Patents and their impact on the fundraising success04.03.2015 11:58
How important are patents as quality signals for start-ups? Do investors rely on them? To analyze this issue, the Swiss Start-up Monitor examined patents and the fundraising success of 164 Swiss start-ups.
The successful development of a new invention is a costly and uncertain process that typically requires external financial resources. However, assessing the value and commercial potential of new inventions can be difficult, especially for external parties. Prof. Dr. Dietmar Grichnik, Professor for Entrepreneurship at the University of St. Gallen (HSG) with the scientific lead of the Swiss-Start-up Monitor, states that “To assess the value of startups in early stages is challenging. Investors assume patents as a positive signal that increases the startup valuation ceteris paribus.” Therefore, signaling quality to investors is a central issue for start-ups.
Entrepreneurs face well-known challenges when raising financial resources required for growth and survival. This is usually due to two main factors. The first factor involves information asymmetries between entrepreneurs and potential external resource providers - a situation in which a start-up has more or superior information about the returns occurring from their investment than potential investors. Hence, external financing may be very costly due to adverse selection and moral hazard problems (Carpenter and Petersen 2002). Second, there is fundamental uncertainty inherent in new inventions and its potential economic value. This uncertainty characterizes the relationship between the innovative effort, or input into the innovative process, and its resulting outcomes (Arrow, 1962). Consequently, the decisions of the potential investors are based on subjective judgments which do not necessarily coincide with entrepreneurs’ assessment. Taken together, information asymmetries and uncertainty make it difficult to evaluate the expected value of an innovative firm. The question remains of whether signaling practices such as patents are an appropriate mechanism to attract external financing.
Higher investment for companies with patents
A comparison between 66 non-patenting start-ups and 64 start-ups with two or more patents and patent applications indicated a slight, yet significant difference in the investment sum. More specifically, non-patenting start-ups received an average funding of 374’000 CHF, while the patenting start-ups received 954’000 CHF on average. How can this result be explained? Patents are an effective mechanism for reducing information asymmetries between the patenting start-up and the external investor. This is because patents are ideal proxies for the quality assessment of start-ups: they are costly to obtain and easily observable and verifiable by outsiders (Czarnitzkia et al., 2013). Thus, entrepreneurs may signal not only the commercial potential of a start-up, but also the founders’ commitment to their invention. Furthermore, patents may serve as a signal for the unobservable and difficult to measure firm characteristics. According to the European Patent Office, an invention must be new, industrially applicable and involve an inventive step in order to be patentable. These requirements, as well as the associated certification process by the patent office, suggest that possessing a patent is the result of successful previous R&D, thus serving as a signal for the firms’ innovative capabilities (Czarnitzkia et al., 2013). Moreover, investors use start-up patents (or more likely, patent applications) as “evidence that the company is well managed, is at a certain stage in development, and has defined and carved out a market niche” (Lemley 2001, p.14). Finally, a deeper look at the age distribution of our sample shows that non-patenting start-ups are on average 4.5 years old, whereas start-ups with multiple patents have an average age of 6.9 years. This two-year age difference between the two groups may partially explain our result. That is to say, the older firms may have more patents simply because they might have done multiple investment rounds, as compared to younger firms.
To sum up, besides the original function of patenting to protect a new invention, through the reduction of information asymmetry and uncertainty patents may additionally serve as a signal to potential investors which may help start-ups attract external financing more easily compared to non-patenting ventures. However, even if patenting seems to be a good signal, a crucial point remains. To convey information to potential investors through patents also means leaking valuable information out to competitors. In order to gain a deeper understanding of the effects signaling has on the success of fundraising, other signaling mechanisms such as prototypes and third-party affiliations need to be analyzed.
The Swiss Start-up Monitor is a joint research initiative of the University of St.Gallen, ETH Zurich and University of Basel supported by the Commission of Technology and Innovation (CTI), Gebert Rüf Stiftung and AVINA Stiftung. The main goal is to build up an exclusive panel of Swiss start-ups in order to foster entrepreneurship on a micro- and on a macro-economic level. This aim will be achieved by collecting and analyzing data of Swiss start-ups on an aggregate and anonymous level, providing high data security and user controllability at any time. The recent sample size is 1832 start-ups in the public directory and 791 in the private area for registered user. Visit the Start-up Monitor Homepage to get more information: www.startupmonitor.ch.