Driving Innovation: Firm Diversity and the Startup Ecosystem

Much has been written about the startup economy and the budding American entrepreneurial spirit in response to the Great Recession. The fact that the United States has been experiencing the largest expansion of venture capital deal-making since the dot com bubble lends credence to this focus. However, the majority of venture capital deals are concentrated in just six urban areas: the Bay Area, New York, Boston, Los Angeles, Seattle, and Austin. These cities have dominated commercialized innovation for years, but other cities around the country are attempting to create startup ecosystems through public-private incubators, including 1871 in Chicago, Launch Tennessee in Nashville, and Scale Up Milwaukee in Milwaukee. Whether empowering small entrepreneurs will pay off is an important question and one on which Ajay Agrawal, Iain Cockburn, Alberto Galasso, and Alexander Oettl shed some light in their recent paper, “Why are some regions more innovative than others? The role of small firms in the presence of large labs.” These authors find that a diverse makeup of firms in a given region tends to increase innovation relative to homogeneous regions.

Agrawal et al. investigate the relationship between large firms conducting commercial research and the presence of smaller firms in their ecosystem. The authors use United States Patent and Trademark Office data from 1975 to 2000, providing detailed information on regional patent activity and the affiliation of inventors filing patents. The key finding is that regional innovation is maximized in a diverse ecosystem, which is defined as a Metropolitan Statistical Area (MSA) having at least one large lab, one lab with approximately 54 inventors, and a number of small labs with an average of nine inventors. The authors propose that an abundance of small firms in the presence of large firms creates an environment that makes large firm innovators more comfortable with leaving their employers to start new companies.

The authors measure the effects of MSA diversity on the citation count for patents issued to inventors and find a large positive effect of diversity on the number of innovations per inventor. The authors use a five-year forward citation weight for patents as an indirect measure of patent value, meaning that the more citations attributed to a given patent, the more valuable that patent. Statistical analysis suggests that when the MSA is diverse, citation-weighted patents increase by about 17 percent. When the analysis is run looking at unweighted patent counts, the correlation between diversity and innovation remains significant but drops below nine percent. This implies that a diverse MSA leads not only to an increase in innovation but to an increase in innovation quality.

To better understand the relationship between firm diversity and innovation, the study considers the relationship between diversity and spin-out behavior, non-compete agreements, and large lab focus. The authors argue that the primary way diversity impacts innovation is through spin-out activity. Spin-out activity is defined as a new lab with a patent application in the first year of lab activity by an inventor who previously patented in a large lab. The team finds a significant effect of diversity on spin-out activity, but the results are limited because the data was restricted solely to patent activity. This restriction is limiting in that there is the potential for a small firm founder to have worked at a large firm without necessarily previously applying for a patent.

To counter this limitation, the researchers look at the effects of diversity and strong enforcement of non-compete clauses on innovation. Their reasoning is that when spin-outs are difficult to form, the effect of diversity on innovation will be limited. Indeed, when high enforcement is accounted for in regression analysis, results suggest that high enforcement of non-compete agreements has a negative effect on the level of citation-weighted patenting.

Another mechanism that influences the effect of diversity on spin-out activity is the level of focus in the MSAs’ large labs. Diversity should have a larger impact on spin-out activity when large labs are more focused and less willing to invest in commercializing innovations that “misfit” with their current strategies. The study analyzes the impact of focus and diversity on innovation and finds that the correlation is stronger if the large labs have a narrower focus. This implies that employees can spinout misfit innovations into new, small firms.

A notable limitation of the study is the reliance on patent activity as a measure of innovation, since not all innovation is necessarily patented. The authors also suggest that further studies could include additional factors that might affect innovation performance, including demographics, which would help provide a richer investigation of innovation markets.

The policy implications from this study are mixed. They do not prescribe a singular response for cities looking to increase their innovation activity. Instead, the authors argue that regional innovation policies are state-dependent. In a region with many large firms but with few entrepreneurs, city officials may see returns through encouraging or sponsoring incubators or accelerators. However, in a region with many small firms and no large anchor firms, a city may be better off trying to attract large firms. Additionally, the implications of high enforcement of non-compete agreements suggest that a region as a whole may benefit from a loosening of enforcement, potentially to the detriment of larger firms.

Article Source: Ajay Agrawal et al., “Why are some regions more innovative than others? The role of small firms in the presence of large labs.” Journal of Urban Economics 81 (2014): 149-165.

Feature Photo: cc/(Philippe Lewicki)