Competition or cooperation?

Much has been made of the importance of alliances in the biotech industry. Large pharmaceutical firms are particularly good at testing and marketing drugs, but are facing pipeline shortages, while smaller start-ups are better at research and innovation. Alliances can help each benefit from the other. Research alliances between firms and with universities are also important drivers of innovation - as demonstrated by W. Powell and others.

Is this a phenomenon specific to biotech or a general one? Are the gales of creative destruction no longer a threat to large incumbent firms? Joshua Gans, David Hsu and Scott Stern set out to formulate some general rules in a paper presented by K@W.

The researchers found that the likelihood of start-ups cooperating with established companies depends upon three factors:
1) the strength of the startups’ intellectual property rights;
2) whether they have relationships with intermediaries such as venture capitalists; and
3) whether their industry requires big investments in things such as manufacturing and distribution.

To draw their conclusions, they surveyed 118 technology start-ups.

“In economic environments like the biotechnology industry – where patents are relatively effective in protecting [intellectual property rights], firms face high relative investment costs, and brokers are available to facilitate trade – start-up innovators tend to earn their returns from innovation through the market for ideas, acting as an upstream supplier of ‘technology’ rather than as a horizontal innovation-oriented competitor,” the authors write. “In contrast, when investment costs for the entrant are relatively low and the technological innovation is not protected by patents, as in the disk-drive industry, the disclosure threat tends to foreclose the ideas market. Start-up innovators in this environment are more likely to commercialize their innovations through product market competition.”

Patents protect start-ups from having their inventions stolen by incumbents. That, in turn, gives them greater leverage in negotiations. “Under cooperation, negotiating over the sale of an idea inevitably involves a disclosure risk, eroding the bargaining position of the start-up and reducing the incumbent’s willingness to pay,” the researchers explain. “Increasing the strength of [intellectual property rights] reduces the expropriation threat for either strategy, and thus it increases the absolute expected returns to start-up innovators.” Negotiations often lead to cooperative relationships such as joint ventures and even acquisitions.

It’s not only the small biotechs that have embraced the cooperative model of innovation, Hsu pointed out in an interview. Merck & Co., the giant drug maker based in Whitehouse Station, N.J., has made partnering a cornerstone of its strategy for bringing new drugs to the market. Two of its leading products – Fosamax, an osteoporosis drug, and Cozaar/Hyzaar, a hypertension medication – came to the company via license agreements.

Of course, negotiating, like marriage, requires a partner, and finding the right one can make the difference between happiness and divorce. But as a rule, start-ups aren’t well-suited to finding good partners. They tend to be small and thus stretched thin. What they need are matchmakers, that is, intermediaries such as venture capitalists, lawyers and accountants.

Intermediaries often specialize in particular industries, working mostly with, say, biotech or information-technology companies. As a result, they have a deep knowledge of the industry’s players; they know whether those players are looking for partners and whether they can be trusted in negotiations. Likewise, they can vouch for the value of a startup’s innovation and the ability of its founders. Hsu and his co-authors find that start-ups that work with intermediaries are more likely to choose cooperation over competition.

Finally, “As the sunk costs of product-market entry increase, the gains from trade between start-up innovators and incumbents also increase, so start-ups will be more likely to forgo competition,” they point out.

What does all this mean if you are an entrepreneur with a company or a manager within a big, established firm? Ideally, it will help you pick the right path, cooperation or competition. But as Hsu points out, no formula fits all companies within an industry. Two of the best-known and biggest biotech companies – Amgen and Genentech, both based in California – partnered early on with established companies. But they invested the earnings from those partnerships in becoming fully integrated pharmaceutical companies.