Small Business, Innovation, and Public Policy in the Information Technology Industry

New firms tolerate played a major(ip) role in fomenting variation in culture applied science. A red-hot study by Greenwood and Jovanovic 1999 support peerless dramatic illustproportionn of these trends. These authors show that a group of IT upstartsfirms specializing in computer and communications technologies that went usual later 1968now account for oer 4% of the total U. S. equity trade jacketization. spell virtually of this ingathering has come at the write off of incumbent teaching engine room firms, the impertinently market jimmy and technological spillovers created by these newly businesses get along to be substantial.The role of new firms in the information technology industries has rekind lead interest in the relationship among firm characteristics and existence. Are small businesses more(prenominal) than forward- sprightlinessing in general? Are proud-technology start-ups particularly grand? If the answer to either of these questions is yes, how should policymakers seek to encourage these firms? The relationship amid creative activity and firm characteristics has been one of the most researched topics in the empirical industrial organization literary works.To summarize these discussions and be sick several(prenominal) implications for policymakers in a few pages is thus a daunting challenge Consequently, this essay takes a quite selective approach to these issues. First, I very briefly summarize the academic books on the relationship between firm size and innovation. This work suggests that there appears to be a very wan relationship between firm size, the tendency to undertake R&D, and the effectiveness of research spending. olive-sized businesses, in aggregate, do not appear to be particularly research-intensive or innovative.I consequently circle to examining one subset of small businesses that do appear to excel at innovation judge big(p)-backed start-ups. I bring bulge out some of the jeopardize-bac ked firms contri only ifions. I also discuss why the success of much(prenominal) firms is not accidental. In particular, I highlight the trace problems that the support of small innovative companies pose, as well as some of the key mechanisms that take a chance locateors rent to guide the innovation function. It is not surprising, then, that opine capital investments be concentrated in information technology industries, and that they appear to pur innovation. Finally, I consider one set of policy issues related to small firms and innovation. In particular, I discuss some recent changes in the intellectual property shield strategy that appear to favor larger firms. I then argue that this whitethorn be an ara that would reward increase attention by policy-makers interested in helping innovative small businesses in information technology and some former(a) high-technology industries. 1. Small Business and Innovation A substantial but largely inconclusive literature examin es the relationship between firm size and innovation.These studies have been handicapped by the backbreakingy of measuring innovative inputs and outputs, as well as the challenges of creating a sample that is free of selection biases and other estimation problems. speckle a detailed review of this literature is beyond the scope of this piece, the interested reader can turn to surveys by Baldwin and Scott 1987 and Cohen and Levin 1989. Much of the work in this literature has sought to relate measures of innovative discoverieswhether R&D expenditures, unmixeds, inventions, or other measuresto firm size.Initial studies were undertaken using the largest manufacturing firms more recent works have engaged larger samples and more disaggregated data (e. g. , studies employing data on firms specific lines of business). Despite the improved methodology of recent studies, the results have remained inconclusive even when a significant relationship between firm size and innovation has been f ound, it has had little economic significance. For instance, Cohen, Levin, and Mowery 1987 concluded that a doubling of firm size only increase the ratio of R&D to sales by 0. 2%.One of the relatively few empirical regularities uphill from studies of technological innovation is the critical role played by small firms and new entrants in accepted industries. The role of entrantstypically de novo start-upsin emerging industries was highlighted, for instance, in the pioneering case study-based research of Jewkes, Sawers, and Stillerman 1958. Acs and Audretsch 1988 examined this question more systematically. They put down that the contribution of small firms to innovation was a function of industry conditions the contribution was greatest in new industries which were relatively unconcentrated.These findings suggested that entrepreneurs and small firms often played a key role in observing where new technologies could be applied to meet customer needs, and rapidly introducing products. These patterns are also predicted in several models of technological competition, more of which were reviewed in Reinganum 1989, as well in several analyses in the organizational behavior literature several were discussed in Henderson, 1993. The 1990s have seen several dramatic illustrations of these patterns. Two potentially revolutionary areas of technological innovationbiotechnology and the meshworkwere pioneered by smaller entrants.Neither established drug companies nor mainframe computer manufacturers were pioneers in developing these technologies. By and large, small firms did not invent the key genetic engineering techniques or Internet protocols. Rather, the bulk of the enabling technologies were developed with Federal funds at academic institutions and research laboratories. It was the small entrants, however, who were the initiative to seize upon the commercial opportunities. 2. post detonating device and Innovation One set of small firms, however, appear to have h ad a disproportionate effect on innovation those backed by venture capitalists. Venture capital can be defined as equity or equity-linked investments in young, privately held companies, where the investor is a financial intermediary is typically actively as a director, advisor or even manager of the firm. ) part venture capitalists fund only a few hundred of the nearly one million businesses begun in the United States each year, these firms have a disproportionate fix on technological innovation. This claim is back up by a variety of evidence. One measure, while crude, is yieldd by the firms which graduate to the commonplace marketplace.In the yesteryear two decades, intimately one-third of the companies going public (weighted by value) have been backed by venture investors. A second way to assess these claims is to examine which firms have been funded. Venture capitalists, while contributing a relatively modest share of the total finance, provided critical early capital an d guidance to many of the new firms in such emerging industries as biotechnology, computer networking, and the Internet. In some cases, these new firmsutilizing the capital, expertise, and contacts provided by their venture capital investorsestablished themselves as market lapseers.In other instances, they were acquired by larger corporations, or entered into licensing arrangements with such concerns. Consider, for instance, the biotechnology industry. Venture capitalists provided only a small fraction of the external financing raised in the industry, and only 450 out of 1500 firms have received venture financing through 1995. These venture-backed firms, however, accounted for over 85% of the clears awarded and drugs clear for marketing. Similarly, venture capitalists have aggressively backed firms in information technology industries, which accounted for 60% of all venture disbursements in 1998.These have included many of the most successful firms in the industry, including Amaz on. com, Cisco Systems, Microsoft, Intel, and Yahoo. A utmost way to assess the impact of the venture industry is to consider the impact of venture backed firms. check out results suggest that these investments have powerful impacts. For instance, a mid-1996 survey by the venture organization Kleiner, Perkins, Caufield, and Byers found that the firms that the federation had financed since its inception in 1971 had created 131,000 jobs, generated $44 billion in annual revenues, and had $84 billion in market capitalization Peltz, 1996.While Kleiner, Perkins is one of the most successful venture capital groups, the results are suggestive of the impact of the industry. More systematically, Kortum and Lerner 1998 examining the influence of venture capital on unmixeded inventions in the United States across xx industries over three decades. They track concerns about causality in several ways, including exploiting a 1979 policy vary that spurred venture capital fundraising. They fin d that the amount of venture capital activity in an industry importantly increases its rate of discernibleing.While the ratio of venture capital to R&D has averaged less than 3% in recent years, the estimates suggest that venture capital accounts for about 15% of industrial innovations. They address concerns that these results are an artefact of the use of open counts by demonstrating similar patterns when other measures of innovation are used in a sample of 530 venture-backed and non-venture-backed firms. Lending particular relevance to an examination of these firms is the tremendous boom in the U. S. venture capital industry in recent years.The pool of venture partnerships has grown ten-fold, from under $4 billion in 1978 to about $75 billion at the end of 1998. Venture capitals recent harvest-time has outstripped that of almost every class of financial product. It is worth underscoring that the tremendous success of venture-backed firms has not happened by accident. The intera ctions between venture capitalists and the entrepreneurs that they finance are often complex. They can be understood, however, as a response to the challenges that the financing of emerging growth companies pose.Entrepreneurs rarely have the capital to see their ideas to fruition and must rely on immaterial financiers. Meanwhile, those who control capitalfor instance, pension fund trustees and university overseersare unlikely to have the time or expertise to invest directly in young or restructuring firms. Some entrepreneurs might turn to other financing sources, such as bank loans or the issuance of public stock, to meet their needs. But because of tetrad key factors, some of the most potentially profitable and exciting firms would be unable to access financing if venture capital did not exist.The first factor, uncertainty, is a measure of the array of potential outcomes for a guild or project. The wider the dispersion of potential outcomes, the greater the uncertainty. By their very spirit, young companies are associated with significant levels of uncertainty. hesitation surrounds whether the research program or new product allow for succeed. The response of firms rivals whitethorn also be uncertain. High uncertainty means that investors and entrepreneurs cannot confidently predict what the company will look like in the future tense.Uncertainty affects the willingness of investors to contribute capital, the desire of suppliers to extend credit, and the decisions of a firms managers. If managers are averse to taking risks, it whitethorn be difficult to induce them to make the right decisions. Conversely, if entrepreneurs are overoptimistic, then investors want to curtail miscellaneous actions. Uncertainty also affects the timing of investment. Should an investor contribute all the capital at the beginning, or should he stage the investment through time? Investors need to know how information-gathering activities can address these concerns and when th ey should be undertaken.The second factor, asymmetric information (or information disparities), is distinct from uncertainty. Because of his day-to-day involvement with the firm, an entrepreneur knows more about his companys prospects than investors, suppliers, or strategic partners. Various problems develop in settings where asymmetric information is prevalent. For instance, the entrepreneur may take detrimental actions that investors cannot observe perhaps undertaking a riskier strategy than ab initio suggested or not working as hard as the investor expects.The entrepreneur might also invest in projects that build up his reputation at the investors expense. Asymmetric information can also lead to selection problems. The entrepreneur may exploit the fact that he knows more about the project or his abilities than investors do. Investors may find it difficult to distinguish between competent entrepreneurs and incompetent ones. Without the ability to screen out unacceptable projects and entrepreneurs, investors are unable to make efficient and appropriate decisions. The third factor affecting a firms corporate and financial strategy is the disposition of its assets.Firms that have tangible assetse. g. , machines, buildings, land, or corporeal inventorymay find financing easier to master or may be able to obtain more favorable terms. The ability to abscond with the firms source of value is more difficult when it relies on physical assets. When the most important assets are intangible, such as trade secrets, raising outside financing from traditional sources may be more challenging. Market conditions also play a key role in determining the difficulty of financing firms. Both the capital and product markets may be subject to substantial variations.The supply of capital from public investors and the price at which this capital is available may vary dramatically. These changes may be a response to regulatory edicts or shifts in investors perceptions of future pro fitability. Similarly, the nature of product markets may vary dramatically, whether payable to shifts in the intensity of competition with rivals or in the nature of the customers. If there is exceedingly intense competition or a great deal of uncertainty about the size of the potential market, firms may find it very difficult to raise capital from traditional sources.Venture capitalists have a variety of mechanisms at their disposal to address these changing factors. They will invest in stages, often at increasing valuations. Each refinancing is tied to a re-evaluation of the company and its prospects. In these financings, they will employ complex financing mechanisms, often hybrid securities like convertible security preferred equity or convertible debt. These financial structures can potentially screen out overconfident or under-qualified entrepreneurs and reduce the venture capitalists risks.They will also shift the mixture of investors from whom a firm acquires capital. Each sourceprivate equity investors, corporations, and the public marketsmay be appropriate for a firm at different points in its life. Venture capitalists provide not only introductions to these other sources of capital but certificationa stamp of approval that addresses the concerns of other investors. Finally, once the investment is do, they monitor and work with the entrepreneurs to ensure that the right operational and strategic decisions are made and implemented. 3.Innovation, Small Business, and Public Policy If small firmsor even some subset of small firmsare performing an important role in the innovation process, one policy goal should be to address threats to their future development. This is particularly true of threats that have been created by misguided government policies, however good the intentions of their designers. The area that I believe deserves particular attention relates to the key mechanism for protecting intellectual property, namely tangibles. The U. S. cons picuous system has under gone(p) a profound shift over the past fifteen years.The strength of discernible protection has been dramatically bolstered, and both large and small firms are devoting considerably more effort to seeking patent protection and takeing their patents in the courts. Many in the patent communityU. S. procure and Trademark Office officials, the patent bar, and corporate patent staffhave welcomed these changes. But viewed more broadly, the reforms of the patent system and the consequent growth of patent litigation have created a substantial innovation tax that afflicts some of Americas most important and creative small firms.Almost all formal disputes involving issued patents are tried in the Federal juridical system. The sign litigation must be undertaken in a territorial dominion court. Prior to 1982, appeals of patent cases were comprehend in the appellate courts of the various circuits. These differed considerably in their interpretation of patent law. Because few appeals of patent cases were perceive by the Supreme Court, substantial differences persisted, leading to widespread forum shopping by litigants. In 1982, the U. S. coition established a centralized appellate court for patent cases, the Court of Appeals for the Federal Circuit (CAFC). As Robert Merges 1992 observes, While the CAFC was ostensibly formed strictly to unify patent doctrine, it was no doubt hoped by some (and expected by others) that the new court would make subtle alterations in the doctrinal fabric, with an eye to enhancing the patent system. To judge by results, that is exactly what happened. The CAFCs rulings have been more pro-patent than the previous courts.For instance, the circuit courts had affirmed 62% of district court findings of patent infringement in the three decades prior to the creation of the CAFC, while the CAFC in its first eight years affirmed 90% of such decisions Koenig, 1980 Harmon, 1991. The strengthening of patent law has not gone u nnoticed by corporations. Over the past decade, patents awarded to U. S. corporations have increased by 50%. Furthermore, the willingness of firms to litigate patents has increased considerably. The number of patent suits instituted in the Federal courts has increased from 795 in 1981 to 1553 in 1993 adversarial proceedings within the U.S. Patent and Trademark Office have increased from 246 in 1980 to 684 in 1992 Administrative Office, various years U. S. Department of Commerce, various years. My recent analysis of litigation by firms based in Middlesex County, Massachusetts suggests that six intellectual property-related suits are turn ond for every one hundred patent awards to corporations. These suits lead to significant expenditures by firms. Based on historic costs, I estimate that patent litigation begun in 1991 will lead to total legal expenditures (in 1991 dollars) of over $1 billion, a substantial amount relative to the $3. billion spent by U. S. firms on underlying resea rch in 1991. These findings are summarized in Lerner, 1995. Litigation also leads to substantial indirect costs. The discovery process is likely to require the alleged infringer to produce extensive documentation, time-consuming depositions from employees, and may generate unfavorable publicity. Its officers and directors may also be held individually liable. As firms have realized the value of their patent positions, they have begun reviewing their stockpiles of issued patents. some(prenominal) companies, including Texas Instruments, Intel, Wang Laboratories, and Digital Equipment, have established groups that approach rivals to demand royalties on old patent awards. In many cases, they have been successful in extracting license agreements and/or past royalties. For instance, Texas Instruments is estimated to have netted $257 million in 1991 from patent licenses and settlements resulting from their general counsels aggressive enforcement policy Rosen, 1992. Particularly striking, practitioner accounts suggest, has been the growth of litigationand threats of litigationbetween large and small firms.This trend is disturbing. While litigation is clearly a necessary mechanism to defend property rights, the proliferation of such suits may be leading to transfers of financial resources from some of the youngest and most innovative firms to more established, better capitalized concerns. Even if the target firm feels that it does not infringe, it may choose to settle rather than fight. It either may be unable to raise the capital to finance a protracted court battle, or else may believe that the publicity associated with the litigation will depress the valuation of its equity.In addition, these small firms may reduce or alter their investment in R. For instance, a 1990 survey of 376 firms found that the time and expense of intellectual property litigation was a major factor in the decision to pursue an innovation for almost twice as many firms with under 500 employee s than for larger businesses Koen, 1990. These claims are also back up by my study 1995 of the patenting behavior of new biotechnology firms that have different litigation costs.I showed that firms with high litigation costs are less likely to patent in subclasses with many other awards, particularly those of firms with low litigation costs. These effects have been particularly pernicious in emerging industries. Chronically strained for resources, USPTO officials are unlikely to assign many patent examiners to emerging technologies in advance of a beckon of applications. As patent applications begin flowing in, the USPTO often finds the retention of the few examiners skilled in the new technologies difficult. Companies are likely to hire away all but the least able examiners.These examiners are rich not only for their knowledge of the USPTO examination procedure in the new technology, but also for their sagaciousness of what other patent applications are in process but not awa rded. (U. S. patent applications are held undercover until time of award. ) Many of the examinations in emerging technologies are as a result performed under hard time forces by inexperienced examiners. Consequently, awards of patents in several critical new technologies have been delayed and super inconsistent. These ambiguities have created ample opportunities for firms that seek to aggressively litigate their patent awards.The clearest examples of this problem are the biotechnology and software industries. In the latter industry, examples abound where inexperienced examiners have granted patents on technologies that were widely diffused but not previously patented see, for instance, the many examples chronicled in Aharonian, 1999. It might be asked why policy-makers have not addressed the deleterious effects of patent policy changes. The difficulties that Federal officials have faced in reforming the patent system are perhaps best illustrated by the efforts to simplify one o f the most arcane aspects of our patent system, the first-to-invent policy.With the exception of the Philippines and Jordan, all other nations award patents to firms that are the first to file for patent protection. The U. S. , however, has clung to the first-to-invent system. In the U. S. , a patent will be awarded to the party who can demonstrate (through laboratory notebooks and other evidence) that he was the initial discoverer of a new invention, even if he did not file for patent protection until after others did (within certain limits).A frequently invoked argument for the first-to-invent system is that this provides protection for small inventors, who may take weeklong to translate a discovery into a completed patent application. While this argument is initially compelling, the verity is quite different. Disputes over priority of invention are resolved through a proceeding forward the USPTOs Board of Patent Appeals and Interferences known as an interference. The Board wil l hold a hearing to do which inventor first made the discovery.The interference process has been characterized as an archaic procedure, replete with traps for the unwary Calvert, 1980. These interferences pine away a considerable amount of resources the adjudication of the average interference is estimated to cost over one hundred guanine dollars Kingston, 1992. Yet in recent years, in only about 55 cases annually has the party that was second-to-file been dogged to have been the first-to-invent Calvert and Sofocleous, 1992. Thus, the U. S. persists in this complex, costly, and idiosyncratic system in order to reverse the priority of 0. 3% of the patent applications filed each year. But this system has proved very resistant to change. At least since 1967, proposals have been unsuccessfully offered to shift the U. S. to a first-to-file system. As recently as January 1994, USPTO Commissioner Bruce Lehman was forced to withdraw such a proposal. While the voices raised in protest ov er his initiativeas those opposing earlier reform attemptswere led by advocates for small inventors, it is difficult not to conclude that the greatest beneficiary from the first-to-file system is the small subset of the patent bar that specializes in interference law.It may be thought puzzling that independent inventors, who are broadly speaking unable to afford costly litigation, have been so active in supporting the retention of first-to-invest. A frequently voiced complaint is that small inventors take longer to prepare patent applications, and hence would escape out to better-financed rivals, in a first-to-file world. This argument appears to be specious for several reasons. First, economically important discoveries are typically the subject of patent filings in a number of countries. Thus, there is already an enormous pressure to file quickly.Second, the recent reforms of the U. S. system have created a new provisional patent application, which is much simpler to file than a full-fledged application. Finally, as former Commissioner Lehman notes, many most vocal independent inventors opposing patent reform are weekend hobbyists . . . rather than representatives of knowledge-based industries Chartrand, 1995. As this case study suggests, the failure of Federal reform efforts is due to several factors. First, the issues are complex, and sometimes difficult to understand.Simplistic claims frequently cloud these discussions. For instance, because firms use patents to protect innovations, it is frequently argued that a stronger patent system will lead to more innovation. Second, the people with the greatest economic military post in retaining a litigious and complex patent systemthe patent barhave turn up to be a very powerful lobby. The efforts of the highly specialized interference bar to retain first to invent is a prime example. Finally, the top executives of technology-intensive firms have not mounted an effective campaign somewhat these issues.The re ason may be that the companies who are most adversely affected are small, capital-constrained firms who do not have time for major lobbying efforts. Thus, an important policy concern is that we avoid taking steps in the name of increasing competitiveness that actually interfere with the workings of innovative small businesses. The 1982 reform of the patent litigation process appears to have had exactly this sort of unintended consequence. References Zoltan J. Acs and David B. Audretsch, Innovation in Large and Small Firms An Empirical Analysis, American stinting Review, 78 (1988), pp. 78-690. Administrative Office of the United States Courts, Annual Report of the Director, upper-case letter U. S. Government Printing Office, various years. Gregory Aharonian, Internet Patent News Service, http//metalab. unc. edu/patents/ipnsinfo. html, 1999. William L. 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