IPOs and Innovation

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday August 15, 2012 at 10:33 am
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Editor’s Note: The following post comes to us from Shai Bernstein of the Department of Finance at Stanford University.

Corporate managers, bankers, and policy makers alike have expressed concerns that the recent dearth of initial public offerings (IPOs) has caused a breakdown in the engine of innovation and growth. In the paper, Does Going Public Affect Innovation?, which was recently made publicly available on SSRN, I explore whether the transition to public equity markets indeed affects innovation, and if so, how. Theoretically, the effect of IPOs on innovation is ambiguous. On the one hand, going public provides improved access to capital that may allow firms to enhance their innovative activities; on the other hand, market pressures and potential departure of employees following the IPO may lead to opposite results.

To answer this question, I use standard patent-based metrics to capture changes in innovative activity in the years around the IPO and focus on three important dimensions of firms’ innovative activity: internally generated innovation, the productivity and mobility choices of individual inventors, and the acquisition of external innovation.

Estimating the effects of going public on innovation, however, is challenging due to an inherent selection bias associated with the decision to go public. For instance, if firms choose to go public following an innovative breakthrough, a decline in post-IPO innovative performance may reflect reversion to the mean rather the actual effect of going public. To overcome this difficulty, I focus only on firms that selected to go public and compare the long-run innovation of firms that went public with that of firms that intended to go public but withdrew their IPO filings due to reasons unrelated to their innovative activity. This allows the comparison of innovative performance of firms that went public with private firms that are at a similar stage in their life cycle.

The results illustrate a complex trade-off between public and private ownership forms. I find that the quality of internal innovation of firms that went public declines relative to firms that remained private. Additionally, public firms experience both an exodus of skilled inventors and a decline in productivity among remaining inventors. However, access to public equity markets allows firms to partially offset the decline in internally generated innovation by attracting new human capital and purchasing externally generated innovations through mergers and acquisitions.

Do these results suggest that IPOs adversely affect innovation? Not necessarily. First, it is important to remember that these findings explore only the ex-post effects, i.e., what happens to innovation once a firm transition to public equity markets. Having more vibrant IPO markets may generate, ex-ante, a more active entrepreneurial and innovative sector, which is not the focus of my current research. Second, while market pressures may force public firms to focus on commercialization which can limit internal innovation, public equity markets also provide an improved access to capital, which allows firms to alleviate this effect by the purchase of external technologies as needed (mostly from private firms, as I find). Moreover, even the departure of key inventors may be efficient from a social perspective, as it allows entrepreneurs to pursue their next innovative ventures.

Overall, these results suggest that the exact timing in which technological firms select to go public is particularly important, as it has implications for both the type of projects they pursue and the type of human capital they obtain.

The full paper is available for download here.

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