Anne Marie Knott

Entrepreneurial Risk and Market Entry

This paper attempts to reconcile the risk-bearing characterization of entrepreneurs with the stylized fact that entrepreneurs exhibit conventional risk-aversion profiles. We propose that the disparity arises from confounding two distinct dimensions of uncertainty: demand uncertainty and ability uncertainty. We further propose that entrepreneurs will be risk averse with respect to demand uncertainty, yet “apparent risk seeking” (or overconfident) with respect to ability uncertainty. To examine this view, we construct a reduced-form model of the entrepreneurs entry decision, which we aggregate to the market level, then test empirically. We find that entrepreneurs in aggregate behave as we predict. Accordingly, risk-averse entrepreneurs are willing to bear market risk when the degree of ability uncertainty is comparable to the degree of demand uncertainty. Potential market failures exist in instances where there is a high demand uncertainty but low performance dispersion (insufficient entry), or low demand uncertainty but high performance dispersion (excess entry).

On the Strategic Accumulation of Intangible Assets

The resource-based view holds that firms can earn supranormal returns if and only if they have superior resources and those resources are protected by some form of isolating mechanism preventing their diffusion throughout industry. One isolating mechanism that has been proposed for intangible assets is their accumulation process. The hypothesis is that intangible assets are inherently inimitable because would-be imitators need to replicate the entire accumulation path to achieve the same resource position. Thus, entrants can never catch up to incumbents.An interesting challenge to this hypothesis is counterfactual evidence that entrants sometimes outperform incumbents. Such counterfactual evidence should not exist if the theory is strictly correct. This paper attempts to reconcile resource accumulation theory with the counterfactual evidence. We do so by building an intermediate good-production function for a firms intangible asset stocks. We test the contribution of the intangible asset stock to the firms final good-production function and examine the extent to which that asset stock deters rival mobility in the pharmaceutical industry.We find that the asset accumulation process itself cannot deter rivals, because asset stocks reach steady state rather quickly. Entrants can achieve an incumbents intangible asset stock merely by matching its investment until steady state. Thus, we conclude that the accumulation process per se is not an isolating mechanism. While this is perhaps the most important contribution, another contribution is an empirical methodology for characterizing the accumulation function.

Nirvana efficiency: a comparative test of residual claims and routines

Two widely adopted views of firm efficiency are agency theorists’ residual claims and organization theorists’ routines. The agency view holds that ownership structures (and their proxies) are the primary source of efficiency differences between firms. The organization theory view holds that organizational routines are the primary source of efficiency differences between firms. We conduct an empirical test that compares the relative value of residual claims and routines in generating firm efficiency, while controlling other factors. We find support for both views, but more importantly find that the average value of routines is roughly an order of magnitude higher than residual claims. # 1999 Elsevier Science B.V. All rights reserved. JEL classification :L 2

Implications of Innovation Measurement

We introduce and test a firm-level innovation-efficiency measure new to the finance literature. The measure, RQ, defined as the firm-specific output elasticity of R&D, was first developed in the management literature. RQ has low correlation with existing innovation input, output and efficiency measures. We test RQ in a number of innovation tests common to the finance literature and find that RQ is robust in all tests of firm value even after controlling for previous innovation measures. The results suggest that RQ may serve as a relevant complementary measure of a company’s innovation.

Outside CEOs and Innovation

Research Summary: Innovation is the principle driver of firm and economic growth. Thus, one disturbing trend that may explain stagnant growth is a 65% decline in firms’ R&D productivity. We propose that the rise of outside Chief Executive Officers (CEOs) may be partially responsible for the decline because those CEOs are more likely to lack technological domain expertise necessary to manage R&D effectively. While this proposition was motivated by interviews with Chief Technology Officers (CTOs), we test it at large scale. We find that firm R&D productivity decays during the tenure of outside CEOs relative to that of inside CEOs. We further find this effect is more pronounced for firms with high R&D intensity and for firms employing outside CEOs with more remote experience, lending circumstantial support for the underlying assumption regarding lack of expertise. Note that this is not a call for boards to avoid outside CEOs, rather it is recommendation to consider the implications for innovation. Managerial Summary: While outside CEOs offer advantages over internal candidates, we argue one unintended consequence is weaker innovation. This argument was prompted by two coincident trends: a 65% decline in companies’ R&D productivity and a doubling of outside Chief Executive Officers (CEOs). The argument was reinforced by interviews with Chief Technology Officers (CTOs), who recounted shifts in orientation from R&D as an investment to R&D as an expense that occurred shortly in response to a new CEO. We felt this shift was more likely with outside CEOs because they may lack technological domain expertise necessary to effectively manage R&D. Our results are consistent with the argument—company R&D productivity decreases under outside CEOs. Note, however, that we don’t advocate avoiding outside CEOs, rather we recommend R&D firms consider technological domain expertise during CEO hiring.

The Puzzle of Market Value from R&D

Theory holds that if firms have been investing optimally, then increases in R&D should decrease market value. However, a substantial empirical record demonstrates the opposite: increases in R&D increase firms’ market value. To resolve this puzzle we develop and validate an analytical model linking R&D to market value, and provide empirical evidence that R&D does indeed drive market value in the manner explicated by the theory. We further find that the stylized fact of market value increasing in R&D stems from substantial (68% of firms) underinvestment in R&D. For that subset of firms, increasing R&D brings them closer to optimal and accordingly increases their market value. However, for firms whose investment exceeds the optimum, increases in R&D decrease market value, as theory expects. The suboptimal investment appears due to the fact firms use industry rules of thumb rather than optimization to establish their R&D investment. They likely resort to these rules of thumb because they lack precise knowledge of their R&D productivity. Such lack of knowledge is not surprising given that neither of the leading academic measures of firms R&D productivity (patents or TFP) is consistent with all the model’s propositions.

Multi-Divisional Structure and Innovation

A fundamental question in corporate strategy is how headquarters in multibusiness firms can create value above and beyond the burden of its own overhead. The leading theories from Chandler and Williamson hold this is possible through resource allocation across businesses. Yet there are multibusiness firms for whom reallocation opportunities are limited, e.g., chains. Accordingly, we propose, model and test an alternative theory, one in which HQ facilities market-like dynamics between businesses that fuel innovation and growth. Whereas Chandler’s and Williamson’s theories involve the visible hand of managers, ours involves an invisible hand of managers. We construct an interacting agent model of the theory, which yields three propositions relating multibusiness structure to firm growth. We test those propositions in the banking industry, and obtain results consistent with the model’s predictions. In particular knowledge growth increases in the number of units, heterogeneity in their knowledge and increases then decreases in their geographic distance. Interestingly, once we account for these structural elements, scale and hierarchy both suppress innovation. Thus, neither Williamson’s nor Chandler’s theories hold in our setting (consistent with the argument motivating the need for an additional theory).

Reconciling the Firm Size and Innovation Puzzle

Since Schumpeter, there has been a lively debate regarding the optimal firm size for innovation. Empirical results have settled into a puzzle: R&D spending increasing with scale, while R&D productivity decreases with scale. Thus large firms appear irrational. We propose and test two alternative resolutions of the puzzle: 1) that it arises from measurement problems, and 2) that firm size endogenously drives R&D strategy, and that the returns to R&D strategies depend on scale. To test both propositions we use recently available NSF BRDIS survey data of firms R&D practices (strategies) as well as a broader measure of R&D productivity. Using the broader measure, we find that both R&D spending and R&D productivity increase with scale—thus offering one resolution to the puzzle. We further find that while large firms and small firms differ in the types of R&D they conduct, there is no type whose returns decrease in scale—there are merely types for which the small firm penalty is less severe. Thus Schumpeter appears to be correct--large firms are the major engine of growth, they both spend more in aggregate than small firms, and are more productive with that spending.

Outsourced R&D and GDP Growth

A major trend over the past few decades is open innovation. Interestingly this trend coincides with a substantial decline in R&D productivity. This paper examines whether these trends are related. Looking at one form of open innovation (R&D outsourcing), I find it has increased 2050%. I further find it is unproductive -- it generates no increase in revenues. This result is robust to controls for the type of firms who outsource, and the type of projects they outsource. Moreover neither the productivity of outsourced R&D nor internal R&D has changed over time. This is encouraging. It suggests firms can restore their R&D productivity and by gradually insourcing R&D.

Equity Stakes and Exit: An Experimental Approach to Decomposing Exit Delay

Exit delay is an important problem for entrepreneurs as well as managers, however it is not well understood. One reason for the limited understanding is that rational theories of delay and behavioral theories of delay both anticipate that delay increases with the magnitude of sunk cost and the degree of uncertainty. Accordingly it is difficult to disentangle the two forms of delay. Further within behavioral delay, there has been limited effort to isolate which of the numerous proposed mechanisms underpin it. We attempt to do both by conducting a laboratory experiment for which optimal exit is well-defined and in which an entrepreneur group with equity stakes is compared to an advisor group whose compensation was based only on quality. The experiment yields three findings. First, we find that equity stakes induce both rational delay and behavioral delay. Entrepreneurs with equity stakes have near optimal exit thresholds, but they have more pronounced asymmetric updating than advisors. Second these differen...