What Happens to Innovation When the Financial Incentives Change?

The following year, Larry Page and Sergey Brin renamed their project Google. Fast-forward to today, and what started as a humble dissertation project has evolved into the world’s most valuable public company.

Like Page and Brin, many university researchers have the option of transitioning their work from the confines of the laboratory into the commercial world by either founding startup companies or licensing their technology. But why do some academics chose to do this while others pass on the opportunity?

New research from the Kellogg School suggests that university researchers are much more likely to choose to transfer their ideas into the economy if they have the right motivation—that is, a bigger slice of the pie.

To explore this, Kellogg’s Benjamin F. Jones analyzed data from a telling natural experiment in Norway.

In 2003, Norway ended what was termed the “professor’s privilege,” a policy that gave university researchers full rights to their intellectual property or to any new business ventures they created while employed by the university. The reform—partly inspired by the current system in the U.S.—shifted the balance towards the universities, who took two-thirds of those rights.

Jones and his collaborator Hans K. Hvide at the University of Bergen found a dramatic drop in both entrepreneurship and the rate of patenting by university researchers after this change.

“By giving those rights to the university, you’re encouraging the university to invest in technology transfer to the private sector. But you are also taking rights away from the individual researcher,” says Jones, a professor of strategy and the faculty director of the Kellogg Innovation and Entrepreneurship Initiative. “The huge decline in innovation suggests that researchers really cared about those rights.”

The findings have implications for innovators outside of universities as well.

Looking to Norway

As every economist knows, much of human behavior can be explained by incentives.

Imagine that you help bootstrap your friend’s startup in exchange for half the equity. A few months later, your friend breaks the news to you that a high-profile angel investor has come into the picture, and your portion of the company will drop to 10 percent. How will that affect the amount of work you put into making the startup a success?

“There’s a very long-standing question in economics and innovation about how you split the pie,” Jones explains. “How can you split the pie to encourage the right amount of effort from the people involved?”

Jones and Hvide turned to comprehensive data from Norway, knowing that the reforms to professor’s privilege could provide unprecedented insight into pie-splitting within the context of university innovation. The country’s well-maintained databases on startups and patents allowed them to perform a thorough analysis of the reform’s direct impact.

“Scandinavian countries are very good at collecting data about everything that’s going on inside their boundaries, and they give access to that data to researchers,” he says. “That allowed us to look systematically at startup activity by university researchers, which would be very hard to do in the U.S.”

Skin in the Game Really Matters

They found very stark changes in innovation after the demise of professor’s privilege.

From 2000–2002, 25 startups emerged from universities, on average, per year. This dropped to 11 per year from 2003–2007, which constitutes a 56 percent decrease. And, importantly, this was happening while the nonuniversity startup rate remained constant. University startups also took a dive on quality measures, such as rate of survival and amount of sales made by the company of its product.

Similarly, the rate of patenting by university researchers also went down after the reform. The researchers found a 53 percent drop in the number of researchers applying for a patent in a given year. Quality of university patenting, defined as the number of times each patent was cited by later patents, also took a post-reform hit.

“Norway did a lot better pre-reform, and it looks like, if you had to choose between these two approaches, the professor’s privilege had a big advantage,” Jones says.

And the advantage is not just for the researcher, but for the university as well. While full professor’s privilege gave the university no part of the pie, getting a small percent might be better than two-thirds, if the amount of overall innovation increases because the researchers are motivated by their larger share.

“Broadly, the findings here suggest that you want to push the incentive back towards the researcher and not towards the university,” Jones says. “This creates more innovation for society.”

His results have implications for entrepreneurs outside of academia as well. For example, when allocating rights between multiple investors and the founding team of a startup, it would be worth considering how that will impact each party’s level of effort. Further, the sharp reaction by university researchers may also inform tax policy, to the extent that shifting income shares away from the individual researcher is analogous to an increasing tax rate on entrepreneurs.

Implications for the U.S.

Norway made its policy change in part to emulate the U.S. system, in which researchers only hold on average 40 percent of the rights (with exact allocation percentages differing from school to school). Other European countries such as Germany, Austria, and Finland have also done away with the professor’s privilege, instituting new policies that cite the success of U.S.-based innovation as one justification.

Because of the variations in policies at American universities and the limited data on American startups, it is difficult to replicate Jones’s study in the U.S. However, results of a 2008 study that analyzed licensing income generated by universities are consistent with the Norway analysis. In that paper, economists found that U.S. universities that provide greater royalty incentives to faculty tended to see more total licensing income. Up to a point, the financial hit for the university on a given patent can be more than compensated for by the increasing number of patents produced—meaning everyone wins: the faculty innovators, the broader economy, and even the universities themselves.

Of course, some university entrepreneurs and inventors will choose to bring their ideas to market even with low royalty shares. But to maximize the potential for trailblazing companies to rise out of a university—and for their products to benefit society along with the economy as a whole—policies must take university researchers’ incentives into account.

“Generally, we think of innovation as the process that drives economic growth,” Jones says. “Thus, we should embrace an innovation policy that encourages more of it.”