Why Start-Ups?

Joseph Bankman
Ronald J. Gilson, Columbia Law School


The prototypical start up involves an employee leaving her job with an idea, and selling a portion of that idea to a venture capitalist. Yet the idea should be worth more to the former employer. In this setting, the former employer can be expected to have better information concerning the employee-entrepreneur and the technology, have opportunities to capture economies of scale and scope not available to a venture capital-backed start-up, and will receive more favorable tax treatment than the start-up should the innovation fail. In connection with an auction of the idea, the former employer should have both a more accurate estimate of its value and receive an element of private value not available to the venture capitalist. In turn, this should give rise to a powerful winner's curse: each time a venture capitalist wins the auction, it will have paid more than a party that has better information and receives an element of private value, in contrast to the venture capitalist's receipt of only common value. The puzzle, then is why we ever observe start-ups? Our analysis of the former-employer's bidding strategy stresses the impact on the employer's ongoing research effort of purchasing a share in the employee's idea for a price comparable to what a venture capitalist would pay. Where research is a team effort, an employer's bidding creates an incentive for employees to establish internal property rights to their research efforts. Such influence activities reduce the future output of the employer's R&D efforts. Thus, in setting the internal incentives of its research employees -- in effect, the employer's internal bid for the discovery -- an employer must trade off the between the strength of the incentives and the impact on the overall research effort of high individual payoffs to innovation. The employer sets the internal payoff to discovery to equalize the marginal benefit of an additional unit of incentive (a higher bid) and the marginal cost of the resulting decrease in the effectiveness of its research effort. Some employees are therefore allowed to leave, and start-ups are observed.