For generations, would-be entrepreneurs and economists believed that start-up companies were created to bring new innovations to the market rapidly and to compete with or displace established firms. The noted economist Joseph Schumpeter famously referred to this process of continuous innovation and displacement as “creative destruction.” Due to this conventional wisdom, the first instinct of most executives at start-ups today is to try to use new technology to outcompete larger, more established, and less innovative firms.
But trying to outmaneuver or outinnovate an incumbent is not always the best way to succeed as a new company. In fact, in certain situations, cooperating with a would-be “competitor,” rather than directly competing with it, can increase the likelihood of successfully commercializing a new technology and increasing the firm’s return on investment.
Cooperation may be achieved through several mechanisms, such as licensing the innovation, forming a strategic alliance, or selling the technology outright to a competitor. As is true for any strategic decision, pursuing a cooperation strategy would make sense for a start-up only if it could obtain a higher return on investment by doing so than by engaging in an alternative strategy (in this case, the alternative would be to directly compete with the incumbent firm).
A study published in the Rand Journal of Economics investigated the chosen commercialization strategies of 118 entrepreneurs in five economic sectors. Researchers Scott Stern (professor of Management and Strategy, Kellogg School of Management), Joshua Gans (Melbourne Business School and Intellectual Property Research Institute of Australia, University of Melbourne), and David Hsu (Wharton) revealed that the return on investment tended to be higher for a cooperation strategy than a competition strategy when one or more of three conditions existed for the start-up company. These conditions are the following:
1) The firm has a high degree of control over its intellectual property rights
2) The firm enjoys low deal transaction costs
3) There is a high sunk cost requirement for the firm to compete in its industry
By evaluating whether any of these three conditions exist, start-up executives can greatly increase their likelihood of successful product commercialization and boost their return on investment.
Condition 1: Strong Intellectual Property Rights (IPR)
An innovator’s commercialization strategy depends heavily on the threat of expropriation associated with its product’s underlying technology. By choosing to compete, the start-up risks that the established firm will attempt to reverse-engineer the innovation. If the start-up chooses to cooperate instead, there is a disclosure risk inherent in the negotiating process that can reduce its bargaining power. Strengthening its IPR brings several benefits for the start-up. First, it increases the value of its innovation during a negotiation. Second, it increases the validity of a competitive threat against the incumbent if negotiations break down and cooperation fails.
Not surprisingly, start-up companies with at least one patent are more than twice as likely as non-patent-holders to pursue a cooperative strategy. The study results support this assertion. As Table 1 shows, start-ups in industries where patent rights are strongest and who tend to hold more patents as a result, have been much more likely to pursue cooperative strategies, as these have tended to be higher-return strategies for them.
Figure 1: IPR v. Probability of Pursuing a Cooperation Strategy
The implication for a start-up company is simple: if patent rights are valuable in your industry and if your firm possesses strong patents, then licensing your technology to or forming a strategic alliance with an incumbent may provide you with a higher return on investment than trying to compete directly.
Indeed, in a follow-on study examining a similarly chosen sample of two hundred technology entrepreneurs who chose a cooperation strategy, more than 70 percent waited until after uncertainty over patent grant had been resolved (a process that takes several years). Patent grant is associated with a very significant increase in the speed of commercialization and licensing for start-up innovators.
Condition 2: Low Transaction Costs
While strong IPR may increase the likelihood of cooperation strategies, it may also increase the start-up’s transaction costs associated with contract negotiations. In these situations, the presence of a third-party broker or investor, such as a venture capitalist, can decrease transaction costs in a number of ways. First, these brokers can use their network of contacts to identify companies with whom the start-up is likely to be able to cooperate. Second, by adding experience in corporate governance, these brokers can help to alleviate any structural barriers in the start-up’s management or oversight functions that could impede its ability to make a deal. Finally, third-party brokers can increase the start-up’s credibility in a negotiation by evaluating and certifying the company’s innovation.
These three factors have a subtle but real effect on a company. Start-ups that enjoy venture backing may reap the benefits of ultimately lower transaction costs associated with a negotiated deal. As a result, the company may find that cooperating with an incumbent, or directly selling its technology to an incumbent, can provide it and its investors with a higher return on investment.
Condition 3: High Sunk Cost Requirements for Their Industry
A new entrant may find a cooperation strategy more valuable than competing when the sunk costs associated with market entry are high. Under these conditions, it may be difficult for the company to gather enough resources to enter the industry on its own. It is noteworthy that sunk cost requirements vary from industry to industry.
As an example, sunk cost requirements in the software industry are relatively low because little infrastructure is required to support the development of software code. In contrast, in an industry such as biotechnology, distribution channels, brand recognition, regulatory knowledge, and production expertise make it expensive for start-ups to enter alone. This situation makes leveraging the assets and resources of an established firm a more viable option. The study showed that start-ups have pursued cooperation strategies more often when sunk costs in their industries are high, which reflects the higher value of such strategies in these situations. Table 2 illustrates these findings.
Figure 2: Sunk Costs vs. Probability of Pursuing a Cooperation Strategy
New entrants in an industry should evaluate the initial entry costs relative to available resources. This evaluation can provide critical information about whether to pursue a cooperation or a compete strategy against an established firm.
Start-ups benefit more from cooperation strategies than compete strategies when they possess strong intellectual property rights, when they can utilize brokers to facilitate trade, or when they can leverage the assets of established firms to commercialize their innovation. In these situations, a start-up can earn higher returns by acting as an upstream supplier of innovation rather than as a horizontal innovation-oriented competitor. In other words, by participating in the market for ideas rather than in the market for products, new companies can make the best use of their innovations.
By evaluating the strength of its intellectual property rights, the likely transaction costs of deal-making, and the required sunk costs in its industry, a start-up can make a fully informed decision about whether to cooperate with competitors or to directly compete with them. If the right conditions exist, “creative cooperation” may be a better option than “creative destruction.”