Why Start-ups?

The prototypical start-up involves an employee leaving her job with an idea and selling a portion of that idea to a venture capitalist. In many respects, however, the idea should be worth more to the former employer. 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\u27s 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. The puzzle, then, is why do we ever observe start-ups? Professors Joseph Bankman and Ronald J. Gilson suggest three interrelated explanations. First, the venture capitalist may have superior information with respect to some subset of employee innovations. Second, employer bids on employee innovation can create an incentive for employees to establish internal property rights in their research efforts that may reduce the future output of the employer\u27s research and development efforts. Finally, employees are not homogenous. The attractiveness of venture capital financing depends critically on employee personal characteristics, such as risk aversion. The employer sets the internal payoff to discovery – its bid – to equalize the marginal benefit of retaining employees who might otherwise leave to the marginal cost of establishing unfavorable incentives for future research and development for those employees who do not find venture capital financing a close substitute for continued employment. In some cases, this calculus might lead to a no bid policy. In virtually all cases, the pay-off will be set too loll to retain all employees, and start-ups ensue