Corporate Venture Capital and Incumbent Firm Innovation Rates

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<ol><li> 1. Corporate Venture Capital and Incumbent Firm Innovation Rates Gary DushnitskyMichael J. Lenox Stern School of BusinessStern School of Business New York University New York University 44 West 4th St. Suite 750 40 West 4th St. Suite 717 New York, NY 10012New York, NY 10012Tel: (212) 998-0283 Tel: (212) 998-0261Fax: (212) 995-4235 Fax: (212) 995-4235 gdushnit@stern.nyu.edu mlenox@stern.nyu.edu Draft: March 1st , 2002Working Paper. Please do not quote or cite without authors permission. 2002 G. Dushnitsky &amp; M. Lenox </li><li> 2. Corporate Venture Capital and Incumbent Firm Innovation RatesAbstractIn this paper, we focus on the potential strategic benefits to corporate venture capital, i.e.equity investments in entrepreneurial ventures by incumbent firms. In particular, we ask dofirms that invest corporate venture capital learn about and appropriate new technologies andpractices from those ventures they invest? Our investigation builds on two theoretical pillars.First, that incumbent firms operating in competitive markets are inclined towards introducinginnovations. Second, that the knowledge necessary to generate innovation may likely resideoutside the boundary of the incumbent firm and in entrepreneurial ventures. Thus, we proposethat corporate venture capital programs may be instrumental in harvesting innovations fromentrepreneurial ventures and thus an important part of a firms overall innovation strategy. Tothis end, we directly explore the relationship between corporate venture capital and incumbentfirm innovation by analyzing a large panel of public firms that pursued venturing activity orpatented over a thirty-year period. We find that increases in corporate venture capitalinvestments are associated with subsequent increases in firm quality patenting. The findings ofthis study have important implications for the functioning of corporate venture capital programsand the ability of firms to innovate in general.Keywords: corporate venture capital, innovation, knowledge, entrepreneurshipShort Title: Corporate Ventures &amp; Innovation 2002 G. Dushnitsky &amp; M. Lenox1 </li><li> 3. Corporate Venture Capital andIncumbent Firm Innovation Rates At the beginning of this new century, established corporations have become importantplayers in the venture capital industry. In 2000, more than 400 firms sponsored corporateventure capital programs that invested close to $16 billion. These investments representapproximately 15% of all venture capital investments -- a sharp increase from the relativelymeager $20 million invested by corporations in new ventures in 1993 (Venture Economics,2001). Why are established firms investing in new ventures? Do these firms simply hope toreap the high financial returns that venture capitalists experienced in the late 1990s? Or, dothese firms have other strategic reasons for investing in new ventures?In this paper, we focus on the potential strategic benefits to incumbent firms by investingcorporate venture capital (CVC). We define corporate venture capital as any equity investmentin an entrepreneurial venture by an incumbent firm (Gompers &amp; Lerner, 1998). We considerboth investments in independent ventures (Gompers and Lerner, 1998) and investments inventures that consist of former employees (Burgelman, 1983; Garud and Van de Ven, 1992). Inparticular, we are interested in whether CVC investments result in knowledge spillovers toincumbent firms. Do firms that invest corporate venture capital learn about and appropriate newtechnologies and practices from those ventures they invest? For example, do increases in CVCinvestments lead to increases in incumbent firm patenting levels?Our investigation builds on two theoretical pillars. First, that incumbent firms operatingin competitive markets are inclined towards introducing innovations (Schumpeter, 1942; Arrow,1962). This is in part because incumbent firms need to innovate constantly in order to sustainprofitability (Roberts, 1999; Hamel, 2000). Second, that the knowledge necessary to generateinnovation may likely reside outside the boundary of the incumbent firm (Arrow, 1974; Cohen &amp; 2002 G. Dushnitsky &amp; M. Lenox2 </li><li> 4. Levinthal, 1990). In particular, increases in the relative significance of human-capital (Zingales,2000) imply that entrepreneurial startups may be a valuable source of such knowledge (Kortumand Lerner, 2000; Shane, 2001a). Placed together, these two pillars suggest that incumbents mayseek innovation outside their organization and within competent entrepreneurial ventures. Wepropose that corporate venture capital programs may be instrumental in harvesting innovationsfrom entrepreneurial ventures and thus an important part of a firms overall innovation strategy.Previous empirical research on venture capital investments by corporations has focusedprimarily on the narrow, financial returns to investing in new ventures. A number of studieshave found that investments in general in related ventures by incumbent firms had a significantlylower return than investments by venture capitalists (Gompers &amp; Lerner , 1998; Siegel, Siegel &amp;MacMillan, 1988). The ventures themselves, however, performed equally well when funded byrelated incumbent firms or by venture capitalists (Gompers &amp; Lerner , 1998; Sykes, 1990;Shrader &amp; Simon, 1991; Thornhill &amp; Amit, 2000).A handful of empirical studies do provide some evidence that corporate venturing activityresults in important strategic benefits to firms (Rind, 1981; Sykes, 1990; Block &amp; MacMillan,1993; Sorrentino &amp; Williams, 1995; Shrader &amp; Simon, 1997). Unfortunately, these studies relyon case studies or small sample surveys and focus on either overall firm financial performance orproject-progress measures. None of these studies evaluate the effect of corporate venture capitalon incumbent firm innovation.In this paper, we directly explore the relationship between corporate venture capital andincumbent firm innovation. We analyze a large, unbalanced panel of U.S. public firms duringthe time period 1969-1999. Of those firms in our dataset, approximately two hundred and fiftyfirms engaged at least in some level of CVC investing during the time period. Data is pulled 2002 G. Dushnitsky &amp; M. Lenox3 </li><li> 5. from VenturExpert, Compustat, and the U.S. Patent databases. Discrete choice, fixed-effect andrandom-effect models are adopted to establish a relationship between CVC investment intensityand patenting.Our contribution is in exploring whether increases in CVC investments lead to increasesin incumbent firm patenting levels. We find that increases in CVC investment are associatedwith subsequent increases in citation-weighted, firm patenting rates. The findings of this studyhave important implications for the functioning of corporate venture capital programs and theability of firms to innovate in general. While alternative inter-organizational forms such astechnology alliances have been extensively studied (e.g., Ahuja, 2000; Powell, Koput &amp; Smith-Doerr 1996), corporate venture capital has been the subject of less formal, empirical analysis.Moreover, if knowledge spills over to incumbent firms, there are incentives for new ventures toseek alternative sources of funding such as venture capital. The likely impacts of this ongovernance will be the subject of future studies.Theoretical BackgroundIn his later years (and in contradiction to his earlier writings), Schumpeter (1942)introduced the view that established firms are most likely to be innovative. According toSchumpeter, incumbent firms possess the capital and skilled personnel necessary to produceinnovations as well as the complementary assets necessary to appropriate the resultant rents.Subsequent research postulated that incumbent firms operating in competitive markets areinclined towards innovating in part because of the need to continuously innovate in order tosustain profitability (Arrow, 1962; Roberts, 1999; Hamel, 2000). A rich game theoretic literature 2002 G. Dushnitsky &amp; M. Lenox 4 </li><li> 6. also provides evidence that, under some conditions, incumbent firms are more likely thanpotential new entrants to invest in innovation (see Reinganum, 1989 for a review).Despite this economic inclination to seek innovation by established firms, numerousresearchers have highlighted the organizational limitations of incumbents to generate innovationsinternally (Henderson, 1993). The view that incumbent firms face difficulties in generatingground breaking, radical innovations is well established (Tushman and Anderson, 1986;Henderson, 1993). Innovation in large part requires the integration of diverse knowledge sets.To the extent there are constraints on the creation and sharing of knowledge within a singleorganization, incumbent firms may find that they lack the knowledge necessary to innovate.Numerous remedies have been suggested. Incumbent firms may, for example, be able toovercome their inability to internally generate innovations by exploiting knowledge external tothe firm (Cohen and Levinthal, 1990). This has been the focus of many studies that investigatethe ability to create new knowledge through the recombination of knowledge acrossorganizational boundaries (Henderson and Cockburn, 1994; Rosenkopf and Nerkar, 2001;Almeida, Dokko and Rosenkopf, 2001). External knowledge can be accessed and assimilatedthrough different avenues including regional learning (Saxenian, 1990), recruitment of high-human capital personnel (Almeida and Kogut, 1999), and strategic alliances (Hagedoorn &amp;Schakenraad, 1994; Powell, Koput &amp; Smith-Doerr 1996).In addition to these vehicles, we propose that corporate venture capital may be animportant component of a firms innovation strategy. We advance the idea that a transformationhas transpired that has induced incumbents to seek innovation outside their organization andwithin competent entrepreneurial ventures. In the later half of the twentieth century, highlyskilled human capital (labor) has become more important in generating innovation than physical 2002 G. Dushnitsky &amp; M. Lenox5 </li><li> 7. capital (Zingales, 2000). In this new setting, the property rights literature (Grossman and Hart,1986) predicts that skilled workers will disassociate themselves from incumbents and formindependent firms. Such disposition towards non-integration explains the proliferation ofventures headed by independent entrepreneurs. Indeed, Shane (2001a) provides direct empiricalevidence that new venture formation is associated with underlying entrepreneurial inventionsthat are technologically radical or that have high economic value. Kortum and Lerner (2000)support these findings, observing that entrepreneurial, human-capital intensive ventures generatehigh levels of patenting output.Thus, the knowledge necessary to generate innovations may likely reside outside theboundary of the incumbent firm and within innovative new ventures. Corporate venture capitalmay provide a robust avenue to access this knowledge. Indeed, the declared goal of NokiaVentures, the CVC program of Nokia, is to fuel future growth and to boost new product andlong-term business development (Business Wire, 1998). By investing in a new venture,incumbent firms may be able to learn about new technologies or practices. With this knowledge,they may be able to innovate existing products or services or diversify into new lines of business.CVC investment may allow incumbents to manage threats from potential entrants within theircore businesses especially in the crucial early stages of new technological regimes (Shane,2001b). Additionally, learning about novel technologies before their rivals increases thelikelihood of identifying future alliance partners or acquisition targets (Ahuja, 2000).A similar point has been made in the related technology alliances literature. To the extentthat entrepreneurial startups possess valuable knowledge, corporate venture capital may providea firm a window onto the operations of portfolio companies that can generate similar advantagesto those associated with having innovative alliance partners. Hagedoorn &amp; Schakenraad (1994) 2002 G. Dushnitsky &amp; M. Lenox 6 </li><li> 8. and Ahuja (2000) indicate that knowledge from innovative alliance partners may spillover andpositively affect the innovativeness of a firm. Stuart (2000) shows that firms patenting ratesincrease the more technologically advanced are its alliance partners. Rothaermal (2001) arguesthat incumbent firms that pursue alliance formation with new ventures improve their newproduct development when faced with radical technological changes.CVC investing firms may learn from new ventures in a number of ways. Anecdotalevidence suggests that incumbent firms institute specific organizational routines to encourageand funnel learning from the ventures they invest. Sony Corporation created two parallel anddistinct functions responsible for knowledge transfer between its portfolio companies and thecorporation (Venture Capital Investment in Israeli Companies, International Business Forum,March 27-28, 2001). Sonys CVC group, Sony Strategic Venture Investments, played the role ofventure-capitalist -- sitting on the ventures board and helping manage the portfolio company. Inthis role, they were exposed to the technologies and practices of the venture. In addition, Sonysbusiness divisions established liaisons with the ventures. These liaisons specific goal was tolearn about and source the portfolio companys technology.Such organizational practices need not lead to expropriation by the incumbent and harmto the new venture. The venture may secure entrepreneurial rents from its technology due to astrong appropriability regime (perhaps because of tight patent protection). Any learning thattakes by the incumbent firm merely opens a window onto new technologies that leads to furtherinnovation. For example, Ahuja and Lampert (2001) find that experimenting by establishedfirms with novel, pioneering technologies increases the likelihood that they will createsubsequent breakthrough inventions. By tapping an external source of knowledge in this case, 2002 G. Dushnitsky &amp; M. Lenox7 </li><li> 9. an entrepreneurial venture a firm will become more innovative. Investments in innovative newventures may increase a firms absorptive capacity (Cohen &amp; Levinthal, 1990). Evidence to DateThe empirical evidence of learning from CVC investment is sparse. Previous economicresearch on corporate venture capital has focused on the narrow, financial benefits to investing innew ventures. Gompers &amp; Lerner (1998) in a study of over thirty thousand investments roundsfound that investments in related ventures by incumbent firms had a significantly lower returnthan investments by venture capitalists. However, the ventures themselves performed equallywell when funded by related incumbent firms or by venture capitalists. These results did nothold for incumbent firms who invested in new ventures that were in unrelated businesses. Thefindings of the Gompers &amp; Lerner study are consi...</li></ol>

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