Startup Licensing in the Shadow of R & D Competition

Aiming to uncover the R&D incentives of startup innovators, we study how startup firms transfer their intellectual property (IP). In particular, we examine how startups that lack productive capacity license their patented technology to downstream incumbent producers who have the R&D ability, post licensing, to produce a variant of the startup’s technology. Since startup firms usually have only one asset, their IP, such a variant technology can deter market entry. Thus, how one should best respond to this moral hazard challenge is of vital importance to these innovative market entrants. We argue that exclusive licensing contracts that involve a full front-payment are the optimal solution as they permit the startup to capture monopoly profits while diluting the licensee’s incentives to create a variant, allowing the startup to appropriate the licensee’s R&D cost. The above contract is not the obvious choice for startup firms as non exclusive contracts can dilute this moral hazard for all incumbents, allowing the startup to capture the R&D cost of all the licensees. Since exclusive front-loaded contracts are indistinguishable to a buyout our analysis offers support to the open innovation paradigm, where established incumbents frequently choose to acquire their technology through startup buyouts. Nonetheless, considering that the non-licensees still have the capacity to produce a variant the possible development of a variant technology diminishes the buyout price that the startup can hope for. Therefore, there is room for policies that aid startup firms in downsizing the fear of copying. For this purpose, we propose that interesting parallels can be drawn between the way the music industry monitors and enforces IP rights through Collecting Societies and the need of startup innovators to reduce this fear.