Usefulness of the article : Startups and innovation in SMEs are attracting increasing attention both in public debate and in political discourse. The first part of this note focused on explaining the role of young companies in the dynamics of innovation. This second part looks at the specific difficulties that startups may encounter in their innovation process. It also discusses the potential benefits of public support.

Summary:

• SMEs and startups play a very important role in the production of so-called disruptive innovations.
• They also face greater difficulties in their innovation activities. Access to capital markets, which is already difficult for financing innovation activities, is even more so for this category of companies.
• They also encounter difficulties specific to them, both in the R&D phase and at the time of commercialization.

In October 2020, WIPO published its 13th edition of the world’s most innovative countries. This caused quite a stir in France. The country rose four places, from^16th to^12th. In 2021, it gained another place to reach^11th position.

One of the main reasons for this change is the development of a strong startup ecosystem.

Since then, the press has often referred to France as a new « startup nation. » Interest in this ecosystem shows no sign of waning with the major investment plan launched on Tuesday, October 12, 2021, by French President Emmanuel Macron. The plan gives pride of place to private R&D and disruptive innovation, in which small and young companies play an essential role.

Public support seems all the more welcome given that SMEs and startups face greater difficulties in their innovation activities. On the one hand, access to the financial market, already difficult for all companies, is even more complex for this sub-population (see part 1). In addition, certain barriers exist that are specific to them. This note focuses on this second category of barriers.

1) The « liability of newness, » a long-recognized phenomenon

Since the 1960s, it has been established that young companies and organizations are more likely to fail and go bankrupt in their early years. This phenomenon is referred to as the « liability of newness. » The more innovative a company is, the stronger this phenomenon is. It is often explained by a lack of access to financial markets and a strong need for young companies to professionalize and develop their skills.

Indeed, young companies usually find it more difficult to implement an innovation strategy that is sufficient to capture the returns on their innovation. This is due in particular to their lack of skills, resources (especially human resources), legitimacy (information asymmetry), and networks. Numerous papers have shown that non-financial aspects, particularly organizational and human aspects, play an important role in the growth and success of startups (Stinchcombe 1965, Hellman and Puri 2002, Söderblom, Samuelsson et al. 2015, Veugeler and Schneider 2018).

2) Structural difficulties in industrialization activities

A. The often-cited phenomenon of the valley of death

One of the first difficulties documented in the literature is the Valley of Death. Frank, Sink et al. (1996) define the valley of death as follows: « The valley of death occurs when the developer of a particular technology has successfully demonstrated its effectiveness but is unable to obtain the financing necessary for scaling up and manufacturing. » In other words, it refers to the difficulties encountered by a JEI (Jeune Entreprise Innovante, or Young Innovative Company) that has successfully developed a technology during an R&D project but is unable to raise the necessary funding to industrialize and commercialize its innovation. It is therefore mainly a financing problem that occurs in the so-called start-up and growth phases, which are the final phases in the life of a startup.

This period is characterized by a high need for liquidity without equivalent inflows. The need for cash flow is a classic phenomenon in any production process and a traditional element of corporate finance analysis. However, it is accentuated here by the total absence of other activities that generate revenue, as well as by uncertainty about the success of commercialization. For young innovative companies, we talk about cash burn rate, which is the speed at which a young innovative company spends and exhausts the funds raised in venture capital before generating its first positive cash flows.

The valley of death is a capital problem. The solutions are therefore mainly financial. On the private side, this involves the development of late-stage activity in private equity. This often corresponds to Series C or D fundraising, i.e., a third or fourth round of fundraising. In France, despite the clear growth of venture capital activities over the last decade, funds specializing in late-stage financing remain in the minority. Venture capital activity is mainly concentrated in the early-stage segment, which intervenes upstream. According to the venture capital barometer, published annually by EY, in 2020 Series A and B rounds were almost twice as high in volume as Series C and subsequent rounds (€2.2 billion compared to €1.2 billion). The same was true for the previous years 2018 and 2019. However, an improvement can be seen in growth equity funds, which operate at the most advanced stage. They experienced strong growth over a very short period, rising from €430 million in 2018 to €576 million in 2019, reaching €1.676 billion in 2020. A similar trend, albeit more modest, can be observed for Series C and above fundraising, which amounted to €931 million in 2018 compared to €1.211 billion in 2020.

This trend probably reflects two realities. On the one hand, it certainly attests to the necessary development of venture capital activities in France. Figure 2 below shows the rapid growth of assets invested in startups by VC funds. The number of transactions has followed a similar trajectory, rising from 574 deals in 2016 to 736 in 2019 and 620 in 2020[1]. However, it is also likely linked to the development of a pool of startups that are now reaching a certain level of maturity[2].

Figure 2—Startup fundraising in France broken down by maturity (in thousands of euros), source: EY

Figure 3 – Startup fundraising in France broken down by maturity (%), source: EY

Despite limited activity in France in late-stage funds, there is little detailed quantification that truly measures the extent of the valley of death phenomenon. In 2021, the French Treasury simply noted that the three-year survival rate of young companies in the information and communication sector was higher overall than in neighboring European countries. This figure remains a largely imperfect estimate.

B. Predation of startups by large groups: between myth and reality

A second structural difficulty specific to JEIs is predation. This is the phenomenon whereby a company with market power limits competition by adopting strategies to crush emerging technologies. The term « predatory acquisition » is generally used to refer to the acquisition of JEIs or patents developed by these companies in order to « bury » the technology. However, the phenomenon of predation seems to be broader than that. In economic literature, two expressions have emerged that distinguish two possible aspects of this phenomenon: the « kill zone » and « killer acquisitions. »

Kill zones occur upstream of the innovation process, when companies with high market power put in place mechanisms that limit the expectations of future demand for new entrants. In this way, they discourage entrepreneurship and VC investment in their traditional markets.

At the other end of the innovation process are « killer acquisitions. » These are predatory takeovers of start-ups or technology to bury innovations. Academic literature has recently addressed this topic, and some studies report evidence of such behavior in certain sectors in certain countries[5].

However, at this stage, it is very difficult to measure the extent of the problem and how widespread it is. In this regard, a study published by the French Treasury estimates that the phenomenon is limited. According to their estimates, predatory acquisitions represent between 1% and 10% of startup acquisitions, which is still a marginal volume. However, they acknowledge that their study has limitations, particularly in terms of the size and completeness of the database used. If such a phenomenon were more widespread, it would not be purely financial, as competition issues are central to it. It therefore calls for a response on two fronts: on the one hand, where appropriate, giving JEIs the means to bring their own technology to market. On the other hand, when acquisition seems an appropriate exit strategy, adequate competition law regulations and control procedures should be put in place. A response to these phenomena would be all the more important given that the amount of public aid allocated to startups is increasing, whether direct (subsidies) or indirect (tax credits, tax breaks). The social loss is therefore twofold. On the one hand, there is a loss linked to the non-development of the technology in which funds have been invested. On the other hand, there is the loss of public investment in startups, money that has not been allocated to other purposes.

3) An ever-present economic threat

It is important to remember that venture capital is a risky and therefore volatile investment. During the COVID crisis, as we have seen, this was not the case in France. Globally, a contraction was observed (Figure 2). More generally, academic research has already demonstrated the cyclical nature of venture capital. Even in the event of a sectoral crisis, exposed venture capital funds tend to pass on the shock to other sectors in their portfolio. Startup financing therefore remains structurally fragile.

Furthermore, and in conclusion, the lowering of barriers to entry into entrepreneurship, which is an undeniable gain, is leading to the emergence of new frictions in the venture capital market. Recent economic literature has noted an increase in information asymmetry, particularly in the early-stage segment. In addition to financial support, certification mechanisms, whether private (innovation and project competitions) or public (selective aid programs), are likely to become more important in the startup ecosystem.

Figure 4 – Decline in venture capital financing following the Covid-19 crisis, source: WIPO 2020

Conclusion

Small businesses play a key role in driving innovation, particularly in the area of disruptive innovation. However, they are also more sensitive to market failures in innovation and potentially more vulnerable to certain competitive pressures.

Support from public authorities therefore seems appropriate and timely. This support should include financial assistance, but not only that. A broader and more multifaceted public policy is often a factor in effectiveness. In particular, it includes the creation of an appropriate legal environment (business training, potential competitive control tools, facilitation of venture capital activities).

In this respect, the growth of venture capital funds and a pool of startups in France seems to demonstrate the implementation of a relevant policy. However, the development of these segments creates new challenges that will require responses.

Arrow, Kenneth. « Economic Welfare and the Allocation of Resources for Invention. » In The Rate and Direction of Inventive Activity: Economic and Social Factors, 609-26. Princeton University Press, 1962. https://www.nber.org/system/files/chapters/c2144/c2144.pdf.

Baumol, William J. The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism. 4th print., and 1st paperback print. Princeton Paperbacks. Princeton, NJ: Princeton Univ. Press, 2004.

Cohen, Wesley. Chapter 4 -Fifty Years of Empirical Studies of Innovation Activity and Performance. Handbook of the Economics of Innovation, Vol. 1, 2010. https://www.sciencedirect.com/science/article/abs/pii/S016972181001004X.

Cunningham, Colleen, Florian Ederer, and Song Ma. « Killer Acquisitions. » SSRN Electronic Journal, 2018. https://doi.org/10.2139/ssrn.3241707.

Englebert, Philippe. « Startups in France. » Que sais-je?, 2021.

EY. « EY Venture Capital Barometer in France, » 2019.

———. “EY Venture Capital Barometer in France,” 2020.

Frank, Clyde, Claire Sink, LeAnn Mynatt, Richard Rogers, and Andee Rappazzo. « Surviving the ‘Valley of Death’: A Comparative Analysis. » The Journal of Technology Transfer 21,^no. 1-2 (March 1996): 61-69. https://doi.org/10.1007/BF02220308.

Hafied, Faÿçal, Charik Rachiq, and Guillaume Roulleau. « Venture Capital and the Development of French Start-ups. » Trésor-éco No. 276 – Direction Générale du Trésor, 2021. https://www.tresor.economie.gouv.fr/Articles/f830eb26-dce7-4b50-91b9-3df5607fce17/files/59b4e67d-3fb6-47fb-9e6c-c43a6c8a5a97.

———. « Acquisition of stakes in French start-ups: predation or development? » Working Paper No. 2021/1 – Directorate General of the Treasury, 2021. https://www.tresor.economie.gouv.fr/Articles/2021/02/11/prise-de-participation-dans-les-start-ups-francaises-predation-ou-developpement(The financing of innovation in France: a comparative analysis of the United States and the United Kingdom).

Hall, Bronwyn H., and Josh Lerner. « The Financing of R&D and Innovation. » In Handbook of the Economics of Innovation, 1:609-39. Elsevier, 2010. https://doi.org/10.1016/S0169-7218(10)01014-2.

Hellmann, Thomas, and Manju Puri. « Venture Capital and the Professionalization of Start-Up Firms: Empirical Evidence. » The Journal of Finance 57,^no. 1 (February 2002): 169–97. https://doi.org/10.1111/1540-6261.00419.

Hottenrott, Hanna, and Robert Richstein. “Start-up Subsidies: Does the Policy Instrument Matter?” Research Policy 49,^no. 1 (February 2020): 103888. https://doi.org/10.1016/j.respol.2019.103888.

Howell, Sabrina T. « Financing Innovation: Evidence from R&D Grants. » American Economic Review 107,^no. 4 (April 1, 2017): 1136–64. https://doi.org/10.1257/aer.20150808.

———. “Reducing Information Frictions in Venture Capital: The Role of New Venture Competitions.” Journal of Financial Economics 136,^no. 3 (June 2020): 676–94. https://doi.org/10.1016/j.jfineco.2019.10.009.

Kamepalli, Sai Krishna, Raghuram Rajan, and Luigi Zingales. “Kill Zone.” Cambridge, MA: National Bureau of Economic Research, May 2020. https://doi.org/10.3386/w27146.

Schneider, C., and R. Veugelers. “On Young Highly Innovative Companies: Why They Matter and How (Not) to Policy Support Them.” Industrial and Corporate Change 19,^no. 4 (August 1, 2010): 969–1007. https://doi.org/10.1093/icc/dtp052.

Söderblom, Anna, Mikael Samuelsson, Johan Wiklund, and Rickard Sandberg. “Inside the Black Box of Outcome Additionality: Effects of Early-Stage Government Subsidies on Resource Accumulation and New Venture Performance.” Research Policy 44,^no. 8 (October 2015): 1501–12. https://doi.org/10.1016/j.respol.2015.05.009.

Stinchcombe, Arthur L. “Social Structure and Organizations.” In Advances in Strategic Management, 17:229–59. Bingley: Emerald (MCB UP), 2000. https://doi.org/10.1016/S0742-3322(00)17019-6.

Veugelers, Reinhilde, and Cédric Schneider. « Which IP Strategies Do Young Highly Innovative Firms Choose? » Small Business Economics 50,^no. 1 (January 2018): 113–29. https://doi.org/10.1007/s11187-017-9898-y.