How Startups Decide When to Sell

A MODEL BY ANDREA FOSFURI SUGGESTS THAT STARTUPS WITH MORE CAPABLE FOUNDING TEAMS CAN AFFORD TO WAIT UNTIL THEIR IDEA HAS BEEN DEVELOPED INTO A PROPER INNOVATION, WHILE THOSE WITH LESS CAPABLE TEAMS HAVE TO COMMIT TO THE EARLY, LESS LUCRATIVE MARKET

A lucrative exit is the final goal of many startups. All of them face a dilemma between selling early at a lower price or investing in the development of their invention into a proper innovation and selling later at a higher price… but only if they survive. A paper by Andrea Fosfuri and co-authors Ashish Arora and Thomas Rønde, forthcoming in Management Science, studies the timing of sales and finds that it depends on the capability of the founding team. More capable teams tend to sell later; less capable teams tend to sell early, and those in the middle tend to stay flexible, not committing to an exit time.
 
The scholars also show that a startup is more likely to sell late when venture capital is more abundant and intellectual property protection is weaker. The same is true when developing the so-called absorptive capacity (i.e., the ability, that a buyer must possess, to understand, develop and integrate nascent technology) is expensive.
 

In the model developed by Professor Fosfuri and his co-authors, startups have limited resources, that can be allocated either to trying the early market (when a startup has only a patent or a prototype), or to developing the invention for the late market (with a functioning technology or a viable product). Development, though, requires scale-up and execution capabilities, which differ across startups and that, on average, are more common in established firms. Waiting for the late market can thus be risky, because startups are more prone than incumbents to errors in developing an idea into an innovation.
 
“For every Siri there is a Qwiki”, Prof. Fosfuri says. Siri developed its virtual assistant in stealth mode for more than two years, then marketed the technology as an app before being acquired two weeks later by Apple. The automated video startup Qwiki, on the contrary, rejected a $100mln offer from Google in 2011, only to be acquired for $50mln by Yahoo two years later.
 
On the other hand, potential buyers can participate in the early market only if they have enough absorptive capacity. Thus, only a subset of the potential buyers participate in the early market, which translates into less competition and a lower price. More subtly, fewer participants also mean a lower likelihood of a good match between the startup and the buyer. Part of the value of a startup, the authors explain, is idiosyncratic: it depends on the fit with a buyer’s technology, and a good fit is less likely when only a few buyers participate. Any circumstance that reduces the number of buyers participating in the early market (such as the cost of developing absorptive capacity) is an incentive for startups to only try the late market.
 
Since the capabilities of the founding team are the most relevant resource for a startup, startups with capable managers go for the late market, while those with less capable teams are forced to commit to the early market. Founding teams with intermediate execution capabilities dedicate resources to both finding an early buyer and developing the invention.
 
Some factors can affect the timing choice. Greater intellectual property protection, for instance, makes trying the early market less expensive (startups don’t have to worry about other firms using their ideas) and weaker protection can induce startups to stay in stealth mode until a late market. Greater availability of venture capital, furthermore, leads to a reduction in execution failures, i.e. an increase in the probability to reach a later stage. The paucity of startups in the early market due to venture capital abundance, the authors observe, can discourage incumbents from developing absorptive capacity and this can be one of reasons why American companies are cutting their investments in science.
 
Ashish Arora, Andrea Fosfuri, Thomas Rønde. “Waiting for the Payday? The Market for Startups and the timing of Entrepreneurial Exit”, forthcoming in Management Science, published online in advance.

by Fabio Todesco