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Building a Name

For Startup Companies, Partnering With Prestigious Firms is Good Business

Research by Toby Stuart

Many investors are seduced by enticing claims made by the new breed of high technology startups that promise revolutionary breakthroughs, from cancer cures to superconducting materials. The payoffs sound inviting -- but when there are a vast array of competing, early-stage technologies, how can investors discern which companies will be winners?

Toby Stuart, assistant professor of organizations and strategy at the University of Chicago Graduate School of Business, acknowledges that accurately judging the quality of young and unknown companies presents a difficult challenge for today's investors and analysts. He believes that when it is difficult to evaluate a new venture based on its own very limited track record and early-stage science, investors look for other cues that they can understand and assess. In a recent paper, "Interorganizational Endorsements and the Performance of Entrepreneurial Ventures," Stuart and co-authors Ha Hoang of Case Western University and Ralph C. Hybels of the University of Illinois at Chicago investigate how the networks of young technology companies affect their ability to acquire the resources to fund costly development programs.

The authors claim that, faced with great uncertainty regarding the quality of a young company, outsiders must rely upon the reputations of the affiliates of the company -- including strategic alliance partners and major customers -- to make judgments about the company's quality. The argument is that well-known strategic partners can led instant credibility to a startup, increasing investor confidence in the quality of the firm and therefore the likelihood that the company will succeed. The authors' analyses focus on the degree to which the performance of young biotechnology companies is affected by the reputations of their business partners. Although the authors focus on the biotech industry, with its proliferation of startups, it is easy to apply their findings to young, emerging companies in any industry. In fact, Stuart has demonstrated that the same dynamic operates in the semiconductor industry.

The authors evaluate a sample of 301 young, venture capital-backed biotechnology firms specializing in the development of human diagnostics and therapeutics. To perform the analyses, they compiled a comprehensive database on strategic alliances in biotechnology, recorded the private financing histories of all firms in the sample, and collected information on more than 30,000 U.S. biotechnology patents.

For young, venture-backed companies, two crucial performance variables are (1) the speed at which the company moves from incorporation to initial public offering (IPO), and (2) the valuation (market capitalization) of the firm when it has an IPO. Among other measures, the authors relied on these performance variables to test their main predictions:

Hypothesis 1: The higher the prestige of the strategic alliance partners (including collaborators in research, development, manufacturing and marketing) of a young company, the better the performance of the new venture.

"Our results support the core argument that young companies with prominent business partners perform better than comparable firms that lack such partners," says Stuart. "There is a transfer of status to the young company, which builds confidence about the quality of the new venture among potential customers, suppliers, employers, collaborators and investors. Through this process, young companies gain an advantage in the competition for resources."

In addition to the reputation advantages of having high-status partners, young companies may also benefit from access to their partners' high-quality resources. For example, large and established pharmaceutical firms typically have excellent skills in shepherding drug candidates through the regulatory process and large sales and marketing organizations. The authors believe that reputation and resource access work in tandem to create strong advantages for young companies with these prominent partners.

Interestingly, the authors found that the less that is known about a new company, the greater the influence of the reputation of its strategic partners on appraisals of its value, and on its ultimate performance. This led them to propose a second prediction:

Hypothesis 2: The greater the uncertainty about the quality of the company, the larger the impact of the prominence of the startup's exchange partners on its performance.

To illustrate this point, Stuart discusses two firms in the sample: Cytogen and Invitron. At the time of IPO for these two firms, both organizations had strategic alliance partners with similar reputations: American Cyanamid, a respected company, had formed an alliance and purchased a stake in Cytogen, and Monsanto, also a respected company, held an equity position in Invitron. However, Cytogen was six years old at IPO while Invitron underwent an IPO when it was less than three years old. Stuart's theory predicts that the younger company, Invitron, should receive a sizable boost from its relationship with a well-known partner. His results indicate that Invitron would gain a 91 percent increase in market value because of its partnership with Monsanto. By contrast, because Cyanamid had a six-year history and was therefore much easier to evaluate based on its own merits, having Cyanamid as an equity investor was predicted to produce a negligible increase (less than 1 percent) in the predicted market value of Cytogen.

"As young firms age, as they grow, and as they develop a track record of proprietary achievements," says Stuart, "the prominence of their business associates plays a diminishing role in outsiders' assessment of their quality." The reason for this is that the quality of the firm is more readily detectable when it has a history and track record that can be observed and evaluated.

The robust empirical results from the authors' study reveal important guidelines for young biotechnology companies, as well as upstarts in other industries. Young companies can acquire better reputations, access to valuable resources, and access to other important relationships by initially establishing relationships with prestigious partners. In addition, they can also benefit by establishing connections with well-known individuals. Biotech firm Gilead Sciences gained attention because of the visibility of the members of its board of directors, which included a former secretary of defense, a former secretary of state, and the chairman of Intel. Similarly, technology companies often have scientific advisory boards, and staffing these panels with prestigious researchers is another tactic for enhancing visibility.

Stuart's research lends additional support to the potential positive "chain reaction" of business networks. In his sample, young firms that have well-known equity partners were more likely to possess prominent alliance partners and to utilize prestigious investment banks. Similarly, because high status venture capitalist firms maintain close relationships with leading investment banks, startups that are funded by these venture capitalists tend to secure the prestigious investment banks to syndicate their IPOs.

"Once again we see the possibility that acquiring a prominent sponsor creates new opportunities to establish additional relationships for a young firm, which in turn increases awareness of the firm and attracts new offers to do business," observes Stuart. "Building a new technology company is a very expensive, highly competitive, and uncertain endeavor. It is difficult to overstate the advantages of having the right connections when competing to launch a viable organization."

Toby Stuart is an assistant professor of organizations and strategy at the University Chicago Graduate School of Business.

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