Why Some Start-ups Choose Cooperation over
Published: April 07, 2004 in
When faced with the challenge of commercializing its AIDSdrug, Trimeris Inc., a small biotech company based in Durham,N.C., didn’t hire a sales force or sink money into marketing.
Instead, it called in Hoffman-La Roche Inc., the Swisspharmaceutical giant. In 1999, tiny Trimeris and burly Rochehammered out an agreement under which Roche agreed to put itsproduction and marketing might behind Trimeris’ drug, calledFuzeon, in exchange for a piece of the profits. In January, thetwo companies announced that they were extending theirpartnership.
sort of arrangement has become common in the drug industry. Small biotechs such as Trimeris innovate,creating promising drugs and vaccines, while big drug companies such as Roche look to partner withthem, lending their heft to the biotechs’ promise.
In a co-authored paper entitled, When Does Start-up Innovation Spur the Gale of Creative Destruction,Hsu argues that this sort of cooperation belies the popular idea of technological innovation. In the usualformulation, start-ups sneak in with new products and swipe sales from incumbent leaders. As a result,the innovators grow, while the older companies stagnate, even shrink. That’s certainly been the case inthe hard-drive industry, for example, and in online retailing.
But sometimes the market operates more benignly, with new entrants such as Trimeris cooperating withestablished players such as Roche. Suddenly, the gale of creation doesn’t look so destructive.
Understanding what leads some start-ups to choose cooperation over competition was the impetus forHsu’s article, written with co-authors Joshua Gans at the   All materials copyright of the Wharton School of the University of Pennsylvania.                    Page 1 of 3  and Scott Stern at Northwestern University, and published in the RAND Journal of Economics. Theresearchers found that the likelihood of start-ups cooperating with established companies depends uponthree factors: 1) the strength of the startups’ intellectual property rights; 2) whether they haverelationships with intermediaries such as venture capitalists; and 3) whether their industry requires biginvestments in things such as manufacturing and distribution. To draw their conclusions, they surveyed118 technology start-ups.
“In economic environments like the biotechnology industry – where patents are relatively effective inprotecting [intellectual property rights], firms face high relative investment costs, and brokers areavailable to facilitate trade – start-up innovators tend to earn their returns from innovation through themarket for ideas, acting as an upstream supplier of ‘technology’ rather than as a horizontalinnovation-oriented competitor,” the authors write. “In contrast, when investment costs for the entrantare relatively low and the technological innovation is not protected by patents, as in the disk-driveindustry, the disclosure threat tends to foreclose the ideas market. Start-up innovators in this environmentare more likely to commercialize their innovations through product market competition.” Intellectual property rights take many forms, the most obvious being patents. A patent gives its ownerthe exclusive right to commercialize an invention for a specified period. “Firms with at least oneproject-related patent are more than twice as likely to cooperate relative to those with no patents,” theauthors write.
Patents protect start-ups from having their inventions stolen by incumbents. That, in turn, gives themgreater leverage in negotiations. “Under cooperation, negotiating over the sale of an idea inevitablyinvolves a disclosure risk, eroding the bargaining position of the start-up and reducing the incumbent’swillingness 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 tostart-up innovators.” Negotiations often lead to cooperative relationships such as joint ventures and evenacquisitions.
It’s not only the small biotechs that have embraced the cooperative model of innovation, Hsu pointed outin an interview. Merck & Co., the giant drug maker based in Whitehouse Station, N.J., has madepartnering 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 companyvia license agreements.
Of course, negotiating, like marriage, requires a partner, and finding the right one can make thedifference between happiness and divorce. But as a rule, start-ups aren’t well-suited to finding goodpartners. 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 orinformation-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   All materials copyright of the Wharton School of the University of Pennsylvania.                    Page 2 of 3  negotiations. Likewise, they can vouch for the value of a startup’s innovation and the ability of itsfounders. Hsu and his co-authors find that start-ups that work with intermediaries are more likely tochoose cooperation over competition.
Finally, they find that start-ups will be less likely to cooperate if they have to devote a lot of money togearing up to compete. “As the sunk costs of product-market entry increase, the gains from tradebetween start-up innovators and incumbents also increase, so start-ups will be more likely to forgocompetition,” they point out.
For example, within the car manufacturing industry, an auto plant is massive and costly. The owner hasto invest hundreds of millions of dollars before producing the first car. If a start-up develops a newmotor, it therefore might be better off licensing its technology to an established carmaker rather thantrying to build its own plant from scratch. The drug industry operates in much the same way. Bringing anew drug to market takes about a decade, and requires hundreds of scientists and safety and efficacy teststhat last years. Once federal regulators deem a drug safe and effective, the manufacturer needs an army ofsales people and a hefty marketing budget to reach out to doctors and their patients.
All this suggests that big, established players have a hefty advantage in making and selling drugs, exceptthat they haven’t proved very good at developing new ones, at least not in the last decade. Biotechstart-ups such as Trimeris have shown themselves to be more innovative, devising new drugs andtechniques. And they have tended to license their inventions to big established players such as Roche.
“The probability of cooperation is highest in biotechnology,” the researchers state.
What does all this mean if you are an entrepreneur with a company or a manager within a big, establishedfirm? Ideally, it will help you pick the right path, cooperation or competition. But as Hsu points out, noformula fits all companies within an industry. Two of the best-known and biggest biotech companies –Amgen and Genentech, both based in – partnered early on with established companies. But they invested the earnings from those partnershipsin becoming fully integrated pharmaceutical companies.
“Not all biotechs earn their returns by partnering,” Hsu explains. “We’re not saying one thing is best foreveryone. There’s variation in commercialization strategies. What we’re saying is, ‘This is the averagebehavior and here are the drivers.’”   All materials copyright of the Wharton School of the University of Pennsylvania.                    Page 3 of 3 

Source: http://www-management.wharton.upenn.edu/hsu/inc/doc/media-mentions/david-hsu-knowledge-at-wharton-april-2004.pdf


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