SPAWNING AND SPIN-OFFS

1. SPAWNING AND SPIN-OFFS Josh Lerner

2. Integration is a central concern of organizational economics Typical questions of exploration: Make versus buy decision. Determinants of vertical integration. Contracting in various collaborative arrangements.

3. A neglected arena Decision to develop idea in-house, or instead to spin-out in mainstream economics: One of clearest illustrations of firm boundaries being drawn. More attention to these issues in the strategy, organizational sociology literature.

4. Theoretical strands Management inertia. Internal capital markets. Others�

5. Management inertia Large, established firms more likely to spawn because: They are less capable of responding to radical technological change--slaves to their existing customers: Foster Henderson and Clark. Henderson. Christensen [1997].

6. Internal capital markets Large, established firms more likely to spawn because: They are less capable of evaluating new investment opportunities: Information flows poorly through the hierarchy (Stein [2000]). Inefficient internal capital markets (Scharfstein and Stein [2000]). They optimally turn down diversifying (entrepreneurial) investment opportunities.

7. Other stories Anton and Yao (1995), Wiggins (1995): Contracting difficulties lead to riskier and longer-to-develop projects being pursued in stand-along start-ups. Hellmann (2002): Entrepreneurs prefer corporate VC, but corporate VC cannot commit avoid opportunistic behavior, particularly if start-up cannibalizes existing product.

8. Some other related literature Extensive literature on corporate structure and performance. Growing work on financial institution structure and investment performance: Investment banks. S&Ls. Mutual funds.

9. Other related literature (2) Explorations of features and role of private equity organizations: Cross-sectional variation in incentive schemes and contractual covenants, and their rationales. Exploitation of contractual features by private equity investors to maximize own profits.

10. But basic conclusion holds Relatively little attention to process by which firms are severed. Neglect particularly severe on empirical front. Not very surprising: Severe data constraints! Spawning can be friendly or hostile.

11. Will discuss two initial forays Looking at different sides of same coin: When do corporations fund ventures and what happens to them? When do established firms �spawn� entrepreneurs? In many senses, initial cuts at very complex issues.

12. The Determinants of Corporate Venture Capital Success Paul Gompers and Josh Lerner

13. Outline Brief history of corporate venture capital programs. Case study of a corporate venture capital program: Xerox Technology Ventures, 1988-1996. Excellent financial returns but ultimate dissolution.

14. Outline (2) Empirical comparison of >32 thousand venture capital investments: Summary statistics. Performance of investments. Duration of programs. Discussion of implications.

15. A brief history Cyclicality of entire venture industry. Corporate programs have mirrored pattern: Late 1960s. Early and middle 1980s. Today. Key patterns from earlier activity.

16. Venture programs begun at 100 major corporations, 1961-1990

17. Initial activity Numerous successful venture-backed firms in 1960s: Digital Equipment, Raychem, Memorex, Scientific Data Systems, etc. Corporations sought to emulate success. Most common mechanism was �New Venture Division�: >25% of Fortune 500.

18. Nature of new venture divisions One major type was internal: Encouraged researchers to undertake new projects as freestanding business units. Sought to identify projects that would not be undertaken otherwise, or at a slow pace. Nurtured entrepreneurial units as if free-standing businesses.

19. Nature of new venture divisions (2) Second major type was external: Investing in independent young companies. Sometimes investments were made by corporate officials; in other cases, gave funds to outside venture capitalists. Often sought to have strategic ties as well. Range of hybrid programs.

20. Rapid decline Severe decline in public markets and new venture activity in 1973. Major shake-out among independent venture firms. Corporations soon followed: typical corporate venture program began in late 1960s lasted only four years.

21. Rebirth in 1980s Dramatic growth in venture fundraising in early 1980s; much publicity around Apple, Genentech, Compaq, etc. Corporations began establishing again internal and external programs. By 1986, external corporate programs accounted for 12% of venture pool.

22. Similar pattern Decline in public market values and activity in 1987; dramatic drop in fundraising by independent venture funds. Almost 40% of corporate programs abandoned in four years. Corporate funds fell to 5% of venture pool by 1992.

23. More recent activity Recent high returns to independent venture funds. Opportunities and challenges posed by the Internet and other information technologies. Over two dozen programs launched in 1996 alone.

24. Observations about earlier programs Cyclical element: venture capital went into and out of fashion. But three key design problems limited the success of corporate programs: Multiple objectives. Unstable structure. Inadequate incentives.

25. Problem 1: Multiple objectives Many programs sought to accomplish multiple objectives: Providing a window on new technologies. Identifying acquisition candidates. Generating an attractive financial return for the firm. Outsiders often saw these multiple goals as a sign of weakness.

26. Problem 2: An unstable structure Corporate venture programs were often quickly abandoned as a result of: Failure to first understand the venture industry. Top management turn-over and/or infighting. Resistance from R&D personnel and lawyers. Need for better accounting performance. Few had well-defined legal structure, which deter others from working with them.

27. Problem 3: Inadequate incentives Corporations were often reluctant to commit to large payoffs to their venture managers and internal entrepreneurs. Studies suggested that successful risk-taking was often scarcely rewarded; while failure was excessively punished. Recruitment and retention were consequently frequent concerns.

28. Case study: Xerox Technology Ventures Set up by Xerox in response to failure to develop technologies at PARC. Designed to fund scientists within Xerox and to take ultimately firms public. Made as close to a venture fund as possible: Mission. Autonomy. Incentive schemes.

29. What happened Invested ~$30+ million. Write-offs: Decisus (2/91). QuadMark (12/95). PixelCraft (6/96).

30. What happened (2) Harvested: Advanced Workstation Products (7/91): $15M acquisition price. Documentum (2/96): $323M market cap at time of IPO. Document Sciences (9/96): $124M market cap at time of IPO. Several others in �pipeline.�

31. Conservative calculation IRR of 56%. $219M in capital gains: $175M for Xerox. $44M for XTV�s GPs. Probably other intangible benefits for Xerox.

32. What happened (3) XTV fund was terminated in 1996. Replaced by Xerox New Enterprises, a fund with: Reduced autonomy. Little focus on spinning out firms or financial return. Traditional corporate compensation scheme. Approach and compensation had apparently been substantial issue within corporation.

33. Empirical analysis Research design: Use VentureOne database. Look at characteristics and success of corporate venture capital investments. Compare to traditional venture investments.

34. VentureOne Established in 1987. Collects profiles on venture-backed firms from firms and investors on monthly basis. Excludes firms just funded by angels, SBICs, corporations. Collects data on firms (e.g., industry, employment, sales), and financings (investors, amount, valuation). Incentives for cooperation.

35. Classifying venture investors Identifying independent groups: Venture Economics database. Identifying corporate groups: Checked against Venture Economics database, corporate directories, VC guides, and press stories. Eliminated financial institutions and purely financial corporate subsidiaries. 460 distinct groups.

36. Limitations Missing � Traditional venture capital funds with corporate venture activities. Strategic investments made through financial subsidiaries. Some partnerships where sole limited partner but unclear affiliation.

37. Limitations (2) General limitations of VentureOne database: Only began data collection in 1987. Increasing comprehensiveness over time. High-tech focus. West Coast focus.

38. Empirical analyses Summary statistics. Comparison of investment success: Outcome for portfolio firms. Initial valuation. Comparison of program duration.

39. Few differences in investment mix Similar locations. Corporations somewhat less likely to back start-up or profitable firms. Similar narrow industry mix. Slightly later financing rounds and older firms.

40. Ideally would compare returns Difficulties in observing amount invested in each round. Difficulties in quantifying indirect benefits, especially to non-financial investors. Difficulties in market- and risk-adjusting returns. Instead use two proxies.

41. Corporate-backed firms have greatest success Probability of going public is larger for corporate investments. Probability of liquidation is slightly lower for corporate investments. Robust to regression analysis.

42. Assessing valuations Why might corporate investors invest at a premium: Are corporations being �duped�? Does this reflect indirect benefits to corporations? Test in univariate and regression analyses.

43. Assessing valuations (2) Test explanations by examining patterns of price premiums: Are corporations paying more where there is a strategic fit? Are they paying more when distant technology which is little understood? Lack of difference may reflect both effects.

44. Assessing �staying power� Substantial difference in number of investments in each type of program: We use three measures of duration: Number of investments. Active time span. Ratio of active to possible time span. Corporate funds are much more likely to cease making investments. In regressions, confined to those corporate funds without a strategic focus.

45. Assessing �staying power� (2) Two explanations for shorter duration: Response to radical technological change. Once period of discontinuity is over, program is not needed. Example of pharmaceutical industry�s response to �biotechnology revolution.� Poor structure.

46. Assessing �staying power� (3) Hard to reconcile with observed empirical patterns: If former explanation, might expect strategic programs to be shortest-lived. If latter, both strategic and non-strategic programs should rapidly fail.

47. Wrapping up Strategic programs quite successful. Unfocused programs less so: Less success of portfolio forms. Equally high valuations. Instability of programs. Consistent with complementarities view.

48. Puzzles Can reconcile with claims that structure is critical? One possibility: Lack of strategic focus may be correlated with particularly poor incentives and reduced autonomy. Why do unfocused programs get established?

49. Entrepreneurial Spawning Paul Gompers, Josh Lerner, and David Scharfstein

50. Where Do Entrepreneurs Come From? Process of entrepreneurship widely seen as a �good� thing, yet little know about how the process actually takes place. Existing literature in finance and economics largely takes this as given. Focuses on the contracts used, sorting, performance, etc. [Hellmann and Puri (2000), Gompers (1997), Kaplan and Stromberg (2003)] Little focus on where entrepreneurs come from. OB literature on the process that we try to speak to as well.

51. Our Paper Attempt to address the gap in existing finance and economics literature. Focus on where a certain class of entrepreneurs come from. Focus on venture capital-backed universe. Important source of innovation. Especially in certain key industries. Kortum and Lerner (2000). >50% of IPOs in second half of 1995-2000. Policymakers focus on promoting venture capital sectors. Try to distinguish between two theories of entrepreneurial spawning. Fairchild vs. Xerox.

52. Fairchild Semiconductor Founded in 1957 by 8 defectors from Shockley Semiconductor Soon leave Fairchild along with other engineers to start some of the most famous firms in Silicon Valley: Intel, AMD, National Semiconductor, Kleiner Perkins. These firms go on to spawn even more: Chips & Technologies, Cyrex, Cirrus Logic, �.

53. Xerox In the 1970s, Xerox�s Palo Alto Research Center invents much of the technology underling personal computing, but Rochester-based headquarters doesn�t want to fund the projects Employees leave in frustration, founding many successful companies including 3Com, VLSI, Adobe and they even license key technology to Apple.

54. Two stories Entrepreneurial firms more likely to spawn because they: Expose workers to a network of potential suppliers of labor, capital, and goods as well as customers (Saxenian [1994]) Help workers learn how to be entrepreneurs by exposing them to the entrepreneurial process Select for less risk averse employees Established firms more likely to spawn: Due to stories delineated above.

55. Our Empirical Approach Assemble a database of entrepreneurs who leave public companies to start new VC-backed firms. Calculate the amount of spawning by public companies. Analyze the firm characteristics that affect spawning levels. Analyze how a firm�s spawning level changes over time. Look at relatedness of spawning and spawned firms.

56. The Data Again based on VentureOne. Focus on founders and initial executive officers, particularly their prior employer: Compiled by VentureOne. Must have joined new firms between 1986 and 1999: Dates due to data limitations. When data on prior employer missing, ascertained through LEXIS-NEXIS, SEC files, web sites: More successful firms have more complete data.

57. The Data (2) Characteristics of Public Spawning Companies Prior VC backing (Venture Economics +) HQ Location: Silicon Valley or Massachusetts (identified via Compustat) Focus: single segment (identified via Compustat segment data) Patents through NBER Patent Database (Hall, Jaffe and Trajtenberg) Quantity in 6 classes Quality: citations received adjusted by subcategory and vintage Originality: extent to which patent cites multiple categories of patents (similarly adjusted)

58. Table I Growing level of spawning: Reflects growth of VC activity. Large fraction of spawned companies in tech industries. About 45% of all startups are spawned by public companies.