R&D Competence, Diversification, and Going Public

Abstract

We examine the effects of differential initial competence within highly innovative startup firms on their innovation strategies and growth. Using a detailed project-level development database for private firms in the drug industry sector, we show that firm R&D competence is persistent over long periods of time. This suggests that the large part of the cross-sectional variation in R&D performance is initially determined. Based on the persistence of R&D competence, we find that firms with high initial competence are more likely to be exploitive by focusing on their best segment and grow faster and more successfully than firms with low initial competence. Specifically, they exit through an IPO earlier or receive greater amounts of venture capital funding. By contrast, firms with low initial R&D competence tend to be explorative, operating in multiple segments (diversifying), to increase the value of their innovation under the option-like payoffs of innovation. Medicare Part D legislation as an exogenous shock to diversification incentives suggests a likely casual relationship between diversification and firm growth. Our results are consistent with persistent initial competence leading to different innovation strategies and growth.