Selling to incumbent firms encourage creators to focus on high-quality research projects, write Pehr-Johan Norbäck, Lars Persson and Roger Svensso

Persson, Lars

Svensson, Roger

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7/6/2016The advantage of selling an invention instead of turning itinto a businessblogs.lse.ac.uk /businessreview/2016/07/06/the-advantage-of-selling-an-invention-instead-of-turning-it-into-a-business/It is well known that entrepreneurs play an important role in challenging existing oligopolies through de-novo entry(i.e., with a new business) in the market. In this study, we show that the entrepreneur is also a challenger throughthe aggressive development of inventions for sale.This development incentive is particularly strong when the invention has such a high quality that incumbent buyerstry to preempt each other from acquiring the invention. In a preemptive acquisition, an acquirer pays a high price inorder to keep the target firm out of the hands of its rivals.The role of an aggressive invention supplier may be even more important than the role of a de-novo entrant.Preemptive acquisitions give entrepreneurs the incentive to increase their efforts in high-quality research projects sothat the expected welfare in society can increase despite the risk of increased market power.The welfare benefits of such “creative destruction and productive preemption” then crucially depend on whetherthere is bidding competition over entrepreneurial firms, i.e. whether acquisitions are preemptive (where incumbentsbid their full valuation) rather than entry deterring (where incumbents only pay the entrepreneur her entry value).Innovation and commercialisation for sale have become a crucial feature of the innovation and start-up market. Forinstance, in the Silicon Valley Bank’s annual Startup Outlook report 2016, it is pointed out that today’s start-ups aimat being acquired rather than making an IPO. According to a survey of 900 start-ups in the report, 17 per cent of thestart-ups aimed for an IPO, 19 per cent aimed at staying private, while more than half – 56 per cent – had the goal ofbeing acquired. Start-up for sale seems to be the name of the game for entrepreneurs in the tech-sector today.In a recent theoretical study, we examine how the choice for entrepreneurs (start-up companies) to sell theirventures (inventions) or to enter the market and compete with incumbents (i.e. make an IPO or stay private) maydepend on market competition and the quality of the venture (invention).1/3We first examine what type of inventions (ventures) — in terms of their quality — will be sold? At first sight, it seemsreasonable that the level of quality should not matter, since the entrepreneur’s reservation price and incumbents’willingness to pay should be equally affected by a change in quality.However, we show that the incentive for commercialisation by sale relative to commercialisation by entry increaseswith a higher quality of the invention. To see why, first note that an incumbent’s valuation of the invention consists ofthe incumbent’s product market profits when owning the invention relative to the profits it generates when a rivalpossesses the invention.Then note that a higher invention quality increases entrants’ and acquirers’ product market profits in a similarfashion, but also reduces the profits of the incumbent as a non-acquirer. This implies that the incumbents’ willingnessto pay for the invention increases more than the entrant’s profit in quality. Thus, entrepreneurs with great inventionsor great business ideas will not be able to resist selling their ventures, since they will be offered so high acquisitionprices from incumbents.Should we then be worried that entrepreneurs sell their venture and do not challenge the incumbents in the productmarket? Not necessarily. In fact, we show that the expected consumer welfare can be higher undercommercialisation by sale than under commercialisation by entry, despite the increased market power for theacquiring incumbent firm in the product market. The reason is that entrepreneurs who sell their inventions will havea stronger incentive to develop high-quality inventions than entrepreneurs who aim at entering the product market.Incumbents are, of course, hurt by this creative destruction process ignited by the entrepreneurs and thus have anincentive to undertake research to block entrepreneurs’ research activities. We then show that incumbents’ researcheffort can reduce, but not eliminate, the entrepreneurs’ incentives to innovate for entry or sale.In recent decades in Europe and the US, government policies have favoured the growth of small firms as comparedto the alternative to sell or license inventions. This has been accomplished by tax-favouring the market entry ofentrepreneurs, or by offering subsidies for SMEs. The results derived in the paper suggest that industry policies thatdisfavour innovation for sale over innovation for entry may be harmful. The reason is that reducing the cost of sellinginventions may not only have a direct positive effect on the reward for entrepreneurship, it may also create biddingcompetition over high-quality inventions, which may further increase the incentives for high-quality entrepreneurialresearch.Policies that improve the merger and acquisition market could then be preferred. Such policies may involve makingthe tax system neutral between keeping and selling a firm, or improving the legal system to reduce the transactioncosts associated with acquisitions in order to ensure a bidding competition over target firms.♣♣♣Notes:This article is based on Creative destruction and productive preemptive acquisitions, in the Journal ofBusiness Venturing, 2016, vol. 31, issue 3, pages 326-343The post gives the views of its authors, not the position of LSE Business Review or the London School ofEconomics.Featured image credit: Ingenious mechanisms for designers and inventors, by Jonathan Lin, CC-BY-SA-2.0Before commenting, please read our Comment Policy2/3Pehr-Johan Norbäck is Senior Researcher fellow at the Research Institute Industrial Economics(IFN). He has published papers in a number of leading academic journals. His main researchareas are within entrepreneurship, industrial economics and international trade- and investments. Lars Persson is deputy director of the Research Institute Industrial Economics (IFN). Further, heis Adjoint Professor at the School of Economics and Management, Lund University, CESifo Fellow,and Research Fellow at CEPR, He has published papers in a number of leading academicjournals. His research focuses on Competition policy, entrepreneurship, industrial economics,international investments, R&D, as well as venture capital and private equity.Roger Svensson is Senior Researcher at the Research Institute Industrial Economics (IFN). Hehas published papers in a number of leading academic journals. His research focuses oninnovations, intellectual property rights, Government interventions, entrepreneurship andmonetary policy. Copyright © 2015 London School of Economics3/3

The advantage of selling an invention instead of turning it into a business

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