Exposed: Venture Capital, Competitor Ties, and Entrepreneurial Firm Innovation Emily Cox-Pahnke (University of Washington) Rory McDonald (Harvard Business School) Dan Wang (Columbia University) Ben Hallen (University of Washington) With support from NSF and the Kauffman Foundation

Introduction How do relationships formed with other organizations impact an entrepreneurial firm’s innovation efforts?

Introduction Early relationships are critical for success  Overcome initial resource constraints and disadvantaged positions  Gain access to diverse audiences such as potential investors, partners, the media, and customers Overall, relationship formation is a strategy to overcome “liability of newness” (Katila et al. 2008; Ozcan/Eisenhardt 2009; Hallen 2008; Vissa 2011; Gulati/Higgins 2003; Pollock/Gulati 2007; Santos/Eisenhardt 2009; Eflring/Hulsink, 2003; Stinchcombe 1965; Baum et al. 2000)

Introduction Optimistic perspective on external relationships  “Locus of innovation”; “Networks of learning” Recent entrepreneurship research supports this notion  Relationships  financial resources, social status, expert advice Advice to entrepreneurs: “Don’t go it alone” (Powell et al. 1996; Ahuja 2000; Stuart et al. 1999; Ruef 2002; Baum et al. 2000)

But, are there conditions under which early relationships might actually inhibit a new firm’s innovation efforts?

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Problem “Losing one of your main investors to a competitor is not a good sign.” But most were concerned about the potential for unwanted knowledge transfer (or leakage) that could undercut their competitive advantage One entrepreneur worried that his firm could become “part of a hedging game where IP may be leaked in one direction or the other.”

Problem Mohr Davidow scenario is not unique “It’s often that we will see startups that seek our support that are either directly or indirectly competitive with our existing portfolio companies…I’ve seen plenty of firms (big and small), fund direct competitors.” - Venture capitalist

Problem Mohr Davidow scenario is not unique

Problem Mohr Davidow scenario is not unique “It’s often that we will see startups that seek our support that are either directly or indirectly competitive with our existing portfolio companies…I’ve seen plenty of firms (big and small), fund direct competitors.” - Venture capitalist Potential to harm entrepreneurial companies “When a VC invests in competitive companies, it’s like an open marriage. It sounds all well and good, but it’s going to create problems down the road.” - Investor “At my startup, our investors had a competitive company in their portfolio. It was a disaster. I never knew whose interest they were looking out for.” - Entrepreneur

What are the downsides of early relationships for firms trying to innovate?

Networks, Innovation, and Competitive Exposure Gain resources, but expose technological core to competitors who share their same investors Risk of competitive exposure or leakage is pronounced:  When powerful intermediaries have opportunity/motivation to channel or redirect information flows  When innovation outcomes are predicated on competitors’ actions Theory linking competitor ties, leakage, and innovation Dushnitsky/Shaver 2009; Burt 1999; Pollock 2004; Katila/Chen 2008; Boudreau/Lakhani 2011)

Hypotheses H1: Entrepreneurial firms with more indirect ties to competitors (through a shared investor) will be less innovative than firms with fewer such ties. Negative effect of indirect competitor ties on innovation is greater for: 2. Firms that are earliest among competitors to form ties 3. Less committed ties than competitors 4. More geographically distant than competitors 5. Firms that share high-status VCs with competitors FAFA FBFB FCFC IAIA IBIB

Research Setting All Minimally Invasive Surgical (MIS) device firms in the U.S. Founded between Attempted to develop a device 147 VC backed firms Complete industry segment

Research Setting MIS context Innovation, competition is dynamic/intense Intermediaries are not only common, but necessary VC’s motivations may depart from entrepreneurs Outcomes are highly skewed (driven by a few large “home runs”) “Andreessen Horowitz’s investing strategy is that in any given year only 15 companies will make up more than 90 percent of the returns.” – NY Times

Data Sources Innovation: FDA Databases Funding relationships: VentureXpert, VentureOne Competition: FDA/ Frost and Sullivan Controls: CorpTech directory, LexisNexis, USPTO 30 interviews with entrepreneurs, VCs, regulators, industry experts and analysts

Measures Unit of analysis Firm-year (1400 firm-years) Dependent variable FDA approval for Class III devices (510K + PMA) 734 total Independent variable # of ties to competitors (same competitive sub-segment) Control Variables (age, region, funding, alliances, patents)

Analysis Zero Inflated Poisson (ZIP) Regression Model

Results

In any given year 53% of firms had at least 1 indirect tie to a competitor Out of 751 VC firms in sample 17% invested in competing firms

Results H1: More indirect ties to competitors impedes innovative output Having at least one such tie decreases the average number of product introductions by 30% in a given year

Results H1: More indirect ties to competitors impedes innovative output Having at least one such tie decreases the average number of product introductions by 30% in a given year 2. Firms that are earliest among competitors to form ties -Reduces expected product introductions by 34% 3. Less committed ties than competitors -Reduces expected product introductions by 55% 4. More geographically distant than competitors -Reduces expected product introductions by 56% 5. Firms that share high-status VCs with competitors -Reduces expected product introductions by 21%

Additional analyses Subsample analysis (funding before patents) Difference-in-differences Alternative dependent variables (speed-to-approval) Capturing information flows more directly (patent citations)

Contributions Networks of Collaboration and Learning vs. Networks of Competition and Leakage Early Investment Relationships: Exacerbating the Liability of Newness?

Implications

Advice to entrepreneurs “Don’t go it alone” needs revision.

Implications Advice to entrepreneurs “Don’t go it alone” needs revision. Entrepreneurs may be right to look at VC as a “necessary evil” Avoid investors that have a tendency to back direct competitors “What you want is to work with investors that will always be doing what’s best for the company, not what’s best for them.”