Show Me the Right Stuff: Signals for High‐Tech Startups

• DOI: http://doi.org/10.1111/jems.12012
• Author: Annamaria Conti,Frank T. Rothaermel,Marie Thursby
• Date: 01 June 2013
• Published date: 01 June 2013

Show Me the Right Stuff: Signals for High-Tech

Startups

ANNAMARIA CONTI

Scheller College of Business

Georgia Institute of Technology

Atlanta, GA 30308

annamaria.conti@scheller.gatech.edu

MARIE THURSBY

Scheller College of Business

Georgia Institute of Technology, and NBER

Atlanta, GA 30308

marie.thursby@scheller.gatech.edu

FRANK T. ROTHAERMEL

Scheller College of Business

Georgia Institute of Technology

Atlanta, GA 30308

frank.rothaermel@scheller.gatech.edu

We present a theoretical model of startup signaling with multiple signals and potential differences

in external investor preferences. For a novel sample of technology incubator startups, we empir-

ically examine the use of patents and founder, friends, and family (FFF) money as such signals,

finding that they are jointly endogenous to venture capital and business angel investment in

the startups. For this sample, venture capitalists appear to value patents more highly than FFF

money, while the reverse is true for business angels. Moreover, the impact of patents on venture

capitalists is larger than the impact of FFF money on business angels.

1. Introduction

One of the most important challenges facing entrepreneurs in technology startups is

access to capital (Denis, 2004; Shane and Stuart, 2002). With little or no observable

history of performance and uncertain technology, a major issue for these entrepreneurs

is how to signal their company’s value to potential investors. One such signal is an

entrepreneur’s own investment (Leland and Pyle, 1976). For technology startups, patents

are also a potential signal. Indeed, the Berkeley Patent Survey finds that one of the most

important reasons for startups to patent is to secure funds (Graham and Sichelman, 2008;

Graham et al., 2009).1There is also empirical evidence that alliances (Stuart et al., 1999;

We are indebted to Jerry Thursby for insightful comments and suggestions. We also thank Thomas Astebro,

David Beck, Victor Bergonzoli, Carolin Haeussler, Matt Higgins, David Hsu, David Ku, Josh Lerner, Laura

Lindsey, William Oakes, Florin Paun, Carlos Serrano, Scott Shane, Rosemarie Ziedonis, and seminar partic-

ipants at the 2010 NBER’s Entrepreneurship Working Group Meeting for their valuable comments. Conti

acknowledges support from the Hal and John Smith Chair in Entrepreneurship for support via a TI:GER

Postdoctoral Fellowship and the Swiss National Foundation. Thursby acknowledges NSF Award #0221600,

and Rothaermel acknowledges NSF SES 0545544.

1. On average, “improving chances of obtaining financing” ranked second in importance among the seven

reasons considered. Startups in the software sector also rated “enhancing the firm’s reputation” more highly

C2013 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume22, Number 2, Summer 2013, 341–364

342 Journal of Economics & Management Strategy

Hsu, 2004), Nobel laureates as advisors (Higgins et al., 2011), and founder attributes

(Burton et al., 2002) as well as patents (Hsu and Ziedonis, 2008, 2011; Haeussler et al.,

2009) are correlated with startup value, suggesting they could serve as signals.

Withmultiple such mechanisms, how should managers choose signals? We address

this topic in the context of two signals, patents and investment of founders, friends, and

family (FFF) funds. We provide theoreticaland empirical results on investment in these

signals as a function of the cost of signaling and investor preferences. The theoretical

model considers a situation of asymmetric information in which the founders of a

startup have private information about the technology underlying their business. The

value of the startup is a function of the probability of success of the technology, but

also the founders’ commitment. In seeking external investment, the founders consider

using patents as a signal of the probability of success and FFF money as a signal of

their commitment. In our model, both signals have other uses as well, and so they

are productive signals in the sense of Spence (1974). The theory also incorporates the

observation that different classes of investors (i.e., business angel and venturecapitalists)

vary in the extent to which they value startup characteristics (Osnabrugge and Robinson,

2000; Graham et al., 2009). Investor preferences are known to the founders when they

choose their investment. Thus optimal investment is a function of both cost, which

is well documented as important (Amit et al., 1990) and investor preferences. We then

examine our predictions in the context of technology startups incubated in the Advanced

Technology Development Center (ATDC) from 1998–2008.

We provide conditions under which it is worthwhile for startup founders whose

technologies have a high probability of success to signal their company’s “quality,” and

we characterize the investment in patents relative to FFF money in terms of their cost

and investor preferences.Independent of investor preferences, founders of these startups

(high-quality startups hereafter) optimally invest more in patents and FFF money than

they should in a situation of symmetric information. However,when a potential investor

places more weight on the quality of the technology than founder commitment, high-

quality startups should invest more in patents than FFF money relative to the symmetric

information case. Conversely, when a potential investor values founder commitment

more highly, the startup should invest relatively more in FFF money. Finally, when the

potential investor is indifferent between the two attributes, the signal ratio is inversely

proportional to the ratio of their costs. Thus, what distinguishes our model from prior

models of multiple signals (Milgrom and Roberts, 1986; Engers, 1987; Grinblatt and

Hwang, 1989) is that the investment in the signals, in equilibrium, depends on the

preferences of the external investors.

Empirically, we consider the impact of patents filed and FFF money on venture

capitalist and business angel investments, respectively. To this scope we use novel data

which builds on the startup database examined by Rothaermel and Thursby in their

analysis of university ties and incubator startup performance (2005a, 2005b). These data

include information on the investment of business angels and venture capitalists, the

amount of FFF money invested in the firm, and the number of patents filed, which

we augmented with information from the startup business plans and a survey of the

founders.

Our empirical estimation addresses whether patents and FFF money are endoge-

nously determined variables with regard to startup financing. Understanding this is

than firms in other sectors. Thus the authors interpret signaling as a primary reason for software patenting

(Graham and Sichelman 2008, p. 161).