Does Innovation Die When A Firm Goes Public?31 August, 2017 / Articles
There’s an aura of pride and success surrounding a company that manages to go public. It’s a feat very few companies manage to achieve. But what if going public actually hurts a company’s underlying innovation?
A new provocative Third Way report by Stanford Finance Professor Shai Bernstein begs the question: Should hoodie-clad tech hotshots really dream of ringing the New York Stock Exchange bell?
Today, fewer and fewer companies are making the decision to go public. For starters, 90% of new companies fail. An even smaller fraction make it to the public markets. In 1996, there were 706 companies that went public. In 2016, there were 105, an 85% drop over two decades.
Bernstein specifically looks at how the decision to go public affects a company’s innovation. He compares innovation between two different groups of companies—those that filed to go public but held back and those that followed through and took the plunge. While it is difficult to quantify the quality of innovation, Bernstein measures it by looking at companies’ patents and whether these ideas were used as building blocks for new inventions and innovations.
Bernstein’s finding is surprising: Innovation starts to decline roughly two years prior to a company going public and continues to decline in the five years thereafter. By comparison, firms that filed to go public but stayed private innovated at higher rates.
So what is it about going public that hurts innovation?
One explanation involves the innovators themselves. Bernstein shows that inventors are less inclined to work for a publicly traded company. In fact, inventors were 18% more likely to leave after the company went public. Part of the reason for this is that early-stage companies present more potentially lucrative opportunities for the inventors who get in on the ground floor. Once a company goes public, inventors often see it as the time to cash out and move on to other ventures.
Further, companies also tend to become more bureaucratic and focused on commercialization when they go public, an environment that may not appeal to early-stage inventors.
Losing innovators is one part of the equation. The other is a shift in corporate strategy, as public companies often use capital to acquire outside innovation. Specifically, Bernstein shows that the probability of acquiring patents through acquisition jumps after a company decides to go public. In the first year after going public, there’s a 10% chance of acquiring an external patent compared to 2% for companies that stay private. In the first five years after the IPO, roughly 30% of the patent portfolio of the firm is composed of patents attained through acquisitions.
Firms shift from innovating in-house to acquiring technologies externally because C-suites face different incentives once they are in the public markets. Innovation is a risky endeavor, one that can take a long time to materialize. Managers have to explain profits once a quarter to investors. If a company’s innovation doesn’t show returns fast enough, there’s growing concern that shareholders will lose patience and sell, causing a drop in the stock price.
Bernstein’s data shows that short-termism pushes previously innovative companies to pursue innovation through acquisitions. He does this by comparing the decisions of chief executives who also chair their companies’ boards to chief executives who answer to a different board chair. The companies with separate board chairs saw significantly larger drops in innovation, indicating that corporate managers whose jobs depend on another are less likely to take risks with innovation.
This is not to say that if a company goes public, its days of value creation are over. We see examples of public companies innovating every month—from new iPhones to new blind spot monitors on your car. But Bernstein’s data offers a cautionary tale for companies looking to balance innovation and the benefits of tapping IPO markets.
The fact is, we need both. IPO markets play a valuable role for the longevity of many companies, and more Americans should have the ability to take part in well-functioning capital markets. Innovation leads to growth, both in terms of spurring new businesses as well as the jobs that accompany them. We need to make sure one doesn’t cannibalize the other.