Benefiting from Rivals’ Breakthroughs

Common sense would dictate that a competitor’s breakthrough is bad news for a company. But the company’s investors might think otherwise. Anita M. McGahan, Everett W. Lord Distinguished Faculty Scholar and professor at Boston University’s School of Management, and Brian S. Silverman, J.R.S. Prichard and Ann Wilson Chair in Management at the University of Toronto’s Rotman School of Management, studied U.S. patent filings by 4,168 companies from 1975 through 1999 and subsequent moves in the capital markets. As expected, they discovered that when a company files a patent that is important — a breakthrough that is cited by many subsequent patent filings — its investors are enthusiastic. But they found that a company’s investors are also upbeat when one of its established competitors files an important patent. The company’s “Tobin’s Q” — the ratio of its financial market value (think stock market capitalization plus outstanding debt) to the replacement value of its assets — tends to increase when those filings are announced.

So to the extent that investors’ sentiments include rational expectations of how the company can generate commercial value from its assets, an innovative competitor is a good thing. A breakthrough could lead to lucrative new market segments, areas in which a company might find new growth, even if it is not the initial leader.

On the contrary, when innovation is introduced into an industry from outside its circle of recognized competitors, it sends an entirely different message. Outsiders — whether they are university researchers, tinkerers in their garages or corporate research and development centers — have more potential to turn market dynamics upside down, it would seem. New telephone technologies like cellular phones and Voiceover Internet Protocol telephony, for example, threaten the business model of existing telecommunications providers. Thus, investors aren’t so keen when a new player owns an important piece of intellectual capital, be it a technology or a business method.

But outsider innovators don’t always have the upper hand. “Industry structure is critically important to who wins from innovation,” says McGahan. “The relationship among industry structure, market power and innovation is something we need to understand better.”

Industry structure includes the importance of patents and of complementary assets, the authors explain in their 2006 paper “Profiting from Others’ Technological Innovation: The Effect of Competitor Patenting on Firm Value,” a paper that has been accepted for publication in Research Policy. Industries like semiconductor manufacturing or pharmaceuticals, for example, have strong patent appropriability regimes. Patents convey a lot of protection to their holders, in part because there is a high incentive and established mechanisms to bring patent-infringement lawsuits. On the other hand, in industries like manufacturing, patents afford little protection because in many cases, they can be reverse-engineered or effectively replicated without infringing on the original patent, McGahan asserts.

So the researchers took a look at industries at both ends of the spectrum — those with strong and weak patent regimes — according to a Yale University survey of senior R&D executives in the 1980s. Here they found that in industries with weak patent regimes, most important innovations, even those by industry outsiders, are a positive for the company. The idea is that newcomers will not be able to leverage their new patents to take business away from industry insiders without the insiders themselves benefiting. In these environments, “if you are an insider, you may have market power that doesn’t only protect today’s profits.” explains McGahan. “It may also exclude outsiders from winning from innovation.”

Likewise, the authors looked at industries in which complementary assets — namely sales and service infrastructures — were important. Again, in some industries, sales and service forces are vital for competition. It’s very hard, for example, to get prescription drugs to consumers without a strong sales force to get the word out to doctors.

In industries where sales and service are crucial, as determined by the same Yale survey of senior R&D executives, important innovation by outside inventors is a positive for industry insiders. In other words, when a sales or service force is vital in getting products to customers, incumbents benefit from innovations because new entrants will need to leverage the incumbent’s complementary assets in order to exploit their patents’ commercial value. “If I come up with [an invention] in my garage,” explains McGahan, “the companies that are going to make the money off it are the ones with the sales force. They can either copy what I’ve done or they can license it from me at favorable terms.” Thus, when a company has a great sales force, investors tend to cheer innovation regardless of its source.

For more information, contact Anita McGahan at amcgahan@bu.edu or Brian Silverman at silverman@rotman.utoronto.ca. The paper can be downloaded from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=902933.