Asexual reproduction of firms

Management scholars love to study corporate spin-offs. Every now and then companies decide to split off parts of their business or pursue new ideas by founding a new legal entity. Such an organizational split is supposed to be advantageous when it comes to managing certain types of innovative ventures. Google’s recent reorganization is an example that the large conglomerate of more or less independently operating companies seems to become more popular again in the tech world.

Parent companies often provide capital and directly influence strategic decisions of spin-off. From a management perspective knowledge flows and the boundary of firms are of interest. How do parent firms develop innovative ideas that they later decide to pursue in an independent venture? What amount of knowledge transfer to the spin-off is necessary to enable it to succeed?* And why are do some business sections remain internal whereas others are split off?

Luís Cabral and Zhu Wang (find the paper here) look at the topic from an industry dynamics angle. Economists are traditionally concerned with entry and competition in markets. Loosely speaking, for an economist the boundary of a firm is defined by whether two entities are possibly competing with each other. If a parent holds 100% of a spin-offs’ shares and dictates its strategy, a legal separation of the two companies would still not bear much meaning for an economist. If a spin-off, however, acts somewhat independently it can in turn affect strategic decisions of the parent. This is a completely different perspective than in management science because employees leaving their company to found a start-up do not only constitute a knowledge flow but also a market entry that affects competition.

In their model, there are two mechanisms how spin-offs can occur. Employees of a company could learn that they have a great business idea and great entrepreneurial skills and therefore will leave to start their own business (type I spin-off). Such a brain drain will hurt the parent company as valuable talent leaves (the authors have in mind cases like top-level designers or engineers leaving the company). The second type of spin-off occurs when employees foresee a bad future for their parent company and leave with the sense that they could do a better job on their own. The causal relationship between parent’s success and spin-off creation has thus two directions.

The model creates three main implications:

  1. Spin-offs are more likely to survive (i.e., are more productive) than other entrants to the market because only talented employees will leave the parent company to found a start-up.
  2. There is a negative relationship between spin-offs and parent survival because either talented employees leave (type I) or the spin-off is motivated by poor parent performance (type II).
  3. Spin-offs of surviving parents are better because parent survival is a sign for type I spin-offs.

They are tested on an interesting new data set of the early U.S. automobile industry (in the period of 1895-1969). Nowadays, we’re so used to the automobile market being highly concentrated and dominated by a few very large players. But back in the early days there were actually many manufacturers operating in the industry; and some of them were quite small. And around 18% of these firms were founded as spin-offs of existing producers. In the 1920s, the industry eventually experienced a shakeout and developed the market structure we’re familiar with.

All main implications created by the model are confirmed. Cabral and Wang conclude that although spin-offs might hurt parent companies due to brain drain, they can nevertheless be an efficient reallocation of human capital. That’s why policies like “covenant not to compete” clauses should be employed with caution. In addition, the deserting employee will engage in competition with its old employer and is thereby likely to increase product variety and social welfare.

* A related topic are academic spin-offs by scholars who found their own companies with ideas they developed at the university. Here, the same kind of exchange processes are of interest.

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