Venture capital, debt financing, and the capital markets do not provide enough money to develop new technologies fully and typically, corporate financing, provides the remaining monies to develop new innovations (Teece, 1992). One, and the most likely, source of corporate financing for firms developing innovative products since Teece's (1992) work has been alliances. Recent research indicates firms tend to choose between capital market funding and the alliance market for funding depending on the availability of funding in the capital markets (Lerner, Shane, & Tsai, 2003). Thus, the funding necessary for firms developing innovative products potentially comes from both the capital markets and from alliances.
Previous work shows venture capital involvement increases initial public offering (IPO) values (Stuart, Hoang & Hybels, 1999), improves the survive rate of IPO firms (Fisher, & Pollock, 2004; Jain, & Kini, 2000), and improves the number of alliances formed (Colombo, 2006; Gans et al., 2002; Hsu, 2006; Lindsey, 2008). Previous work on the number of alliances formed seems to assume that more alliances are better. To our knowledge, no one has investigated the impact venture capital firms have on the amount of money firms developing innovative products generate from the alliances they form. In addition, one would expect venture capital backed firms to be more efficient in forming alliances assuming venture capital provide valuable assistance in the alliance formation process. Thus, this research combines tests of efficiency and benefits to the target firm by testing how quickly firms form alliances and the remuneration those firms receive from the alliances they form.
This work directly addresses the impact of venture capital on money obtained through alliance contracts, and in doing so, also addresses the need for additional research on the impact venture capital has in the alliance markets (Gans et al., 2002). We also address the need to better understand the benefits small innovative firms receive from the alliances they form (Alvarez et al., 2005; Coombs et al, 2006) and on the alliance formation process in general (Ahuja, 2000).
This study is unique because we investigate how quickly firms developing innovative products form alliances and the financial benefits they receive from those alliances in the same study. The first hypothesis parallels previous work on venture capital impact in the capital and alliance markets that indicates venture capital involvement has a positive impact on firms developing innovative products (i.e. Colombo, 2006; Finkle, 1998; Gans et al., 2002; Hsu, 2006; Lerner, 1994). Hypothesis 1 tests whether firms developing innovative products using venture capitalists will form alliances more quickly than firms that turn public without venture capital backing during the time period in this study. Second, we examine the remuneration firms developing innovative products receive as a result of the alliances they form. Hypothesis 2 tests if venture capital involvement will increase the remuneration promised firms developing innovative products in the alliance contract(s) around the IPO period.
We use the biotech-pharmaceutical industry to test our hypotheses, and we find support for both of our hypothesis. In addition, the data in this sample also indicates many innovative firms in the biotech industry turn public and form alliances simultaneously with, or very shortly after the IPO process. Our findings extend the knowledge related to venture capital involvement during the alliance formation process, and the funding of firms developing innovative products. We fully discuss the implications of our hypotheses, and the finding that firms developing innovative products seem to be forming alliances and turning public simultaneously.
THEORY AND HYPOTHESES
Firms developing innovative products that are often years away from releasing a product have limited financing options. The tradition understanding of the financing options is as follows: typically, firms developing innovative products start with investments by the entrepreneurs starting the company. Angel funding if it's available sometimes follows the initial funding. Later, venture capital firms provide meaningful amounts of additional funding to continue firm development and prepare the firms developing innovative products for an IPO (Lerner, 1994; Lerner, 1995). The IPO potentially provides the firms developing innovative products with the single largest influx of money it will have to continue development of the product. Secondary offerings (selling more shares of stock on a public market) can also provide additional revenue for continued growth after an IPO. At some point, the firms developing innovative products will release the product to the consumer market or sell the product to another firm, and to generate income.
In some industries, established firms choose to invest in innovation through alliances rather than, or in addition to, developing innovations internally. Previous research suggests alliances provide a means to share complementary resources, benefits, and risk, among firms (Hitt, Dacin, Levitas, Arregle, & Borza, 2000; Ireland, Hitt, & Vaidyanath, 2002). Established firms choose to finance innovations in other firms to reduce risks (see: Bowman & Hurry, 1993; Folta & Miller, 2002; McGrath, 1997; McGrath & Nerkar, 2004; Reuer & Tong, 2005; Vassolo, Anand, & Folta, 2004 for a complete explanation); they lack the ability or desire to develop and utilize new technologies (e.g., Tushman & Anderson, 1986) or both. Similarly, firms developing innovative products have several reasons to choose an alliance over capital market funding. Firms developing innovative products often lack complementary resources like commercialization expertise, specialized manufacturing expertise, or specialized marketing expertise in addition to needing funding and therefore, seek partners who can provide funding in combination with other complementary resources (Rothaermel & Boeker, 2008; Teece, 1986). An alliance can be a desirable alternative to capital market funding for firms developing innovative products when capital market funding is scare, expensive, or when the firms developing innovative products also needs complementary resources in addition to funding (Lerner, Shane & Tsai, 2003; Teece 1986).
The Information Asymmetry problem in alliances formation
Theory suggests that alliances provide some protection to firms developing innovative products from appropriation when those firms pass private and valuable knowledge about an innovation directly to another firm (Arrow, 1962; Bhattacharya & Ritter, 1983; Hennart, 1988; Leland & Pyle, 1977). Legal agreements typically define the parameters of an alliance (Anand & Khanna, 2000; Gulati, 1998; Kogut, 1988; Oxley & Sampson, 2004; Reuer & Arino, 2002; Reuer & Arino, 2007; Ring & Van de Ven, 1992). Thus, knowledge can pass safely among the partners as long as both partners are mutually dependent on each other for continued development of the innovation (Hamel, 1991), and the alliance contract includes the appropriate protections for the firms involved (Liebeskind, 1996).
However, we contend the alliance formation process in most cases has high information asymmetry among potential partners and more closely resembles an open-market exchange of valuable knowledge described by Arrow (1962) rather than an exchange of knowledge protected by an alliance agreement described above. Forming an alliance takes place before the alliance contract is signed and the collaboration formally begins. Protecting valuable knowledge is generally difficult without a carefully constructed contract (Liebeskind, 1996). Predatory, or opportunistic behavior is often a meaningful threat to firms developing innovative products that rely on alliances to provide outside financing (Lerner, Shane & Tsai, 2003). Therefore, the alliance formation process leaves firms developing innovative products seeking alliances with the decision to risk appropriation of valuable knowledge and pass as much information as possible to the potential alliance partner to encourage alliance formation; or conversely, the firms developing innovative products can withhold valuable information to reduce the probability of appropriation but then, the firms developing innovative products potentially jeopardizes the alliance because the potential partner will not recognize the value of the innovation. In sum, the alliance formation process closely resembles Arrow's (1962) description of selling knowledge on open markets.
Signaling improves transactions among firms with inherently high information asymmetries by providing a differentiating equilibrium among firms without transferring valuable knowledge that could be appropriated. There are two kinds of market signals: direct signals and indirect signals. Direct signals are observable characteristics or attributes of a firm that provide clues about an unobservable characteristic or attribute of that firm. Indirect signaling, the type provided by venture capital, is based on the idea that a firm can be certified as a high-quality firm by third party (Brau & Fawcett, 2006). Indirect signals are trustworthy when the third party would suffer a meaningful loss by falsely representing the target firm (Megginson & Weis, 1990). Economists have long recognized the activities of intermediaries improve market efficiency by enabling investments in environments with otherwise prohibitive levels of information asymmetry (Lerner, Shane & Tsai, 2003). Venture capital firms along with underwriters and analysts are recognized as intermediaries for investors in the capital markets (e.g. Barron, Byard, Kile, & Riedl, 2002; Carter & Dark, 1993; Carter, Dark, & Singh, 1998; Carter & Manaster, 1990; Kimbrough, 2007; Lerner, Shane, & Tsai, 2003; Lindsey, 2008; Logue, Rogalski...