intermittent windshield wiper was developed by the independent inventor Robert Kearns; shortly after showing his design to Ford Motor company, Ford introduced their own intermittent windshield wiper based on a design and technology close to that of Kearns. For over twenty-five years, Ford (and the rest of the auto industry which adopted and then build on the Ford design through cross-licensing agreements and the like) did not pay Kearns’s firm any royalties on his innovation; it was not until 1990 (and after extraordinary personal perseverance on the part of Kearns in pursuing patent litigation against Ford and other auto manufacturers) was he able to extract even a portion of the economic returns due to his technological innovation through (Seabrook, 1994). In each of these cases, a promising start-up invention was not followed up with successful commercialization by the initial innovator.

Together, these cases raise key

strategic questions for start-up innovators: •

1

Was the failure of the Dvorak design or the inability to appropriate returns on the intermittent windshield wiper inevitable, or might an alternative

In this specific case, David (1986) highlights the specific role by the process of technology standardization and the specific role played by network externalities in helping to explaining the very low diffusion rate of typewriter designs such as Dvorak.

3

commercialization strategy produced a more favorable outcome for the innovator? •

What is the “right” commercialization strategy for a given invention?

To address these questions, it is useful to examine strategies employed by technology entrepreneurs who in fact have successfully profited from their ideas.

Of key interest

here is that this examination does not lead to a simple statement of best practice; instead, different

(successful)

technology

commercialization strategies.

entrepreneurs

employ

extremely

different

On the one hand, there are a number of (extremely well-

known) cases where successful commercialization by a start-up involves the restructuring of established market structure and patterns of market power. For example, when Sun Microsystems entered the workstation market as a start-up innovator, it was mostly discounted by more established firms such as Digital, IBM, and Apollo Systems. However, Sun translated its overall technological vision (“the network is the computer”) into a concrete series of technological, organizational, and market positioning choices which allowed Sun to emerge as the dominant firm within its core market within five years after its founding. On the other hand, some of the most recent spectacular financial successes by technology entrepreneurs have been earned not by direct entry but through integration into the value chain constructed by established industry players. For example, in the field of interconnection technology, companies such as American Internet Corporation and Growth Networks developed technology and positioned themselves for acquisition by the market leader, Cisco Systems; in the case of the 20-month-old Growth Networks, the $355 million acquisition secured an extraordinary return for the firm’s stakeholders -- at the time of the acquisition, Cisco paid more than $1 million per

4

employee in order to integrate this firm’s technology and technology development team into its Internet routing business. The main goal of this paper is to provide a framework for understanding the fundamental drivers of these differences in commercialization strategy by start-up innovators.

Our analysis is organized around the contrast between two alternative

“commercialization principles”: competition and contracting.

Under a competition

approach, profiting from technological success involves direct entry into the product market and posing a challenge to established sources of market power; in other words, the start-up innovator uses their technological leadership to construct a new value proposition for the industry.

In contrast, under a contracting strategy, successful

commercialization involves working with established firms to integrate the start-up innovator’s technology and ideas into the existing value proposition in the industry. Simply put, the key strategic commercialization choice facing start-up innovators is between the product market and the “ideas” market. The

remainder

of

this

paper

first

describes

these

two

principles

of

commercialization in more detail; we highlight both the types of industries and competitive environments where we tend to see one strategy or the other and, from a more theoretical perspective, the benefits and costs associated with each approach. We then turn to the development of our commercialization strategy framework.

In addition

to providing a way of understanding the differences in commercialization strategy across different environments, the framework provides a guide as to the elements of strategy appropriate for particular competitive environments and some guidance for public policy, particularly in the areas of antitrust and intellectual property.

5

2.

Profiting From Innovation: The Product Market versus the “Ideas” Market For many technology-based start-ups, reaching the commercialization stage is the

first opportunity to truly define a firm’s strategy and positioning. Prior to the irreversible strategic choices related to commercialization, the start-up innovator is often able to have multiple strategic visions coexist among the firm’s managers and within the organization more generally; indeed, technology entrepreneurs often exploit this ambiguity to attract initial investors and employees, each of whom has a different vision of the opportunities afforded by the new organization. However, the process of choosing how to bring a new technology to the market forces a company’s managers to confront a set of concrete choices about how to translate their technological vision into sustainable competitive advantage. By successfully implementing these strategic decisions, the organization begins to reflect areas of competence necessary for success within a given strategy.2 One view of competition – attributed to Joseph Schumpeter – sees innovationbased entry as the principal means of the eroding incumbent market power. Indeed, Schumpeter’s main concern was that innovation might become beyond the reach of the smaller firm. This is because the increasing internal financial resources required to bring those products to final consumers could only be feasibly undertaken by larger incumbents who have little incentive to create products that cannabalize their existing sunk assets. Hence, competition would fall away along with previous patterns of technological dynamism. 2

Of course, the relationship between organizational definition and firm strategy is more iterative than the perspective provided here. However, particularly for start-up innovators, the commercialization process is the first instance in which concrete strategic decisions are made and are then reflected in the organziation’s

6

In recent times, however, there is renewed interest in the process by which smaller

research-oriented

firms

pursue

innovative

activity.

In

particular,

the

Schumpeterian view – widespread in the economics literature3 – that small firms will commercialize their innovations by competing with incumbents in the product market has been challenged anecdotally, empirically and theoretically. Anecdotally, there are many examples of firms where small, research-oriented start-ups never enter the product market directly. Instead, they choose to commercialize their innovations by contracting – by means of licensing, partnerships or acquisition – with product market incumbents. Such cooperative commercialization strategies are commonplace in among biotechnology startups. Empirically, there appears to be heterogeneity in commercialization patterns across industries. Figure 1 depicts the proportion of small firm innovations that chose cooperative rather than competitive commercialization paths by industry group.4 The pattern confirms the anecdotal evidence regarding cooperation used in biotechnology versus more competitive strategies in among smaller electronics firms. This heterogeneity is

substantial;

suggesting

important

industry-specific

drivers

of

commercialization

strategies.

boundaries and structures (Burgelman, 1994). Also, short discussion of dynamic capabilities (Teece, Shuen, and Pisano, 1998). 3 See, for example, Gilbert and Newbery (1982) and Reinganum (1989). 4 This was based on a sample of over 100 small firms surveyed by Gans, Hsu and Stern (2000).

7

Figure 1: Probability of Cooperation by Industrial Segment (from Gans, Hsu and Stern, 2000)

0.6

0.5

0.4

0.3

0.2

0.1

0 Biotechnology

Industrial Equipment

Electronics

Instruments

Computer Software

Industrial Segment

Finally, from the perspective of economic theory, there are two reasons why a cooperative path would result in greater rents being appropriated by small firms than if they pursued a competitive path. First, by cooperating with product market incumbents, small start-ups avoid the costly investment in complementary assets required for successful product market entry. Instead, a cooperative arrangement allows the innovation to be combined with an incumbent’s existing complementary assets; thereby, minimising potential cannabilisation. Second, a cooperative path avoids the dissipation of monopoly rents that might otherwise occur with product market competition. Generally, the sum of profits of an incumbent and entrant from competition are lower than the

8

profits the incumbent might earn if it had exclusive access to the innovation. Hence, choosing a cooperative path preserves industry rents precisely because it subverts the competitive impact of an innovation. The broad implication of all this is that the potential for cooperative commercialization paths to be chosen by small start-ups challenges the Schumpeterian notions that independent innovation was a force of creative destruction and that innovation that requires complementary assets for commercialization will become the exclusive domain of larger, financially-resourced incumbents. When start-ups choose a cooperative path they explicitly minimise the destructive tendencies for innovative activity and act to reinforce rather than subvert product market power. Also, in so doing, the possibility of commercializing innovations through a market for ideas rather than the product market per se, gives smaller firms an opportunity to appropriate rents from innovative activity without the need for costly investment in complementary product market assets. In effect, the ability of small start-ups and incumbents to trade in markets for ideas is a substitute for product market competition based on innovation. Consequently, innovation is neither an avenue for increased competition nor is it necessarily the exclusive domain of less innovative incumbent firms. When cooperation is possible there will be a lot less destruction but a lot more creation than Schumpeter envisaged. From the above discussion, it can be seen that the choice between cooperative and competitive commercialization paths is both an important phenomenon – the patterns of which differ across industries – that gives rise to crucial considerations in the role of innovation as a competitive force in product markets. Thus, it becomes important to

9

consider in detail why some start-ups in some industries tend to follow more cooperative commercialization paths than those in other industries. Hence, a goal of this paper is to identify the critical factors that drive this choice and what they mean for the strategies of entrants and incumbents and overall patterns of technological change at an industry level. Also, by identifying factors that determine commercialization paths we can also provide a means of predicting such patterns and informing start-ups and incumbents of important directions they might commit to as part of their research strategies. Finally, we will then be able to use these factors to sort among prior perspective that treat some or all of these factors as fixed.

3.

Benefits and Costs of Trading in Ideas Markets The previous section outlined the broad choice facing start-up innovators as to

whether to commercialize their innovation by competing with established firms in the product market or contracting with those firms through the ideas market. This choice depends not so much on the absolute returns it will receive from a cooperative path per se but on its return relative to a choice of competition. This distinction is important as transactions in ideas markets take place in the shadow of potential returns by competing in product markets. That is, competition is both an alternative commercialization path and potentially the default option for start-up innovators. Consequently, some factors – such as stronger intellectual property rights and a greater competitive advantage to smaller firms – will give the start-up higher returns on either path whereas we seek here to identify the factors that will cause those firms to favour one commercialization path over another.

10

From this perspective, a competitive choice is really one of choosing to by-pass ideas markets entirely. That is, a start-up sees value in committing to a product market presence rather than exploring intermediate trading options for the innovation itself. This means that we need to consider what the benefits and costs are to start-up firms in engaging in ideas market trading as opposed to avoiding such trades altogether (at least given the current stage of development of their innovation). There are several clear benefits of commercializing innovations through ideas markets. Essentially, these are the same type of benefits that would arise from nonintegration of the start-up firm in product market activities; allowing it to develop ‘ideas’ production as its core competency. First, commercializing through ideas markets means that costly duplicative investments are avoided. The start-up firm themselves avoids the costs associated with developing assets for manufacturing, distribution and marketing that may already exist elsewhere. Established firms that cooperate with the start-up avoid having to engage in imitative research programs that would become necessary as they attempt to ‘catch-up’ with a new entrant. At the very least, a cooperative strategy allows the incumbent and start-up to use their common advantages to economize on further development and commercialization costs. Second, a start-up focused on innovation and that is rewarded only in terms of the value of that innovation to incumbent firms has high-powered incentives to create innovations that are of specific value to those firms (Aghion and Tirole, 1994). Hence, start-up innovations will complement rather than cannibalize an incumbent’s existing assets and allow it to be a more effective competitor in product markets. Thus,

11

established firms can utilize some important advantages smaller, focused firms possess in generating ideas. MORE? Finally, a cooperative path pursued by trading innovations in ideas markets avoids the dissipation of monopoly rents that might otherwise occur with product market competition. Generally, the sum of profits of an incumbent and entrant from competition are lower than the profits the incumbent might earn if it had exclusive access to the innovation. Hence, choosing a cooperative path preserves industry rents precisely because it subverts the competitive impact of an innovation. The end result is softer product market competition and an extension of the incumbent’s product market franchise. Notice that there are distinct benefits to ideas market trading in terms of increasing industry-wide returns from the innovation. The avoidance of duplicative investments, the creation of incentives by start-ups minimizing cannibalization and the softening of product market competition increase or preserve industry profits relative to a situation where the start-up avoided such contracting. However, while the start-up’s returns are likely to be higher, the more important are each of these benefits, the start-up will also be concerned with their expected returns from this path as opposed to competition. In particular, if the process of searching and engaging in negotiations with incumbent firms was costly or itself weakened a start-up firm’s potential competitive position in the product market, the start-up might have an incentive to by-pass such contracting opportunities. To see this, we consider some potential frictions that make it difficult to transact in and maintain ideas markets. First, in order to contract with an incumbent partner, a

12

start-up must search for and convince that incumbent of the value of their innovation. Such search costs must be incurred ex ante, so naturally a start-up will be concerned about their eventual return. If it is difficult to convince incumbents of the value of an innovation, rather than incurring the transaction costs associated with doing so, a start-up may find it more attractive to take their chances in product market competition. Hence, a start-up may choose a competitive strategy even though ex post there would have been mutual gains to trade in the idea itself. Second, there is a more fundamental problem associated with contracting over ideas: the disclosure problem. The difficulty with selling an idea is that the potential buyer needs to see the idea and understand it in order to establish their willingness-to-pay for the idea. However, it is possible that such disclosure may lead to opportunistic behaviour by the buyer who may expropriate the idea claiming that it was already known. Arrow (1962) sums up the problem In the absence of special legal protection, the owner cannot, however, simply sell information on the open market. Any one purchaser can destroy the monopoly, since he can reproduce the information at little or no cost. Thus the only effective monopoly would be the use of the information by the original possessor.

He goes on … … there is a fundamental paradox in the determination of demand for information; its value for the purchaser is not known until he has the information, but then he has in effect acquired it without cost. Of course, if the seller can retain property rights in the use of the information, this would be no problem, but given incomplete appropriability, the potential buyer will base his decision to purchase information on less then optimal criteria. He may act, for example, on the average value of information in that class as revealed by past experience. If any particular item of information has differing values for different economic agents, this procedure will lead both to a non-optimal purchase of information at any given price and also to a non-optimal allocation of the information purchased.

At one level, this is just a problem of imperfect property rights. An idea as an asset is not easy to own and control. It is not easy to exclude users and, moreover, secrecy as a means of exclusion is given up whenever there is an attempt to trade the idea. The idea seller is

13

faced with low prices regardless of whether the idea is revealed prior to trade or not. This is a problem because of necessary private information: •

Idea value: the buyer does not know the true value of the idea (lowering price prior to revelation).

•

Idea source: the source of the idea is not ex ante or ex post verifiable (lowering price after revelation)

If either of these private information problems were eliminated there would be no disclosure problem. This is because the use of the idea by the buyer must be verifiable. If this were not the case then only by resolving the idea source problem could the disclosure problem be solved. Consequently, the start-up firm may anticipate such expropriation and avoid contractual negotiations altogether. Hence, the possibility of disclosure problem is a reason why a market for ideas may not exist. Essentially, it is a problem of a weakness in the start-up’s intellectual property protection over their innovation. An ironclad patent would give the start-up the ability to exclude the incumbent firm from utilising innovations that may have been disclosed during negotiations.5 Alternatively, a strong competitive option could, as Anton and Yao (1995) suggest provide a start-up firm with indirect protection in situations where property rights are weak. If a start-up could enter product market competition and if the incumbent’s profits from monopoly as opposed to competition were large, then failure to reach agreement could become relatively more costly for the incumbent firm than any returns

5

Example of windshield wiper case described here.

14

from expropriation. In effect, the incumbent decides to pay the start-up so as to preserve monopoly rents rather than for the value of the innovation per se.6 This suggests that there are two factors that will be critical in determining whether the start-up chooses a cooperative or competitive commercialization path. First, as an incumbent’s complementary assets become more important in generating a value from the innovation, the incumbent and start-up will have an enhanced incentive to reach a contracting agreement and avoid costly duplication of those assets. This is especially the case when start-up entry into the product market may lead to a large loss in profits to the incumbent. The absence of such complementary asset places the incumbent and start-up on a more equal footing in product market competition making such competition relatively more attractive from the small firm’s perspective. Second, as the start-up’s ability to exclude the incumbent from utilizing the innovation increases, the lower are the costs that it bears in transacting in the market for ideas. In effect, strong intellectual property protection is the lubricant of a wellfunctioning ideas market and creates incentives for start-ups to be concerned about the industry profits from the innovation that could be achieved through cooperation as opposed to competition. Without such protection, fear of disclosure may lead to the startup pursuing a more secretive path; controlling the innovation through commercialization stages in order to gain a competitive edge over the incumbent in the product market.

6

Like Rasmusen (1988).

15

4.

A Framework for Commercialization Environments In the previous section we explained why commercialization paths of competition

versus cooperation are a choice for start-up firms and how their relative likelihood relates to the importance of incumbent complementary assets and the strength of intellectual property protection. In this section, we build upon this insight to suggest that the two dimensions of incumbent complementary assets and intellectual property protection can be combined to yield a framework that completely covers patterns of competitive interaction through innovation over all industries. That is, our framework suggests that these two dimensions fundamentally guide start-up and incumbent research and competitive interactions in both ideas and product markets. To see this more clearly, we ask two questions of the commercialization environment a start-up may be faced with following the successful generation of a commercializable innovation: •

(Intellectual Property Protection) Can innovation by the start-up preclude effective development by the incumbent?

•

(Complementary Asset Availability) Do the incumbent’s complementary assets contribute to the value proposition from the new technology?

Notice that there are four possible combinations of yes/no answers to these questions. Table 1 labels each of the resulting environments and our purpose is to describe each in turn. In particular, for each we will describe start-up strategies, incumbent strategies, real world industry examples and the related research literature.

16

Table 1: Identifying Commercialization Environments Do incumbent’s complementary assets contribute to the value proposition from the new technology

Can innovation by the start-up preclude effective development by the incumbent?

3.1

No

Yes

No

Yes

Head-to-Head Competition/Attacker’s Advantage

Internal Development or Reputation-Based Ideas Trading Ideas Factory/Contracting or Spot Trading of Ideas

Internal development or Non-exclusive Licensing

Head-to-Head Competition

Consider an environment where start-ups have limited abilities to exclude imitative development by the incumbent but where incumbents do not possess important complementary assets that could not be accessed elsewhere. In this environment, the start-up and incumbent face a level playing field. On the one hand, this frees the start-up from duplicating previous incumbent investment. On the other, however, it is an environment where the start-ups technological leadership may be fleeting. Competition in this type of industry is likely to be intense with incumbents facing constant entry challenges that destroy the value of existing competencies and where start-ups face difficulties in appropriating value from their innovations over the longer-term; as they become incumbents in an environment that does not value incumbency. In this world, start-up’s have an opportunity to capture market leadership by the effective development of competence destroying technology. That is, attackers have an

17

advantage (Foster, 1985). Moreover, there are few opportunities for the start-up to contract with current market leaders due to the relative salience of a disclosure problem. Consequently, the most effective start-up strategy is one of ‘stealth.’ They gain competitive advantage by choosing niche customers, reconfiguring architectures and not provoking a competitive response from incumbents until it is ‘too late.’ For incumbents, the basis of their competitive advantage is based on products not competencies. Indeed, each may persist in name only with incumbents benefiting from research strategies that dismiss their current competencies and instead focus on technological opportunities that might be occupied by new entrants. A sustainable market position involves constant reinvention and pre-emption of rivals. When studying similar environments, Christensen (1997) sent a message to incumbents that they might be subject to S-curve ‘blind spots’ (i.e., that fail to not that their current products are reaching the end of an accelerated growth period and instead assume continued growth). Consider, for example, Figure 2 that demonstrates the lack of leadership by established firm in the hard disk drive sector. In response, an effective strategy for the incumbent involves constant monitoring of new developments and a clearer integration of market knowledge and technical know-how.

18

Figure 2: Leadership of Entrant Firms in the Hard Disk Drive Sector

Source: Christensen (1997), p. 23.

In the end, this is a world of tight integration between research and commercialization

and

where

market

leadership

is

ultimately

determined

by

technological leadership. Competition forces firms to undertake high levels of risky R&D investment in order to survive with established firms falling into ‘competency traps’ and becoming subject to the attacker’s advantage. (e.g., Softbank). On the other hand, startups will invest in seemingly duplicative complementary assets in terms of manufacturing, marketing etc. as part of establishing a novel value proposition.

19

3.2

The “Ideas Factory”

Standing in complete contrast to head-to-head competition is the ideas factory environment. In this world, the answer to our two questions is affirmative with start-ups able to exclude further development of the innovation by the incumbent but where the incumbent

possesses

complementary

assets

the

innovation

is

specialized

to.

Consequently, trade in markets for ideas is both feasible and highly desirable so that start-up firms can specialize in innovation – the so-called ideas factory (Pisano) – and contract with incumbents to commercialize the innovation in the product market through an exclusive licensing arrangement (Gans and Stern, 2000). Therefore, the key issue for start-ups is no long if they should contract with an incumbent but when. Moreover, their performance will depend critically on the degree of bargaining power they command in markets for ideas; that is, their ability to play incumbents off against one another and prevent work-around technologies from gaining a product market foothold. In this environment, entering into the product market is both highly costly and potentially very low in return. Consequently, the threat of competition does not play a crucial role in bargaining so that start-ups have maximal incentives to tailor their innovations to incumbents’ existing asset base; i.e., minimise cannibalization. For incumbents, start-up technology would not be viewed as a threat as it is in head-to-head competition. Instead, it is a critical source of improvement to the current product set. Their sustained market position requires co-opting potential competitors through the ideas market; indeed, to the point of assisting start-ups with technical and financial assistance. The primary challenge is to balance internally developed and externally available technologies in the product development process.

20

To see how an ideas factory works consider the intensively studied than the “patent race” for human insulin that occurred in the late 1970s (a popular account of this research is provided in an entertaining book by Hall (1988)). Closely watched at the time by industry observers and public policy makers, the development of a human insulin product represented the first commercially-oriented product in the novel field of “biotechnology;” as such, innovative investments towards that development goal were closely watched and the scientific and commercial issues which arose set the context for debates about the proper use and organization of biotechnology research (for a useful summary of these debates, see Krimsky (1982)). In the twenty years since the successful development of insulin by the start-up firm Genentech, the case of human insulin has been used again and again as an example to motivate different models of technological competition (for instance, the main case used to explain technological competition and patent races to business school students is The Race to Develop Human Insulin (Parese and Brandenberger, 1992)). Most analysts date the commencement of this case of technological competition to a research conference hosted by Eli Lilly in May, 1976.

As the world’s leading

producer of insulin for diabetics, Lilly arranged the conference to assess whether novel recombinant DNA tools could be utilized to produce human insulin, providing a qualityimproving substitute to the pork and beef insulin that had been used historically in the treatment of diabetes.

While molecular biologists were extremely excited by the

possibilities of rDNA from a scientific perspective, few analysts or scientists expressed a belief that there would be important commercial applications in the near future;

21

moreover, most of the main researchers were employed by universities, limiting their incentives and opportunity to explore commercial applications. The Lilly research meeting, along with continued encouragement by Lilly in the form of research funding and commitments to license commercializable technology, provided researchers with new information that financial returns could be realised through the application of the new scientific tools.

As a result, three separate research

teams pursued programs aimed at the “expression” of the insulin gene (a necessary condition for commercial exploitation of the rDNA techniques). Two of the teams, based at the biology/biochemistry departments of Harvard and UC-SF, were essentially university research labs diverting attention and resources away from purely scientific projects and towards the commercially relevant human insulin project.

The third team

was initiated by Genentech, a start-up biotechnology firm founded by an entrepreneur (Bob Swanson) and a scientist (Herbert Boyer), which operated outside of the confines of a university research lab. According to all accounts of the research, each of these three teams was aware of the investments by the others and acted to “pre-empt” the other teams’ research success. For example, the UC-SF research team violated NIH rules regarding the use of genetic materials in their experiments; this type of violation was serious enough so that a leading researcher speculated that “Capitalism sticking its nose in the lab has tainted interpersonal relations…the UCSF team was in competition with a group at Harvard which was known to be working with better source material.” (David Martin, quoted in Wade, 1977, p. 1342). As well, the Harvard team, headed by Walter Gilbert, chose to discontinue support for a well-regarded graduate student, Forrest Fuller, precisely

22

because Fuller was unable to successfully contribute to his assigned portion of the commercialisation project (see Hall, 1988, pp. 176-178). Perhaps most telling, Genentech chose to pursue an alternative research strategy – gene synthesis – which was more amenable to commercialisation prospects because it was not subject to burdensome NIH regulations governing the use of genetic materials. Despite the use of this alternative approach, the possibility of pre-emption was one of the most important tools used by Genentech management in motivating their researchers. As recounted by Roberto Crea, one of the principal Genentech scientists, “Definitely the name of Wally Gilbert was in Swanson’s mouth all the time.

That we had to beat

him…Swanson used that as a management tool to keep pressure on Goeddel, knowing that Goeddel was so competitive.” (Roberto Crea, quoted in Hall, pp. 219) Under the threat of pre-emption, each research team pursued human insulin until August, 1978, at which time Genentech researchers were able to successfully synthesize the human insulin gene in bacteria, opening the door to the first commercial application of biotechnology.

One day after their experiment was validated, Genentech signed an

exclusive license agreement with Eli Lilly which granted Lilly the manufacturing rights to Genentech’s intellectual property and contracting with Genentech for collaboration on certain of the scale-up activities for which Genentech would have greater expertise. One of the distinctive feature of the negotiations around this license is that, despite Lilly’s encouragement of the research, Lilly turned out to be an extremely strong negotiator, deemphasising Lilly’s need for the technology (they could continue to use animal insulin) and discounting claims by Swanson of the viability of the product (Hall, p. 23*).

23

The irony of this case is that the realised gains from this research investment came in the form of a license to the incumbent – Eli Lilly. Most prior economic models of technological competition which evaluate the relative R&D incentives of incumbents and entrants exclude this possibility by dictating competition in the product market after the realisation of the innovation.

While Lilly did pursue a research program, Lilly’s main

investments were focused towards encouraging research by independent researchers, confident that successful innovations could be licensed and that the independent research teams would be in a relatively weak bargaining power in negotiations. What is perhaps most interesting about this case is that it is, by all accounts, not unique for the biotechnology industry.

Except for a small number of exceptions,

biotechnology firms either became licensors of their technology to a large established firm (which retained responsibility for FDA approval procedures, marketing, etc…) or were purchased outright by such a firm through an acquisition.

As noted by Orsenigo,

“the NBFs, born to exploit commercially their unique skills in the new technologies, attempted to integrate forward and to acquire capabilities in production but, in most cases, became specialized suppliers of very specific technical know-how.” (Orsenigo, p.145).

Indeed,

despite

a

“radical”

change

in

the

scientific

underpinnings

of

pharmaceutical research and waves of entry by independent research firms attempting to exploit these scientific opportunities, there has been little change in the downstream sales leadership of pharmaceutical products (excluding mergers and acquisitions between companies) (Henderson and Cockburn, 1996; Gambardella, 199*). Instead of sustained waves of displacement of incumbents, the set of incumbents has remained relatively

24

constant and the incentives for entry for independent firms has been the expectation of being acquired by one of these incumbent firms. Thus, the ideas factory paints a picture of a competitive environment focused on the ideas market. While there may be some competition between start-up firms and established firms in that market, once an innovation is generated, there are substantial gains to trade as those firms become complementors. As a consequence, there may well be frequent changes in technological leadership and the sources of innovation as start-up firms compete to generate innovations but these changes will not translate into changes in market leadership (see Table 2 that demonstrates the persistent market leadership of established pharmaceutical firms). In effect, start-up firms compete with each other for priority in negotiations with the market leader whose own position is assured by this process and their existing product market asset base. New technologies reinforce and build upon this base because the key to maximizing returns in the ideas market depends on such reinforcement. Indeed, for that reason it is encouraged by established firms. Table 2: Pharmaceutical Firm Market Leadership Sales Rank, 1997 1 2 3 4 5 6 7 8 9 10

Company

Date Established

Merck Bristol-Myers Squibb American Home Products Pfizer Abbott Labs Eli Lilly Warner Lambert Baxter Schering-Plough SmithKline Beecham

17th century 1887, 1856

Sales Rank, 1973 2 9

1926

6

1848 1900 1876 1852 1931 1851 1830

7 21 11 3 79 15 31

Sources: Various corporate web sites; BioWorld 1998; James, 1977.

25

3.3

Winner-Take-All Competition

There is no necessary reason why the answers to our two questions should be correlated; that is, there are shades of grey to these aggressively competitive and mutually cooperative outcomes. Indeed, one could have a situation where a start-up’s innovation is excludable but also overturns the value of incumbents’ assets. The formal economics literature emphasises the potential for a non-integrative outcome by demonstrating the profitability of widespread licensing once an innovator has established property rights over an innovation (Arrow, 1962). However, until that point incumbents and start-ups should compete aggressively to be the first to win control of an innovation either through a patent (Gilbert and Newbery, 1982; Reinganum, 1989) or the establishment of a technological standard (Katz and Shapiro, 1987). Thus, incumbents and start-ups are participants in a winner-take-all race. Consequently, incumbents should view their innovative activity as partly defensive against the potentially highly incentivized entrant start-ups (Reinganum, 1989). So for start-ups, a winner-take-all market is a tremendous opportunity where they are unconstrained by past investments but have maximal ability to earn returns form an innovation; if they succeed in the race to patent or in establishing a standard. However, in this they face an aggressive response from others precisely because returns are so high. Incumbents with established monopolies will be keen to preserve them. Their competitive advantage, however, rests on similar terms to start-ups and not on their established competences. Moreover, the benefits of maintaining their monopoly may be eroded in part by potential weakness in the bargaining position in markets for ideas as start-ups have solid alternative options. Indeed, it is only be ceding rents to upstream technology

26

partners that incumbents can hope to sustain their market position. But such sustained presence comes at the cost of profits. Just as it was in dog-eat-dog competition where incumbents were forced to accelerate cannibalistic R&D investments, an incumbent’s profit base is eroded by the need to pay dearly for cannibalistic innovations in the market for ideas. EXAMPLES: RETAILING? STANDARDS WARS This competitive environment is potentially very intense but also the industry rents accruing to successful innovation are higher. Where the rents go depends much less on becoming the market leader per se but developing the winning technology. That is the source of bargaining power over the value chain and, indeed, gives technological providers an opportunity to use this power to “buy” the benefits of incumbency.

3.4

Reputation-Based Ideas Trading

When a start-up’s innovation is not excludable but incumbents possess key complementary assets, while there is a large incentive to trade in ideas, ideas markets themselves are difficult to establish and maintain. In a head-to-head competitive world, the incentive for trade is not there; making competition the feasible commercialization path. Firms there are driven towards secrecy while keenly monitoring for technological opportunity. When there is a value to incumbency, incumbents themselves drive the potential value of ideas trading. However, unless they manage short-term temptations to expropriate rents from start-ups, incumbents will be forced to rely in in-house research capabilities – with consequent low powered incentives on researchers (Aghion and Tirole, 1994). In this scenario, the rate of innovative activity will be diminished.

27

A more favourable outcome is possible if incumbents can develop a reputation for rewarding start-ups for successful innovation even though they might be able to imitate an idea relatively easily. That reputation encourages start-up entry in an otherwise incomplete contracting world and, moreover, encourages a closer working relationship between start-ups and incumbent firms. Incumbent firms that succeed in establishing relational research contracts (Baker, Gibbons and Murphy, 2000) will be able to generate a greater rate of product innovation than their competitors. This provides those incumbents with an opportunity to move beyond the highly integrated structures in dogeat-dog competition and use a virtual ideas factory model to sustain market leadership. Symantec Corporation practices this type of strategy. It has established a reputation for acquisition of entrepreneurial start-ups at a reasonable price and also the sensitive integration of those firms into its larger organization. Consequently, software developers have come to see Symantec as a potential partner in development rather than a competitor. USER-BASED INNOVATION MODEL This environment will be characterized by far less market and technological stability than other structures. In most cases, the lion’s share of innovation is the result of internal development. Nonetheless, a substantial opportunity exists for incumbents to encourage external innovation by providing rewards and incentives through relational contracting despite the lack of property rights and potential for expropriation and hold-up of start-up researchers.

28

5.

Empirical Evidence The main argument of the previous section was that the dimensions of intellectual

property protection and the importance of incumbent complementary assets allow us to characterize alternative commercialization environments facing start-up innovators. In particular, for each combination of answers to our guiding questions, we can identify the profitability of cooperative as opposed to competitive commercialization strategies and how this alters the strategic positions of incumbents and start-ups in both product and ideas markets. Of particular interest is the start-up’s choice of cooperation over competition. As noted earlier, this choice is critical in determining whether the locus of technological competition is ideas or product markets and whether the Schumpeterian gale of creative destruction actually blows or not. If start-ups pursue cooperative commercialization strategies, incumbent market power is likely to be reinforced rather than challenged by start-up innovation. Gans, Hsu and Stern (2000) provide an empirical examination of the choice of commercialization strategy and, in particular, how that choice relates to intellectual property protection and the importance of specialized complementary assets. Table 3 reports their principal findings arising from their survey of start-up firms that have successfully generated a commercially viable innovation over a range of industry segments. Notice that, as predicted in Section 3, cooperation is more likely to be chosen over cooperation when intellectual property protection is strong and complementary assets are important.

29

Table 3: Proportion Choosing Cooperation

No patents At least one patent

Number of Patents Associated with the Project

Entrant’s Cost of Acquiring Necessary Complementary Assets

Relatively Low

Relatively High

14%

31%

35%

56%

30

Conclusion TO BE DONE ...

31

References

Aghion, P. and J. Tirole (1994), “The Management of Innovation,” Quarterly Journal of Economics, 109 (4), pp.1185-1210. Anton, J.J. and D.A. Yao (1994), “Expropriation and Inventions: Appropriable Rents in the Absence of Property Rights,” American Economic Review, 84 (1), pp.190209. Arora, A. and A. Gambardella (1994), “The Changing Technology of Technological Change: General and Abstract Knowledge and the Division of Innovative Labour,” Research Policy, 32, pp.523-532. Arrow, K.J. (1962), “Economic Welfare and the Allocation of Resources for Invention,” in The Rate and Direction of Inventive Activity, Princeton University Press: Princeton, pp.609-625. Arrow, K.J. (1982), “Innovation in Large and Small Firms,” in Ronen (ed.) Entrepreneurship. Baker, J.B. (1995), “Fringe Firms and Incentives to Innovate,” Antitrust Law Journal, 63, pp.621-641. Cockburn, I. and R. Henderson (1994), “Racing to Invest? The Dynamics of Competition in Ethical Drug Discovery,” Journal of Economics and Management Strategy, 3 (3), pp.481-519. Cohen, W.M. and D.A. Levinthal (1989), “Innovation and Learning: The Two Faces of R&D,” Economic Journal, 99 (397), pp.569-596. Cusumano, M.A. and R.W. Selby (1995), Microsoft Secrets, Free Press, New York. Daly, J. (1992), “Microsoft Make Fox-y Move,” Computerworld, March 30, 1992, p.4. Gambardella, A. (1992), “Competitive Advantages from In-House Scientific Research: The US Pharamaceutical Industry in the 1980s,” Research Policy, 21, pp.391-407. Gans, J.S., D. Hsu and S. Stern (2000), “When Does Start-Up Innovation Spur the Gale of Creative Destruction?” mimeo., MIT (available at www.mbs.unimelb.edu.au/jgans/research.htm). Gans, J.S. and S. Stern (2000), “Incumbency and R&D Incentives: Licensing the Gale of Creative Destruction,” Journal of Economics and Management Strategy (forthcoming). Gilbert, R. and D. Newbery (1982), “Preemptive Patenting and the Persistence of Monopoly,” American Economic Review, 72 (3), pp.514-526.

32

Gilbert, R. and S.C. Sunshine (1995), “Incorporating Dynamic Efficiency Concerns in Merger Analysis: The Use of Innovation Markets,” Antitrust Law Journal, 63, pp.569-601. Hall, S.S. (1988), Invisible Frontiers: The Race to Synthesize a Human Gene, London: Sidgwick & Jackson. Henderson, R. (1993), “Underinvestment and Incompetence as Responses to Radical Innovation: Evidence from the Photolithographic Alignment Equipment Industry,” RAND Journal of Economics, 24 (2), pp.248-270. Katz, M.L. and C. Shapiro (1987), “R&D Rivalry with Licensing or Imitation,” American Economic Review, 77 (3), pp.402-420. Krimsky, S (1982), Genetic Alchemy: The Social History of the Recombinant DNA Controversy, MIT Press, Cambridge (MA). Nelson, R.R. (1958), “The Simple Economics of Basic Scientific Research,” American Economic Review Pallatto, J. (1992), “Microsoft’s Ill Fated Omega DB Was Bargaining Chip in Fox Affair, the Aborted Omega Databse,” PC Week, Ziff-Davis Publishing, December 14, p. 89. Perry, S. (1992), “Microsoft Will Buy Database Software Company in $173 Million Bid,” Reuters, March 24, 1992. Reinganum, J.F. (1982), “Uncertain Innovation and the Persistence of Monopoly,” American Economic Review, 73 (4), pp.741-748. Reinganum, J.F. (1989), “On the Timing of Innovation,” in R. Schmalansee and R. Willig (eds.), Handbook of Industrial Organization, Vol.1, Elsevier, pp. Salant, S.W. (1984), “Preemptive Patenting and the Persistence of Monopoly: Comment,” American Economic Review, 74 (1), pp.247-250. Shapiro, C. (1985), “Patent Licensing and R&D Rivalry,” American Economic Review, 75 (2), pp.25-30. Smith, G.D. (1985), The Anatomy of a Business Strategy: Bell, Western Electric, and the Origins of the American Telephone Industry, Johns Hopkins Press: Baltimore (MD). Stern, S. (1995), “Incentives and Focus in University and Industrial Research: The Case of Synthetic Insulin,” in N. Rosenberg (ed.), Sources of Medical Technology: Universities and Industry, National Academy Press: Washington (DC), pp.157187. Stern, S. (1996), “Incentives and Knowledge in Organizational and Technological Change: The Case of Drug Discovery in the 1980s,” mimeo., MIT.

33

Teece,

D.J. (1987), “Profiting from Technological Innovation: Implications for Integration, Collaboration, Licensing, and Public Policy,” in D.J. Teece (ed.), The Competitive Challenge: Strategies for Industrial Innovation and Renewal, Ballinger: Cambridge (MA), pp.185-220.

Wade, N. (1977), “Recombinant DNA: NIH Rules Broken in Insulin Gene Project,” Science, 197 (Sept 30), p.1342.