and the winner is—acquired. entrepreneurship as a contest yielding radical innovations

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    ARTICLE IN PRESSG ModelESPOL-3052; No. of Pages 16Research Policy xxx (2014) xxxxxx

    Contents lists available at ScienceDirect

    Research Policy

    jo ur nal ho me page: www.elsev ier .com/ locate / respol

    nd the winner isAcquired. Entrepreneurship as a contest yieldingadical innovations

    oachim Henkela,b,, Thomas Rndec,b,1, Marcus Wagnerd,e,2

    Technische Universitt Mnchen, TUM School of Management, Arcisstr. 21, 80333 Munich, GermanyCenter for Economic Policy Research (CEPR), London, UKCopenhagen Business School, Department of Innovation & Organizational Economics, Kilevej 14A, K3.72, 2000 Frederiksberg, DenmarkUniversitt Augsburg, Chair in Innovation and International Management, Universittsstr. 16, 86159 Augsburg, GermanyBureau dEconomie Thorique et Applique (BETA), Strasbourg, France

    r t i c l e i n f o

    rticle history:eceived 16 December 2013eceived in revised form 9 September 2014ccepted 9 September 2014vailable online xxx

    eywords:adical innovationntrantncumbent

    a b s t r a c t

    New entrants to a market tend to be superior to incumbents in originating radical innovations. Weprovide a new explanation for this phenomenon, based on markets for technology. It applies in industrieswhere successful entrepreneurial firms, or their technologies, are acquired by incumbents that thencommercialize the innovation. To this end we analyze an innovation game between one incumbent anda large number of entrants. In the first stage, firms compete to develop innovations of high quality. Theydo so by choosing, at equal cost, the success probability of their R&D approach, where a lower probabilityaccompanies higher value in case of successthat is, a more radical innovation. In the second stage,successful entrants bid to be acquired by the incumbent. We assume that entrants cannot survive ontheir own, so being acquired amounts to a prize in a contest. We identify an equilibrium in which thecquisitionarkets for technologyame theory

    incumbent performs the least radical project. Entrants pick pairwise different projects; the bigger thenumber of entrants, the more radical the most radical project. Generally, entrants tend to choose moreradical R&D approaches and generate the highest value innovation in case of success. We illustrate ourtheoretical findings by a qualitative empirical study of the Electronic Design Automation industry, andderive implications for research and management.. Introduction

    What is the division of labor in the production of innovationsmong large established firms and small entrepreneurial ventures?his fundamental question has attracted the interest of scholars andolicy makers alike, and has spawned a broad literature going backo Schumpeter (1912) and as far as Say (1827). While the evidences somewhat mixed, the overall picture is that incumbent firmsevelop most of the incremental innovations but that entrants playn important role in the creation of breakthroughs (e.g., SchererPlease cite this article in press as: Henkel, J., et al., And the winner isAcRes. Policy (2014),

    nd Ross, 1990; Van Praag and Versloot, 2007). Baumol (2010, p. 25)xplains this as the result of a process where [T]he giant companiesay account for the major share of the economys R&D financing,

    Corresponding author at: Technische Universitt Mnchen, TUM School of Man-gement, Arcisstr. 21, 80333 Munich, Germany. Tel.: +49 89 289 25741;ax: +49 89 28925742.

    E-mail addresses: (J. Henkel), (T. Rnde), (M. Wagner).1 Tel.: +45 3815 2573.2 Tel.: +49 931 318 9046.

    ttp:// 2014 Elsevier B.V. All rights reserved. 2014 Elsevier B.V. All rights reserved.

    but these better established firms tend to minimize risk by special-izing in incrementally improving the most promising of the radicalinnovations they purchase, license or adapt from the smaller firmsthat created them.

    Early theoretical studies point out that incumbents have weakerincentives than start-ups to invest in R&D in situations where theywould replace their own products (Arrow, 1962) but that theyhave stronger incentives to invest if their market power is threat-ened by entry (Gilbert and Newbury, 1982; Reinganum, 1983).However, there is an important distinction with respect to howthe innovations of start-ups are commercialized. The abovemen-tioned models assume that start-ups enter the product marketand compete with incumbents. Yet, as Baumol (2010) pointsout, a cooperative agreement between an entrant and an incum-bent regarding commercialization, in general should be superiorboth because of increased market power and because entrantstypically lack the broad resource bases of incumbents. Reflect-quired. Entrepreneurship as a contest yielding radical innovations.

    ing this point, some more recent theoretical studies allow fora successful entrant to be acquired by (or to license its inven-tion to) an incumbent (Gans and Stern, 2000; Kleer and Wagner,2013).

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    shadow of acquisition (or, technology licensing) was first analyzedtheoretically by Gans and Stern (2000). They modeled in detailthe negotiations between an incumbent and an entrant over anARTICLEESPOL-3052; No. of Pages 16 J. Henkel et al. / Resear

    Our paper contributes to this stream of literature. However,ur approach differs in two respects from earlier work. First, weote that in many industries the number of start-ups seeking toe acquired is, for each technological innovation, higher than theumber of start-ups that eventually succeed. In such a market,tart-ups compete to be acquired. Second, with the notable excep-ion of Frnstrand Damsgaard et al. (2009), the previous studieshoose innovation efforti.e., budget spentas the players choiceariable. However, selecting an R&D project is often a question ofhich path to follow rather than how much to invest. As an illus-

    ration, consider Vertex Pharmaceuticals (Pisano et al., 2006). With given R&D budget, the biotech firm had to pick two from fourromising drug candidates, each characterized by its own successrobability, and value in case of success. In addition, the typicallyimited financial resources of entrants make it unlikely that theyould achieve more radical innovations by outspending incum-ents. Furthermore, in many industriesamong them software andiotechnologycapital requirements in the early phases of R&Drojects are modest, and so budget spent is not the most relevantever for innovation radicalness. It is thus a plausible assumptionhat entrants distinguish themselves from incumbents by choosingore radical R&D approaches with lower success probability andoncomitant higher value in case of success.

    In our model, we consider an industry consisting of one incum-ent and N entrants. The firms conduct R&D with the aim ofeveloping an innovation at a fixed cost normalized to zero. Onlyhe incumbent can commercialize an innovation, so the entrantsoal is to be acquired. The firms choice variable is the successrobability of their R&D projects, with projects with lower suc-ess probability having a higher value in case of success. All firmsave access to the same R&D possibilities, described by a functioninking the projects value in case of success to its success proba-ility. In the first stage of the game, firms select their projects; inhe second stage, after the outcomes of the projects are realized,uccessful entrants compete to be acquired by the incumbent.

    The main results of our analysis are the following. There alwaysxists an equilibrium in which all entrants choose more radical R&Drojects than the incumbenti.e., projects with lower success prob-bility, and in case of success, higher value. In this equilibrium, allntrants choose pairwise different strategies; competition betweenntrants drives the radicalness of their innovation in the sensehat a larger number of entrants leads to an increase in the valuen case of success of the most radical innovation project. In turn,o equilibrium exists in which the incumbent chooses the mostadical project. Furthermore, for a specific value function and N 3e show that the equilibrium in which the incumbent chooses the

    east radical project is unique. We show that our key results areobust to changes in the timing of the R&D decisions, the distri-ution of bargaining power in the market for acquisitions, and thentroduction of more incumbents. We thus obtain the rather robustesult that, overall, entrants pursue more radical innovations thanhe incumbent. The economic intuition behind this result is relatedo the value of having the second best technology. The incumbentenefits from its technology both when it is best (and it is usedo produce) and when it is second best (and it is used to reducehe price paid for the best technology). Therefore, the incumbentas an incentive to pursue a more incremental technology with aigher success probability than an entrant who only benefits fromts technology when it is the best one and is acquired.

    We i


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