How common ownership of start-ups improves innovation efficiency
Common ownership of start-ups by venture capitalists has a positive impact on correlative ratios between R&D output to funding
This article is republished with permission from Knowledge @ Wharton, the online business journal of the Wharton School at the University of Pennsylvania, which owns the copyright to this content.
When venture capital firms own equity in more than one competing start-up in an industry, they have the ability to improve innovation efficiency by redirecting their investments away from laggards in their portfolio towards those that show more promise. The VCs may stop funding those lagging start-ups, but continue to extract value from them by getting them to shift their focus to non-overlapping projects.
Those are the main findings of a recent study conducted by Wharton finance professor Luke Taylor, Xuelin Li, assistant professor of finance at the University of South Carolina and Wharton doctoral finance student Tong Liu. They detailed their findings in a research paper titled, Common Ownership and Innovation Efficiency.
The researchers studied common ownership in the pharmaceutical industry, covering 1045 Phase I drug projects conducted by 481 US start-ups between 2015 and 2018 and financed by 764 VC firms. They measured innovation efficiency as the total number of drugs receiving approval from the US Food and Drug Administration (FDA), scaled by the total amount of VC funding provided to all start-ups active in that category.
The study found that “common ownership rates are positively correlated with the ratio of R&D output to funding” where R&D output refers to drug candidates reaching FDA approval. That measure of innovation efficiency does not have a causal interpretation, but “it is consistent with common ownership helping to avoid excess duplication of R&D, producing more approved drugs per dollar of aggregate R&D” the paper stated.
Looking on the ‘bright side’
Common ownership of start-ups by VCs has both a “dark side” and “a bright side”, according to Taylor. “I was interested in knowing if there would be a bright side of common ownership, through its effect on innovation,” he said. “The research lately has been focused on the dark side of common ownership, which can lead those companies to compete less with each other, and that can raise consumer prices.”
The study found common ownership achieving gains that go beyond those for the firms in their portfolios. “The bright-side interpretation of what we’re finding is that common ownership may be helping us as a society,” said Taylor. “It may be helping us to reduce duplication of R&D in patent races. When firms are in a patent race with each other, and when they’re competing really fiercely with each other, they tend to invest more in R&D than is good for society. A common owner can come in and coordinate these firms that are in a patent race, and help solve that market failure.”
The paper noted that start-ups are important for generating innovation, and VC-backed start-ups generate a large share of the innovation in the US economy. The study focused on the pharmaceutical industry because that “is a big part of what VCs do”, Taylor said.
He summarised the three main results from the study: First, common ownership leads investors to hold back lagging drug projects. Second, common ownership leads investors to restrict funding to lagging start-ups. And last, common ownership leads these VC investors to redirect innovation at start-ups that have fallen behind.
“If the firms instead have different owners, they fail to internalise the negative spill-overs they impose on each other,” the paper stated. “The lagging project is therefore likely to continue, even if it is socially suboptimal.”
The paper documents the case of New England Associates (NEA), a VC firm that in 2012 had invested in two Boston-based start-ups, Intarcia and Rhythm Pharmaceuticals, which were in Phase I clinical trials of their drugs to treat obesity. By December 2012, Rhythm’s project moved from Phase I to Phase II, gaining an edge over Intarcia’s project. NEA subsequently cut off its funding to Intarcia, which abandoned its obesity drug project and shifted its focus to diabetes treatments. This case fits well into the study’s overall pattern: Some VCs use a “horse race” investment strategy where they invest in closely competing start-ups, wait for one to gain an edge, and then reduce funding to the lagging start-up while redirecting its innovation.
Common ownership is “way more common” in the pharmaceutical industry than one would have expected, Taylor said, noting that 39 per cent of start-ups the study covered share a VC in common with a close competitor. “If you’re the founder of a pharma start-up, it’s important to know whether your VC investors are also invested in your competitors. According to our results, common ownership can influence whether your funding gets cut off in the future and whether your drug projects make it through clinical trials.”
The study identified other outcomes when VCs have common ownership of start-ups:
- When a common VC abandons a start-up, other VCs often do not step in to fill the financing hole
- The results on financing patterns are stronger for VCs with larger ownership stakes in a start-up since they have stronger control rights, making it more feasible for them to hold back projects
- The results are stronger also for less-diversified VCs and for lagging and pioneering projects that have similar technologies or belong to a narrowly defined drug category
- Common owners redirect lagging firms’ innovation activities toward new projects in non-overlapping categories and form financing alliances with large pharma companies in those categories.