Governing the innovation process in entrepreneurial firms

Gideon D. Markmana,1, David B. Balkinb,*,Leon Schjoedtb,2

aLally School of Management and Technology, Rensselaer Polytechnic Institute, 110 8th Street, Troy,

NY 12180, USAbCollege of Business and Administration, University of Colorado, Boulder, CO 80309, USA

Received 22 June 2000; received in revised form 12 December 2000; accepted 19 January 2001

Abstract

We challenge the implicit assumption that entrepreneurs are the sole owners of their young firms

and we suggest that because cutting-edge innovation projects are complex, they create substantial

information asymmetry between entrepreneurs and their investors. Linking previous research on

governance, entrepreneurship, and innovation, we ask what forms of governance and incentive

systems are conducive to spur and implement innovation among young entrepreneurial firms. Using

agency theory and building on the rich literature on governance, we make eight practical suggestions

regarding the governance of young entrepreneurial firms. We suggest that early and effective

governance systems may help entrepreneurs and investors work in alignment with each other’s best

interests. D 2001 Elsevier Science Inc. All rights reserved.

Keywords: Innovation; Entrepreneurship

1. Introduction

High technology firms’ new products may count for more than 50% of their annual sales

(Schilling & Hill, 1998). Although innovation and new product development may be

1047-8310/01/$ – see front matter D 2001 Elsevier Science Inc. All rights reserved.

PII: S1047 -8310 (01 )00040 -2

* Corresponding author. Tel.: +1-303-492-5780; fax: +1-303-492-5962.

E-mail addresses: balkin@spot.colorado.edu (D.B. Balkin), markmg@rpi.edu (G.D. Markman),

leon.schjoedt@colorado.edu (L. Schjoedt).1 Tel.: + 1-518-276-6833; fax: + 1-518-276-8661.2 Tel.: + 1-303-786-0689; fax: + 1-303-492-5962.

Journal of High Technology

Management Research 12 (2001) 273–293

dominant drivers of competition and strategic advantage, the burgeoning of information and

communication technologies and the globalization of industries have blurred industry

confines and made competitive innovation extremely challenging to assess and govern

(Prahalad & Hamel, 1994). For example, television, telecommunications, and utility compa-

nies are blending into one mega-industry (Hitt, Keats, & DeMarie, 1998). Such trend is a

reality among many software firms who provide financial services, airline companies who

sell mutual funds and mortgage services, automobile makers who become retail outlets for

insurance and financing, and toy manufacturers who now compete also in the aerospace

industry with decoy radio-controlled miniature aircraft. As industry boundaries and the

competitive landscape continue to evolve, they intensify uncertainty, ambiguity, and strategic

discontinuities. From a governance perspective, management of innovation projects under

such dynamism is highly complex and uncertain.

In this paper, we examine the relationship between corporate governance and the process

of innovation in entrepreneurial firms with a focus on those in the high technology industry.

While the formation of a well specified corporate governance system is usually given

greater consideration after the occurrence of a major company milestone, such as an initial

public offering (IPO), to represent the interests of diverse shareholders (Monks & Minow,

1996), we contend that in younger, privately held firms prior to going public, effective

corporate governance procedures can add value to innovation projects and their outcomes.

By utilizing appropriate governance systems in an entrepreneurial firm, in terms of the

procedures, size, and quality of membership of the board of directors, as well as the

application of incentive systems, innovation projects should have a greater likelihood of

achieving their desired results.

Research on new business formation defines entrepreneurship as the process by which

new organizations come into existence (Gartner, Carland, Hoy, & Carland, 1988).

Consistent with this filed, we define entrepreneurial firms as new start-up businesses

formed by one or by a group of founding entrepreneurs. We suggest that, due to their

young age and limited resources, to succeed at creating value, entrepreneurial firms must

out-innovate their competitor and vie effectively against diverse rivals including mature

and resourceful companies. Innovation is most critical to achieving a competitive

advantage if the entrepreneurship is developing a high technology product or service.

It must quickly establish legitimacy, create synergistic alliances, excel in quality at low

cost, and satisfy increasingly diverse, yet informed, customers with distinct needs.

Although many entrepreneurial firms develop unique and what appears to be promising

products, in the long run it is firms that repeatedly exceed customers needs and that

allocate their developmental resources effectively that succeed. To survive and thrive,

entrepreneurial firms must have high completion rates of new products that meet not

only their budget constraints and sales objectives, but their scheduled timeline as well

(Schilling & Hill, 1998).

Unfortunately, research on both innovation and entrepreneurship take a multitude of

forms; the literature on innovation and entrepreneurship is fragmented, there is limited

integration, and cumulative knowledge is less than its parts (Damanpour, 1991). Hence, our

discussion of governance of entrepreneurial firms focuses on the growth stage of the

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293274

organization life cycle — prior to IPO and in which governance structure is rapidly

changing (Kanzanjian, 1988). The growth stage of the organizational life cycle is of

particular interest since it is closely related to the act of entering new or established markets

(Lumpkin & Dess, 1996). At this stage, firms are involved in building their foundation,

which includes formalizing the organization, searching for additional capital and allies, and

developing a product or service. Many firms during the period of interest are approximately

7 years old and are experiencing rapid growth with concrete plans for an IPO. Our

discussion also centers on entrepreneurship in high technology industries where the process

of innovation is critical to achieving competitive advantage.

If competitive advantage is a function of valuable, scarce, and difficult-to-imitate

innovation projects (Barney, 1991), the critical question we examine is what forms of

governance and incentive systems are best suited to spur and implement successful

innovation projects among entrepreneurial firms? To answer this question, we review the

literature on innovation management. Recognizing that not all innovation projects lead to

successful products or services, we argue that two striking features of many innovation

projects — successful or not — is information complexity and asymmetry. The more ground

breaking the innovation efforts firms undertake, the greater the information asymmetry that

are formed between entrepreneurs and their investors. We also assume that since many

entrepreneurs — particularly during the growth stage and after capital infusion — own only a

small share of their firm, it is theoretically misleading to infer that they are the only owners of

their young firms or that agency conflicts are negligible.

Section 1.1 commences with a discussion on information asymmetry commonly observed

between entrepreneurs and their investors. We then discuss the peculiar relationships between

innovation, complexity, and information asymmetry as they relate to entrepreneurship.

Finally, we review the governance literature and outline rationales for eight implications

regarding the governance of entrepreneurial firms.

1.1. Entrepreneurial innovation and information asymmetry

The notion of information asymmetry between entrepreneurs and their investors is not new

(cf. Cable & Shane, 1997). Entrepreneurs have unique knowledge concerning opportunities

and about combining intangible and tangible resources to exploit these opportunities in a

novel fashion (Kirzner, 1997). They also have private knowledge about the day-to-day work

of their business activities and better information about the future technology. Investors, on

the other hand, have access to capital, pertinent connection to potential customers and

suppliers, and can establish venture credibility and legitimacy. This suggests that the

management of information and knowledge asymmetries may play an influential role in

whether investors provide entrepreneurs with the necessary capital to continue building their

new ventures.

The success of new ventures hinges not only on entrepreneurs’ ability to discover, develop,

produce, and sell their innovation, but also on their aptitude to harness investors’ support.

Despite the fact that cooperation and information symmetry between entrepreneurs and

investors seem desirable, parties to a venture frequently act uncooperatively. Asymmetric

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293 275

information and diverging perceptions thereof lead entrepreneurs and others who deal with

them to make different judgments about the venture’s present and future objectives and

asymmetric expectations may create and exacerbate future conflicts such as during additional

rounds of money-raising initiatives. This is so since stakeholders make decisions based on

imperfect information regarding future estimates of the venture’s probability of success

(Cable & Shane, 1997). We therefore suggest that building entrepreneurial ventures require

entrepreneurs and investors to work very closely with each other, to share knowledge, and to

reduce information dissonance.

Notwithstanding that in order to adequately evaluate a venture’s growth potential and

probability of success, investors must have complete access to timely and accurate information,

many refuse to sign nondisclosure agreements. To protect themselves against careless or even

opportunistic investors, entrepreneurs react by withholding information about their discoveries.

Imperfect intellectual and property laws and the prospect of costly litigations further motivate

entrepreneurs to share some, but not all, pertinent technical details with their investors. Thus, as

suggested by Sapienza and Korsgaard (1996), entrepreneurs are goaded to obscure, conceal, or

even to manipulate information. This means that entrepreneurs — particularly when they seek

capital — try to strike a delicate balance between disclosing all knowledge about their

innovation and keeping key technological knowledge as asymmetric as possible.

Since capital investments are tied to technological projections of innovation initiatives

and entrepreneurs want to acquire as much funding as possible, they frequently manipulate

information; they overproject their venture’s future performance and underreport their

expected obstacles and competition. For example, entrepreneurs may not disclose bad

news about test marketing and product innovation obstacles. More importantly, poor

venture performance can shift ownership control away from entrepreneurs, bring in

professional management, and dilute the entrepreneurs’ ownership. Antidilution clauses

protect the investors; the cost of additional financing may be born by the entrepreneurs

when the new stocks are issued at a lower price (Cable & Shane, 1997). Similarly,

entrepreneurs’ behaviors also create further information asymmetry. Company cars, travel,

lodging, and meals that entrepreneurs may perceive as necessities, investors may view as

frivolous or misused. Finally, new ventures also demand a high degree of expertise,

dedication, and personal sacrifices, all of which put physical, emotional, and social tolls on

entrepreneurs and their families (Baron, 1998). Although entrepreneurs prefer their

ventures to succeed, many circumstances threaten entrepreneurs’ conscientiousness and

devotion to the ventures’ goals. Promises of dedication and achievement that were made in

earnest when securing capital may become obsolete when the venture demands priceless

personal sacrifices.

In sum, entrepreneurs and their investors may appraise a venture’s technological and

innovation potential differently. This suggests that there are many forces that impel

entrepreneurs to manipulate information and actively create knowledge asymmetry regarding

their technological discoveries. Yet, perception asymmetry — regardless whether true or not

— damages entrepreneur–investor relationships. As will become clear shortly, we suggest

that early governance considerations may mitigate some of the information asymmetry

problems typically incurred during innovation undertakings.

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293276

2. Innovation and complexity: an overview

This section describes the strong association between innovation and complexity. It

emphasizes that the more involved and ground breaking the innovation efforts firms

undertake, the greater the complexity and information asymmetry that are formed between

entrepreneurs and their stakeholders.

Innovation that links market and technological opportunities is central to entrepreneurship

(Drucker, 1985; Kirzner, 1997). Multidimensional in nature, innovation is the creation of

new products or processes that create value. The strategic importance of both product and

process innovation has long been known to have a strong influence on performance,

particularly, though clearly not exclusively, for entrepreneurial firms. Successful innovation

management is crucial for global competitiveness and has important national implications.

Franko (1989) had observed that in 1960, US firms held more than two-thirds of the world

market in 10 of the top 15 major industries. While in 1970, the US firms still dominated 9

of those 15 industries, by 1980 their domination was limited to only 3 (Franko, 1989). Since

high-performing firms also tended to invest more heavily on R&D, diminished industry

share is due to the fact that the US firms reduced their investments in innovation (Hitt,

Hoskisson, Ireland, & Harrison, 1991a, 1991b). Declined innovation may also be due to

managers’ disinclination to bear the costs and risks of uncertain long-term development of

product and process innovation (Hoskisson & Hitt, 1994). We concur, but we suspect that

implementation failure (e.g., failure of the governance system) — not only innovation

failure per se — also keeps firms from deriving adequate competitive benefits from their

product and process innovations.

High tech firms can introduce new products or services that embody novel technologies

and attain first-mover advantage when they effectively compress cycle times of various

innovation and production projects. In turn, first-mover advantage can be sustained when

firms harvest experience curve economies ahead of competitors, usurp scarce assets, create

switching costs to consumers, and build brand recognition and loyalty. It has been argued

elsewhere that brand loyalty is particularly important in industries characterized by rapid

technological innovation (Schilling & Hill, 1998). Early adopters, technology enthusiasts,

assume that a brand — in the absence of objective assessment of the technology — is a

surrogate for product quality and features. We suggest that despite brand-name recognition

and economies of scale, entrepreneurial firms can still compete effectively against larger and

more resourceful companies. For example, lean manufacturing techniques allow shorter

production runs and thus reduce the importance of economies of scale (Schilling & Hill,

1998). Similarly, Internet-banking has allowed a score of community banks to create global

presence and to compete rather effectively against national banks (Bowe, 1999).

Complexity and innovation are codependent: the more extensive a firm’s degree of

innovation, the greater the complexity entrepreneurs, their top management team (TMT),

and their investors face. As firms increase their innovation undertaking, interdisciplinary

tasks, interdependent actions, and coordination demands increase the intricacy placed on the

young firms and on their investors. Many technological discoveries and innovation projects

— particularly long-term intentions — are at odds with investors’ mindsets, which exacerbate

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293 277

information asymmetry between the entrepreneurs and their investors. Likewise, diverse

customer base, high number of competitors, and industry regulations increase the volume,

variety, and disunity of the information that executives must process (Weick & Van Orden,

1990). Since there is a tremendous pressure for innovation projects and technological

discoveries to strike synergies across existing products, processes, or services, they simulta-

neously increase entrepreneurial complexity and investors’ perceived information asymmetry.

In sum, the blurring of industry boundaries and the new competitive landscape motivates

many firms, particularly entrepreneurial firms, to innovate. However, as the level and extent

of innovation projects increase, they create higher complexity and greater information

asymmetry between the entrepreneurs and their stakeholders. We next examine more closely

the relationships between governance and innovation.

3. Governance, innovation, and entrepreneurship: is there a problem?

Although effective governance of young entrepreneurial ventures is of interest to the

investment community (venture capitalists, business angels, bankers, etc.), to consultants,

academics, and, of course, to entrepreneurs, most governance research is focused on large and

mature organizations. For example, Ward (1997) suggests that governance mechanisms

frequently fail to adequately monitor and control top-level managers’ strategic decisions

(Ward, 1997). Others point that well-functioning governance can result in a competitive

advantage (Kroll, Wright, Toombs, & Leavell, 1997). Westphal and Zajac (1997) have stated

that the board of directors is rapidly evolving into a major strategic force. Controlling the

strategic direction and performance of their firms, organizational governance ensures that

decisions follow strategic paradigms (Davis, Schoorman, & Donaldson, 1997). Governance is

also used to establish the line of command among agents whose interests may be in conflict

(Williamson, 1996).

While media exposure of and research regarding inadequate governance brought certain

modifications, some governance advocates point that too harsh or unfair criticism would

inhibit risk-taking initiatives and uncertain innovation projects. Much of a firm’s wrong-

headedness, the argument goes, is an honest strategic mistake and not a substantive

governance problem. Others argued that it is overly pessimistic to assume that mangers act

primarily based on their own self-interest as opposed to their firm’s best interest (Finkelstein

& D’Aveni, 1994). While the fear of overcorrecting for executives’ passivity is valid,

empirical evidence continues to support the thesis that failure to govern strategic decisions

results in significant negative effects on the firm’s performance as measured by strategic

competitiveness and financial data (Comment & Jarrell, 1995).

And yet, despite the wide research effort on corporate governance, little of that rich

knowledge spilled over — let alone applied — to the entrepreneurship domain. This is so, at

least in part, due to the implicit assumption that an entrepreneur is the primary owner of his or

her venture and thus, the sole decision-maker. While this assumption may be true during the

early and seed stages, it is doubtfully the case during the growth stage, which may include

pre- and post-IPO phases, and in which investors actively monitor the strategic posture of the

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293278

new venture. We suggest, therefore, that information asymmetry and complexity impact the

relationships between entrepreneurs and their investors, and that the simplified view that

entrepreneurs — particularly during the growth stage — are ‘‘sole owners’’ ignores many

agency perils. Since entrepreneurs, members of boards of directors, and professional

managers and investors may have different perceptions, motives, and interests, the use of

early and well structured governance may help alleviate several agency hazards.

Ignoring this important link between governance, entrepreneurship, and innovation is

surprising; it has long been recognized that innovation is a key to competitive advantage

(D’Aveni, 1994; Hitt, Hoskisson, & Kim, 1997). As the innovations by rivals quickly make

existing products obsolete, many products’ life cycles are compressed thus demonstrating

Schumpeterian creative destruction. The assumption is that successful innovation is the basis

for competitive advantage, which in turn, leads to above-average rents, growth, and further

innovation. Thus, a young firm’s ability to manage innovation could lead to sustainable

competitive advantage,whereas lowor failed innovationmaymean early failure andbankruptcy.

Nourishing the innovation process, however, requires entrepreneurs’ confidence and vision

to make sizeable investments in R&D projects and take substantial risks by launching a

steady stream of new — sometimes revolutionary and frequently uncertain — products to the

market. Innovation may also require entrepreneurial firms to consider acquisitions, alliances

(even with their own rivals), and/or the creation of novel management initiatives. It also

involves learning from mistakes and failures that are an unavoidable part of the innovation

process (Maidique & Hayes, 1984). For example, Apple Computer’s Newton, a palm top

computer, resulted in a high visibility market failure when consumers rejected it. Yet the

knowledge that is gained even from failures can be applied to improve products that may

eventually be embraced by the market.

3.1. A model of governance and the innovation process

A model of governance and the innovation process in entrepreneurial firms is shown in

Fig. 1. The model suggests that the following factors influence innovation project character-

istics and/or the success of the innovation project: (1) the application of long-term pay such as

equity-based compensation; (2) the lack of duality of the CEO and chairperson of the board of

directors; (3) reduction of information asymmetry between founding team members; (4) size

and quality of the founding team; (5) lack of seniority of the founding team members; (6)

ratio of outside board members to internal board members; and (7) size and composition of

the board of directors. The model also suggests that (8) the presence of governance and long-

term incentive systems are likely to influence whether innovation is produced internally or

bought from external suppliers. Fig. 1 suggests eight theoretical propositions that will be

explained in the remainder of the paper.

In the next sections, we describe the role of governance in the context of young entrepre-

neurial firms’ innovation undertaking and develop eight propositions regarding such associa-

tions. We begin with a discussion of pay as a tool to align entrepreneurs with their investors and

explain the implications of CEO duality. We then review the purpose of the TMT, board of

directors, and finally, we conclude with a discussion of acquisitions and in-house innovation.

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293 279

3.2. Incentive structure and innovation

Both agency theory and the information-processing perspective are concerned with the

efficient arrangement and distribution of information as well as the various incentives or

mechanisms to reduce information asymmetry. Agency theory assumes that certain gover-

nance mechanisms and monetary incentives facilitate the process and transfer of information

(Jensen & Meckling, 1976); the information-processing perspective suggests that the ability

to effectively process and transfer information is rare and valuable. Taken together, these

views suggest a relationship between innovation and complexity, and the way to govern both.

The appropriate incentive structure may act as a surrogate form of governance in situations

where it is costly or difficult to monitor the behavior of an entrepreneur. Although we now

have substantial knowledge regarding the effective use of incentives such as cash (e.g., salary

and bonus) and long-term contingent pay (e.g., stock options) and how they can substantially

lessen monitoring costs (Beatty & Zajac, 1994), little of that knowledge has been transferred

to the entrepreneurship literature. In this section, then, we will make theoretically based

recommendations regarding pay as a substitute for monitoring.

Since entrepreneurs tend to invest most of their nondiversifiable and nontradable capital in

their young firms and since their wealth is derived primarily from such undertaking, we

suspect that they are more risk-averse than their investors who normally diversify their wealth

portfolios. For example, venture capitalists tend to spread their investment portfolio across

several different entrepreneurial ventures representing diverse technologies. Thus, unless

monitored by their investors or given the appropriate incentives, entrepreneurs are more likely

to avoid undertaking risky innovation projects compared to the preferences of the investors.

Because new venture success is highly uncertain and innovation projects exacerbate

monitoring problems, we predict that increased innovation will be associated with increased

use of long-term forms of pay that is tied to the firm’s financial performance. Specifically, the

spatial complexity associated with the development of new and highly uncertain products or

Fig. 1. Governing the innovation process in entrepreneurial firms.

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293280

services makes information gathering and monitoring of entrepreneurs more difficult.

Consequently, as investment in long-term innovation increases, the difficulty and thus cost

of monitoring increases. To overcome such monitoring challenges, to reduce uncertainty, and

to maintain control, investors can increase the use of long-term pay (or reduce the use of

short-term pay) in the mix of total compensation. Since long-term pay that is tied to firm

performance rewards entrepreneurs for maximizing investors’ wealth, they are less likely to

take advantage of the increased information asymmetry resulting from long-term innovation

projects. Doing so will also motivate entrepreneurs to converge their interests with the firm’s

innovation goals.

Because the difficulty of monitoring increases with the complexity of innovation,

entrepreneurial firms with a high degree of innovation would be inclined to resort to long-

term compensation as an incentive alignment device. For example, Gomez-Mejia, Balkin, and

Welbourne (1990) reported that venture capitalists recommend allocating equity-based

compensation to the TMT in high tech firms that receive funding so that equity equals a

significant portion of the team’s total pay. By increasing entrepreneurs’ long-term pay,

investors reduce their own risk, converge entrepreneurs’ interests with their own, and thus

offer entrepreneurs incentives to monitor themselves. Finally, from a signaling perspective,

when entrepreneurs accept stock options, even if inefficient from a risk-bearing perspective, it

signals to investors the firm’s innovation potential. We therefore expect that the application of

long-term pay for the entrepreneur will motivate further investment in long-term innovation

projects. This rationale is summarized as follows:

Proposition 1: Ceteris paribus, an entrepreneurial firm’s degree and intensity of

investment in innovation is positively related to an increase in the proportion of long-

term pay in the pay mix for an entrepreneur.

3.3. Separation of the CEO and chairperson of the board positions

Duality — when an entrepreneur simultaneously holds the positions of both the CEO and

chairman of the board — is widespread in both large and emerging firms (Boyd, 1995). Some

suggested that duality establishes unity of command and clarifies decision-making authority

(Daily & Dalton, 1997; Finkelstein & D’Aveni, 1994). Since under duality the CEO is the

chairman and vice versa, duality eliminates the peril of information asymmetry between these

two roles. We suggest, however, that the separation of these positions decentralizes power and

authority, fractures organizational rigidity, and allows unstructured innovation to take place.

Brown and Eisenhardt (1998) provide many examples of companies that leverage success-

fully on the delicate structure–chaos interplay, including Intel’s MMX processor for high-

speed graphics, Gillette’s new shaving designs; Miramax’s new movies; and Sun’s JAVA

strategy. We suggest that complex environments, like those of young firms that invest heavily

in uncertain innovation, additional specialization, delegation of authority, and division of

responsibility, may more than compensate for reduced unity in decision-making. That is,

intensive investment in innovation may necessitate young firms to sacrifice some perception

of unity of command and tolerate certain information asymmetries in exchange for greater

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293 281

dispersion of power and authority regarding their innovation projects. The presence of an

outside board chairman — who is not the CEO — represents additional monitoring of the

entrepreneurs (Beatty & Zajac, 1994). It also allows young firms to capitalize on higher

brainpower and to empower the board. Consequently, we suggest that young firms that do not

consolidate the positions of the CEO and chairman of the board will invest more heavily in

their innovation projects. This logic is reiterated as follows:

Proposition 2: An entrepreneurial firm’s level of investment in innovation is

positively related to the practice of separation of the CEO and the chairperson of the

board positions.

3.4. The composition of the founding team of entrepreneurs

As suggested earlier, we assume that many new high tech ventures are built around

founding teams — individuals who identify the initial opportunity and develop a strategy to

exploit it (Cooper & Daily, 1997). This is not surprising because teams help reduce cycle

time in new product development (Ancona & Caldwell, 1992); increase innovation

(Eisenhardt & Tabrizi, 1995); span organizational boundaries (Ancona, 1990); and improve

product and service qualities (Lawler, Mohrman, & Ledford, 1995). Entrepreneurial teams

help attain strategic maneuvers including attaining first-mover advantages, forming strategic

alliances, or developing discontinuous innovations (Tushman & Anderson, 1986). We

suggest that entrepreneurial teams also allow firms greater agility to enter markets quickly

and maintain responsiveness to changing market conditions. Teams are particularly crucial

in the context of technological entrepreneurship because investment decisions are based, at

least in part, on the quality of the founding team (Gupta & Sapienza, 1992). Such founding

members are the repositories of much of the technical and management knowledge, skills,

and ability that make up the intangible assets of the firm (Cooper & Daily, 1997). The

founding team is the firm’s strategic apex and information-processing center (Sanders &

Carpenter, 1998).

Research suggests that team members with diverse backgrounds have several advantages,

including a broader knowledge base that allows innovation projects to draw on more

information sources (Schilling & Hill, 1998). By teaming members of different functional

areas into one innovation project, cross-fertilization of ideas occurs and a wide variety of

knowledge is gathered (Damanpour, 1991). The founding team is responsible for critical

resource allocation and decisions regarding investments in new products and technologies

(Burgelman, 1991), competitive maneuvers such as thrusts, feints, and gambits (McGrath,

Chen, & McMillan, 1998), and decisions regarding entry into new markets and acquisitions

(Hitt et al., 1991a, 1991b).

Just as innovation and information asymmetry heighten the agency issues between

entrepreneurs and their investors, the same may also occur among multiple members of a

founding team of entrepreneurs. For example, specialization and complexity of various

innovation projects may require members of the founding team to allocate critical

responsibilities or otherwise rely on their subordinates (Weick & Van Orden, 1990). Such

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293282

a shift is consistent with the information-processing view whereby a team has greater and

better processing capacity and is able to attend to a greater number of cues than any one

person individually (Haleblian & Finkelstein, 1993). American Airlines’ frequent-flyer

program in the early 1980s has been attributed to TMT diversity (Labich, 1990). Likewise,

diversity in cognitive style of TMTs in the US banking industry accounted for a large

variance in technical and administrative innovations (Bantel & Jackson, 1989). Yet from the

agency perspective, reliance on multiple team members is likely to increase the information

asymmetry, perceived by any member of the founding team and to some extent by their

investors. Moreover, the more intensively firms invest in innovation projects, the greater the

delegation and division of labor among team members. This means that as members’

specialized knowledge increases, so does the agency challenge due to information asym-

metry. We suggest, therefore, that excellence in cutting-edge innovation may incur some

levels of information asymmetry between diversely competent team players. This suggestion

is echoed in the following proposition:

Proposition 3: Investment in innovation and success thereof are a function of team

members’ ability to reduce information asymmetry and thus fully capitalize on their

diverse and complementary skills.

Due to their strategic role, founding entrepreneurs, personally and as a group, deal with the

utmost complexity the firms face (Hambrick, Cho, & Chen, 1996). They must quickly

process large amounts of diverse and conflicting information, and their ability to do so is both

valuable and rare (Henderson & Fredrickson, 1996). Given the increased complexity arising

from innovation in the context of emerging firms, entrepreneurs are tasked with many

information-processing requirements, which we suggest, can be facilitated by effective

governance arrangements.

Because the capacity of teams to deal with complexity is superior to that of individuals

(Dutton & Duncan, 1987), their cumulative knowledge, skill, and abilities may be important

ingredients to a young firm’s success. Past research used team composition and size (i.e., as

proxies for skills’ quality and quantity, respectively) as control variables in strategy regarding

TMTs. Sanders and Carpenter (1998), for example, found that a larger TMT was positively

associated with its degree of internationalization. Others suggested that because larger teams

have greater information-processing capacity, they can solve more complex problems

(Jackson, 1992). Firms with larger teams — as compared with smaller teams — and who

operate in complex environment tend to perform better (Haleblian & Finkelstein, 1993).

Likewise, if a firm’s management team is, at least to some extent, a scarce resource, then

larger and more competent teams are key to the firm’s success (Hambrick & D’Aveni, 1988).

Since a firm’s degree of innovation is associated with the complexity its TMT faces, we

suggest that increased investment in innovation will be proportional to the size and quality of

its founding entrepreneurs. This reasoning is summarized in the following proposition:

Proposition 4: An entrepreneurial firm’s degree of investment in innovation and success

thereof is a function of the size and quality of the founding team of entrepreneurs.

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293 283

While many activities are strewn with impediments demanding effort, ingenuity, and

endurance, the paths to innovative achievements in entrepreneurial pursuits are particularly

scattered with snags and inherent short-term disincentives. Innovation projects levy heavy

personal sacrifices; they demand that entrepreneurs exert emotional, physical, and intellectual

effort, while the benefits — if and when they are finally materialized — go through a

serendipitous process of developmental refinement with numerous setbacks (Markman,

Balkin, & Baron, 2000). Resistance and negative market reactions to unconventional thinking

and sanctions thereof that entrepreneurs may endure also represent disincentive. Since new

inventions clash with existing products and services, they threat constituencies who have a

vested interest in preserving the status quo. As innovative efforts frequently bring social and

market rejection before they bring fame and fortune, innovators must endure hardships and

persevere against tough odds. For example, after Gillette acquired Braun — mainly for its

electric shaver technology — Mockler, Gillette’s chairman, advocated — despite stiff internal

resistance — capitalizing on Braun’s quality and innovation reputation to make Gillette a

leader in small appliance markets. Although in 1990, Braun had led only the hand blenders’

market, which accounted for 6% of its sales, 6 years later it had dominated other domains

such as oral care appliances, epilators, and hair dryers. In other words, unyielding to skeptics

brought Gillette a US$1.7 billion and world leadership in products that generated 82% of its

sales (Cottrill, 1998).

Top mangers’ success and seniority may affect their propensity to initiate change and

innovation (Hill & Phan, 1991). Research shows that as TMTs excel, their tenure increases,

and as their tenure increases, past courses of action are increasingly used to guide future

decisions and actions. Also, as group norms and pressures for conformity are created,

candidates with similar experiences and perspectives are hired into the TMT, and greater

attachment to established policies and practices is exhibited (Boeker, 1997). Such behaviors

increase the likelihood that rather than being a catalyst for change and innovation,

experienced TMTs may become a weighty source of organizational inertia. The challenge

is that success and succession can simultaneously lead to strategic myopia and inflexibility.

That is, organizational rigidities and inertia prevail when the strengths that lead to competitive

advantage and strategic competitiveness are emphasized despite the fact that they are no

longer competitively relevant. We therefore propose that:

Proposition 5: Increased seniority of the TMT will be negatively associated with the

level of investment in innovation activities in entrepreneurial firms.

3.5. The board of directors

Although imperfect, the board of directors is an important and formal mechanism for

monitoring top managers (Fama, 1980; Fama & Jensen, 1983). A fundamental responsibility

of the board of directors in new ventures, many of whom are investors, is to monitor and

ascertain that entrepreneurs’ decision-making provides good value for the shareholders — the

company’s legal owners. However, the diffusion of ownership often gives rise to agency

problems and managerial opportunism (Williamson, 1993), whereby certain strategic deci-

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293284

sions may serve the interests of the entrepreneurs while diluting the owners’ gains (Amihud &

Lev, 1981). Because entrepreneurs have access to superior information regarding firms’

resources and performance, they can take advantage of such information asymmetry and

curtail investors’ gains (Fama & Jensen, 1983). When organizational structure and size

increase in complexity, a critical characteristic of board members — from the investor’s

viewpoint — is that they should be independent of the entrepreneurs. Board members are

supposed to provide positive oversight of strategies, including rigorously scrutinizing all

decisions, actions, and maneuvers against performance standards. Although board members

should act in the investors’ best interest, many boards fail to challenge the entrepreneurs’

policies and directives when the latter fall short of market expectations. Robert Holland, Ben

and Jerry’s CEO, is a case in point. He resigned after a relatively brief tenure following

disagreements with the powerful founders over broad social agenda that frequently did not

align with shareholders’ interests.

Diffusion of ownership among a large number of shareholders increases the need for the

board of directors to monitor entrepreneurs’ activities. While all board members are expected

to protect the interests of investors, under certain circumstances, inside and outside directors

act differently. For example, assuming that outside directors have incentives not to collude

with founding entrepreneurs (Fama & Jensen, 1983), they can ratify major strategic

initiatives, hire, fire, and set the compensation of these entrepreneurs. A heavy use of

insiders on the other hand suggests relatively weak monitoring (Beatty & Zajac, 1994). Since

entrepreneurs are normally in a position to influence an inside director’s career advancement

in their new venture, insider-dominated boards imply problematic self-monitoring and

particularly weak monitoring of the founding team. Although some governance scholars

assert that insiders — because they are indebted to their entrepreneurs — interfere with

vigilant monitoring, others have argued that insiders positively affect entrepreneurs’ ability to

process complex information about the young firm and thus to make strategic decisions

(Baysinger & Hoskisson, 1990). Nonetheless, when innovation projects are at odds with a

short-term objective championed by the entrepreneurs, inside directors are more likely to

close ranks behind them than outside directors. Accordingly, in the presence of a higher ratio

of outside to inside directors, we would expect the percentage of outside directors on the

board to represent a stronger force towards innovation. Entrepreneurs are assumed to be more

risk-averse than the investors are because the former assets are more closely tied to the

performance of the new venture. Outside directors represent the risk preferences of investors

to the board. Likewise, outside directors (e.g., investors), in addition to their monitoring role,

are likely to be providers of cash, know-how expertise, or external contacts to a new venture.

Our proposition therefore is that:

Proposition 6: A higher ratio of outside to inside directors will be associated with

higher risk taking and more extensive levels of investment in innovation in

entrepreneurial firms.

Increased innovation undertaking exposes boards to more diverse and complex governance

and strategic challenges. Research suggests that the board size and composition may be a

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293 285

function of the complexity of the firm’s environment (Sanders & Carpenter, 1998). Since

multimember teams increase the overall information-processing capacity of the group

(Jackson, 1992), entrepreneurial firms may manage increased complexity due to newness

by recruiting and adding board members who have complementary expertise in the respective

innovation projects. For example, Stephen S. Kahng, who founded Power Computing in 1993

to produce and sell clones of Macintosh computers, recruited Dell’s marketing executive, Joel

J. Kocher. It is believed that Kocher’s expertise in direct sales was one of the key factors

enabling Kahng to reached US$700 million in sales in 1997 (Burrows, 1997). Thus, one

response to the complexity associated with innovation is to — selectively and complemen-

tarily — add qualified members to the board.

However, and despite Haleblian and Finkelstein’s (1993) suggestion that group size is

positively related to information-processing capability, large groups can become quite

unwieldy (Sanders & Carpenter, 1998). For example, if board size increases to accommodate

environmental complexity, newness, and legitimacy, how will firms avoid succumbing to the

dysfunctional problems involved with managing large groups? We speculate that it is in just

such complex situations that the interaction (and the adequate balance) between board size,

composition (e.g., inside to outside ratio as well as members’ knowledge, skills, and abilities),

and access to timely and accurate information matters. That is, extremely small boards may

have accurate and timely information, but only about a limited set of innovation projects. On

the other hand, members of excessively large boards may have substantial amount of

cumulative information regarding their young firm’s innovation project, but will be

challenged to adequately communicate this among them in a timely manner. Insiders tend

to have better access to timely and accurate information, but their loyalty to the lead

entrepreneur may restrain their acceptance of immediate changes such as being frequently

associated with both ground-breaking innovation and young entrepreneurial undertaking. On

the other hand, outsiders tend to be more daring in their sponsorship of innovation initiatives,

but suffer from limited and untimely information at best and information asymmetry at worst.

This leads to the following proposition:

Proposition 7: Entrepreneurial firms’ investment in innovation activity is positively

related to board size and board composition.

4. Innovation: to make or buy?

Commitment to in-house innovation is a factor of managerial willingness to allocate

resources to and champion activities in research and development that lead to new

technologies, processes, products, and services. Although there is a consensus that entrepre-

neurs appreciate innovation and see it as crucial to their company’s survival and growth, there

are disagreements regarding strategies to achieve innovation. Venkataraman and McMillan

(1997) suggest that new business formation occurs through internal development, mergers

and acquisitions, or through cooperative strategies. After their inception and particularly

during the growth stage, entrepreneurial firms can develop innovations in-house (i.e., through

direct investment in internal R&D or strategic alliances) or — when the technology is

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293286

available elsewhere — they can acquire or license it. Thus, certain acquisitions or license

agreements may substitute for in-house innovation. Unfortunately, and due to obvious

resource constraints associated with innovation undertaking during the growth stage,

entrepreneurial firms are more likely to emphasize either acquisitions or internally based

innovations — but rarely both (Hitt et al., 1991a, 1991b). From the governance perspective,

each innovation strategy (acquisition and in-house investment in R&D) is associated with

different risks and benefits.

Pro-acquisition advocates argue that in-house innovation projects do not guarantee actual

product innovation or firm competitiveness and growth. Many new products never reach

commercialization and many — and frequently most — of those that do reach the market still

fail to generate an economic return (Schilling & Hill, 1998). NetTV, a 5-million venture, is a

case in point. Customers rejected the venture’s WorldVison, a US$3,000 system that

combined 29-in. monitor with an advanced PC to allow Web surfing and TV-watching

despite CompUSA’s attempt to sell it. This suggests that frequently, a young firm’s scarce

resources are wasted on expensive R&D equipment and facilities as well as on highly

uncertain and time-consuming projects (Gomes, 1998). Since time is an integral component

of financial returns — every venture performance is measured by total returns over a time

period — it, too, can impact innovation management. Time represents an even larger

challenge to entrepreneurs as they must identify a high-return opportunity, attract financial

resources, quickly move products to market, and grow the venture to profitable stages before

the window of opportunity vanishes. Also, many innovative ventures are based on time-

sensitive information, where original ideas and processes soon may be replicated if not totally

replaced by other ventures (Schoonhoven, Eisenhardt, & Lyman, 1990). Given the impor-

tance of first-mover advantages to subsequent innovation and business success, new ventures

often depend on the speed of implementation, which to a large extent may be a function of

complementary acquisitions. For example, Amazon.com, through a series of acquisitions, is

now offering not only books, but also music, video, gifts, greeting cards, and auctions. In

short, acquisitions are more tuned to the ephemeral window of opportunity, offer immediate

entrance to new or existing markets, and thus allow faster growth than can be achieved

through only internally generated innovation projects. Despite the fact that they are not risk-

free, acquisitions — due to the acquired firms’ established product lines and financial

statement — are perceived as easier to forecast than internally based product innovation.

Pro-acquisition arguments also suggest that acquisition-related debt can exert positive

and disciplinary pressure on entrepreneurs to be more efficient and to transfer funds from

questionable operations to wealth-generating activities. Well-planned acquisitions may

actually enhance firm innovation, growth, and overall value, particularly when used to

complement or enhance R&D projects, patent rights, and innovative processes not owned

by the acquiring firm. For example, Chaudhuri and Tabrizi (1999) report that Advanced

Micro Devices (AMD) and NexGen assessed each other very carefully before the former

acquired the latter in 1996. The two companies operated in engineering-team-dominated

environments, rather open and communicative cultures, and shared a common vision to

beat Intel. NexGen passionately shared AMD’s vision of beating Intel. Their due diligence

and smooth integration paved the way for a successful redesign and launch of the K6 and

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293 287

K7 microprocessors. Also, many innovation projects now require the complementary assets

of more than one company (Schilling & Hill, 1998). This suggests that some acquisitions

fail not because they inherently lacked innovation value, but because the acquiring firms

mismanaged them.

We, however, suggest that acquisitions require extensive preparations (e.g., search and

analysis), laborious negotiations, and finally, after the acquisition — particularly when they

turn south — painstaking coordination. That is, acquisitions place substantial toll on

entrepreneurs’ time, cognitive stamina, and energy, and may lead to dangerous escalation

of commitment (McCarthy, Schoorman, & Cooper, 1993). Evidence suggests that acquis-

itions may result in reductions in basic research, R&D budgets, number of patents owned by

the firm, and in competitiveness (Hitt et al., 1991a, 1991b). Likewise, excessive acquisitions

can potentially dilute a young company’s brand recognition. Interestingly, R&D investments,

returns on assets, and liquidity in the post-acquisition era are frequently lower than the pre-

acquisition period. Innovation through acquisitions rather than in-house research and product

development may subject entrepreneurs to increased managerial commitment to the acquis-

ition, particularly after the acquisition is consummated. And as their commitment to the

acquisition increases — mainly when unexpected problems arise — entrepreneurs may even

de-emphasize in-house innovation undertaking, which may result in decreases in resource

allocations into long-term R&D projects.

Some entrepreneurs, if given a choice, may lack the vision and propensity to take the

necessary risks and will avoid long-term investment in innovation. For example, despite that

R&D projects are a precursor to commercial products and are necessary to further develop

cutting-edge technologies (Schilling & Hill, 1998), risk-averse entrepreneurs may redeploy

firm resources from R&D to projects or goals with shorter payback periods, such as mergers

and acquisitions. By implementing unrelated diversification strategies to expand their firms’

innovation portfolio, entrepreneurs reduce managerial employment risk and compromise the

long-term strategic competitiveness of their young firms. In fact, since it is more time

consuming, risky, and requires substantial intellectual capital to develop long-term innovation

in-house than to buy it via acquisitions, some entrepreneurs may overdiversify. They may

ignore the trade-off between short-term gains and the high possibility of an empty innovation

pipeline farther out in the future (Hitt et al., 1991a, 1991b).

The negative effect acquisitions can have on in-house investments in innovation may also

have an effect on the additional levels of debt that young firms absorb to complete and to

materialize their acquisitions. Not only debt leads to conservative innovation strategies, it also

constrains a firm’s operation, increases its financial risk, and weakens its ability to resist

hostile takeovers. In short, time, cognitive attention, and energy associated with acquisition

combined with managerial risk aversion may result in lower resource allocations to in-house

investment in innovation. Due to obvious resource constraints, most entrepreneurial firms

tend to either buy (e.g., acquisitions) or make (e.g., in-house innovation projects) their

innovations, but rarely do both. This leads to the following and last proposition:

Proposition 8: Since acquisitions provide immediate innovation benefits with less

certain capabilities, whereas in-house innovation projects represent more salient

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293288

financial and strategic risks (i.e., they are difficult, uncertain, and have long time

horizons) but with more potential for developing innovation capabilities, in the absence

of strong governance and adequate incentives, entrepreneurs will prefer to buy their

innovation rather than develop it.

5. Discussion

Although both governance and innovation have been central to strategic management,

theoretical and empirical links between the two and entrepreneurship are lacking. To address

this gap, we asked how various governance mechanisms affect young entrepreneurial firms’

innovation effort and challenged the assumption that the entrepreneurs — particularly after

the seed stage — are the sole governors of their firm’s innovation. Indeed, it is our view that

in reality, multiple stakeholders, including major investors, strategic partners, members of the

board of directors, customers, and even the end users of the innovation, continuously

negotiate the allocation of resources that lead to additional innovation. Like Sanders and

Carpenter (1998), our overarching theoretical framework linked innovation with governance

and it is based on the logic that as innovation increases, so does complexity and information

asymmetry. And since increased complexity and information asymmetry place higher

demands on information processing and give rise to agency problems, young firms should

manage such demands by instituting more efficient (in terms of information acquisition and

monitoring) governance arrangements. Taken together, the combination of information

processing and agency theories provides a richer context for the study of innovation

management than either perspective alone offers. By recognizing agency theory’s roots in

information economics and its theoretical ties to information processing, one can conceptu-

alize a large set of governance arrangements (e.g., incentives, TMTs, board structures, and

acquisitions) in the context of growth-oriented entrepreneurial firms.

In the context of founding entrepreneurial teams, for example, a classic agency situation

emerges when innovation increases complexity, information-processing demands, and

information asymmetry thereof. Increased innovation is associated with increases in both

TMT’s specialized knowledge of a firm’s diffused markets and operations and the ambiguity

surrounding team members’ actions (Nohria & Ghoshal, 1994). This, of course, makes

monitoring of entrepreneurs more difficult. Despite that agency theory suggests that

monitoring problems may be resolved through governance arrangements that align the

interests of the entrepreneurs with the profit-maximizing intentions of investors, we indicate

that little is known about the governance of entrepreneurial firms at the growth stages of the

life cycle.

Most firms — and entrepreneurial firms are no exception — face multipoint competi-

tion and thus, their success is a function of their ability to manage complexity within their

competitive landscape. A critical determinant of a firm’s ability to successfully deal with

such complexity is a function of its governance (Daily & Schwenk, 1996). Entrepreneurial

firms manage and cope with information-processing demands and agency issues arising

from innovation through various governance mechanisms including — but not limited to

G.D. Markman et al. / Journal of High Technology Management Research 12 (2001) 273–293 289

— longer-term pay to founding entrepreneurs, the separation of chairman and CEO

positions, larger and diverse founding teams, adequate composition of the board of

directors, and strategically derived decisions on the balance between in-house innovation

and acquisitions.

Innovation and its associated complexity have important implications for the agency

relationship and the monitoring of entrepreneurs, particularly in high technology firms. First,

since innovation spurs entrepreneurs to acquire highly specialized knowledge (Nohria &

Ghoshal, 1994) and since such knowledge increases information asymmetry between them

and their investors, innovation may compound the agency problem. Second, innovation is

also likely to increase the ambiguity surrounding cause–effect relationships, provide multiple

decision options, and thus result in greater agent discretion and even a source of principal–

agent discord. Taken together, information asymmetry and discretion due to innovation may

hinder direct monitoring of entrepreneurs. Thus, it should not be surprising that venture

capitalists usually avoid making investments in high technology firms outside of a 1-h driving

radius of their office. By maintaining close physical proximity to their investments, venture

capitalists are able to become active investors by working more closely with entrepreneurs in

their investment portfolio, which helps to manage some of the information asymmetries for

the venture capitalists.

We echo Hitt et al. (1991a, 1991b) who suggest that since in-house innovation in new

ventures may have long time horizons, uncertain outcomes, and their revocation has no

immediate negative outcomes, heavy debt frequently forces entrepreneurs to reallocate

payments away from such activities. Boards should be weary of and strive to restrain

entrepreneurs for whom discipline and motivation to innovate are a direct function of their

firm’s debt. We suggest that an emphasis on acquisitive growth and risk-averse mindset may

cause entrepreneurs to reduce their commitments to in-house innovation. While not all

acquisitions are a stumbling block for innovation, we take the position that many high-growth

entrepreneurial firms do use acquisitions as a substitute for innovation. Our message is that

while one can apply an acquisition strategy and still be innovative, continuous investment in

in-house innovation is crucial for a firm’s long-term longevity and viability. Hence, firms

should consider related and complementary acquisitions when their own in-house innovation

projects are thriving.

Acknowledgments

We acknowledge with appreciation the useful suggestions of Maritza I. Espina on earlier

versions of this research.

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