Heard off the Street: Does going public cramp innovation?

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Selling shares to the public is a great way for young companies to generate the capital needed to continue innovating and growing. But being beholden to investors who are inordinately focused on quarterly returns can stifle a newly minted public company's entrepreneurial drive and innovation.

Stanford University finance professor Shai Bernstein found something interesting when he studied what happened to innovation after companies launched initial public stock offerings, or IPOs.

After analyzing about 1,800 companies that went public or considered an IPO between 1985 and 2003, Mr. Bernstein found the quality of innovation fell by about 40 percent in the five years after a technology-based company went public.

There were two reasons: tech-savvy inventors who spawned pre-IPO innovation left after the stock offering, and those who remained were less productive.

But Mr. Bernstein also found that the companies used cash from an IPO to acquire innovation, either by buying technology or hiring people who could generate it.

"It's not a story in which going public adversely affects innovation," he said. "It changes the way you innovate, but IPOs are crucially important for the innovation ecosystem."

The Stanford professor said he took a look at the issue because more than 40 percent of the companies that have gone public since 1970 were technology based. He wanted to examine whether issuing stock affected innovation.

Theoretically, there are two general views of what may happen.

Some believe IPOs help companies finance innovation because they provide capital companies lacked before tapping public markets. More money means more innovation.

But others feel the initial public offerings weaken the incentives of inventors whose genius made the stock sales possible. Going public gives outside investors a stake in their success, so the inventors may not be as motivated as they were when they reaped all the fruits of their labor. Or their newfound wealth may prompt them to leave and pursue new ventures they own and control.

In addition, public companies are more likely to succumb to short-term pressures from investors to bump up the stock price. That could result in chasing less risky projects that offer quick benefits and are easier to explain to investors.

"The drive to meet quarterly growth expectations may affect the focus on the long-term type of projects that may be the more innovative projects," Mr. Bernstein said. "There are potential downsides to going public."

However, he said the emphasis on generating revenue can lead to products coming to market sooner.

"These pressures may in fact be a positive thing," he said.

Mr. Bernstein said his research indicates that after going public, tech-based companies pursue more conventional projects, which runs counter to conventional wisdom that IPO cash boosts innovation. Mr. Bernstein also found that key inventors are more likely to leave after an IPO and that the quality of innovation generated by those who remain declines.

He measured innovation by examining almost 40,000 patents that companies were awarded before and after they revealed plans to go public. He also rated the quality of those patents.

Patents that relied on a wider range of technologies were rated higher. So were patents that were used as building blocks for patents that were subsequently issued. Mr. Bernstein said similar methods have been used by other studies and that "patents provide a reasonable proxy for the innovation of a firm."

Five years after an IPO, more than 20 percent of the patents held by companies Mr. Bernstein studied were acquired rather than developed internally. Moreover, the acquired patents "are of higher quality than the patents produced internally following the IPO," Mr. Bernstein wrote.

His work revealed that inventors were 18 percent more likely to leave a company after it went public and that the quality of patents developed by those who stayed declined 48 percent. The drop was mitigated by a post-IPO company's ability to attract new inventors who producer higher quality patents, Mr. Bernstein found.

He said the drop in innovation was not so drastic when the CEO of the company was also the chairman.

Mr. Bernstein believes holding both positions could make the executive less susceptible to short-term pressures and more inclined to pursue ambitious research and development projects. Having both jobs would make the executive more confident that he would not be dismissed for taking risks that did not pay off. Inventors were also less inclined to leave if the CEO was also the chairman, he said.

Mr. Bernstein said his research indicates companies have to consider the trade-offs between remaining private and going public, choices that will affect their research and development efforts as well as their ability to finance growth and retain talented workers. Despite the drop in innovation, there can be significant benefits to going public, he said.

"My study does not suggest that IPOs are negative," Mr. Bernstein said.

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Len Boselovic: lboselovic@post-gazette.com or 412-263-1941.


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