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
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
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
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
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
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.
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
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
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.