Elsevier

Research Policy

Volume 36, Issue 2, March 2007, Pages 193-208
Research Policy

Patents, venture capital, and software start-ups

https://doi.org/10.1016/j.respol.2006.10.002Get rights and content

Abstract

This paper analyzes the relation between the patenting behavior of startup firms and the progress of those firms through the venture capital cycle. Linking data relating to venture capital financing of software startup firms with data concerning the patents obtained by those firms, we find significant and robust positive correlations between patenting and several variables measuring the firm's performance (including number of rounds, total investment, exit status, receipt of late stage financing, and longevity). The data also show that (1) only about one in four venture-backed software firms acquired even one patent during the period of the study; (2) patenting practices very considerably among the sub-sectors of the software industry; and (3) the relationship between patent metrics and firm performance depends less on the size of the patent portfolio than on the firm's receipt of at least one patent.

Introduction

Throughout their relatively short histories, the software and venture capital industries have been intertwined. Formed in the mid-1960s, the software industry grew rapidly throughout the 1970s, and by the 1980s the United States had a large and well-developed software industry with more than one thousand firms.1 Software firms enter and exit the industry with great frequency, and, evidenced by the size and frequency of investments, the venture capital model seems to work quite well for these firms.

The modern venture capital industry started modestly shortly after World War II. As recounted in Gompers and Lerner (2001), the industry struggled through a series of boom-and-bust cycles until the end of the 1970s. However, since about 1980, the modern model of syndicated limited partnerships investing funds largely derived from pension portfolios has transformed early-stage finance by increasing the availability of capital to young and risky firms. The potential for high growth rates and high operating margins attracts venture capitalists to firms touting highly innovative products, despite the absence of physical assets or operating histories necessary to obtain investment through traditional sources. Thus, the availability of venture capital likely has contributed both to the rapid pace of innovation and to the fragmented structure of the software industry.

As these industries have matured, the intellectual property protections available for software have shifted as well. From the mid-1960s when the Copyright Office formally decided to permit registration of computer programs through the late 1980s, copyright provided relatively strong protection for software. Early the next decade, a series of appellate decisions narrowed the scope of copyright for broader structural features of computer programs. However, major firms in the industry by that time had already begun turning to patent protection. Then, beginning in the 1980s and coming to fruition by the mid-1990s, judicial opinions and administrative actions began to adopt a more expansive approach to the breadth and strength of software patents.

As of late, patents have become particularly controversial in the software industry. The recent spread of patents and the cost and frequency of litigation have raised concerns, not only in the United States, but also in the European Union and Japan. This article bypasses many of the important public policy questions that those controversies entail, and instead focuses on the question whether patents are valuable to the firms that have them. If patents do not have a positive value for the firms that acquire them, then it is unlikely that the net effects of the patent system are positive. This question is surprisingly difficult to answer.

Patents might have private value to firms if they help firms attract financing or if they allow firms to exploit the value of internal research and development investments. There has been a good deal of empirical work, predominantly dealing with relatively large companies, examining the relation between patent counts and R&D.2 Similarly, we have some empirical information about the role of patents in the software industry in particular. The most detailed published study of the industry is Graham and Mowery's 2003 book chapter. Their work compares patent grants in certain IPC classes with R&D expenditures for large packaged-software firms. They conclude that the propensity to patent (measured in patents per $100M R&D dollars) rose by about 50% (from about 2.0 to 3.0) from 1988 to 1996.

Those contributions aside, the literature addressing the role of patents in small firms or in small software firms is underdeveloped, primarily due to the paucity of data. There are, however, good reasons to consider the role of patenting in software startups. The lack of concentration in the industry, for one thing, suggests that smaller firms play a significant role. Moreover, some data suggest that small firms in our economy contribute disproportionately to R&D investment and innovative activity.3 One possible explanation from the industrial organization literature is that property rights facilitate an industrial structure in which relatively small firms develop pieces of products assembled by larger firms (Arora and Merges, 2004, Gans et al., 2002).

Mann (2005a) reports qualitative empirical work (a series of interviews of venture capitalists, lenders, and executives at software startups and large software firms) suggesting that patents have a variety of potential positive effects, depending on the stage of firm's development. For firms in the pre-revenue stage, patents have little or no value; investors at this stage generally pointed to product market experience and management acumen as being more pertinent to initial investment decisions. For revenue-generating startups, patents seem to have positive value (in limited sectors). Investors commonly referred to the need to identify firms that will have sufficient market power to earn profits. Investors in those firms regard patent protection as a tool that might provide sustainable differentiation. Patents have ambiguous value for larger firms in that they facilitate cross licensing so that large firms can maintain a competitive equilibrium with other large established firms.

In this paper, we turn to a quantitative analysis of the first two stages of that framework: the role of patents for pre-revenue and later-stage startups. Specifically, by analyzing patent and financing data for a group of software startups, we can learn more about the significance of patents for those firms. Although many features of the data are ambiguous and suggest avenues for further inquiry, they do suggest that patents play a role of some importance in the development of firms seeking to enter the software industry, albeit one that depends substantially on the type of firm.

Specifically, the data suggest that:

  • Patent acquisition (or application) at the time of initial investment is largely irrelevant to the firm's subsequent progress through the venture capital cycle, measured by any metric.

  • Patent acquisition is significantly correlated with any of several variables that are indicators of the firm's progress through the venture capital cycle (including number of rounds, total investment, and longevity).

  • The rates of patenting differ substantially from sector to sector within the industry, indicating that even among software firms there are differences in the use of patents.

Section 2 of the paper explains the data and the methods that we use to analyze it. Section 3 presents the empirical findings. Section 4 analyzes the implications of the empirical findings. Section 5 is a brief conclusion.

Section snippets

Data

This paper responds to the gap in the literature discussed above, by analyzing the relation between the patenting practices of software firms and their acquisition of venture financing and progress through the venture capital cycle. Given the relative lack of data on private firms and in an effort to test the hypotheses developed in Mann (2005a), we decided that a study of venture-backed software firms – for which there is at least some data – would be a good proxy for a study of new entrants

Results

The purpose of the research is to examine the relation between patenting and venture capital investment and performance data. The data shed light on a number of related questions not previously examined in the literature. Accordingly, before we turn to that point, we provide descriptive information about patenting rates and differences in patenting by location and sector.

Analysis

The data presented in Section 3 are limited in a number of ways. For one thing, the dataset includes a narrow slice of the software industry: young firms that received their first round of venture financing during a relatively short period preceding the market crash in 2001. As explained in Mann 2005a, patents play a very different role in mature firms. Moreover, there is good reason to believe that the commercialization strategies of startup firms that are not venture-backed might differ

Conclusion

The question of whether patents actually foster innovation is an intractable one that cannot easily be resolved by empirical evidence, primarily because it is impossible to provide comparable datasets in which the same opportunities for innovation are available to firms with and without the incentives and constraints provided by a system of intellectual property. To be sure, historical data on such questions strongly suggest that intellectual property has a significant effect on the direction

Acknowledgments

The authors thank Ashish Arora, David Hsu, Josh Lerner, and Rosemary Ziedonis for comments, Tracey Kyckelhahn for assistance with data collection and statistical analysis, and PWC Moneytree and VentureSource for providing complimentary access to data used in this project.

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