The Architecture of Innovation: The Economics of Creative Organizations by Joshua Lerner

Author:Joshua Lerner
Language: eng
Format: mobi
ISBN: 9781422143636
Publisher: Harvard Business Review Press
Published: 2012-08-27T14:00:00+00:00

Uneasy Oversight

Venture investors typically have many tools through which they can steer the companies that they fund, from preferred stock with special privileges to board seats to the right to replace the founder as CEO. But any successful venture-backed start-up must be a partnership between the financiers and the entrepreneurs who ultimately do the hard work of running the firm. Even if the venture capitalist desires to micromanage every company in the firm’s portfolio, the limits of time and attention will lead inexorably to a reliance on entrepreneurial managers.

Entrepreneurs, to be sure, have made wonderful contributions to the world. From Henry Ford to Mark Zuckerberg, our world has been transformed—and our nation enriched—because of the vision and focus of these leaders. But alongside these great accomplishments often comes a kind of egotism and paranoia that can lead to value-destroying behavior, a pattern as well documented in the novels of Charles Dickens and Honoré de Balzac as in issues of BusinessWeek and Fortune.

Economists rather drily refer to these tensions as involving “private benefits of control.” The entrepreneur may choose actions that gratify him- or herself rather than create value for the firm as a whole. The most obvious examples are outright wasteful expenditures, such as the launch parties thrown by dot-com entrepreneurs during the late 1990s that became sufficiently notorious to merit their own copiously documented entry in Wikipedia.28

Even more pernicious are decisions that seem reasonable at face value, but ultimately take the firm in the wrong direction. Frequently, these take the form of entrepreneurs seeking to go head-to-head with established players, and become industry giants themselves. But often to do this, the firm must make huge, risky investments in developing manufacturing skills, a professional sales force, and the like: complementary assets that are often very challenging to build. In many instances, as Joshua Gans and Scott Stern discuss, the fledgling firms would have been far better off earning returns in the “market for ideas”: licensing their concepts to larger firms or simply selling the start-up in its entirety.29 Whatever the motivation for the decision to go it alone, such episodes are sufficiently commonplace that my colleague Noam Wasserman has tagged them “choosing to be king.”30

Nowhere is this tendency more evident than in the biotechnology industry, whose history is littered with the carcasses of start-ups that sought to take on Eli Lilly or Novartis mano a mano. Ilan Guedj and David Scharfstein provide systematic evidence of the costs of such behavior.31 They look at young biotechnology firms specializing in cancer treatment that have not yet garnered any revenues from product sales, and contrast them with established, typically much larger pharmaceutical firms. After a drug compound has been identified through preclinical research, the biggest investments that biopharmaceutical firms must make are the clinical trials they must conduct to prove the safety and efficacy of a potential new drug: the U.S. Food and Drug Administration requires three rounds of tests of increasing stringency. They hypothesize that the small firms, which typically go public

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