Consensual spinoffs (work in progress) Simon Parker (University of Western Ontario) Mark Sanders (University of Utrecht)

Research questions Why do we see new venture spinoffs rather than in-house development? Why are some of these “intrapreneurial”… – i.e. firm ownership stake and sometimes firm managerial involvement …while others are “entrepreneurial”? – i.e. employee starts a truly independent new venture? Slide 2 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Previous literature New ideas emerging within incumbents are not exploited, owing to – Inflexible internal routines (Winter, 1984) – Poor fit with core business (Cassiman & Ueda, 2006) – Different information (Klepper & Thompson, 2006) – Multi-task conflicts (Hellmann, 2007) Litigation and conflict – Klepper (2006), Agarwal et al (2009) Slide 3 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Motivation and Approach Evidence of consensual spinoffs in some industries Rothwell (1984): ICT and CAD; Phillips Cluster (NL) We explore this possibility theoretically – Using a simple principal-agent model – In which one of 3 possible outcomes can arise endogenously: Internal in-house development (Case A) Intrapreneurship (Case B) Entrepreneurship (Case C) Slide 4 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Contribution Three players: employee, manager & owner – Everyone risk-neutral Two mechanisms explain why B can replace A as the optimal mode of organization: – Double Moral Hazard – Limited Liability And C dominates B as well as A if double moral hazard is particularly acute in spinoff project Slide 5 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Contribution (contd.) We explain the spectrum of possible (consensual) organizational forms – Predict which types of ventures will end up in which outcome E.g. our model predicts that more radical innovations more likely to be developed via spinoffs than commercialized in-house – More generally, the choice for one form over another is shown to depend on the parameters in the model Slide 6 of 2619 November 2010 RENT Conference Maastricht, Netherlands

The model: set-up Project 1In House Project 2In House SpinoffIntrapreneurialEntrepreneurial (R&D) Worker Manager Owner Case ACase BCase C Slide 7 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Double Moral Hazard P 1,2 = probability of success in project 1,2. e 1,2 M,E = costly effort of (M)anager and (E)mployee in projects 1 and 2. β 1,2, γ 1,2 are parameters such that β 1,2 +γ 1,2 < 1 θ = normalization parameter such that probability < 1 Note that efforts are substitutes and free riding will occur when: 1. Success of the project is a noisy signal of effort 2. Effort is unobservable to all but the agents themselves… …which we assume. Slide 8 of 2619 November 2010 RENT Conference Maastricht, Netherlands

First Best Total Surplus Π is the pay-off received in the good (upperbar) and bad (underbar) outcome. Slide 9 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Problem for the Agents Problem for the Manager and Employee (case A) b j M,E is the bonus received in the good outcome and the other agent’s effort level is taken as given. Slide 10 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Spinoffs as a Solution for DMH Problem for the Owner (case A) (Double) Moral Hazard reduces induced effort levels below optimal. Given that marginal productivity of both is bounded (not infinite as effort drops to 0)… …full specialization may be preferred to joint development. Slide 11 of 2619 November 2010 RENT Conference Maastricht, Netherlands

But why spinoff? …Cases B and C eliminate the problem of double moral hazard in project 1 and both projects, respectively… …but the owner can also force (full) specialization by setting bonuses (to 0)… …so double moral hazard is not sufficient to explain spinoffs. An additional benefit of spinoff might be the limited liability for the owners. Assume: Owners take an equity share in spinoffs. Equity cannot have a negative value. This Limited Liability then reduces the downside risk, but… …of course creditors will demand compensation for the default risk… …reducing the return in the good state as well. Slide 12 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Limited Liability is the markets expectation of the spinoff’s success probability. risk neutral creditors require a premium CC to compensate for default risk: for a negative lower support pay-off in case of failure is 0 and in case of success is: Slide 13 of 2619 November 2010 RENT Conference Maastricht, Netherlands

The Owners’ Choice The owners will set bonuses and equity shares such that… …they maximize their surplus… …and incentive compatibility constraints are satisfied… …and participation constraints are satisfied. Then choose among case A-C to maximize own value. Slide 14 of 2619 November 2010 RENT Conference Maastricht, Netherlands

The Owners’ Choice V OA <V OB Proposition 1:It is more likely that the owner chooses Spinoff over In- House Development if: The outside option for employees is larger (obvious) The spread for project 1 is larger (DMH) The lower support for project 2 is more negative (LL) The upper support for project 2 is less positive (DMH) The market success probability for project 2 is higher. (LL) Slide 15 of 2619 November 2010 RENT Conference Maastricht, Netherlands

The Owners’ Choice V OC >V OB Proposition 3:It is more likely that the owner chooses Entrepreneurial over Intrapreneurial spinoff if: The lower support for project 2 is more negative The upper support for project 2 is less positive The market estimate of success probability for project 2 is lower. We also show that V OA >V OB implies V OA >V OC for V OB V OC. The value of β 2 is also an important driver of the choice between C and B… …and can be tied to the double moral hazard problem. Note that for β 2 = 0 and for β 2 = 1-γ 2 the owner would always prefer case C… … but B can be preferred for values between these extremes. Slide 16 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Conclusions Proposal Case A: In HouseNot A: Consensual Spinoff Case B: Intrapreneurial Case C: Entrepreneurial Weak DMH; Positive or small negative downside risk Strong DMH project 1; Large negative downside risk Intermediate DMH; Small negative downside risk Strong or Weak DMH project 2; Large negative downside risk Slide 17 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Implications and Limitations Our model predicts that: Firms may strategically decide to allow spinoffs particularly when: Radical Innovations Young Industries Our model implies that: Governments may want to facilitate and stimulate consensual spinoffs in: Entrepreneurial Economies At the Technology Frontier In light of our results: Firms may want to revise their strategy on IPR and R&D. Governments may want to revise Limited Liability and Labor Regulation. Slide 18 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Implications and Limitations Our model at this point… …cannot explain conflictual Spinoffs. …has modeled limited liability in a particular (non GE) way. …has complex comparative statics in β and γ. …is a useful starting point for a more unified theory. …uses well-known modeling tools and concepts and can thereby be firmly embedded in the extant literature. …can (and should) be tested more formally in the data. Your comments, questions and discussion are most appreciated… …and thank you for your kind attention. Slide 19 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Problem for the Agents Problem for the Manager (case B): Slide 20 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Problem for the Agents Surplus for the Employee (case B): and α B is the equity share taken by the parent firm in the spinoff. Where Slide 21 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Spinoffs to exploit LL Surplus for the Owner (case B): Bonuses still set proportional to the spread between best and worst outcome. LL reduces spread for project 2 (when lower support <0). No bonus and/or wage but equity share paid to employee. Slide 22 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Limited Liability Induced Efforts (case B) Note that induced efforts are lower than optimal in project 2 due to DMH and LL. Slide 23 of 2619 November 2010 RENT Conference Maastricht, Netherlands

Limited Liability Similarly we can find Induced Efforts (case C) Note that now induced efforts are lower than optimal in project 2 due to LL only. Slide 24 of 2619 November 2010 RENT Conference Maastricht, Netherlands

The Owners’ Choice Slide 25 of 2619 November 2010 RENT Conference Maastricht, Netherlands

The Owners’ Choice Slide 26 of 2619 November 2010 RENT Conference Maastricht, Netherlands