Locating innovation: The endogeneity of technology, organizational structure, and financial contracting

Columbia Law Review

Volumn 110, Issue 3, 2010, Pages 885-918

  Gilson, Ronald J ^a,b,c  

^a STANFORD LAW SCHOOL   (United States)

^b Columbia Law School ^*  (United States)

^c European Corporate Governance Institute   (United States)

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[No Author keywords available]

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EID: 77954396565     PISSN: 00101958     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (107)

1. The literature began with a flurry of groundbreaking studies by Paul Gompers and Joshua Lerner, writing together and separately. This work is compiled and extended in Paul Gompers & Josh Lerner, The Venture Capital Cycle (2d ed. 2004). Steven Kaplan and Per Strömberg extended this work by analyzing a data set of 213 venture capital investment contracts. Steven N. Kaplan & Per Strömberg, Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts, 70 Rev. Econ. Stud. 281, 281 (2003) ("In this paper, we attempt to inform theory by describing in detail the contracts between VCs [venture capitalists] and entrepreneurs."). More recently, Amar Bhidé has broadly examined the effect of globalization on domestic venture capital financing. Amar Bhidé, The Venturesome Economy: How Innovation Sustains Prosperity in a More Connected World (2008).
2. See, e.g., Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets, 47 J. Fin. Econ. 243 (1998) and sources cited therein.
3. See, e.g., Ronald J. Gilson, Engineering a Venture Capital Market: Lessons from the American Experience, 55 Stan. L. Rev. 1067 (2003) [hereinafter Gilson, Engineering Market] and sources cited therein.
4. See, e.g., Gompers & Lerner, supra note 1, at 30 ("[W]e examine compensation terms in 419 venture partnership agreements and offering memoranda for funds formed between 1978 and 1992."); Kaplan & Strömberg, supra note 1, at 281 (explaining each venture capital firm studied provided "contractual agreements governing each financing round in which the firm participated" and, if available, "the company's business plan, internal analyses evaluating the investment, and information on subsequent performance").
5. See, e.g., Gompers & Lerner, supra note 1, at 127-54; Kaplan & Strömberg, supra note 1, at 281-82.
6. In 2006, total U.S. seed, startup, and early-stage venture capital investments amounted to some $5.5 billion. PricewaterhouseCoopers & Nat'l Venture Capital Ass'n, Money Tree Report, available at https://www.pwcmoneytree.com/MTPublic/ns/ nav.jsp?page=historical (select "startup/seed" for "stage"; then select "early stage" for "stage"; then add all figures) (last visited Feb. 10, 2010) (on file with the Columbia Law Review). The combined 2006 R&D spending of Pfizer, Ford, Johnson & Johnson, and Microsoft was approximately $30 billion. Barry Jaruzelski & Kevin Dehoff, The Customer Connection: The Global Innovation 1000, at 10 (2007), available at http://www.strategy-business.com/media/file/sb49-07407.pdf (on file with the Columbia Law Review). The attraction of venture capital-based companies is in their disproportionate success in innovation. See Samuel Kortum & Josh Lerner, Assessing the Contribution of Venture Capital to Innovation, 31 RAND J. Econ. 674, 691-92 (2000) (reporting venture capital-backed companies produced close to three times their proportional amount of patents based on R&D spending).
7. See, e.g., Darian M. Ibrahim, The (Not So) Puzzling Behavior of Angel Investors, 61 Vand. L. Rev. 1405, 1416-20, 1452 (2008); Brent D. Goldfarb et al., Does Angel Participation Matter? An Analysis of Early Venture Financing 3 (Roger H. Smith Sch. of Bus., Working Paper No. RHS-06-072, 2009), available at http://ssrn.com/abstract=1024186 (on file with the Columbia Law Review) (reporting study results indicating firms financed by angel investors alone are more likely to survive than other firms).
8. For example, Pioneer Hi-Bred, a developer of bio-engineered seed stock, and DuPont, a leading producer of plant pesticides, combined large parts of their research efforts in a joint venture focused on developing genetically engineered seeds. Bloomberg News, DuPont to Invest $1.7 Billion in Pioneer Hi-Bred, N.Y. Times, Aug. 8, 1997, at D3.
9. See, e.g., David T. Robinson & Toby E. Stuart, Financial Contracting in Biotech Strategic Alliances, 50 J.L. & Econ. 559, 559-60 (2007) [hereinafter Robinson & Stuart, Financial Contracting] (describing pharmaceutical joint ventures between small biotech companies and mature pharmas).
10. See Ronald J. Gilson, Charles F. Sabel & Robert E. Scott, Contracting for Innovation: Vertical Disintegration and Interfirm Collaboration, 109 Colum. L. Rev. 431, 450-58 (2009). Even the examples given are limited to commercial locations of innovations; university and government-based research projects are not mentioned.
11. See Ronald Coase, The Nature of the Firm, 4 Economica 386, 390-91 (1937).
12. Franco Modigliani & Merton H. Miller, The Cost of Capital, Corporate Finance and the Theory of Investment, 48 Am. Econ. Rev. 261 (1958) [hereinafter Modigliani & Miller, Cost of Capital].
13. Coase was explicit that liability's location was irrelevant only in a transaction-cost-free world; his point was that because the world was so messy, the study of frictions should be at the core of the agenda. R.H. Coase, The Problem of Social Cost, 3 J.L. & Econ. 1, 43 (1960). Miller reports having the same point in mind. Writing thirty years after the irrelevancy propositions were first published, Modigliani & Miller, Cost of Capital, supra note 12, Miller stated that "[l]ooking back now, perhaps we should have put more emphasis on the other, upbeat side of the 'nothing matters' coin: showing what doesn't matter can also show, by implication, what does." Merton H. Miller, The Modigliani-Miller Propositions After Thirty Years, J. Econ. Persp., Fall 1988, at 99, 100 [hereinafter Miller, The Modigliani-Miller Propositions]. Of course, that implication drove a significant research agenda in financial economics over the thirty years following its publication.
14. See, e.g., Bengt R. Holmstrom & Jean Tirole, The Theory of the Firm, in 1 Handbook of Industrial Organization 61, 78-86 (Richard Schmalansee & Robert Willig eds., 1989).
15. As Miller put it in 1988, capital structure irrelevance was simply "an implication of equilibrium in perfect capital markets." Miller, The Modigliani-Miller Propositions, supra note 13, at 99.
16. Oliver Williamson, The Economic Institutions of Capitalism 47 (1985) (defining opportunism).
17. Sanford J. Grossman & Oliver D. Hart, The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration, 94 J. Pol. Econ. 691, 693-95 (1986);
18. Oliver Hart & John Moore, Property Rights and the Nature of the Firm, 98 J. Pol. Econ. 1119, 1152-53 (1990) ("[W]e have ignored issues having to do with the dissemination of information and with how coordination takes place between individuals with different sources of information but possibly similar goals. . . . [W]e believe that our analysis has identified some of the forces determining the boundaries of the firm.").
19. Both the transaction cost and property rights literatures are surveyed in Francine Lafontaine & Margaret Slade, Vertical Integration and Firm Boundaries: The Evidence, 45 J. Econ. Literature 629, 649-62 (2007).
20. Sharon Belenzon, Tomer Berkovitz, and Patrick Bolton make a similar point, stressing a Coasean perspective in assessing the allocation of R&D between business groups and conglomerates. Sharon Belenzon et al., Intracompany Governance and Innovation 23-37 (Nat'l Bureau of Econ. Research, Working Paper No. W15304, 2009), available at http://ssrn.com/abstract=1463897 (on file with the Columbia Law Review).
21. Paul Milgrom & John Roberts, Economics, Organization and Management 221-28 (1992) [hereinafter Milgrom & Roberts, Economics, Organization & Management] (discussing correlation between incentive and monitoring intensity).
22. See David H. Hsu & Martin Kenney, Organizing Venture Capital: The Rise and Demise of American Research & Development Corporation, 1946-1973, at 14 Indus. & Corp. Change 579, 580 (2005).
23. Ronald J. Gilson, Value Creation by Business Lawyers: Legal Skills and Asset Pricing, 94 Yale L.J. 239, 243 (1984) [hereinafter Gilson, Value Creation].
24. See, e.g., Gompers & Lerner, supra note 1, at 65-90 (providing extended analysis of current research); Gilson, Engineering Market, supra note 3, at 1070-76 (detailing structure).
25. See Mark C. Suchman & Mia L. Cahill, The Hired Gun as Facilitator: Lawyers and the Suppression of Business Disputes in Silicon Valley, 21 Law & Soc. Inquiry 679, 690-91 (1996) (exploring role of lawyers in developing venture capital structure);
26. Mark C. Suchman, The Contracting Universe: Law Firms and the Evolution of Venture Capital Financing in Silicon Valley 31-33 (Jan. 2006), available at http://www.ssc.wisc.edu/ -suchman/drafts/kuniverse.web.pdf (unpublished manuscript, on file with the Columbia Law Review) (same).
27. Recently, a number of articles have taken aim at the characterization of a lawyer's role reflected in the text above. See, e.g., George W. Dent, Jr., Business Lawyers as Enterprise Architects, 64 Bus. Law. 279, 286-95 (2009);
28. Steven L. Schwarcz, Explaining the Value of Transactional Lawyering, 12 Stan. J.L. Bus. & Fin. 486, 487, 498-99 (2007). While I am flattered that this formulation of a business lawyer's role still commands attention after twenty-five years, the thrust of the criticism warrants comment. First, commentators suggest that applying theory to engineer the organizations and contracts of innovation is only one, perhaps small, part of a transaction lawyer's role. In short, as Professor Dent puts it, my approach-what he calls the "received model"-"is too narrow." Dent, supra, at 281. He has in mind "a fuller vision showing that business lawyers perform a greater range of activities using a larger set of skills than in the received model." Id. Second, the critics point out, as did I, that other professions can do the very same thing. I agree with both points. Compare Schwarcz, supra, at 487 (arguing "the same types of value . . . could be added in business transactions by any sophisticated party, not necessarily one specially trained as a lawyer"), with Gilson, Value Creation, supra note 20, at 295 ("There is nothing traditionally 'legal' about the role I have described business lawyers as playing, nor are there any special requirements peculiar to lawyers necessary to play this role."). Business lawyers do many other things; transaction engineering is merely the most interesting and challenging. However, I take the broader theme of my now slightly dated claim to be largely accepted by the commentators, and I would happily substitute the following for the received model: A lawyer creates value by taking serious theory developed elsewhere in academia and bringing it to bear on the practice of law. Much theory has been developed since I wrote in 1984. For instance, the notion of teaching law students the tools to create value has given rise to successful courses in "Deals" at Columbia, Stanford, and the University of Pennsylvania Law Schools, among others. On occasion, these courses are taught jointly by the law school and business school.
29. See Victor Fleischer, Deals: Bringing Corporate Transactions into the Law School Classroom, 2002 Colum. Bus. L. Rev. 475, 490-92 (discussing Deals courses).
30. Willie Nelson, My Heroes Have Always Been Cowboys, on Soundtrack: The Electric Horseman (Columbia Records 1984).
31. See Stewart C. Myers, The Capital Structure Puzzle, 39 J. Fin. 575, 589-90 (1984) (describing how cost of capital is function of information asymmetries).
32. Part III, infra, takes up a circumstance when the established firm will be at a disadvantage.
33. See Joseph Bankman & Ronald J. Gilson, Why Start-ups?, 51 Stan. L. Rev. 289, 293-95 (1999) (reviewing tax treatment of startups).
34. Research shows that such companies, fueled by venture capital, produced almost three times their proportional number of patents relative to their share of overall R&D spending in the first decade of the venture capital boom. Kortum & Lerner, supra note 6, at 675.
35. This formulation assumes that the engineer, rather than the employer, has the property rights in the idea, despite the fact that the innovation was typically conceived while the engineer was an employee. For a discussion of the engineer's property rights, see Ronald J. Gilson, The Legal Infrastructure of High Technology Industrial Districts: Silicon Valley, Route 128, and Covenants Not to Compete, 74 N.Y.U. L. Rev. 575, 597-609 (1999) (discussing legal protections of employee knowledge and inventions).
36. Part I.A draws on Bankman & Gilson, supra note 27.
37. The tax analysis is set out in more detail in Bankman & Gilson, supra note 27, at 293-95.
38. See Myers, supra note 25, at 581-85 (describing pecking order theory).
39. Most of the literature addresses the misappropriation problem not with respect to the employer company, but with respect to the prospect of corporate venture capital-for example, the innovating employee taking financing from Microsoft rather than a traditional venture capitalist. See, e.g., James J. Anton & Dennis A. Yao, Start-ups, Spinoffs, and Internal Projects, 11 J.L. Econ. & Org. 362, 370-71 (1995) (analyzing risk of misappropriation through competitor financing). Here the concern is with misappropriation that occurs through the corporate investor's post-financing involvement with the portfolio company. In the case of the employee/employer interaction, the feared misappropriation takes place through pre-bid disclosure.
40. Gilson, Engineering Market, supra note 3, at 1092.
41. See id. (discussing operation of reputation market in connection with venture capital).
42. In the context of the labor market, the role of a reputation market is framed in terms of "implicit contracts." For a model in which employer misappropriation is central to the process, see generally Mariagiovanna Baccara & Ronny Razin, Curb Your Innovation: On the Relationship Between Innovation and Governance Structure (N.Y.U. Stern Sch. of Bus., Working Paper No. CLB-06-010, 2006), available at http://ssrn.com/abstract=1291578 (on file with the Columbia Law Review).
43. Thomas Hellmann, A Theory of Corporate Venture Investing 5-7 (Stanford Univ. Graduate Sch. of Bus., Working Paper No. 1452, 1998), available at http://strategy.sauder.ubc.ca/hellmann/pdfs/tcorpven.pdf (on file with the Columbia Law Review).
44. Paul Milgrom & John Roberts, An Economic Approach to Influence Activities in Organizations, 94 Am. J. Soc. S154, S156-57 (1988) [hereinafter Milgrom & Roberts, Economic Approach]. Bengt Holmström stresses differential measurement and monitoring costs between innovation and other employee activities. If measuring the employee's efforts at innovation is more difficult than measuring her efforts in more routine activities, it may be desirable to restrict the employee's activities.
45. Bengt Holmström, Agency Costs and Innovation, 12 J. Econ. Behav. & Org. 305, 311-12 (1989);
46. Bengt Holmström & Paul Milgrom, Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design, 7 J.L. Econ. & Org. (Special Issue) 24, 25-26 (1991).
47. Bankman & Gilson, supra note 27, at 301-03.
48. John Roberts reports how 3M tried to manage innovation in the face of the incentive problems raised in the text: "Performance measurement for subgroups or individuals, however, tended to involve subjective evaluations or milestones achieved, not the financial numbers generated. Rewards had large non-monetary elements, especially personal autonomy and professional recognition . . . ." John Roberts, The Modern Firm 259 (2004). In other words, 3M dramatically reduced the intensity of the incentives.
49. The time it takes to go from being an early-stage company to an established employer concerned about losing innovative employees to startups seems to be shrinking. See Jessica E. Vascellaro, Google Searches for Ways to Keep Big Ideas at Home, Wall St. J., June 18, 2009, at B1 ("Google Inc. is revamping how it develops and prioritizes new products, giving employees a pipeline to the company's top brass amid worries about losing its best people and promising ideas to start-ups.").
50. See Milgrom & Roberts, Economic Approach, supra note 38, at S156-57 (enumerating costs imposed on organizations by members' "influence activities").
51. Masahiko Aoki, Toward an Economic Model of the Japanese Firm, 28 J. Econ. Literature 1 (1990).
52. Id. at 9. Peter Hall and David Soskice make a similar point but extend the analysis to include a discussion of how the Japanese political structure complements the organizational structure of larger incrementally innovative companies. Peter A. Hall & David Soskice, An Introduction to Varieties of Capitalism, in Varieties of Capitalism: The Institutional Foundations of Comparative Advantage 1, 50-51 (Peter A. Hall & David Soskice eds., 2001).
53. While the text does not refer to the role of financial contracting within the Japanese firm, Aoki stresses the role of the Japanese banks as the primary source of industrial capital during the period when his description was most accurate. Aoki, supra note 43, at 14. Put briefly, the banks provided a buffer from market forces that would have destabilized the incentive structure at the heart of the structure of the Japanese firm. See Hugh Patrick, The Relevance of Japanese Finance and Its Main Bank System, in The Japanese Main Bank System 353, 388-408 (Masahiko Aoki & Hugh Patrick eds., 1994) (discussing lessons from Japanese post-war financial development);
54. Juro Teranishi, Loan Syndication in War-Time Japan and the Origins of the Main Bank System, in The Japanese Main Bank System, supra, at 51, 79 (noting ties between Japanese banks and conglomerates insulated managers from market forces).
55. This section draws on Gilson, Engineering Market, supra note 3.
56. See supra note 1.
57. This is consistent with Milgrom and Roberts' "monitoring intensity principle," which predicts that because intense incentives give rise not only to incentives to perform but also to incentives to cheat, intense incentives require a significant investment in monitoring. Milgrom & Roberts, Economics, Organization & Management, supra note 18, at 226-27.
58. See Paul A. Gompers, Optimal Investment, Monitoring, and the Staging of Venture Capital, 50 J. Fin. 1461, 1461-62 (1995) (explaining operation of staged financing).
59. See William A. Sahlman, The Structure and Governance of Venture-Capital Organizations, 27 J. Fin. Econ. 473, 475 (1990) (reporting venture capital funds invest one-third of their capital in new investments and two-thirds in later round financing of companies already in their portfolios).
60. Conceptually, the signal can support a separating equilibrium in which only high quality entrepreneurs will accept the incentive. Low quality entrepreneurs, whose alternatives are more valuable to them than an incentive contract that requires more talent than they have in order to be profitable, will not. See Edward Lazear, Salaries and Piece Rates, 59 J. Bus. 405, 413 (1986) (describing separating equilibrium where least able workers prefer salary firm, while most able workers prefer piece-rate firm); Sahlman, supra note 50, at 502 ("The governance structure also helps potential investors distinguish between good venture capitalists and weak ones. . . . [G]ood venture capitalists are more likely ... to accept ... a compensation system heavily dependent on investment returns.").
61. See Thomas Hellmann, The Allocation of Control Rights in Venture Capital Contracts, 29 RAND J. Econ. 57, 58 (1998) (explaining pattern of staged vesting). Kaplan and Strömberg report that 41% of a sample of early-stage financings contained entrepreneur vesting requirements. Kaplan & Strömberg, supra note 1, at 292 (finding also 48% of first venture capital financings contain founder vesting requirements).
62. Lee F. Benton et al., Portfolio Company Investments: High-Tech Corporation-Getting to the Term Sheet, in Venture Capital & Public Offering Negotiation 6-1, 6-19 (Michael J. Halloran et al. eds., 3d ed. Supp. 2009); Sahlman, supra note 50, at 507.
63. See Gompers & Lerner, supra note 1, at 91-92 & fig. 5.1 (demonstrating "profits received by general partners of venture capital fund").
64. See Gilson, Engineering Market, supra note 3, at 1083-84 (explaining incentive structure of venture capital incentives).
65. This point originates with Michael C. Jensen, Eclipse of the Public Corporation, 67 Harv. Bus. Rev. 61, 68-70 (1989) (analyzing structure of private equity limited partnership agreements).
66. See supra Part I.B.
67. Denis Gromb & David Scharfstein, Entrepreneurship in Equilibrium 1-2 (NBER, Working Paper No. 9001, 2002), available at http://www.nber.org/papers/ w9001.pdf (on file with the Columbia Law Review).
68. See supra text accompanying notes 44-45 (discussing Japanese success at incremental innovation).
69. Clayton M. Christensen, The Innovator's Dilemma (2000).
70. Id. at ix. For example, in a report that addressed IBM's failure to effectively enter new markets, the diagnosis highlighted IBM's single-minded focus on serving its existing customers: "The company is preoccupied with current served markets and existing offerings. Processes were designed to listen intently to existing customers and to focus on traditional markets. This makes us slow to recognize disruptive technologies and to recognize new markets." Charles A. O'Reilly III et al., Organizational Ambidexterity: IBM and Emerging Business Opportunities 20 (Stanford Graduate Sch. of Bus., Working Paper No. 2025, and Rock Ctr. for Corporate Governance, Working Paper No. 53, 2009), available at http://ssrn.com/abstract=1418194 (on file with the Columbia Law Review) [hereinafter O'Reilly et al., Organizational Ambidexterity] (emphasis omitted).
71. Christensen examines examples of the phenomenon in connection with disk drives, electric arc or mini-mill steel producers, and hydraulically activated earth-moving equipment. Microsoft's reaction to search-based advertising appears to have tracked Christensen's pattern. In 2000, before Google had perfected the technique, Microsoft had an early version of the same technology called Keywords. Microsoft shut the product down after two months out of fear of cannibalizing existing revenue streams. See Robert A. Guth, Microsoft Bid to Beat Google Builds on a History of Misses, Wall St. J., Jan. 16, 2009, at 1.
72. A related phenomenon involves companies that recognize that a competing technology has potential; they try to straddle the two technologies, but fail at the task of simultaneously pursuing the existing technology while embracing the new. Michael L. Tushman & Charles A. O'Reilly III, Ambidextrous Organizations: Managing Evolutionary and Revolutionary Change, Cal. Mgmt. Rev., Summer 1996, at 8, 9-10, offer the example of the transition from vacuum tubes to transistors. The leading vacuum tube manufacturers either never entered the transistor market or did enter and failed. The ultimate winners in the transistor market were, as Christensen would predict, the new companies that worked only with the new technology.
73. Christensen describes the strategy as "a policy of implanting projects to commercialize disruptive innovations in small organizations that will view the projects as being on their critical path to growth and success, rather than as being distractions from the main business of the company." Christensen, supra note 60, at 138.
74. See, e.g., O'Reilly et al., Organizational Ambidexterity, supra note 61, at 17-21 (describing successful effort by IBM to address both markets).
75. At the conference where the paper that gave rise to this Essay was first presented, comments by Charles Sabel and Bengt Holmström succinctly demonstrated the pessimistic side. Taking their views together, they argued that firms are good at pursuing known tasks through hierarchical organizations, but that a hierarchy is not good at reprogramming itself. Put differently, the dilemma is that either there is no way to systematize nonincremental innovation-that is, nonincremental innovation is a non-organizational task-or the firm must figure out a way in which the innovation is not disruptive. Bengt Holmström & Charles Sabel, Remarks in Response to Ronald Gilson's Working Paper, Locating Innovation, at the Business Law and Innovation Conference (Oct. 31, 2008). O'Reilly, Harreld, and Tushman offer IBM as an example of a successfully ambidextrous company that took a very different tack than the "skunk works" strategy Christensen recommends. O'Reilly et al., Organizational Ambidexterity, supra note 61, at 19-21. IBM saw the problem as new businesses being marginalized, so it appointed the head of its software group, a multi-billion dollar business, as vice chair of the corporation and the full time head of the new business initiative. IBM's senior vice president for technology then succeeded this individual. In turn, the individuals chosen to lead a particular new business initiative are not younger managers, but according to IBM "are very experienced people, who have built big businesses." Id. at 25-26. For example, the individual chosen to run the new business had previously run IBM's Unix business that had $4 billion in sales. Id. at 26. General Electric Chief Executive Officer Jeffrey R. Immelt similarly describes GE's efforts at ambidexterity. Jeffrey R. Immelt et al., How GE Is Disrupting Itself, Harv. Bus. Rev., Oct. 2009, at 56. Like IBM's efforts to assign very senior managers to run new, potentially disruptive projects, GE seeks to elevate the financial and managerial commitment to the disruptive project, for example by having the project leader "report to someone high in the organization." Id. at 64. While this approach may work for IBM or GE, one would be skeptical of whether it can generalize to other companies, few of whom will have the management depth to move the head of major businesses to a startup business, or the discipline to assure a reporting relationship far enough up the corporate hierarchy. Successfully ambidextrous companies, and switch hitters like Mickey Mantle, may not come along very often.
76. See generally Charles A. O'Reilly, Cisco Systems: The Acquisition of Technology Is the Acquisition of People (Stanford Graduate Sch. of Bus., Case No. HR-10, 1998) [hereinafter O'Reilly, Acquisition of Technology].
77. Id.
78. Cisco is said to have done 70-80% of its product development through internal R&D, although the engineers who had developed many of these products joined Cisco as a result of an acquisition. Id. at 5.
79. John Chambers, Cisco's CEO then and now, described the process in this fashion: Our ideal acquisition is a small startup that has a great technology product on the drawing board that is going to come out 6 to 12 months from now. When we do that, we are buying the engineers and the next-generation product. Then we blow the product through our distribution channels and leverage our manufacturing and financial strengths. Glenn Rifkin, Growth by Acquisition: Cisco's John T. Chambers, The Case of Cisco Systems, Strategy & Bus., Second Quarter 1997, at 91, 100; see Nicole Tempest, Cisco Systems, Inc.: Acquisition Integration for Manufacturing 5 (Stanford Graduate Sch. of Bus., Case No. OIT-26, 2004), available at http://gsbapps.stanford.edu/cases/documents/OIT26. pdf (on file with the Columbia Law Review) ("Cisco viewed acquisitions as a means to ensure that it was offering the 'best of breed' product technology.").
80. John Chambers described Cisco's first acquisition in 1993 of Crescendo as follows: "We took Crescendo's networking product, and within 18 months we had a $500 million run rate. No small company can go from $10 million to $500 million in 18 months. They just can't scale. But we could scale because of our distribution, financial, and manufacturing strengths." Gerry Yemen et al., Cisco: Early if Not Elegant (A) 8 (Univ. of Va., Case Study UVA-BP-0446, 2003), available at http://ssrn.com/abstract= 907938 (on file with the Columbia Law Review).
81. The ability to integrate was particularly necessary for the Cisco incentive system. The need for integration is stressed in O'Reilly, Acquisition of Technology, supra note 67, at 7-9; Tempest, supra note 70, at 15; Yemen et al., supra note 71, at 15.
82. See generally Robinson & Stuart, Financial Contracting, supra note 9 (describing pharmaceutical joint ventures between small biotech companies and mature pharmas).
83. This account of the approval process draws on Gilson, Sabel & Scott, supra note 10, at 468 (describing new drug approval process), and Patricia Danzon et al., Productivity in Pharmaceutical-biotechnology R&D: The Role of Experience and Alliances, 24 J. Health Econ. 317, 318 (2005) (same).
84. Nat'l Inst, of Health, Dep't of Health & Human Servs., A Plan to Ensure Taxpayers' Interests Are Protected, pt. D, § 1 (2001), available at http://www.nih.gov/news/070101wyden.htm (on file with the Columbia Law Review).
85. Joseph A. DiMasi et al., The Price of Innovation: New Estimates of Drug Development Costs, 22 J. Health Econ. 151, 165 (2003).
86. Id. at 166.
87. See, e.g., Sean Nicholson et al., Biotech-Pharmaceutical Alliances as a Signal of Asset and Firm Quality, 78 J. Bus. 1433, 1434 (2005) ("[B]iotech firms pioneered new drug discovery technologies . . . whereas traditional pharmaceutical companies have superior expertise in chemistry . . . .");
88. Walter W. Powell, Inter-Organizational Collaboration in the Biotechnology Industry, 152 J. Institutional & Theoretical Econ. 197, 202 (1996) [hereinafter Powell, Inter-Organizational Collaboration] ("But Biotech proved to be, in Schumpeterian terms, a competence-destroying innovation because it built on a new science base (molecular biology and immunology) that differed significantly from the knowledge base (organic chemistry and its clinical applications) of the mature pharmaceutical industry." (citation omitted));
89. Nadine Roijakkers & John Hagedoorn, Inter-firm R&D Partnering in Pharmaceutical Biotechnology Since 1975: Trends, Patterns, and Networks, 35 Res. Pol'y 431, 444 (2006) (noting growth in alliances "primarily caused by the need of large pharmaceutical companies to access a recent explosion of biotechnological knowledge");
90. see also Louis Galambos & Jeffrey L. Sturchio, Pharmaceutical Firms and the Transition to Biotechnology, 72 Bus. Hist. Rev. 250, 260-76 (1998) (recounting big pharmas' move into biotechnology).
91. See Powell, Inter-Organizational Collaboration, supra note 78, at 199-201 (describing distribution of expertise); Walter W. Powell et al., Organizational and Institutional Genesis: The Emergence of High-Tech Clusters in the Life Sciences, in The Emergence of Organization and Markets (J. Padgett & W. Powell eds., forthcoming 2010) available at http://academic.reed.edu/sociology/ faculty/whittington/Powell-Packalen-Whittington-2010.pdf (manuscript at 14-15, on file with the Columbia Law Review) [hereinafter Powell et al., Institutional Genesis] (same).
92. See, e.g., Powell, Inter-Organizational Collaboration, supra note 78, at 203 (describing expertise in small biotech companies).
93. See, e.g., Nicholson et al., supra note 78, at 1434 (citing large pharmas' capabilities with FDA process as cause of alliances).
94. See supra Part II (discussing Christensen's argument that inability to recognize disruptive technology's potential contributes to industry leader displacement).
95. See Powell, Inter-Organizational Collaboration, supra note 78, at 199-200 (describing this resemblance).
96. For example, in 1986, Eli Lilly, a large Midwestern pharma, acquired Hybritech, a San Diego-based early-stage biotech company, for $300 million. The outcome of the acquisition was described as follows: "Within one year, no Hybritech employees remained with Lilly, but more than 40 San Diego biotech firms were subsequently founded by former Hybritech employees. ... A senior scientist at Hybritech quipped that the merger 'was like 'Animal House" meets "The Waltons.'"" Powell et al., Institutional Genesis, supra note 79 (manuscript at 29-30) (citations omitted).
97. See supra Part I.C.
98. See, e.g., Lex Column, Roche Bottom Prices, Fin. Times (Asia), Jan. 31, 2009 ("[B]y going hostile [Roche] might also damage the culture and risk alienating, and so losing, some of the independently minded scientists who built Genentech.").
99. See O'Reilly, Acquisition of Technology, supra note 67, at 7-9 (describing Cisco's integration strategy).
100. Cisco's strategy relied on quick and thorough integration of the acquired early-stage company into Cisco to allow Cisco to commercialize the acquired company's technology through Cisco's product lines-as the CEO of Cisco put it, to "blow the product through our distribution channels and leverage our manufacturing and financial strengths." Rifkin, supra note 70, at 100.
101. Gilson, Sabel & Scott, supra note 10, at 435. The authors discuss in detail the structure of a particular large pharma/small biotech company joint venture. Id. at 467-71.
102. See id. at 492-94 (discussing braiding of explicit and implicit contracts in large pharma/small biotech joint ventures).
103. See David T. Robinson & Toby E. Stuart, Network Effects in the Governance of Strategic Alliances, 23 J.L. Econ. & Org. 242, 243 (2007) (discussing how reputation, measured by centrality within network of companies, affects contractual arrangements between joint venture partners).
104. Josh Lerner & Robert P. Merges, The Control of Technology Alliances: An Empirical Analysis of the Biotechnology Industry, 46 J. Indus. Econ. 125, 128 tb1.1, 129 tb1.2 (1998). The authors also report that joint venture/alliance funding in 1995 exceeded the sum of the next three largest sources of funds for biotech companies. Id.
105. See Gilson, Engineering Market, supra note 3, at 1071 (noting typical ten-year term); supra notes 74-77 and accompanying text (describing prohibitive time and cost associated with FDA approval).
106. Bengt Holmström and John Roberts make this point in a more general fashion. From their perspective, the boundary of the firm is dictated by a mix of problems and responses, which will differ depending on particularized circumstances. Bengt Holmström & John Roberts, The Boundaries of the Firm Revisited, 12 J. Econ. Persp. 73, 75 (1998) ("[O]wnership patterns are responsive to, among other things, agency problems, concerns for common assets, difficulties in transferring knowledge, and the benefits of market monitoring.").
107. See Gilson, Sabel & Scott, supra note 10, at 438-44 (describing reduction in levels of vertical integration in manufacturer supply chain).