Startups: Threats to Legacy Companies, or Opportunities?Published: June 17, 2010 in Knowledge@Emory
Small startup enterprises are often said to be the engine of job growth, thanks to the absence of legacy costs and the presence of lean, nimble management that hasn’t been around long enough to become calcified. But does the constant stream of market newcomers represent opportunities or threats to larger, established businesses?
The new kids on the block may indeed constitute more competition; consider the case of Encyclopedia Britannica. The high-priced encyclopedia heavyweight turned down a licensing deal with an upstart called Microsoft, only to see its revenues slide after Microsoft’s release of a competitively priced encyclopedia on CD-ROM, one of the factors contributing to Britannica’s bankruptcy filing in 1996.
But newcomers and legacy firms can actually benefit from each other, say faculty from Emory University’s Goizueta School of Business and the Emory University School of Law. The key is to address short-term and long-term issues in an effective manner.
“Small and startup firms do tend be more nimble and are willing to take on more risk than their big-company counterparts,” explains William J. Carney, a chaired professor of corporate law at Emory.
In fact when it comes to pharmaceutical and biotechnology companies, “small enterprises partner with big companies all the time,” says Carney, who is a board member of a 65-employee startup that launched in 1998. “From the moment we showed we had a viable chance at a new drug, we were contacted by Roche [a Basel, Switzerland–based global pharmaceutical company] and other firms.”
The arrangement is beneficial to both parties, he adds.
“Large pharmaceutical companies are concerned about the relatively low level of their pipeline,” Carney notes, referring to the number of drugs in development. “Because drug development can take so long, it can be more efficient to find a smaller company that has promising candidates and simply purchase it or establish licensing arrangements with it. From the startup’s viewpoint, the big company has the deep pockets to fund the years of research and development that can go into the new-drug process and run into the hundreds of millions of dollars.”
In 1990, for example, Roche bought a controlling stake in Genentech, one of the pioneers in the biotechnology segment. In 2009, Roche bought out Genentech’s remaining outstanding stock shares to ensure its continued access to Genentech’s drug discovery pipeline.
“Now the big question is whether or not Roche will continue to let Genentech operate as a stand-alone unit,” Carney says. “The same corporate culture that enables smaller companies to make advances—and makes them so attractive to slower-moving, large firms—may be threatened by big-company oversight.”
Big firm–small firm partnerships in the pharmaceutical and technology sectors may get most of the publicity, but Carney says there’s plenty of action going on in other industries, even “old economy” ones such as manufacturing.
“As foreign-based automakers continue to shift production to the U.S. in pursuit of operating and other efficiencies, small, niche supplier startups are springing up to service them,” he says. “This is particularly prevalent in the southern states, where right-to-work and other labor-related legislation can let manufacturers and their suppliers turn out competitively priced products.”
That’s brought Japanese automakers Toyota and Nissan to states like Kentucky and Tennessee, and German car companies like BMW to South Carolina. In February, South Korea’s Kia Motors Corp. opened a $1 billion automobile manufacturing plant in West Point, Georgia, that is capable of producing 300,000 cars annually.
While both sides may win in a big company–small company partnership, the larger firm may actually get the most benefits, according to Anne M. Rector, director of the Technological Innovation: Generating Economic Results [TI:GER] program that Emory Law jointly runs with Georgia Institute of Technology’s College of Management.
“Based on the work I do with in the TI:GER program, I’d say that in the life sciences arena, at least, the larger companies are mostly the beneficiaries of entrepreneurial ventures in the big companies’ industries,” she says. “In biomed, for example, a small company might be formed to develop a new diagnostic device; might get grants, and angel and venture capital money to move the device through early stages; and then might be bought out by a big company where the product fits with the big firm’s focus.”
This way, the bigger company doesn’t put up its own research and development funds, instead paying a premium for the small firm but acquiring a product that “has progressed downstream so much that the large company avoids the risk of losing a significant amount of R&D money,” Rector explains.
Carney adds that the partnership between big and small companies can also generate a wave of business for small, local suppliers, particularly in the automotive industry.
The trend represents a reversal of the old model of vertical integration long favored by car giants like Ford and General Motors.
“At one time, Ford and other companies thought it was more efficient and economical to own all of the assets involved in all of the stages of production,” Carney notes. “But in the long run, vertical integration can introduce significant inefficiencies that can be costly for a company to deal with. For some time the trend has been towards outsourcing component tasks and then integrating the products at a central point.”
Similarly, at one time Asian and European automakers depended on suppliers in their home countries, and a completed car would be transported to the U.S. for sale.
But as more overseas car companies set up shop in the U.S.—initially to get around prohibitive tariff and other restrictions—stretching the supply chain from Asia or Europe didn’t work well with the manufacturers’ just-in-time, or lean inventory, approach. The logical answer, says Carney, was to tap into local suppliers that are only too eager to fill the gap, especially with the virtual collapse of GM and Chrysler, two of the U.S.’s Big Three carmakers.
That’s not to suggest, however, that there aren’t challenges to the relationship between a startup and a larger, established company.
“Even though both companies often benefit when smaller firms partner with large ones, some stumbles can still occur,” says Charles Goetz, a senior lecturer of organization and management and a distinguished lecturer in entrepreneurship at Goizueta. “Large companies tend to grow bureaucratic, with a thick layer of middle management that may shy away from innovation. When a mature firm like this deals with a smaller, nimble company, the small firm may feel stifled and the management—which is what the big partner wanted to begin with—may leave. I’ve seen this happen with some frequency in the technology segment, but it can occur across industries.”
Indeed, when smaller firms try to partner with large ones, “simply getting your foot in the door to deliver a proposal to an established firm can be tough,” says Carney. “Often, they’ve already got established relationships with other suppliers and partners, so they may not be very interested in hearing what you’ve got to say.”
Despite that, he adds, in a slow economy like this, companies are keen to find new ways of increasing efficiencies and cutting costs, so an enterprise that can offer innovative goods or services at a competitive price point may indeed be able to get an audience with the right officials at the larger company.
“But once a smaller firm is able to swing a deal, it’s likely to face new challenges,” Carney notes. “For example, securing the capital to gear up and service the new, large-company customer can be difficult, especially in today’s constrained credit market. But a detailed business plan and good relationships with bankers may help to overcome that hurdle.”
A significant portion of the boost in today’s entrepreneurial activity has been driven by the recession, observes Jagdish Sheth, a chaired professor of marketing at Goizueta and a corporate strategist. The divide between entrepreneurs by choice and previous generations of entrepreneurs by necessity is important because it signals a trend, he adds.
“This time around, we’re getting more entrepreneurs who used to work for a large company but went into business for themselves because of widespread corporate layoffs,” Sheth says. “As a result, there’s a great pool of talent out there that large companies can tap. So I don’t believe that startups necessarily represent a threat to corporations. Instead they can present an opportunity to team with a nimble, proven partner.”
The way that big companies approach that partnership is important, he adds.
“There are three approaches that large firms can utilize to effectively incubate and develop their small-partner counterparts,” Sheth says. “One way is to set up a separate company that focuses on a corporate venture capital fund that exclusively invests in new businesses. By getting in at the startup or early stage, the VC company can likely get a stake at a relatively low price, and may be able to place the large parent company’s former executives into the startup in strategic positions.”
The networking company Cisco Systems Inc. utilizes this strategy on a regular basis, Sheth notes.
“Of course there’s more risk when you invest in a startup, but that can be reduced if you can get your own people in the company,” he says. “Further, if you wait till the startup has matured, you’re likely to pay anywhere from 15 to 100 times more for your stake.”
“Sometimes it’s not efficient for a large company to try to identify early stage entrepreneurs and sit on their boards,” Sheth says. “Instead, as a second approach, they may transfer funds to a third-party venture capital provider that has the expertise in taking a hands-on approach. Among other VCs, Sequoia Capital has a good record, having invested early on in companies like Yahoo!, Apple Computer, Atari, and Oracle."
Finally, he says, some large firms would rather employ a third, stealthy approach that won’t tip off competitors to their plans to develop new technologies or products.
“In this ‘stealth’ mode, a company may shift the smaller enterprise partner to an entirely different location, perhaps in another country,” Sheth explains. This so-called skunkworks approach is often used by defense contractors and pharmaceutical companies. Some favored locations include India, China, and Israel.
But those are tactical concerns, Sheth adds. Perhaps a deeper issue involves the way the management of the larger and smaller firms will or will not mesh.
“A large company must learn how to nurture its smaller partner in a positive way,” he says. “The power and resources asymmetry that exists between the two firms can present challenges to this positive nurturing posture and is a significant concern that should be addressed, not ignored.”
Another consideration is that most entrepreneurs launched their own business in the first place because they did not want to answer to a boss.
“So on the one hand, you’ve got a large firm that tends to be run like an autocracy,” Sheth says. “But this big company needs its upstart’s talent, so the bigger firm may have to bite the bullet and be willing to take on a subservient kind of role regarding its junior partner. This is where the big-small partnership may break down; but if the larger company is willing to be flexible and take on a nontraditional role, it can reap some significant benefits.”