Why start-ups?

The prototypical start-up involves an employee leaving her job with an idea and selling a portion of that idea to a venture capitalist. In many respec ts, however; the idea should be worth more to the former employer. The form er employer can be expected to have better information concerning the emplo yee-entrepreneur and the technology, have opportunities to capture economie s of scale and scope not available to a venture capital-backed start-up, an d will receive more favorable tax treatment than the start-up should the in novation fail. In connection with an auction of the idea, the former employ er should have both a more accurate estimate of its value and receive an el ement of private value not available to the venture capitalist. In turn, th is should give rise to a powerful winner's curse: each time a venture capit alist wins the auction, it will have paid more than a party that has better information and receives an element of private value. The puzzle, then, is why do we ever observe start-ups? Professors Joseph Bankman and Ronald J. Gilson suggest three interrelated explanations. First, the venture capitali st may have superior information with respect to some subset of employee in novations. Second, employer bids on employee innovation can create an incen tive for employees to establish internal property lights in their research efforts that may reduce the future output of the employer's research and de velopment efforts. Finally, employees are not homogenous. The attractivenes s of venture capital financing depends critically on employee personal char acteristics, such as risk aversion. The employer sets the internal payoff t o discovery-its bid-to equalize the marginal benefit of retaining employees who might otherwise leave to the marginal cost of establishing unfavorable incentives for future research and development for those employees who do not find venture capital financing a close substitute for continued employm ent. In some cases, this calculus might lead to a "no bid" policy. In virtu ally all cases, the pay-off will be set too low to retain all employees, an d start-ups ensue.