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Stanford Professor: the power and pitfalls of strategic alliances

Strategic Alliances Strategic Alliances
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When two biotechnology firms joined forces, a one-sided agreement led to the untimely demise of the partnership.

While corporate venturing may be the most intense way that firms interact with startups, it is not the only one.

Another common approach is strategic alliances, when a large firm and a startup agree to cooperatively pursue a project or product, typically in an emerging technology.

A key rationale for these joint efforts relates to the difficulty of assessing startup firms.

Financial investors often have a tough time figuring out whether a new biotechnology or semiconductor company really has a breakthrough technology.

Young firms tend to turn to alliance financing when there is particularly great uncertainty about their prospects and those of their industry as a whole.

Rather than trying to interest sceptical public investors or venture capitalists of their prospects, they turn to corporations for alliance funding.

The larger company’s greater insight into the nature of the technology the firm is working on allows it to make successful investments at times when uninformed public investors are scared away.

Like a venture deal, an alliance typically allows the larger firm to provide funding to the risky technology firm in stages with payments being conditional upon, for instance, innovative progress, the production of a prototype, or the initiation of a phase II clinical trial.

Larger firms also attempt to address these concerns by entering into detailed agreements.

Strategic alliance contracts can run many hundred of pages, spelling out a wide variety of contingencies and how they will be addressed.

The corporations are typically careful to reserve for themselves many of the key control rights, which allow them to guide the strategic direction of the projects.

The time and effort devoted to negotiating these agreements appears to reflect the extent of the uncertainty surrounding the technology.

In many cases, the larger firm will also take equity in the firm, in the hopes of making sure that everyone is “on the same page”.

Strategic alliances have emerged as a primary way in which startups in many emerging industries get funded. But here, too, all is not simple. Numerous distortions can creep in, which lead to less-than-ideal contracts.

In many cases, the larger firms have ample financial reserves, while the startup is needy.

Particularly at times when it is hard to raise funds from the public markets, the smaller firm may feel compelled to under-take an alliance in order to survive.

These imbalances can lead to the signing of one-sided agreements, where all the power is in the hands of the corporation, even though it would make sense for the startup to make many of the decisions.

Philippe Aghion and Jean Tirole developed a model that suggests that one-sided agreements will lead to fewer innovations than ones where neither of the parties suffers from financial constraints, and can arrive at an optimal agreement, which will typically be more balanced.

In addition, the business development officers at the larger firms who negotiate these agreements face a dilemma.

In many industries, the ultimate success or failure of the agreement will often not become clear for many years; in sectors like biotechnology, the verdict will not come in for a decade or longer.

By this point, the negotiators will be off to a new job, probably at another company.

Evaluating the business development group on the ultimate success of the deals they negotiate is almost impossible. Instead, firms tend to look at other things, such as the extent to which the terms in the agreement favour the corporation.

These career concerns can also lead to agreements that are not the most conducive to success.

The dangers of the misshapen relationships that these pressures lead to can be illustrated by the alliance between Ciba-Geigy, a predecessor to the Swiss pharmaceutical giant Novartis, and young Silicon Valley drug delivery specialist ALZA.

ALZA had turned to an alliance strategy after its promising startup ran aground: the California firm had quickly raised a substantial war chest from the public markets in the late 1960s and early 1970s, and just as quickly burned through it developing products that did not work.

The two firms signed a research agreement in 1978, when ALZA was on the verge of bankruptcy.

Although the bulk of ALZA’s technologies were covered by the alliance, the young firm retained the right to also engage in a variety of independent activities, including alliances to exploit technologies that did not conflict with the topics being jointly explored with Ciba-Geigy.

Due to ALZA’s financial weakness at the time of the alliance, Ciba-Geigy was able to obtain vast control rights, such as eight of ALZA’s eleven board seats, majority voting control, extensive information rights, and the ability to guide 90 percent of ALZA’s research activities through a number of review panels that were dominated by Ciba-Geigy representatives.

Despite these seemingly ironclad control rights, numerous tensions arose over the exact type of research the ALZA researchers should be conducting.

In particular, Ciba-Geigy was concerned about other research projects and collaborations for which ALZA representatives kept seeking permission to establish with third parties. Although the boards ultimately approved most of ALZA’s, ALZA representatives became frustrated at the long delays associated with the process. As a result, ALZA scientists began bypassing the various review panels and directly contacting senior Ciba-Geigy officials to engage in outside arrangements.

While detailed reporting and monitoring processes had been stipulated in the original agreement, these proved very difficult to enforce.

Ciba-Geigy officials were also concerned that ALZA scientists were publishing material in journals that disclosed their proprietary technology or might be employed in ALZA’s collaborations with other pharmaceutical firms.

As a result, Ciba-Geigy became increasingly reluctant to disclose its own technologies in the area of drug delivery to ALZA. Ultimately, these tensions led to the dissolution of the research collaboration at the end of 1981.

This conflict while perhaps extreme, illustrate what can go wrong in these alliances.

This one-sided nature of the agreement, brought about by the differing positions of the two firms at the time it was negotiated, created a cascading series of problems that were ultimately impossible to resolve.

But just as with corporate venturing, in many cases, large and small firms are able to overcome their differences, and to create real value from their collaborations.

Not only can we offer many stories of such fruitful partnerships between firms, but more systematic studies also document such success. For instance, Ben Gomes-Casseres, Adam Jaffe, and John Hagedoorn compare pairs of firms that from strategic alliances with otherwise similar firms that do not.

They seek to understand whether these pairs of firms successfully transfer innovative knowledge – a key objective behind the typical alliance. To measure this, they look at how frequently the firms cite each other’s patents.

While some knowledge flows are no doubt accidental or involuntary, if the alliances are fulfilling their intended role, greater interactions between the parties should lead to more mutual citations of each other’s work.

They find that if firms have one recently formed alliance, there is only a modest increase (6 percent) in the probability that they will cite each other.

As the relationship deepens, however, the knowledge flows accelerate: firms with alliances that are three or more years old have 19 percent more citations than nonallied firms, and pairs of firms with seven or more alliances have 63 percent more citations.

These effects are particularly strong for firms that have a more intensive alliance- for instance, if one of the firms purchases equity in the other-or have headquarters close to each other.

These patterns suggest that alliances, just like corporate venturing, do seem to be having real effects in boosting innovation.

 

Reprinted by permission of Harvard Business Review Press. Excerpted from The Architecture of Innovation: The Economics of Creative Organizations. Copyright 2012 Harvard Business Publishing Corporation. All rights reserved.

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