Elsevier

Research Policy

Volume 41, Issue 8, October 2012, Pages 1407-1421
Research Policy

Financial signaling by innovative nascent ventures: The relevance of patents and prototypes

https://doi.org/10.1016/j.respol.2012.02.003Get rights and content

Abstract

External finance is a central issue for innovative nascent ventures. In this study, we argue that innovative nascent ventures may use patents to signal appropriability and prototypes to signal feasibility to potential investors. Using new data on 906 nascent ventures, we find that nascent ventures with patents or patent applications as well as prototyped innovations are more likely to obtain equity finance. However, nascent ventures that can solely signal appropriability by patenting are not more likely to obtain equity finance. This result may indicate that venture capitalists and business angels assign higher value to the appropriability signal when coupled with feasibility and vice versa.

Highlights

► We examine the relationship between innovation and external financing of nascent ventures. ► Patents may signal the ability to appropriate the returns of innovation projects, while prototypes signal their feasibility. ► We use a new and unique database of over 800 nascent ventures in the U.S.A. ► Our results suggest that nascent ventures sending both signals are more likely to obtain equity finance. ► Innovative nascent ventures that solely signal appropriability are not more likely to obtain equity finance.

Introduction

Innovative new ventures fail if they cannot attract resources needed to commercialize new ideas and inventions. Obtaining external resources is a central issue for nascent new ventures since they rarely have sufficient internal resources to finance startup activities. One important problem are information asymmetries between innovative nascent ventures and external financiers. Although the U.S. venture capital industry has grown dramatically since the 1980s, information asymmetries may still inhibit the commercialization of innovative ideas. In fact as Hsu (2004, p. 1805) mentions, “particularly for entrepreneurs without an established reputation, convincing external resource providers such as venture capitalists (VCs) to provide financial capital may be challenging”.

Information asymmetries are likely to be a severe problem, especially for innovative new ventures in the earliest stage of the startup process. Innovative nascent ventures developing their business concepts and operating businesses that do not yet generate revenues tend to possess assets that are knowledge-based and intangible. Consequently, the quality and value of the new venture cannot be directly observed. Such knowledge based resources sometimes might take the form of patent rights, which provides the business a strategic advantage. As expected, patents are also advantageous to gain financial resources too.

The relevance of patents for access to external financial resources is analyzed by Engel and Keilbach (2007). Using a dataset consisting of young German firms, they find that those firms with a higher number of patent applications (size corrected) have a higher probability of obtaining venture capital. This result is in line with the findings reported by Hellman and Puri (2000). Their results suggest that innovators are more likely to obtain venture capital financing than are imitators. Moreover, the results presented by Hsu and Ziedonis (2008) suggest a significant effect of patents on investor estimates of start-up firm value especially in earlier financing rounds. Haeussler et al. (2009) investigate how patent applications and grants improve the ability of capital seeking biotechnology companies in Germany and Britain to attract venture capital financing. Their results suggest that biotechnology companies obtain equity finance earlier if they filed applications for patents whereas ultimate grant decisions do not have an additional effect on the financing decision of venture capitalists.

As signaling is one way to reduce information asymmetries (Spence, 1973), there are reasons to expect that patents act as signals to investors. Patents are means to protect property rights and, consequently, innovative entrepreneurs may use them to signal to potential investors their ability to appropriate the returns of their innovations (appropriability). However, Gompers and Lerner (2001, p. 35) warn that “Although more tangible than an idea, patents and trademarks themselves are not enough to enable a company to obtain financing from most lenders. A soft asset such as patent may have value only when it is combined with other assets, such as the entrepreneur's knowledge of a particular process or technology that the patent involves”. In order to cope with the problem of asymmetric information and to obtain external finance, innovative entrepreneurs may therefore use other or additional signals. Patents as appropriability signals might be valued higher when coupled with signals of feasibility.

Our line of argument is that the development of a prototype may serve as such a signal to potential investors. Innovative nascent ventures may use prototypes to signal the actual feasibility of the proposed project and this signal may allow potential investors to improve their assessment of the commercial potential of the new venture. Prototypes may be the crucial link that actually provides additional value to patents as signals and thus making financing easier. Yet, the role of prototypes is largely neglected by empirical studies that deal with the importance of patenting in attracting investment from venture capitalists. Hence, the relevance of patents might be overrated if the positive effect of patents is to some extent resulting from the (unobserved) existence of prototypes. We contribute to the existing literature by investigating the relevance of patents and prototypes for the external finance of innovative new ventures. In particular, we argue that venture capitalists tend to assign higher value to the signal of patents if innovative nascent entrepreneurs also signal feasibility by developing a prototype and vice versa. Consequently, it can be argued that the value of sending both signals is higher than the value of the sum of separate signals. Hence, we investigate empirically whether new ventures owning a patent or filing an application for a patent that is essential to the business are more likely to obtain equity finance if in addition a prototype has been developed.

Additionally, we contribute to the literature by focusing on innovative nascent ventures. In contrast, previous studies are restricted to analysis of existing firms that survived the start-up phase. Yet, it may be that financing constraints have the greatest impact on deterring potential entrepreneurs from even starting a new firm. Cassar (2004, p. 279) states that for analyses of the financing of business start-ups “the ideal sample would consist of entrepreneurs in the process of starting a venture and tracking these entrepreneurs through the initial stages of business formation”. In this article we therefore shift the lens away from established, incumbent firms, to nascent ventures (entrepreneurs). We use a new dataset to address the point emphasized by Cassar (2004).

We use data obtained from a web-based survey of visitors of a web site that provides information for entrepreneurs who are seeking external finance. In our empirical analysis we focus on nascent entrepreneurs who are in the process of starting a new venture and who were asked to provide information about the characteristics of their innovative nascent ventures. Our Innovative Nascent Entrepreneurs Database (INED) allows us to identify nascent ventures with patents or patent applications, prototypes and provides information on external sources of finance. While it is likely that our data are not representative, our database has some important advantages. In contrast to existing empirical studies, we are able to eliminate the problem of survivorship bias because we analyze ventures at birth. Moreover, we are able to distinguish between nascent ventures that are in the planning stage and those in the very early start-up stage. Furthermore, nationally representative samples tend to be dominated by non-innovative nascent ventures whereas a large fraction of nascent ventures in our sample are ventures with patents or patents applications.

Our empirical results suggest that innovative nascent ventures possessing patents as well as prototypes have a higher probability of obtaining equity finance from business angels and venture capitalists. However, we find that the signal matters to investors only if the nascent ventures are in the early stage of the startup rather than the planning stage. This may indicate that nascent entrepreneurs may have to use their own resources in the planning stage in order to file patents and to develop prototypes and those nascent entrepreneurs who successfully signaled appropriability and feasibility may have a higher probability of attracting investment from business angels and venture capitalists in the early start-up stage. Bank finance, however, does not seem to value any of the signals and is based only on collateral.

In the following section we discuss the issue of financial constraints for innovative firms, followed by a detailed discussion of appropriability and feasibility issues and their relation to financing constraints. Section 3 introduces the data used and provides some descriptive statistics; Section 4 presents empirical results and a final discussion section concludes the study.

Section snippets

Financial constraints of innovative nascent entrepreneurs

The emerging literature on markets for technology analyzes the implications of the presence of markets for technology for firms’ corporate strategies and the factors limiting the development of markets for technology (Arora and Gambardella, 2010). One important insight of this literature is that the possibility of selling and buying technologies enlarges the firms’ strategy space (Arora et al., 2001). Firms do not necessarily have to commercialize their innovations themselves but may choose to

Building the Innovative Nascent Entrepreneurs Database (INED)

To test our hypotheses, the types of data sets providing information about the financial structure of (new) firms that have been used in previous studies are of little use. In contrast to existing studies, we focus on nascent ventures rather than established firms, however young they may be. Thus, a very different type of dataset providing information on innovative activities and financial prospects of nascent ventures is required to test the hypotheses posited in the previous section.

Finding a

Do patents and prototypes affect external financing?

In this section we present estimates of marginal effects which are obtained from separate estimations of the multinomial logit model (MNL) for nascent entrepreneurs in the planning stage and nascent entrepreneurs in the early start-up stage. We did not differentiate between nascent entrepreneurs who rely only on equity finance and those who rely on both, equity and debt. Instead, we estimated the MNL model with the three categories ‘no external finance’, ‘debt finance’ and ‘both sources of

Discussion

In this article we argue that innovative nascent ventures filing applications for patents and developing prototypes may use patents and prototypes as signals to potential investors. While patents may signal the ability of nascent ventures to protect their proprietary innovation (appropriability), innovative nascent ventures may use prototypes to signal the actual feasibility of the proposed project.

We developed three hypotheses on the relationship between patents and prototypes with an

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