Vol. 4 No. 3| Winter 2003


The Changing Nature of Unemployment

Reversing Japan's Downward Spiral

Building a High-Tech Neighborhood

The Value of Control




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Building a High-Tech Neighborhood

What Does It Take to Create the Economic Environment for Entrepreneurship?

Research by Toby E. Stuart

Policymakers around the world have sought to emulate the industrial conditions that gave rise to the Silicon Valley economic dynamo of the 1990s. Although theories about the factors that underlie regional entrepreneurship rates are in abundant supply, there has been little systematic, empirical research to support these theories. New research shows that when acquisitions of private firms and initial public offerings (IPOs) of stock occur
in the same region, these events accelerate the region's rate of new venture formation.

"There isn't a city in the country that wouldn't like to have a vibrant high-tech area in the neighborhood," says Toby E. Stuart, a professor at the University of Chicago Graduate School of Business. Even after the recent meltdown in the technology sector, local governments around the globe continue to search for policies to adopt to promote the high-technology economy in their jurisdictions. Unfortunately, these initiatives have been mostly informal and ineffective.

In the recent study, "Liquidity Events and the Geographic Distribution of Entrepreneurial Activity," Stuart and Olav Sorenson of the Anderson Graduate School of Management at UCLA examine the founding rates for new biotechnology companies from 1985 to 1996 to understand what determines local technology-based entrepreneurship.

The term "liquidity event" refers to 1) the acquisition of an established but still private firm, and 2) an IPO of stock. When a company's stock begins trading on a public market, high-level employees are able to sell their shares after the lock-up period expires, and thus insiders' ownership stakes become liquid assets following the company's transition to public status. Liquidity also follows a publicly traded firm's acquisition of a privately held venture.

This new study focuses on how IPOs of private biotechnology firms and changes in corporate control in this industry influence the founding rates of new companies. Stuart and Sorenson find that acquisitions and IPOs of nearby companies increase founding rates of other new companies in the geographic region of the affected firms. They show that an area with a steady stream of successful biotechnology start-ups that are either acquired or go public will beget other start-ups, which in turn boosts regional economic health.

Stuart and Sorenson argue that acquisitions and IPOs stimulate entrepreneurial activity in a geographic area in part because they weaken the financial bonds that tie senior executives and researchers to their current employers. The inflow of cash removes an important hurdle in the pursuit of other entrepreneurial opportunities.

In their most significant finding, the authors argue that having state-level laws that permit employers to enforce noncompete covenants will constrain the mobility of potential entrepreneurs, thus dampening the health of the entrepreneurial sector of a local economy. Noncompete covenants are standard provisions in employment contracts that temporarily prevent employees from working for competing firms.

The effect of acquisitions and IPOs on founding rates of new companies is much greater in states that don't enforce noncompete covenants.

The Entrepreneurs

In 1986, pharmaceutical giant Eli Lilly acquired Hybritech, at the time a seven-year-old San Diego-based biotechnology firm. Shortly after the acquisition, the CEO and CFO of Hybritech left Lilly to start their own venture capital firm. This firm funded several post-acquisition spin-off companies from the former Hybritech. In total, Hybritech directly or indirectly spawned thirteen biotechnology companies in the San Diego area. Thus, this single acquisition created a surge of entrepreneurial activity for the region.

Stuart and Sorenson use this example to illustrate what they believe to be a general phenomenon: the executive and senior technical ranks of existing organizations include individuals who have a high potential for repeat entrepreneurship, particularly in businesses that involve technically sophisticated products and production processes.

According to the authors, this fact links the level of entrepreneurial activity in a region to the number of liquidity events, because changes in the ownership status of high-tech firms may directly affect the inclinations of the very employees who have latent entrepreneurial aspirations. Moreover, these are the individuals best equipped to create new ventures.

Given that stock in a privately held, early stage technology company is not a liquid asset, IPOs or acquisitions typically represent the first opportunity for insiders to extract significant financial gains from their participation in a company. The cash that company leaders get from selling their stock can be used to subsidize the creation of a new venture, or give them time to raise more capital.

In the case of acquisitions, there is also the potential for a mismatch in organizational cultures, which can create a push for would-be entrepreneurs to depart from their current employers. This is especially the case when large, mature organizations from different industries acquire early-stage technology firms. The resulting disruption frequently leads to the (often unintended) turnover among senior-level personnel at the acquired firm, with some of those individuals choosing to start new companies. The routines, rules, and cultures of the participating firm may change in a way that upsets the habits, preferences, and practices of senior employees.

"We are speculating that there are probably many people in the biotechnology industry who would prefer to work for small, quiet companies that are under the radar and out of public view," says Stuart. "If those individuals have just made a lot of money in an IPO or an acquisition, they may well be inclined to leave."

High visibility IPOs also enhance the opportunities for members of the firm's management team. Leading a new venture to a successful liquidity event sends a compelling message about a manager's abilities in the uncertain world of technology- based entrepreneurship. Venture capitalists, for instance, feel more comfortable sponsoring entrepreneurs with a track record of success. Therefore, the likelihood that an entrepreneur can attract the resources to build a strong company increases once he or she has previously led an organization to an acquisition or IPO. These entrepreneurs will be better able to mobilize capital, and may have greater incentive to depart from their current employer because of the structural changes created by a recent liquidity event.

Noncompete Covenants

Employers typically include noncompete covenants in the labor contracts of new, high-level employees. These clauses specify a designated period following employment during which the employee agrees not to join a rival of his or her current employer. Another common provision prevents former employees of a firm from soliciting the participation of a firm's customers and current employees in new business opportunities.

The ability of entrepreneurs to pursue new ventures depends a great deal on whether these noncompete covenants are enforced. Employment laws in the United States are drafted and implemented at the state level. When enforced, these covenants deter prospective entrepreneurs from leaving to establish competing firms.

Enforceable noncompete covenants also indirectly hinder new venture creation by dampening the chances of early-stage companies to survive. Venture capitalists, for instance, may not want to invest in an early-stage venture seeking funding if they feel that the developing firm is at risk of legal action for violating the terms of noncompete or nonsolicitation covenants.

However, in some states, noncompete covenants are basically not enforceable. California in particular chooses not to enforce these covenants. Stuart and Sorenson point out that this detail may go far in explaining the huge success of California's high-technology sector.

Variation among state law regarding noncompete covenants creates different dynamics for the founding of new organizations. The authors find that urban areas in states that do not enforce noncompete covenants have much greater entrepreneurial activity in the biotechnology sector than states that enforce these provisions. Moreover, the authors find that the incidence of nearby liquidity events results in the creation of many more startups in nonenforcement states. This is because would-be entrepreneurs at affected companies in nonenforcement states face fewer constraints on job changes following liquidity events.

Keeping Entrepreneurship Alive

According to the authors, there are three pieces of infrastructure that enhance a region's high-technology sector: great research universities; flexible state-level legal regimes that do not enforce noncompete covenants; and a healthy supply of venture capital.

Within the past year, venture capital funding for biotechnology has for the most part dried up. As a result of the current lack of funding, acquisitions and IPOs are now a rare occurrence. Biotechnology is much more expensive to develop than other high-tech ventures, though Stuart points out that if firms have compelling enough scientific discoveries, there will always be a market for new technology.

Stuart also notes that the networking angle of their findings is important to consider. Most entrepreneurs have the resources to start companies where they live.

"If you are an entrepreneur and you started a company in Chicago that is acquired or goes public, we believe you will start your next company in the Chicago area," says Stuart.

This is why the authors argue-and find-that liquidity events primarily affect the local entrepreneurial environment.


Toby E. Stuart is Fred G. Steingraber-A.T. Kearney Professor of Organizations and Strategy at the University of Chicago Graduate School of Business.

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