Startup reality check: When the IPO comes, innovation goes

The river of wealth flowing from a tech IPO can drown innovation

It's an article of faith among the digerati of Silicon Valley: Going public is the key to innovation. Sure, an IPO makes them rich (most of the time), they acknowledge, but in the end the whole world benefits from the storm of innovation their newly public companies unleash.

Not so fast.

A study by a finance professor at the Stanford Graduate School of Business finds that innovation slowed down by about 40 percent at tech companies after they went public. That's right: It declined, as measured by the number of patents these companies generate and by the quality of those patents.

What's more, the real generators of innovation -- the inventors -- tend to leave when their companies went public, and the ones who stay behind show a steep decline in "innovation quality." Indeed, the newly public tech companies become much more dependent on buying technology from outside -- usually by making corporate acquisitions, which is to say that they outsource innovation.

Shai Bernstein's study is no broadside against Silicon Valley or the need to raise capital. Without an infusion of cash, which is what an IPO produces, young companies might well die in infancy and thus never innovate. And the prospect of IPO riches does attract huge numbers of bright people to the industry. Still, Bernstein's work is a counterintuitive corrective to a self-serving myth, and it raises important questions about the real wellsprings of creativity and innovation.

Patents measure innovation

As broken as our patent system may be, it's still the best measure of innovation, so that's where Bernstein started his analysis. He looked at thousands of companies that announced plans to go public between 1985 and 2003 and compared those that actually completed their IPOs to those that later withdrew them. To make the comparison as equal as possible, he looked at companies that announced their IPOs in the same year and were in similar technology sectors.

He looked at data on nearly 40,000 patents awarded to companies before and after they said they were going public. But not all patents are created equal when it comes to innovation and originality, so Bernstein factored in two other criteria: He scored the importance of each patent by seeing how many times it was cited in other patent applications, and he scored them by how many different technologies each patent cited.

Five years after those companies went public -- or decided not to -- the results were striking: The quality of the patents issued to the companies that did go public declined by 40 percent. But patents granted to the companies that stayed private didn't change very much.

Do IPOs bring on brain drains?

You don't need a doctorate in finance to know that tech companies are hungry both to buy patents and to buy creative talent. The most egregious -- in my mind, at least -- example of the former was Google's $6 billion purchase of Motorola Mobility, which translated into a cost of about $400,000 per patent.

Then there's the phenomena known as "acqui-hire," in which large companies buy small ones as a means to "hire" talent they've had their eye on, such as Facebook wanted to do when it went after Face.com.

However they go about it, companies want to keep as much talent as possible. But Bernstein's study indicates that going public works against the goal.

He divided inventors into three categories: stayers, leavers, and newcomers. Inventors were about 18 percent more likely to become leavers at companies that went public. Even worse, it appears that the people who stayed became less creative: The quality of their patents plummeted by nearly 50 percent.

One of the reasons inventors leave is pretty obvious: Once they got rich, it was time to move on. Although Bernstein doesn't speak to this point, some of those wealthy leavers are likely to have started their own companies. In that case, there's still plenty of innovation happening, which is a benefit to the industry as a whole, if not to the companies they abandoned.

Then there's the pressure that Wall Street exerts on management. It's well known that too many investors and analysts get very impatient when a public company doesn't produce quick results. That impatience may lead managers to embrace strategies that are safer or more understandable to Wall Street, says Bernstein. As a result, there's less innovation and less incentive for creative people to stick around.

No one is suggesting that tech IPOs are a bad thing. Obviously the industry needs capital and incentives for people to work their best and their hardest. But Bernstein's work is a reality check that those who sing the praises of Silicon Valley should note -- as well as those who rely on startups to feed into the innovation paths in their own businesses.

This article, "Startup reality check: When the IPO comes, innovation goes," was originally published by InfoWorld.com. Read more of Bill Snyder's Tech's Bottom Line blog and follow the latest technology business developments at InfoWorld.com. For the latest business technology news, follow InfoWorld.com on Twitter.

This story, "Startup reality check: When the IPO comes, innovation goes" was originally published by InfoWorld.

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