How IPO’s can affect innovation, talent, and entrepreneurship

Initial public offerings (IPOs) can alleviate financing constraints and help support important activities such as operations, R&D, and expansion. Despite these perceived benefits, new research finds that the transition to public equity – and the financial windfalls that follow – prompt many of a company’s early innovators to depart the firm, which has impacts on both innovation internally and at other firms.  The departures of founders and early employees from post-exit startups presents challenges and opportunities for venture development and entrepreneurial support organizations.

In Innovator’s Dilemma: IPO or No?, Stanford economist Shai Bernstein identifies the advantages and disadvantages of the IPO market, and then examines the consequences that IPOs have on corporate innovation and innovation strategy. In an analysis of more than 2,000 technology firms that submitted IPO filings (and produced roughly 45,000 patents during the eight-year study period), Bernstein finds that firms experience substantial declines in innovation quality after their IPO. A comparison of firms that went public and those that ultimately decided to withdraw their IPO registration suggests that the average quality of innovation declined by about 40 percent five years after the IPO event for the first group, while the latter group remained on their same innovation trajectory. In other words, “innovation simply become narrower, more focused, and more incremental after the IPO,” Bernstein writes.

One potential reason for the decline in innovation quality and originality, according to Bernstein, is that IPOs tend to lead to an increased likelihood that innovative employees depart the firm. Inventors were roughly 18 percent more likely to leave the firm after an IPO, and were more likely to go on to start new ventures. Some potential reasons for this, as proposed by Bernstein, are that early employees may receive substantial financial windfalls after going public, which may incentivize risk-taking, or that those workers could be more inclined to work in entrepreneurial environments.

Bernstein’s findings are similar to those drawn in Going Entrepreneurial? IPOs and New Firm Creation, research released earlier this year in the U.S. Census Bureau Center for Economic Studies. In that article, economists Tania Babina, Paige Ouimet, and Rebecca Zarutskie find evidence that going public increases the likelihood that a company’s employees leave for startups, but discover little support that employees leave for established firms.  They also present evidence that the positive shocks to personal wealth resulting from IPOs allow employees to better tolerate the risks of joining a startup.

It is worth noting that, although IPO listings are on track for their busiest year in nearly a decade, according to a recent report from Ernst & Young, they remain a small share of total exit activity. Research from CB Insights finds that of the 3,358 exits in 2016, only 98 were IPO’s, while a study cited by the Digest last year found that very few high-growth firms (2.2 percent) made an IPO in the 10-years after they appeared in the Inc. 500. Additionally, the ratio of VC investment to exits for the first half of 2017 was at a record high of 11.3 to 1, which suggests even fewer companies are reaching an exit and is takes them longer to exit when they do, according to a ZeroHedge analysis. While IPO’s are an interesting phenomenon, they remain quite uncommon.

Babina, Ouimet, and Zarutskie conclude their article by proposing that recent declines in IPO activity in the U.S. may be causally linked with declines in startup activity. This is because recent declines in IPOs means fewer workers may move to startups, which in turn would decrease levels of new firm creation. Interestingly, the authors find that acquisitions are also associated with employee turnover to startups, but at just one quarter of the magnitude compared to IPOs. Their model estimates that the decline in high-tech IPOs in the early 2000s explains roughly 8.2 percent of the next decade’s “missing employment” from high-tech startups.

The relationship between startup exits, employee departures, and declining innovation is important for practitioners in the technology-based economic development community to understand. As entrepreneurial support and venture development organizations mull the best options for their portfolio companies, successful IPOs are frequently viewed as a White Whale. While successful IPOs are still seen as evidence that a tech hub has “made it,” this recent research adds insight into what “making it” might entail: less innovation at the firm and more employee turnover. 

By focusing on talent instead of firm innovation, however, these findings are also important. Many venture development organizations (VDO's), for example, cite finding experienced C-Level workers for portfolio companies as a significant challenge. Despite research showing that companies become less innovative after an IPO, this does not necessarily mean that the qualities that made the firm innovative to begin with necessarily disappear. The research highlighted above suggests that, after an exit, founders, inventors, and other early employees are interested in starting their own companies or joining new startups – exactly the types of opportunities available with VDO’s.  These workers could also play a valuable mentorship or investment role in the startup community, especially when they have ties to a specific region.  Overall, the impacts and landing spots of the innovators that depart a company after an exit are worthy of additional attention from the research and practitioner communities.