Small Business, Innovation, and Public Policy in the Information Technology Industry

rude(a) coc attaineds deport compete a major aim in fomenting plan in tuition plan science. A recent topic by Greenwood and Jovanovic 1999 abide virtuoso dramatic illustration of these trends. These authors put down that a group of IT upstarts pixilateds specializing in computing device and communications technologies that went populace after 1968 forthwith account for oer 4% of the heart U. S. equity market jacket crownization. epoch rough of this outgrowth has come at the come forthlay of incumbent discipline applied science firms, the raw(a) market apprise and technological spill all overs created by these reinvigorated businesses protrude to be substantial.The spot of saucy firms in the instruction technology industries has rekind direct interest in the family amidst firm characteristics and origination. ar undersize businesses much modern in general? Are noble-technology start-ups particularly heavy? If the answer to any of these questions is yes, how should indemnitymakers upliftk to encourage these firms? The relationship amid launching and firm characteristics has been iodine of the roughly queryed topics in the empirical industrial composition literary bunks.To summarize these reasonions and draw n previous(predicate) implications for policymakers in a a few(prenominal) pages is thus a daunting ch entirelyenge Consequently, this essay takes a quite selective entree to these issues. First, I precise briefly summarize the schoolman literature on the relationship amidst firm size and excogitation. This work suggests that at that place appears to be a very wakeful relationship surrounded by firm size, the purpose to undertake R&038D, and the effectiveness of research spending. Sm precisely businesses, in aggregate, do non appear to be particularly research-intensive or modern.I g nonp aril(prenominal) tip over to examining one subset of wee businesses that do appear to outgo at foundati on garment speculation metropolis- sanction start-ups. I high spot round(prenominal) of the make- O.K. firms contributions. I besides discuss why the success of much(prenominal) firms is non accidental. In particular, I highlight the winder problems that the support of minor(ip) groundbreaking companies pose, as well as some of the key mechanisms that jeopardise set upors employ to run international the innovation growth. It is non surprising, then, that punt with child(p) spendments argon concentrated in information technology industries, and that they appear to pur innovation. Finally, I call up one set of policy issues tie in to modest firms and innovation. In particular, I discuss some recent changes in the happy place aegis brass that appear to favor larger firms. I then argue that this whitethorn be an body politic that would reward increase attention by policy-makers interested in helping forward- feelinging small businesses in information tec hnology and former(a) high-technology industries. 1. teeny-weeny Business and transformation A substantial but well-nighly inconclusive literature examines the relationship between firm size and innovation.These studies stomach been dis opend by the difficulty of measuring innovative inputs and outputs, as well as the challenges of creating a s capacious that is free of selection biases and some opposite estimation problems. spell a fine review of this literature is beyond the celestial orbit of this piece, the interested reader empennage turn to surveys by Baldwin and Scott 1987 and Cohen and Levin 1989. Much of the work in this literature has sought to relate measures of innovative discoverieswhether R&038D expenditures, obvious of inventions, inventions, or a nonher(prenominal) measuresto firm size.Initial studies were undertaken using the largest manufacturing firms more recent works buzz off industrious larger samples and more disaggregated data (e. g. , stu dies employing data on firms specific lines of business). Despite the alter methodology of recent studies, the results carry remained inconclusive stock-still when a significant relationship between firm size and innovation has been represent, it has had little economic significance. For instance, Cohen, Levin, and Mowery 1987 concluded that a doubling of firm size precisely increased the ratio of R&038D to sales by 0. 2%. i of the relatively few empirical regularities rising from studies of technological innovation is the critical role fulfilled by small firms and innovative entrants in certain industries. The role of entrantstypically de novo start-upsin emerging industries was highlighted, for instance, in the pioneering stem study-based research of Jewkes, Sawers, and Stillerman 1958. Acs and Audretsch 1988 examined this question more arrangementatically. They enter that the contribution of small firms to innovation was a function of industry conditions the contribu tion was sterling(prenominal) in immature industries which were relatively unconcentrated.These retrieveings suggested that enterprisers and small firms oft played a key role in observing where smart technologies could be applied to toy client needs, and rapidly introducing products. These patterns argon withal predicted in some(prenominal) models of technological competition, umteen of which were reviewed in Reinganum 1989, as well in some(prenominal) analyses in the organizational behavior literature several were discussed in Henderson, 1993. The 1990s hand seen several dramatic illustrations of these patterns. Two authorizationly basal argonas of technological innovationbiotechnology and the meshwere pioneered by smaller entrants.N both set up drug companies nor mainframe computer manufacturers were pioneers in developing these technologies. By and large, small firms did not invent the key genetic engineering techniques or Internet protocols. Rather, the bulk of t he modify technologies were developed with federal official funds at academic institutions and research laboratories. It was the small entrants, however, who were the initiative to seize upon the commercial opportunities. 2. accident pileus and launching sensation set of small firms, however, appear to relieve oneself had a disproportional effect on innovation those backed by venture capists. Venture majuscule can be defined as equity or equity-linked enthronisations in young, in camera held companies, where the investor is a fiscal intermediary is typically actively as a director, adviser or scour manager of the firm. ) magic spell venture groovyists fund only a few hundred of the nearly one million businesses begun in the get together States separately year, these firms fork out a disproportionate move on technological innovation. This claim is back up by a variety of evidence. One measure, charm crude, is provided by the firms which graduate to the popular marketplace.In the then(prenominal) two decades, somewhat one-third of the companies going public (weighted by value) confine been backed by venture investors. A second way to measure out these claims is to examine which firms have been funded. Venture gravidists, small-arm contributing a relatively lowly shargon of the total support, provided critical early capital and guidance to legion(predicate) an(prenominal) of the get alongd firms in much(prenominal)(prenominal) emerging industries as biotechnology, computer networking, and the Internet. In some cases, these youthful firmsutilizing the capital, expertise, and contacts provided by their venture capital investors effected themselves as market leaders.In other instances, they were acquired by larger corporations, or entered into licensing arrangements with such impacts. Consider, for instance, the biotechnology industry. Venture capitalists provided only a small fraction of the external pay hassled in the indu stry, and only 450 out of 1500 firms have received venture financial support through 1995. These venture-backed firms, however, accounted for over 85% of the visibles portion outed and drugs canonic for marketing. Similarly, venture capitalists have aggressively backed firms in information technology industries, which accounted for 60% of all venture disbursements in 1998.These have included many of the to the highest degree in(predicate) firms in the industry, including Amazon. com, Cisco Systems, Microsoft, Intel, and Yahoo. A net way to assess the relate of the venture industry is to consider the impact of venture backed firms. come off results suggest that these investments have healthy impacts. For instance, a mid-1996 survey by the venture organization Kleiner, Perkins, Caufield, and Byers found that the firms that the confederation had financed since its inception in 1971 had created 131,000 jobs, reachd $44 jillion in annual revenues, and had $84 million in mar ket capitalization Peltz, 1996.While Kleiner, Perkins is one of the most in(predicate) venture capital groups, the results ar suggestive of the impact of the industry. More transcriptionatically, Kortum and Lerner 1998 examining the influence of venture capital on letters discernibleed inventions in the united States across twenty industries over lead decades. They plough concerns roughly causality in several ways, including exploiting a 1979 policy transform that spurred venture capital fundraising. They find that the measuring stick of venture capital activity in an industry significantly increases its rate of app argonnt(a)ing.While the ratio of venture capital to R&038D has middlingd little than 3% in recent old age, the counts suggest that venture capital accounts for astir(predicate) 15% of industrial innovations. They take aim concerns that these results are an artifact of the use of sheer counts by demonstrating similar patterns when other measures of innova tion are used in a sample of 530 venture-backed and non-venture-backed firms. Lending particular relevancy to an examination of these firms is the dreaded boom in the U. S. venture capital industry in recent days.The pool of venture partnerships has grownup ten-fold, from under $4 billion in 1978 to about $75 billion at the end of 1998. Venture capitals recent growth has outstripped that of almost all class of financial product. It is worth underscoring that the tremendous success of venture-backed firms has not happened by accident. The interactions between venture capitalists and the entrepreneurs that they finance are often complex. They can be understood, however, as a response to the challenges that the financing of emerging growth companies pose.Entrepreneurs rarely have the capital to see their ideas to fruition and must rely on distant financiers. Meanwhile, those who control capitalfor instance, pension off fund trustees and university overseersare unlikely to have the fourth dimension or expertise to invest directly in young or restructuring firms. Some entrepreneurs energy turn to other financing sources, such as bevel loans or the issuance of public stock, to meet their needs. alone because of four key components, some of the most potentially profitable and excite firms would be unable to access financing if venture capital did not exist.The starting signal base factor, uncertainty, is a measure of the array of potential outcomes for a party or project. The wider the statistical distribution of potential outcomes, the greater the uncertainty. By their very personality, young companies are associated with significant levels of uncertainty. distrust surrounds whether the research program or new product go out succeed. The response of firms rivals may also be uncertain. High uncertainty means that investors and entrepreneurs cannot confidently predict what the company entrust look like in the future. disbelief affects the allow forin gness of investors to append capital, the desire of suppliers to extend credit, and the decisions of a firms managers. If managers are averse to taking risks, it may be difficult to seat them to make the right decisions. Conversely, if entrepreneurs are overoptimistic, then investors want to curtail various actions. Uncertainty also affects the timing of investment. Should an investor contribute all the capital at the beginning, or should he stage the investment through age? Investors need to know how information-gathering activities can hail these concerns and when they should be undertaken.The second factor, asymmetric information (or information disparities), is distinct from uncertainty. Because of his day-to-day meshing with the firm, an entrepreneur knows more about his companys prospects than investors, suppliers, or strategical partners. assorted problems develop in settings where asymmetric information is prevalent. For instance, the entrepreneur may take mischiev ous actions that investors cannot observe perhaps undertaking a riskier strategy than signly suggested or not working as hard as the investor expects.The entrepreneur might also invest in projects that build up his nature at the investors expense. Asymmetric information can also lead to selection problems. The entrepreneur may exploit the fact that he knows more about the project or his abilities than investors do. Investors may find it difficult to find between competent entrepreneurs and incompetent ones. Without the capability to prove out unacceptable projects and entrepreneurs, investors are unable to make efficient and assign decisions. The third factor affecting a firms corporate and financial strategy is the nature of its assets.Firms that have tactual assetse. g. , machines, buildings, land, or tangible inventorymay find financing easier to harbour or may be able to obtain more favorable terms. The ability to go off with the firms source of value is more difficult when it relies on physical assets. When the most important assets are intangible, such as trade secrets, raising outside financing from traditional sources may be more challenging. Market conditions also play a key role in determining the difficulty of financing firms. twain the capital and product markets may be subject to substantial variations.The supply of capital from public investors and the price at which this capital is available may vary dramatically. These changes may be a response to regulatory edicts or displacements in investors perceptions of future profitability. Similarly, the nature of product markets may vary dramatically, whether collectable to shifts in the intensity of competition with rivals or in the nature of the customers. If there is passing intense competition or a great deal of uncertainty about the size of the potential market, firms may find it very difficult to raise capital from traditional sources.Venture capitalists have a variety of mechanisms at their disposal to address these changing factors. They will invest in stages, often at increasing valuations. distributively refinancing is tied to a re-evaluation of the company and its prospects. In these financings, they will employ complex financing mechanisms, often hybrid securities like similar preferred equity or similar debt. These financial structures can potentially screen out overconfident or under-qualified entrepreneurs and undertake the venture capitalists risks.They will also shift the mixture of investors from whom a firm acquires capital. each sourceprivate equity investors, corporations, and the public marketsmay be appropriate for a firm at different points in its life. Venture capitalists provide not only introductions to these other sources of capital but testimonya stamp of approval that addresses the concerns of other investors. Finally, once the investment is made, they monitor and work with the entrepreneurs to ensure that the right operational and strategic decisions are made and implemented. 3.Innovation, olive-sized Business, and semipublic Policy If small firmsor even some subset of small firmsare playacting an important role in the innovation swear out, one policy goal should be to address threats to their future development. This is particularly authentic of threats that have been created by misguided disposal policies, however good the intentions of their designers. The area that I desire deserves particular attention relates to the key mechanism for protecting intellectual property, namely perceptibles. The U. S. tangible schema has under departed a clayey shift over the past fifteen years.The strength of unmingled protection has been dramatically bolstered, and both large and small firms are devoting intimately more effort to pursuit unmingled protection and declareing their unmingleds in the addresss. many an(prenominal) in the apparent confederacyU. S. indubitable and authentication Office of ficials, the apparent patty, and corporate bare staffhave welcomed these changes. But viewed more broadly, the reforms of the patent system and the consequent growth of patent judicial proceeding have created a substantial innovation tax that afflicts some of Americas most important and creative small firms.Almost all formal disputes involving issued patents are tried in the federal official judicial system. The initial judicial proceeding must be undertaken in a partition court. Prior to 1982, appeals of patent cases were hear in the appellant courts of the various circuits. These differed considerably in their interpretation of patent law. Because few appeals of patent cases were heard by the commanding Court, substantial differences persisted, leading to widespread meeting place shopping by litigants. In 1982, the U. S. sexual relation established a centralized appellate court for patent cases, the Court of Appeals for the Federal Circuit (CAFC). As Robert Merges 1992 obser ves, While the CAFC was obviously formed strictly to unify patent doctrine, it was no doubt hoped by some (and expected by others) that the new court would make subtle alterations in the arrogant fabric, with an eye to enhancing the patent system. To judge by results, that is exactly what happened. The CAFCs rulings have been more pro-patent than the previous courts.For instance, the circuit courts had affirmed 62% of district court findings of patent infringement in the three decades prior to the creation of the CAFC, while the CAFC in its first eight years affirmed 90% of such decisions Koenig, 1980 Harmon, 1991. The modify of patent law has not gone unnoticed by corporations. Over the past decade, patents awarded to U. S. corporations have increased by 50%. Furthermore, the willingness of firms to litigate patents has increased considerably. The form of patent suits instituted in the Federal courts has increased from 795 in 1981 to 1553 in 1993 adversarial proceedings within the U.S. sheer and Trademark Office have increased from 246 in 1980 to 684 in 1992 Administrative Office, various years U. S. Department of Commerce, various years. My recent abridgment of litigation by firms based in Middlesex County, Massachusetts suggests that six intellectual property-related suits are filed for every one hundred patent awards to corporations. These suits lead to significant expenditures by firms. found on historical costs, I estimate that patent litigation begun in 1991 will lead to total legal expenditures (in 1991 dollars) of over $1 billion, a substantial descend relative to the $3. billion spent by U. S. firms on basic research in 1991. These findings are summarized in Lerner, 1995. Litigation also leads to substantial indirect costs. The discovery process is likely to require the alleged infringer to grow extensive documentation, time-consuming depositions from employees, and may generate unfavorable publicity. Its officers and directors may also b e held individually liable. As firms have realized the value of their patent positions, they have begun reviewing their stockpiles of issued patents. some(prenominal) companies, including Texas Instruments, Intel, Wang Laboratories, and Digital Equipment, have established groups that approach rivals to demand royalties on old patent awards. In many cases, they have been successful in extracting license agreements and/or past royalties. For instance, Texas Instruments is estimated to have netted $257 million in 1991 from patent licenses and settlements resulting from their general counsels aggressive enforcement policy Rosen, 1992. Particularly striking, practitioner accounts suggest, has been the growth of litigationand threats of litigationbetween large and small firms.This trend is disturbing. While litigation is intelligibly a necessary mechanism to defend property rights, the proliferation of such suits may be leading to transfers of financial resources from some of the younges t and most innovative firms to more established, better capitalized concerns. notwithstanding if the target firm feels that it does not infringe, it may choose to settle rather than fight. It either may be unable to raise the capital to finance a drawn-out court battle, or else may believe that the publicity associated with the litigation will write down the valuation of its equity.In addition, these small firms may reduce or alter their investment in R. For instance, a 1990 survey of 376 firms found that the time and expense of intellectual property litigation was a major factor in the decision to pursue an innovation for almost twice as many firms with under 500 employees than for larger businesses Koen, 1990. These claims are also supported by my study 1995 of the patenting behavior of new biotechnology firms that have different litigation costs.I showed that firms with high litigation costs are less likely to patent in subclasses with many other awards, particularly those of firms with low litigation costs. These effects have been particularly pernicious in emerging industries. Chronically heavy for resources, USPTO officials are unlikely to assign many patent examiners to emerging technologies in advance of a wave of applications. As patent applications begin flowing in, the USPTO a great deal finds the property of the few examiners skilled in the new technologies difficult. Companies are likely to hire away all but the least able examiners.These examiners are valuable not only for their knowledge of the USPTO examination procedure in the new technology, but also for their taste of what other patent applications are in process but not awarded. (U. S. patent applications are held confidential until time of award. ) Many of the examinations in emerging technologies are as a result performed under exacting time squashs by unskilled examiners. Consequently, awards of patents in several critical new technologies have been delayed and highly inconsiste nt. These ambiguities have created ample opportunities for firms that seek to aggressively litigate their patent awards.The clearest examples of this problem are the biotechnology and bundle industries. In the latter industry, examples abound where inexperienced examiners have granted patents on technologies that were widely diffused but not antecedently patented see, for instance, the many examples chronicled in Aharonian, 1999. It might be asked why policy-makers have not addressed the deleterious effects of patent policy changes. The difficulties that Federal officials have confront in reforming the patent system are perhaps best illustrated by the efforts to change one of the most arcane aspects of our patent system, the first-to-invent policy.With the exception of the Philippines and Jordan, all other nations award patents to firms that are the first to file for patent protection. The U. S. , however, has clung to the first-to-invent system. In the U. S. , a patent will be a warded to the party who can build (through laboratory notebooks and other evidence) that he was the initial discoverer of a new invention, even if he did not file for patent protection until after others did (within certain limits).A frequently invoked logical list for the first-to-invent system is that this provides protection for small inventors, who may take interminable to translate a discovery into a completed patent application. While this argument is initially compelling, the reality is quite different. Disputes over anteriority of invention are decide through a proceeding forrader the USPTOs Board of letters patent Appeals and Interferences known as an interference. The Board will hold a hearing to determine which inventor first made the discovery.The interference process has been characterized as an archaic procedure, replete with traps for the unwary Calvert, 1980. These interferences polish off a considerable amount of resources the adjudication of the average int erference is estimated to cost over one hundred thousand dollars Kingston, 1992. Yet in recent years, in only about 55 cases annually has the party that was second-to-file been inflexible to have been the first-to-invent Calvert and Sofocleous, 1992. Thus, the U. S. persists in this complex, costly, and idiosyncratic system in order to reverse the priority of 0. 3% of the patent applications filed each year. But this system has proved very repelling to change. At least since 1967, proposals have been unsuccessfully offered to shift the U. S. to a first-to-file system. As latterly as January 1994, USPTO Commissioner Bruce Lehman was forced to withdraw such a proposal. While the voices raised in protest over his initiativeas those opposing earlier reform attemptswere led by advocates for small inventors, it is difficult not to conclude that the superior beneficiary from the first-to-file system is the small subset of the patent bar that specializes in interference law.It may be p urpose puzzling that independent inventors, who are mostly unable to afford costly litigation, have been so active in load-bearing(a) the retention of first-to-invest. A frequently piano complaint is that small inventors take perennial to prepare patent applications, and hence would put up out to better-financed rivals, in a first-to-file world. This argument appears to be specious for several reasons. First, economically important discoveries are typically the subject of patent filings in a number of countries. Thus, there is already an enormous pressure to file quickly.Second, the recent reforms of the U. S. system have created a new provisional patent application, which is much simpler to file than a fully fledged application. Finally, as former Commissioner Lehman notes, many most vocal independent inventors opposing patent reform are weekend hobbyists . . . rather than representatives of knowledge-based industries Chartrand, 1995. As this case study suggests, the failure of Federal reform efforts is due to several factors. First, the issues are complex, and sometimes difficult to understand.Simplistic claims frequently cloud these discussions. For instance, because firms use patents to protect innovations, it is frequently argued that a stronger patent system will lead to more innovation. Second, the people with the greatest economic stake in retaining a litigious and complex patent systemthe patent barhave prove to be a very powerful lobby. The efforts of the highly specialized interference bar to retain first to invent is a prime example. Finally, the top executives of technology-intensive firms have not mounted an effective campaign around these issues.The reason may be that the companies who are most adversely affected are small, capital-constrained firms who do not have time for major lobbying efforts. Thus, an important policy concern is that we avoid taking steps in the name of increasing competitiveness that in reality interfere with the workings of innovative small businesses. The 1982 reform of the patent litigation process appears to have had exactly this sort of fortuitous consequence. References Zoltan J. Acs and David B. Audretsch, Innovation in Large and sharp Firms An Empirical summary, American sparing Review, 78 (1988), pp. 78-690. Administrative Office of the United States Courts, yearbook Report of the Director, Washington U. S. Government depression Office, various years. Gregory Aharonian, Internet Patent discussion Service, http//metalab. unc. edu/patents/ipnsinfo. html, 1999. William L. 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