When Do Employees Become Entrepreneurs?

Entrepreneurs often get their ideas from working as employees in established firms. However, employees with ideas can also become intrapreneurs, or even managers of corporate spin-offs. This paper shows how innovation and entrepreneurship are influenced by company policies. Using a multi-task incentives model, we identify a trade-off between focussing employees on their assigned tasks, versus encouraging their exploration of new ideas. We show how the rate of innovation, and the organizational structure of new ventures (startups, spin-offs, internal ventures) depend on factors such as the entrepreneurial environment and the allocation of intellectual property rights. Tel: (650) 723-6815 Fax: (650) 725-6152 E-mail: [email protected] I gratefully acknowledge financial supported from the Stanford Center for Entrepreneurial Studies. I would like to thank Wouter Dessein, Denis Gromb, Hans Hvide, Kevin Murdock, John Roberts, Garth Saloner, Kathy Spier, Scott Stern, Dennis Yao, Michal Waldman, Julie Wulf and seminar participants at Cornell University (Johnson School), Dartmouth University (Tuck), London School of Economics (FMG), NBER (Organizational Economics) Northwestern University (Kellogg), Stanford University (GSB), Stockholm (SIFR) University of British Columbia (Vancouver), University of New South Wales (Sydney), and University of Pennsylvania (Wharton) for their helpful comments. All errors are mine. PLEASE DO NOT QUOTE BEFORE OBTAINING LATEST VERSION AT http://faculty-gsb.stanford.edu/hellmann/index.htm. Where do entrepreneurs come from? Employees of established companies turn out to be one of the most important source for entrepreneurship. The semiconductor industry, for example, has an impressive genealogy, where, generation after generation, employees left their parent company to launch the next entrant.1 In a sample of fast-growing private companies, Bhide (1994) finds that “71% of all founders had replicated or modified an idea encountered through previous employment.” Similarly, Cooper (1985) reports in a broad cross section of industries that 70% of all founders pursued opportunities closely related to their previous employment. A popular response is that established firms are “stupid” to miss out on all these opportunities. To economists this hardly provides a systematic explanation.2 A central tenet of this paper is that the departure of employees to become entrepreneurs can be understood as a natural equilibrium outcome in the process of innovation. In addition, we stress that it is not the only possible equilibrium outcome. While some employees leave, others stay to develop their innovations internally, turning employees into intrapreneurs. 3M, for example, is famous for its policies that allow employees to use 15% of their time to develop new ideas. The company also has an objective of generating 25% of its sales from products that are less than five years old (See Bartlett and Mohammed (1995)). Other firms use their employees’ innovations to found spin-offs. Thermo-Electron is an example of a company that makes extensive use of spin-offs (See Allen (1998)). To get a better understanding of the supply of entrepreneurs, we need to ask how companies handle employee innovations? This paper examines the question of when employees become entrepreneurs from an economic theory perspective. It jointly addresses the two fundamental questions of when employees generate innovations, and whether these innovations are developed inside or outside the firm. The analysis is based on four key ingredients: 1. Employee-driven innovations: Our analysis is concerned with regular employees working in a company’s main line of business, rather than employees specifically hired for R&D.3 As part of their planned activities, employees serendipitously obtain new ideas, that fall outside their assigned job task. The attraction of exploring these unplanned ideas is that employees may generate innovations that create economics rents, larger than they could hope for by sticking to their 1The “traitorous eight” left Shockley Labs to create Fairchild Semiconductor, which itself saw its employees starting, among others, National Semiconductor, Intel, AMD and LSI Logic, which in turn became parents to Cypress, Zilog, Sierra Semiconductor and many other semiconductor companies. 2This “stupidity” notion has been popularized by Smith and Alexander (1999), who describe how Xerox “fumbled the future” by not capitalizing on some of its inventions for the personal computer, such as the mouse. Interestingly, Smith and Alexander put little emphasis on the fact that Xerox’s main line of business was photocopiers, which was highly successful and profitable firm during this period. Chesbrough (2003) provides a more thoughtful analysis of the Xerox experience. 3This distinction also exists in the law, which differentiates between employees hired to invent, versus others.