Factor Payments, Resource-Based Bargaining, and the Creation of Firm Wealth in Technology-Based Ventures David M

Strategic Entrepreneurship Journal Strat. Entrepreneurship J., 2: 339–355 (2008) Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/sej.58

FACTOR PAYMENTS, RESOURCE-BASED BARGAINING, AND THE CREATION OF FIRM WEALTH IN TECHNOLOGY-BASED VENTURES DAVID M. TOWNSEND1* and LOWELL W. BUSENITZ2* 1 Department of Management, Innovation, and Entrepreneurship, College of Management, North Carolina State University, Raleigh, North Carolina, U.S.A. 2 Division of Management, Michael F. Price College of Business, The University of Oklahoma, Norman, Oklahoma, U.S.A.

A central tenet of resource-based logic is that undervalued resources utilized by ﬁ rms organized to exploit them will produce superior economic performance over the long run. Yet when young technology-based ventures pursuing new opportunities do not possess full property over these resources, input providers retain the right to bid up factor prices to match each resource’s marginal productivity. In response to these limitations in extant resource-based logic, we apply and extend Lippman and Rumelt’s full payments and bargaining perspectives and propose an alternative method by which entrepreneurs can generate ﬁ rm wealth through the unique bundling of cospecialized resources. Both theoretical implications and directions for future research are discussed as well. Copyright © 2009 Strategic Management Society.

INTRODUCTION Two unique features of the start-up process among technology-based ventures, however, raise impor- The specifi c actions entrepreneurs take to form and tant challenges to established resource-based logic. exploit opportunities in order to create wealth is First, the ubiquity of environmental uncertainty centrally important to the literature on strategic surrounding technology-based ventures makes it entrepreneurship (Hitt et al., 2001). According to increasingly diffi cult for entrepreneurs (even with resource-based theory, fi rm wealth is created and superior knowledge) to accurately estimate future preserved over the long run through the utilization revenues and costs to determine if a resource is of resources valued at point lower than their mar- indeed undervalued. Second, most technology-based ginal productivity (i.e., undervalued resources, ventures share property rights to inputs with key Barney, 1986) provided these resources are also suppliers (e.g., the technology is licensed, invest- fi xed (or quasi-fi xed) in supply (i.e., the Ricardian ment capital is provided in exchange for equity own- foundation of resource-based theory, Peteraf, 1993). ership, etc.). The existence of partial property rights coupled with systemic uncertainty implies that to the extent environmental uncertainty makes it diffi cult Keywords: technology-based ventures; resource-based theory; for each stakeholder to estimate a priori the rent factor payments; stakeholder bargaining; opportunity forma- tion and exploitation generating capacity of their input, these suppliers *Correspondence to: David M. Townsend, Department of often retain the right to correct any valuation errors Management, Innovation, and Entrepreneurship, College of over time to ensure full payment is received in Management, North Carolina State University, 2801 Founders Drive, Nelson Hall 1343, Campus Box 7229, Raleigh, N.C. exchange for use of the resource. Entrepreneurs con- 27695. E-mail: [email protected] tracting for key resources that seek to exploit new

340 D. M. Townsend and L. W. Busenitz opportunities are, therefore, unable to lock in any specifi c strategic factor remain as a pot of wealth to advantages the venture may have enjoyed from be divided among those who possess residual rights utilizing a resource initially undervalued. of fi rm ownership. This perspective has major impli- Based on these issues, this article argues for an cations for how we think about and examine the alternative framework for investigating the creation development of new opportunities by technology- of fi rm wealth in technology-based ventures. Build- based ventures. ing from Lippman and Rumelt’s (2003a; 2003b) Our emphasis here on resource complementarities recent work outlining the full payments and bargain- offers a more grounded view of what actually occurs ing models, we argue that entrepreneurs can gener- in the resource acquisition process of technology- ate superior fi rm wealth over the long run through based ventures. For example, industry insiders often the unique bundling of complementary resources. recommend that entrepreneurs, in order to create We demonstrate here that under such a model, fi rm superior wealth over the long run, should look for wealth can be created and preserved over the long venture capitalists who can provide value (i.e., run even, when key input providers fully appropriate managerial expertise, legitimacy, etc.—besides just the individual marginal product created through the capital), rather than just taking the deal which takes use of their inputs (e.g., Makowksi and Ostroy, the least amount of equity in exchange for capital. 1995; 2001; Lippmann and Rumelt, 2003a; 2003b). Conversely, venture capitalists often note that one By implication, the unit of analysis in this article of the primary indicators they use in making their shifts from an exclusive focus on the Ricardian prop- investment decisions is whether they think they can erties of individual resources (e.g., Peteraf, 1993; work well with the venture’s management team Peteraf and Barney, 2003) to an analysis of the (Bygrave, 2003). Therefore, potential complementa- synergistic interaction among complementary fi rm rities between the management team and investors resources as the mechanism for wealth creation (such as venture capitalists) appear to play a signifi - through the development of new opportunities. cant role as investors decide whether to fund a new In a regime characterized by high uncertainty and opportunity. At the fi rm level of analysis, we expect partial property rights, the alternative perspective we that when such complementarities emerge among construct here provides several unique advantages individual resources, they account for the variable for resource-based logic over the traditional under- amount of wealth generated by individual fi rms valued resource perspective. Strategic factor market pursuing new opportunities (Foss and Ishikawa, theory builds on the premise that temporary factor 2007). market imperfections create the opportunity for fi rm As a basis for this discussion, we have organized resources to be purchased at a price point below their the article in the following manner. First, we note individual rent-generating potential (Barney, 1986; the current state of the resource-based literature with 2001). Over time, increasing pricing effi ciency will a specifi c focus on the contribution of the underval- determine whether the entrepreneur correctly fore- ued resources perspective as a key component of the casted the true economic value of a particular resource heterogeneity approach. Next, we outline resource (Peteraf and Barney, 2003). The assump- some of the criticisms of the resource heterogeneity tion is that the long-term economic benefi t locked in approach culminating in Lippmann and Rumelt’s by the entrepreneur is derived directly from the recent work on the factor payments and resource exploitation of an earlier valuation error made by bargaining models (2003a; 2003b). Based on this another input provider. But where suppliers retain discussion, we then formulate a series of proposi- partial property rights over their inputs, they reserve tions applying Lippmann and Rumelt’s models to the ability to correct these valuation errors through predict the generation of wealth in technology-based various bargaining tactics with the end objective of ventures. Lastly, we highlight several implications at least securing a payment stream in equilibrium of these propositions for resource-based theory and with their input’s marginal product (Makowski and offer several suggestions for future research. Ostroy, 2001; Lippman and Rumelt, 2003b). Con- versely, when the exploitation of new opportunities occurs through the super additive combination of THEORETICAL BACKGROUND two or more resources, it implies that even if key input providers work to secure these factor pay- Over the past 20 years, resource-based logic ments, surplus revenues not directly attributed to a has emerged as a central paradigm in strategic

Copyright © 2009 Strategic Management Society Strat. Entrepreneurship J., 2: 339–355 (2008) DOI: 10.1002/sej Factor Payments, Bargaining, and Firm Wealth 341 management theory (Lippman and Rumelt, 2003a; Shimizu, 2007; Newbert, 2007). These questions Barney and Arikan, 2001; Barney, 1991). Resource- have immense theoretical and practical signifi cance based theories of organizational performance con- among new technology-based ventures, given that tinue to shape how management scholars think about most fi rms organize around a set of resources whose and explore the causes of fi rm performance (cf. value is often not known a priori (cf. Makadok and Peteraf and Barney, 2003). Within this tradition, Barney, 2001) recent work by Lippman and Rumelt (2003a; 2003b), Factor markets and resource valuation. A central capitalizing on fundamental paradigmatic develop- assumption of resource-based logic is that resources ments in economic theory, constructs two comple- are valuable to the extent they allow fi rms to exploit mentary perspectives (i.e., the factor payments and external opportunities and/or threats (or increase bargaining perspectives) for exploring the link revenues or decrease costs) (Barney, 1991). Priem between resources and performance differentials and Butler (2001a), however, argue that such rea- among fi rms. We now highlight key developments soning is tautological given that competitive advan- in RBT and discuss the substance of specifi c criti- tages created by the use of valuable resources are cisms that have emerged in the literature to provide defi ned in the same terms as the metrics used to a basis for an analysis of how the emerging perspec- value a resource (e.g., the resource increases fi rm tives fundamentally reshape resource-based logic. effectiveness/effi ciency). Barney, while disputing the claims that resource-based logic is tautological does acknowledge that ‘. . . the determination of the Resource heterogeneity and undervalued value of a fi rm’s resources is exogenous to the strategic factors resource-based theory presented in the 1991 article’ At its conceptual core, RBT relies upon the premise (2001: 42). He goes on to suggest that consistent that individual fi rms possess partially heterogeneous with more recent work in RBT, market conditions stocks of resources (Penrose, 1959; Wernerfelt, determine when (or if) resources are valuable. 1984; Barney, 1986; Barney, 1991; Peteraf and The market conditions perspective originally Barney, 2003). Superior fi rm performance (i.e., con- emerged when Barney (1986) argued that manag- ceptualized as economic rents) derives from the ers/entrepreneurs must utilize resources that are implementation of unique strategies leveraging undervalued by strategic factor markets to produce resource base differentials. In RBT, these rents are superior economic performance. Resources are Ricardian, since rent payments are made in exchange undervalued when the price of the particular resource for the use of inputs that are fi xed (or quasi fi xed) in does not fully refl ect the value to be created by the supply (Peteraf, 1993). This implies that when use of the resource (or when the marginal revenue demand for these factors increases as it becomes generated exceeds the marginal cost of utilizing the apparent they can be used to exploit an opportunity, resource). This can occur when the entrepreneur the relative inelasticity of supply will increase the procures a resource at a pricing threshold below that value of these resources. Firms, then, that acquire of its revenue potential. resources at a lower price point than current market To identify these undervalued resources, Barney prices are able to earn economic rents (e.g., net cash (1986) proposes that managers/ entrepreneurs either fl ows in excess of breakeven) and outperform com- utilize superior information or simply capitalize on petitors who are forced to acquire critical resources luck in discovering the resource/market opportunity. at the higher, current market prices. Eventually, however, the increasing pricing effi - While Ricardian economics offers an explanation ciency of strategic factor markets would eliminate as to why performance differentials persist over the possibility of generating positive economic time, the Ricardian framework is less helpful for profi ts because the market will eventually able to explaining how resources become valuable in the fully refl ect the value of the entrepreneur’s strategy. fi rst place. Furthermore, although a considerable By implication, then, the relative pricing effi ciency amount of prior research largely confi rms that of the strategic factor market discourages imitation valuable resources are positively associated with by competitors because the increased demand for the increased fi rm performance, few have explored how strategic resource will increase its acquisition cost these resources are initially accumulated/acquired (or, concomitantly, its value to the entrepreneurial by fi rms or the specifi c factors that determine fi rm). At the base of this argument, however, is the the intrinsic value of a resource (Armstrong and notion that strategic factor markets are not fully

Copyright © 2009 Strategic Management Society Strat. Entrepreneurship J., 2: 339–355 (2008) DOI: 10.1002/sej 342 D. M. Townsend and L. W. Busenitz informationally effi cient (Barney, 1986; Foss and the process—the entrepreneur—benefi ts from the Ishikawa, 2007). undervalued resource. The issue is not that input Dierickx and Cool (1989) argue that some critical providers should not appropriate any rents, given resources affecting a fi rm’s relative performance that profi t generation is a central goal of any corpo- simply are not openly traded on factor markets, but ration. Rather, suppliers appropriating rents in excess accumulate over time, through various ways, in of those required as payments for the use of specifi c fi rms. To the extent fi rms can bundle and deploy strategic factors they provide diminishes the rents these resources to exploit emerging opportunities, payable to other key suppliers, thereby minimizing performance differentials can persist given the dif- the effect of valuable resources on fi rm-level fi culty in transferring these resources between fi rms performance (Coff, 1997; 1999). (Dierickx and Cool, 1989). Building on this argu- Given the need to acquire key inputs from ment, because certain resources are not openly external providers to even initiate operations, traded, strategic factor markets provide limited these challenges can be exacerbated among new pricing information managers/entrepreneurs can use technology-based ventures. In addition to licensing to determine the value of a resource (Denrell, Fang, intellectual property from universities, many tech- and Winter, 2003). Furthermore, even when a nology ventures must also procure investment capital corresponding factor market exists for key resources, from external providers and source other key inputs the emergence of super-additive returns increases from external organizations to construct the resource the diffi culty of accurately valuing resources (Denrell base of the fi rm (cf. Shane and Stuart, 2002; Shane, et al., 2003). The implication is that the price system 2000). The embedded challenges of resource valua- provides only limited information for determining tion and stakeholder appropriation can, in some situ- the value of certain types of and combinations of ations, lead to ineffi cient outcomes where the input resources. provider is not able to fully appropriate the rents Stakeholder bargaining and resource valuation. generated by the use of their specifi c resources Without the aid of an effi cient pricing system, sup- (cf. Makowski and Ostroy, 2001). pliers providing critical inputs to new technology- Appropriation concerns raise the issue of how bar- based ventures have limited information upon which gaining positions initially emerge and subsequently to value their resources. Consider a university licens- evolve among key suppliers (Barney and Arikan, ing a breakthrough technology to a start-up fi rm. 2001). Furthermore, to the degree bargaining posi- Given that a complete external market does not exist tions emerge early on in the resource acquisition for the technology, the university has little informa- process, Barney and Arikan (2001) question whether tion to use to accurately estimate its value. Further- the relative strength of a stakeholder’s bargaining more, a new venture rarely possesses a suffi cient position would be refl ected in the value assigned to asset base to ensure that the university can garner the resource. Under this line of the reasoning, the complete royalty payments for the life of the licens- value of a resource, then, could at least partially be ing agreement. Although the university will use a function of the ability of the supplier to command whatever available information it can fi nd to esti- rents in exchange for use of the resource. Overall, mate future cash fl ows, etc., to accurately value the though, the implication of this line of research is that technology, the inherent uncertainty of this process performance differentials between fi rms are only greatly increases the chance the technology will part of the RBT story. Eventually, the accumulated either be over- or undervalued; The university will rents must be distributed to key suppliers and RBT extract either too many or too little rents in exchange needs further development to explain how this for the use of the technology. process should unfold. In RBT, the ability of the entrepreneur to acquire the technology at a lower price point than its ulti- Factor payments and bargaining models mate value, to date, is generally viewed as a positive for the venture, given that it allows the fi rm (read— In response to these issues, Lippman and Rumelt the entrepreneur) to collect the excess cash fl ows (2003a; 2003b), in two companion articles capital- generated by using the undervalued technology. The izing on recent developments in economic theory gain of the entrepreneur, therefore, comes at the (e.g., Makowski and Ostroy, 2001; 1995), offer expense of the university. The problem with this several revisions to resource-based logic. First, approach, however, is that only one stakeholder in Lippman and Rumelt (2003a) argue that all fi rm

Copyright © 2009 Strategic Management Society Strat. Entrepreneurship J., 2: 339–355 (2008) DOI: 10.1002/sej Factor Payments, Bargaining, and Firm Wealth 343 revenues are payments for the use of specifi c FACTOR PAYMENTS AND resources. Thus, the value of a resource is indicated RESOURCE-BASED BARGAINING by the amount of the fi rm’s revenue that can be attributed to the resource.1 Second, instead of As noted above, the combination of systemic uncer- viewing suppliers as price takers (e.g., assuming tainty and the bargaining power of suppliers derived markets and prices are a given, Makowski and from possession of partial property rights increases Ostroy, 2001), managers/entrepreneurs should be the diffi culty of locking in superior economic returns viewed as creators of new value or even new markets over the long run through the use of undervalued through innovative action (Lippman and Rumelt, resources. Following Lippman and Rumelt (2003a; 2003b). The value—as indicated by its price—of the 2003b), we argue that entrepreneurs can still gener- resource emerges through a complex bargaining ate superior wealth through the construction of process whereby suppliers seek to extract rents from specifi c resource complementarities within the fi rm. a venture based on the relative strength of their bar- We now contextualize the factor payments and gaining position and their relative contribution to the bargaining models within technology-based entre- marginal product of the venture. In this process, preneurship and outline a series of theoretical markets need not play a central role in determining propositions. the a priori value of resources. Third, complementarities between resources create surplus revenues Factor payments and resource valuation that are not directly attributable to specifi c resources and, therefore, allow fi rms to generate wealth in As we mentioned above, given the primary objective excess of the marginal contribution of each resource of predicting the sustainability of competitive advan- (Lippman and Rumelt, 2003a; 2003b). Under these tages between fi rms, early RBT work generally conditions, therefore, fi rms can generate wealth even equated the value of a resource to its ability to enable when individual suppliers seek to achieve some the fi rm to exploit opportunities or defend against equality between the marginal product they provide emerging threats (Barney, 1991). Eventually this and the rents they are able to extract from a perspective was modifi ed to include the ability of venture. resource to increase fi rm revenues and/or decrease Based on these points, Lippman and Rumelt costs. For example, Peteraf noted that ‘. . . fi rms (2003a) argue that the goal of any fi rm is to maxi- with superior resources have lower average costs mize the surplus revenues (e.g., wealth) created than other fi rms’ (1993: 180), refl ecting—at least through the unique bundling of resources (2003a). implicitly—the logic of strategic factor market While this process does create a bargaining chal- theory (Barney, 1986). lenge whereby these surplus revenues must be allo- However, Lippman and Rumelt (2003a) point out cated among the key suppliers, the broader that there exists substantial disagreement in neoclas- implication is that the total wealth created by the sical theory regarding the substance of economic fi rm potentially increases as unique resource com- costs, and that this issue has migrated into RBT plementarities emerge from combining individual through the coupling of superior economic perfor- resources. These resources, however, do not neces- mance with the notion of economic rents (e.g., sarily have to be scarce—or even undervalued—to Peteraf, 1993). The central issue derives from the produce a sustainable strategic advantage, but rather application of opportunity cost logic to the process the unique bundling of resources (even commodi- of valuing resources, particularly when unique ties) can produce superior fi rm wealth (Lippman and complementarities exist between specifi c resources Rumelt, 2003a). Based on this foundation, we now (Lippman and Rumelt, 2003a). Specifi cally, when a develop how the factor payments and bargaining fi rm can leverage complementarities between models enable technology-based ventures to produce resources, two conditions emerge. First, these com- fi rm wealth, even when the fi rm does not possess binations are unpriced by external factor markets full property rights to its inputs. since the value that is created is unique to the fi rm. Second, given that the fi rm is uniquely positioned to capture the value created by the complementary resources, the logic of opportunity costs is no longer 1 Lippman and Rumelt (2003b) offer rent sensitivity analysis as a tool for measuring the variance in revenue each resource is relevant for determining the true economic costs responsible for. of utilizing specifi c resources; there simply are no

Copyright © 2009 Strategic Management Society Strat. Entrepreneurship J., 2: 339–355 (2008) DOI: 10.1002/sej 344 D. M. Townsend and L. W. Busenitz alternative uses between fi rms for complementary Regarding the lack of a role for markets in the resources (Lippman and Rumelt, 2003a). Therefore, pricing of specifi c assets, Lippman and Rumelt fi rm profi ts as the simple difference between a fi rm’s (2003a) argue that the aggregated value of strategic revenues and factor costs are best conceptualized as factors can also be expressed in the total market simple rents versus the more standard concept of capitalization of public fi rms (i.e., again, the value economic rents generally embedded in RBT logic of a resource is a function of discounted future cash (Lippman and Rumelt, 2003a). fl ows). While prerevenue technology-based ventures Valuable resources and fi rm valuation. Even with are almost never publicly traded, they do engage in this extensive discussion regarding the nature of the process of resource accumulation and/or devel- economic rents and costs briefl y outlined above, opment. Furthermore, critical resources are often resource-based theorists are still left with the issue acquired in exchange for at least partial property of how to value resources given the absence of an rights over the residual cash fl ows of the venture external market mechanism. Though subtle, Lippman (i.e., investment capital exchanged for partial equity and Rumelt (2003a) work to resolve this issue by ownership; technology licensed in exchange for making several fundamental contributions to RBT partial equity ownership, etc.). When the ownership through the factor payments perspective. First, over the residual cash fl ows of the venture is set whereas the current dialogue in RBT focuses on the based on the exchange of key inputs for equity own- role of external markets in valuing resources based ership, fi rm value is also determined, since these on the relative tradeability and/or completeness of input providers are basing their equity demands at factor markets (Denrell, et al., 2003), Lippman and least partially on future expected cash fl ows from the Rumelt suggest that value emerges endogenously as venture. Therefore, the value of even privately held the fi rm generates wealth (e.g., ‘. . . net revenues are fi rms still refl ects the aggregated value of the fi rm’s the sum of payments to all resources,’ 2003a: 921).2 strategic resources. By implication, then, the value Specifi cally, the value of a resource is a function of of individual resources can be determined by the the portion of the fi rm-level revenues generated marginal contribution of each to the total valuation by the use of the resource minus the payments made of the fi rm. to the factor owner in exchange for the use of the resource. As such, external markets for resources Proposition 1: There is a positive relationship are not necessary for determining the value of between the expected value of key strategic resources. This condition becomes especially critical resources and the total valuation of technology- when complementarities exist between individual based ventures. resources. Among young technology-based ventures, this The standard empirical strategy in resource-based approach, while helpful, still does not fully resolve studies focuses on the relationship between the valu- the challenge of resource valuation, since most able, rare, and imitability properties of individual young fi rms do not immediately generate revenue resources and fi rm performance (e.g., Crook et al., (cf. Varian, Farrell, and Shapiro, 2004). However, 2008). Lippman and Rumelt (2003a) expand this entrepreneurs and other key suppliers are still making discussion to focus on the properties of the interac- critical investments in resources and decisions tion among fi rm resources. Specifi cally, Lippman regarding the confi guration of these resources in the and Rumelt (2003a) suggest that fi rms are coalitions fi rm during the prerevenue stage. Under these condi- of multiple resources, including commodities and tions, in the absence of revenue, do alternative scarce resources. Since commodity inputs are priced methods exist for valuing resources? on factor markets and prices for these inputs are generally somewhat elastic, Lippman and Rumelt (2003a) suggest that commodity resources and scarce resources play the central role in determining 2 This argument closely resembles recent work by Kohn (2004) the net revenues in a venture. The task of the busi- who argues that a fundamental paradigm shift—from a value paradigm to an exchange paradigm—is underway in economic ness strategist is to create various combinations of theory. In the exchange paradigm, Kohn (2004) argues, eco- these resources in order to maximize the extra cash nomic agents can strategically set prices for their inputs based fl ows (Lippman and Rumelt, 2003a). on expected value and, therefore, value emerges as a conse- quence of their overall bargaining process, rather than as an To create these valuable combinations of resources, input into the bargaining process. entrepreneurs should focus on developing and

Copyright © 2009 Strategic Management Society Strat. Entrepreneurship J., 2: 339–355 (2008) DOI: 10.1002/sej Factor Payments, Bargaining, and Firm Wealth 345 exploiting complementarities among key resources future cash fl ows of technology-based ventures (Lippman and Rumelt, 2003a). Complementarities can be used for determining the value of strategic exist between resources when the total value created resources, these propositions also create a conun- from the combined use of these resources exceeds drum for resource-based theorists. If key suppliers the value created from the individual contribution of believe their specifi c inputs are essential for the cre- each resource (Teece, 1986; Lippman and Rumelt, ation of wealth by the venture, they will likely 2003a). As noted above, resource complementarities command higher factor payments in exchange for are especially important to the creation of fi rm the use of these resources (Lippman and Rumelt, wealth, since various combinations are not priced on 2003b). This line of reasoning is based on recent factor markets—especially as combinations of developments in economic theory shifting the defi ni- resources grow more complex (Lippman and Rumelt, tion of perfect competition away from price taking 2003b) and the value created can generally only be to full appropriation (e.g., Makowski and Ostroy, captured by the coalition of factor providers with 1995; 2001). When markets are perfectly competi- residual rights of ownership within the fi rm. The tive, input providers are able to fully appropriate initial process of organizing a young technology- their marginal contribution to wealth creation in based venture should yield some complementarities the economy (Makowksi and Ostroy, 2001). among strategic factors within the fi rm (i.e., the Recall our earlier example regarding the univer- combined experience and skill of the management sity licensing an undervalued technology to an entre- team in working specifi c technologies, relationships preneurial venture. By implication of the above, we with specifi c funding agents, etc.). Furthermore, to would expect university offi cials to engage in tactics the extent that complementarities do not emerge, to bid up their factor payments as the value of tech- potential signals are provided to other possible sup- nology becomes more apparent over time. These pliers that fundamental fl aws exist with the venture’s increased factor payments, in turn, either increase core value proposition (Lippman and Rumelt, the operational costs of the venture (i.e., increased 2003b). If it becomes apparent that suffi cient com- royalty payments) or reduce the amount of equity plementarities do not exist, a lack of fi t is evident available to other key suppliers (i.e., demand for among key strategic factors within a young venture, more equity) depending upon the specifi c details of and key suppliers would likely conclude that the each contractual arrangement. This erases any venture will not be able to generate suffi cient future temporary advantages stemming from the use of an cash fl ows (i.e., wealth). This would diminish the undervalued strategic resources.4 Furthermore, in value they place on the fi rm as a whole. By implica- both cases, the relative bargaining position of key tion, the degree to which a fi rm can develop comple- suppliers potentially diminishes the amount of mentarities among key strategic resources will wealth (i.e., net cash fl ows) created by the venture increase the total valuation of the fi rm above the that can be distributed among the venture’s residual valuation of a comparable fi rm with the same owners. set of resources but with weaker development of Resource specialization and wealth creation. To complementarities among these resources.3 fully understand the relationship between factor payments, bargaining positions, and the creation of fi rm Proposition 2: There is a positive relationship wealth, we must consider the impact of specialized between the expected value of complementarities resources. This involves most of the earlier work on that emerge among key strategic resources and RBT (see Barney and Arikan, 2001, for a review). the total valuation of technology-based ventures. According to Teece (1986), resource specialization refers to a situation where value creation derived Bargaining and resource valuation Whereas the expected marginal contribution of specifi c resources and resource combinations to the 4 Among technology-based ventures, key stakeholders extract factor payments in the form of either direct compensation or equity positions within the company. For example, whereas investors typically will not take any direct compensation in 3 As we argue in propositions 5–7, resource cospecialization favor of large equity stakes, hired employees often take direct does not inevitably emerge among a set of resources based on compensation coupled with small equity stakes in the company. the properties of these resources. Rather, it is the central task The exact mix of these different types of compensation is an of the entrepreneur to develop cospecialization among these interesting extension of this study, but one we will not address resources. here in much detail.

Copyright © 2009 Strategic Management Society Strat. Entrepreneurship J., 2: 339–355 (2008) DOI: 10.1002/sej 346 D. M. Townsend and L. W. Busenitz from the bundling of complementary resources is now jointly dependent upon both the scientist’s unilaterally dependent on a specifi c resource. For knowledge and the managerial team’s marketing example, suppose the technology licensed by the capabilities. If we were to remove either of these university to the venture was developed by a scien- components, the venture would likely create far less tist who is the only person in the world that can wealth. Value creation in this situation, then, is successfully engineer, adapt, and advance the tech- derived from the cospecialized mix of several nology. Without access to complementary resources resources within the fi rm. within the fi rm, the scientist does not possess the Resource cospecialization produces several inter- tools he/she needs to successfully develop the tech- esting effects on the bargaining position of individ- nology, but perhaps the scientist could gain access ual suppliers within a venture. First, in light of the to these resources in several different fi rms. By fact that the net cash fl ows created by the venture implication, although the only way value can be are a function of the interaction between two created in this situation is through the interaction of resources, the marginal test for determining the the scientist’s knowledge and the venture’s comple- value of strategic resources (suggested by Lippman mentary resources, the scarce resource is still the and Rumelt, 2003a) would indicate that both scientist’s knowledge. resources are equally important for generating wealth Based on these conditions and following the (e.g., remove one from the equation and the net reasoning of Makowski and Ostroy (1995; 2001), we revenue stream falls precipitously). Furthermore, could assume that the scientist—through the univer- supposing Makowksi and Ostroy’s (1995) model of sity—would command higher factor payments (i.e., perfect competition as full appropriation holds, greater royalty payments and/or equity stakes in the factor payments in equilibrium with each resource’s venture) in exchange for the use of his/her special- marginal product would likely be far less than they ized input. In this case, the improved bargaining would be if either resource was simply specialized position of the scientist leads to higher factor pay- (versus cospecialized). By implication, holding the ments made by the venture. Furthermore, higher individual value of a resource constant, the bilateral factor payments reduce the venture’s overall wealth dependence of cospecialized resources implies that that can be distributed to the entire pool of the cost basis of the fi rm would be lower, thereby suppliers. increasing the amount of wealth generated. Even if each stakeholder fully appropriates the marginal Proposition 3: There is a positive relationship product of his/her specifi c input, a large reservoir of between the degree of specialization embedded in surplus revenues (i.e., fi rm wealth) exists which can strategic resources and the corresponding factor then be distributed among the residual claimants. payment (i.e., increased operating costs or equity requirements) necessary to employ these resources Proposition 4: There is an inverse relationship within technology-based ventures. between the degree of cospecialization among strategic resources and the corresponding factor Resource cospecialization and wealth creation. In payment (i.e., increased operating costs or equity light of the negative impact of resource specializa- requirements) necessary to employ each resource tion on wealth creation within technology-based within technology-based ventures. ventures, it is not surprising Lippman and Rumelt (2003a; 2003b) focus their attention on the role of The emergence of cospecialized resources cospecialized resources in the creation of fi rm wealth. According to Teece (1986), resource cospe- So far our discussion has principally focused on cialization emerges when a bilateral dependence wealth creation being a function of the interaction emerges between two or more resources embedded among strategic resources. The wealth-creating within a fi rm. For example, suppose over time an potential of strategic resources is contingent upon entrepreneurial team learns how to successfully how these resources interact with other resources, market the technology developed by the scientist. not simply a static artifact of each individual Although they may not understand how to develop resource. As implied with our technology licensing the technology on their own and, therefore, still need example above, we suggest that the cospecialization to employ the services of the scientist, the actual of resources can emerge over time—even from successful commercialization of the technology is resources that were initially specialized (Siggelkow,

2002). Building on Lippman and Rumelt (2003b), strategy of the fi rm (Porter, 1996). Simple consis- we now argue that the central wealth-creating task tency refers to the ability of certain strategic factors of the entrepreneur is to develop cospecialization to deliver common elements of a venture’s value among a fi rm’s core set of resources. (Siggelkow, proposition. While simple consistency is the weakest 2002; Porter, 1996; Milgrom and Roberts, 1995). form of cospecialization, it nevertheless lays a Strategic fi t and resource cospecialization. In foundation upon which increasing levels of cospe- much of the earlier research on resource comple- cialization can be built by reducing stakeholder mentarities, the central managerial task was to utilize opportunism—and, by implication, reducing these unique resource combinations to achieve stra- corresponding factor payments—through develop- tegic fi t among a fi rm’s strategy, structure, and pro- ing cooperative arrangements among a set of cesses (Milgrom and Roberts, 1990, 1995; Porter, resources. 1996). A central contribution of this literature is that As a largely defensive maneuver, the accumula- rather than seeing fi t as a static equilibrium derived tion of strategic substitutes (i.e., inputs can be sub- from some blueprint confi guration of an organiza- stituted for each other in the venture’s production tion’s resources, developing fi t from complementary processes)5 enables the venture to reduce the corre- resources involves a complex process of exploring sponding factor payments made to each stakeholder. where evolving interactions produce multiple equi- The corresponding reduction in bargaining costs libria (Rivkin and Siggelkow, 2007). This will no occurs because each resource is being used as a doubt involve leveraging trade-offs among various hedge against price increases (i.e., factor payments) resource combinations (Porter, 1996). While it may by the other strategic input provider. Stated differ- not be possible to initially fully maximize fi rm value ently, if one factor provider attempts to charge a from specialized and cospecialized resource pair- higher price for its input, the venture can substitute ings, it is possible to create new value propositions the other input in order to maintain the current costs from novel combinations of resources (cf. Lippman of production. Therefore, the ability to utilize stra- and Rumelt, 2003b). tegic substitutes creates a hedge against opportunis- While similarities exist in building cospecialized tic behavior by input providers since the venture resources across young and mature fi rms alike, can simply utilize substitute inputs if one provider several fundamental differences do exist with young attempts to extract payments in excess of its mar- technology-based ventures. First, among many ginal contribution (cf. Milgrom and Roberts, 1990). young ventures, the strategic focus of the fi rm is Among young ventures, entrepreneurs have a broader often not well defi ned, but potentially is derived set of potential strategic substitutes since the focal from the specifi c resources the fi rm has already outcomes are not well defi ned. accumulated (cf. Sarasvathy, 2001). Second, while The issue, however, with the ability of ventures the venture often possesses a set of key resources, to reduce bargaining costs through the possession of the structure of the organization is generally not yet strategic substitutes is whether such redundancy is a established, but emerges as the venture organizes wise investment for a young venture with low around key elements of the value proposition amounts of fi nancial slack (cf. George, 2005). The (i.e., resource complementarities, Siggelkow, 2002). answer, of course, is dependent upon the extent to Consistent with these differences, the evolution of which key strategic factors provided to the venture strategic fi t develops through the bundling of com- are specialized. For example, given the specifi c type plementary resources. Porter (1996) sees the bun- of commercialization model adopted by many tech- dling of resources involving three progressive stages: nology-based ventures characterized by high fi xed simple consistency, reinforcing other key elements, costs and nonexistent revenues during the start-up and optimization of effort. In the fi nal three proposi- phase (cf. Varian et al., 2004), many are forced to tions developed below, we extend these arguments acquire external capital to fund early operations. to show how resource complements can be built into Initially, investment capital can be considered as a cospecialized resources—a crucial component of specialized resource since the venture is unilaterally fi rm-level strategic fi t. Resource cospecialization stage one: reducing bargaining costs. The fi rst stage in achieving strate- 5 In this article we refer to substitutes in the most general defi ni- tion of the word. Namely, the fi rm can utilize either input to gic fi t through the bundling of resources is simple accomplish the same general objective of the fi rm’s production consistency between the resource and the overall activities.

Copyright © 2009 Strategic Management Society Strat. Entrepreneurship J., 2: 339–355 (2008) DOI: 10.1002/sej 348 D. M. Townsend and L. W. Busenitz dependent upon the investor to cover signifi cant Resource cospecialization stage two: increasing operational losses. Furthermore, to the extent the net revenues. The next stage of bundling resources future fortunes of the venture are contingent upon involves the venture attempting to develop comple- the receipt of early capital investments, investors can mentarities among these resources. As described bid up their factor payments (i.e., equity stakes) to above, resource complementarities emerge when levels that potentially exceed the actual marginal ‘doing more of one thing increases the returns to contribution of the investment capital to the actual doing more of another’ (Milgrom and Roberts, 1995: long-term performance of the organization. 181). A by-product, then, of complementarities To hedge against this possibility, some entrepre- among key resources is super additive returns to the neurs will attempt to accumulate capital from a interaction of two or more variable factors. For variety of sources to reduce the overall bargaining example, among technology-based ventures, a key power of the capital provider (cf. Denis, 2004). early step many ventures must take is the simultane- In some cases, this may involve the acquisition of ous investment in product development and the different types of capital (i.e., debt versus equity development of a team with diverse capabilities that fi nancing) or sourcing capital from a broader set of can move a technology towards commercialization. providers (i.e., strategic and equity investors, cf. In this case, the interaction of resources (technology Denis, 2004). But a far more frequent response since and team complementarities) has the potential to capital raising is a diffi cult and time-consuming increase the effect of each resource on value creation process is the implementation of bootstrapping within the venture. If team capabilities are too fi nancing strategies to at least partially offset certain different or have diverse perspectives on where the early expenses borne by the venture (Winborg and commercialization opportunities are, then comple- Landström, 2001; Van Auken, 2005). In this regard, mentarities are unlikely to develop, crippling the the fi nancial management capabilities of the entre- economic potential of the venture. preneur can serve as at least a partial strategic sub- By implication, suppose a technology venture that stitute for outside capital, thereby reducing the has licensed a set of IP from a university is seeking unilateral dependence of the venture on the investor to hire a qualifi ed CEO to manage the early develop- (e.g., Van Auken, 2005).6 As a defensive maneuver, ment and growth of the company. If key insiders therefore, the accumulation of strategic factor sub- were to utilize an undervalued resource perspective stitutes can reduce the potential of factor providers as the fi lter through which they evaluate potential of engaging in opportunistic behavior by bidding up candidates, they would probably develop some rank the required factor payments. In turn, as a crucial order of candidates based on the combination of the fi rst step, this reduction in the ability of factor pro- value of these candidates’ managerial skills and viders to engage in opportunistic behavior opens the abilities with each person’s salary demands. To the door for cooperative arrangements to be developed extent the fi rm can obtain the services of a skilled between resource providers, since no one input is candidate for a below market wage (i.e,. lower factor irreplaceable in the venture’s production processes. payments), extant strategic factor market theory pre- In no way do we suggest that these strategic factors dicts the fi rm should generate superior economic are perfect substitutes for each other, but at this early performance over the long run. stage, the extent to which each type of input can The challenge, however, with this approach—as produce the key organizational outcome allows we have noted throughout this article—is that when the venture to utilize these different resources as resource providers maintain at least partial property strategic substitutes. rights over their inputs, they retain some bargaining power they can utilize to bid up their corresponding Proposition 5: The accumulation of substitute factor payments over time into equilibrium with the strategic factors reduces the factor payments value they provide to the fi rm. By implication, the required to obtain the services of key individual fi rm cannot lock in long-term economic returns resources within technology-based ventures. derived from paying these individuals below market wages over the long run. In a discussion regarding the impact of resource complementarities on strategic fi t, Milgrom and Roberts (1995) highlight the 6 This specifi c situation reminds us of a common adage in entrepreneurial fi nance circles: the ventures that do not need impact of human resource incentive policies at external capital have the easiest time raising it. Lincoln Electric, a top-performing company in its

Copyright © 2009 Strategic Management Society Strat. Entrepreneurship J., 2: 339–355 (2008) DOI: 10.1002/sej Factor Payments, Bargaining, and Firm Wealth 349 industry. The basic gist of this policy is that the cospecialization of key organizational resources. company tries to precisely measure and compensate Over time, as the highly relevant skills and abilities accordingly the marginal contribution of each of the CEO interact with the particular technology employee. As a result, through a system of bonuses, in development, the joint effect of these combined the encouragement of employee ownership, a policy resources should increase the marginal product of of no layoffs, and other such complementary HR each strategic factor. By implication, the venture policies, superior performers can often signifi cantly should be able to produce higher net revenues given increase their salaries (i.e., factor payment) to match the reduced bargaining costs coupled with the their specifi c contributions to the company while increasing cospecialization between resources. still enabling the fi rm to outperform its rivals. As Proposition 6: The development of strategic factor such, Milgrom and Roberts argue that the comple- complementarities increases the marginal product mentary pay systems and HR programs at Lincoln of bundled strategic factors without a correspond- Electric ‘. . . create strong incentives for high and ing increase in factor payments within technol- growing productivity and the means to achieve it’ ogy-based ventures. (1995: 203).7 Furthermore, since the bonus system operates within a system of complementary factors, Resource cospecialization: optimizing the value each of these factors reinforces the effects of proposition. The third stage in bundling resources is the other factors, thereby decreasing the singular the optimization of effort derived from the interac- importance of any isolated factor for producing tion of core elements within the organization (Porter, superior performance. 1996). However, the complex nature of the organiz- By implication, this example suggests that the ing process often prevents full optimization. The technology venture’s stakeholders should focus their optimization process we describe here allows ven- search on a CEO whose skills, background, and tures to minimize bargaining costs while increasing abilities can reinforce key elements of the value the marginal product derived from use of cospecial- proposition the venture is attempting to create. Fur- ized resource bundles to achieve local optimization thermore, given that it is likely the CEO candidate (e.g., Rivkin and Siggelkow, 2007). Over time, as will eventually bid up his/her factor payments to the value of these bundles becomes apparent, the achieve some equilibrium with the value he/she pro- venture can work to link these key elements to vides to the company, the individuals responsible for achieve more global optimization at the fi rm level. selecting a CEO should be less concerned with However, through this development process, the trying to acquire the services of a CEO for a below accumulation of strategic factor substitutes and the market wage. To be clear, we are not suggesting that experimentation with various resource bundles ventures frivolously spend capital by overpaying for creates the possibility that the venture will develop the services of a particular CEO. Instead, our central stockpiles of redundant and/or unnecessary inputs. observation is that fi rms should (or they eventually Over time these stockpiles may increase the ineffi - will) pay for services of key resources (human or ciency of the venture (cf. George, 2005). As a crucial other) in equilibrium to the value they provide to the fi nal stage in this process, optimization allows ven- company. For a company with low cash reserves, tures to cast off unnecessary inputs while working this implies that they could develop a compensation to integrate key cospecialized resource bundles. package that utilizes more equity ownership in lieu Regarding the optimization of effort, Porter (1996) of direct salary. As we noted above, both forms of describes how the inventory control systems at the compensation serve as a factor payment to the clothing store Gap enable the fi rm to keep store employee. The mutual reinforcement between the shelves stocked without having to maintain large abilities of the CEO candidate and the key in-store inventories (thus keeping costs low). Gap is elements of the value proposition the venture seeks able maintain such a system, because ‘coordination to develop lead to the increasing development of the and information exchange . . . (allows the fi rm) to eliminate redundancy and minimize wasted effort . . .’ (Porter, 1996: 73). Among technology-based 7 Milgrom and Roberts (1995) suggest that Lincoln Electric was ventures, once the relative value of key cospecialized so good at simultaneously lowering prices while delivering resource bundles becomes apparent, the task of the superior service as a result of their complementary HR systems that the company was able to force GE and other large compa- entrepreneur is to link these elements through the nies to exit the industry. process of vertical integration.

In the vertical integration/transaction cost litera- resource providers to generate greater amounts of ture, fi rm scope decisions (i.e., the decision whether wealth than if these resources were not combined to bring a particular resource exchange into the fi rm together. Stated differently, vertically integrating or to let the market manage the exchange process) cospecialized resource combinations allow the are often contingent upon the trade-off between the venture to create super additive returns while simul- level of specialization of the resource and the prob- taneously reducing bargaining costs. Therefore, the ability the transaction partner will engage in oppor- logic for vertical integration decisions is whether tunistic behavior (i.e., increase required factor bringing a particular resource within the fi rm will payments) (Mahoney, 1992; Leiblein and Miller, enable the venture to achieve super additive returns 2003). Barney and Hesterly (2008) draw a similar by leveraging the complementarities among the set conclusion when applying resource-based logic to of resources. Furthermore, once the entrepreneur is vertical integration decisions, and suggest that the able to assess the relative value of particular resource focus of the manager and/or entrepreneur should be combinations, he/she can work to optimize these to reduce the threat of opportunism.8 By establishing combinations through the process of vertical property rights over a particular resource by verti- integration. cally integrating it within a fi rm, the assumption is that the fi rm will be able to reduce the costs of Proposition 7: The process of organizing around ownership by controlling the opportunism of input cospecialized resource combinations enables ven- providers. tures to achieve greater levels of optimization in However, as noted above, full property rights for vertical integration decisions thereby increasing some resources simply cannot be fully transferred the amount of wealth created by technology-based even when these resources are embedded within the ventures. fi rm (Grossman and Hart, 1986; Milgrom and Roberts, 1990). In these cases, the input provider retains bargaining power and can continue to engage in tactics to bid up its factor payment even while its DISCUSSION input is actively employed in the production pro- Research implications cesses within the fi rm. For example, a scientist who develops the technology licensed by a venture, even Empirical tests of RBT. When Dierickx and Cool if this individual is hired into the fi rm, retains the (1989) fi rst raised the issue regarding the link right to command higher factors payments in between the unique bundling of resources and supe- exchange for his/her contribution of the technology. rior economic performance, Barney (1989) sug- Furthermore, to the extent the factor payment gested that unique resource bundles were an example received by the scientist is not in equilibrium with of the social complexity of fi rms; which, in turn, was his/her marginal contribution to the venture, we a factor that made a fi rm’s resource base costly to predict that the scientist would engage in tactics to imitate. Numerous authors, however, have criticized achieve such an equilibrium. By implication, verti- this approach, arguing that by linking both the prop- cal integration cannot reduce the costs of ownership erties of individual resources and the bundling of over a particular strategic factor when the fi rm resources with fi rm performance, RBT confounds cannot establish full property rights over the two distinct levels of analysis (Foss and Knudsen, resource. 2003). To this point, Peteraf and Barney (2003) We argue that entrepreneurs make vertical inte- argue that RBT should be cast at both the enterprise gration decisions with a broader goal in mind than and resource levels of analysis; where resource het- simply mitigating the threat of opportunism. Specifi - erogeneity produces differential value, which aggre- cally, the decision to bring a particular exchange gates into performance differences between fi rms/ relationship within a fi rm is made because potential enterprises. At the basis of their argument, however, complementarities among the resources allow they clarify the central importance of resource heterogeneity in explaining performance differentials between fi rms. 8 This argument refl ects the central tenet of extant resource- This article argues for explaining performance based logic: resources are valuable to the extent they allow the fi rm to pursue emerging opportunities or defend against differentials between technology-based ventures by threats. considering the interaction of bundled, cospecialized

Copyright © 2009 Strategic Management Society Strat. Entrepreneurship J., 2: 339–355 (2008) DOI: 10.1002/sej Factor Payments, Bargaining, and Firm Wealth 351 resources on fi rm performance and not just the prop- scholars about the relative importance of costs versus erties of individual resources. This is consistent with revenues. Throughout much of the prior work on the full payments and bargaining perspectives out- RBT, costs appeared to play a central role in the lined by Lippman and Rumelt (2003a; 2003b). By development of resource-based logic. For example, implication, empirical tests of this model must con- Peteraf and Barney (2003) suggest that RBT, as an sider the effects of resources embedded in a system effi ciency paradigm, offers a model to explain fi rm of resources to explain fi rm performance, thereby performance differentials based on maximizing end shifting the level of analysis to bundles of resources customer benefi ts at an even (lower) cost basis than within the fi rm. Furthermore, whereas RBT does not competitors. Furthermore, Barney’s (1986) argu- recommend the use of a specifi c type of dependent ments regarding the role of undervalued strategic variable (Foss and Knudsen, 2003), we suggest that factors builds upon the idea that fi rms able to source the primary outcome of interest is the creation of inputs at lower price points will outperform their fi rm wealth. rivals, even if the customer benefi ts provided are the Adjusting study designs for testing resource-based same. To this end, Makadok and Coff (2002: 10–11) logic to explain wealth creation among technology- explain that ‘. . . the value of a resource in strategic based ventures helps resolve several emerging issues. factor markets . . . necessarily means the value that In a recent review, Newbert (2007) concludes that a fi rm captures by acquiring a resource—not the support is mixed for the resource heterogeneity value created for the end consumers.’ Conversely, approach across the RBT empirical literature (e.g., Priem (2007) argues that the value a fi rm can appro- only 37 percent of studies were signifi cant). Instead, priate is directly a function of the revenues it gen- empirical support for an organizing approach to RBT erates (top-line growth comes before bottom-line appears much more robust. Furthermore, Newbert growth) and that strategy scholars are neglecting a (2007) notes that the number of empirical studies critical component of fi rm performance. employing the resource heterogeneity approach is An important issue in this discussion is the key actually decreasing while, comparatively, the number factors managers/entrepreneurs must focus on to of organizing studies is increasing. This change is generate superior economic performance. On the occurring in response to some of the conceptual shifts one hand, Barney (1986) argues that if you can in the way scholars understand the relationship acquire undervalued resources, you can lock in eco- between the organization of fi rm resources and fi rm nomic rents over the long run. Priem (2007), on the performance (Newbert, 2007). In contrast, Crook other hand, appears to suggest that if you can maxi- et al. (2008) report in their meta-analytic study that mize the net benefi ts created for consumers, your the valuable, rare, and imitability properties of fi rm can generate higher levels of economic perfor- resources are positively associated with fi rm performance. We believe both perspectives, in isolation, mance. However, this link does not always seem to ignore critical aspects of the wealth creation process hold when key input stakeholders are appropriating in technology-based ventures, and since net cash the value before it gets to the fi rm level. Our view is fl ows are the primary manner through which that consistent with Lippman and Rumelt’s (2003a; residual claimants are compensated, both costs and 2003b) complementary factor payments and bargain- revenues must be simultaneously considered. ing perspectives, the mechanism by which resources Implications for transaction cost theory and RBT. impact fi rm performance is contingent upon how the One of the recent developments in the resource- resource interacts with other resources in the fi rm. based literature is the development of a link between This approach differs fundamentally from the more RBT and transaction costs economics (TCE) (e.g., common approach of examining the direct effect of Madhok, 2002; Foss and Foss, 2005; Mayer and individual resources on fi rm performance moderated Salomon, 2006). This dialogue between transaction by organizational attributes. Instead, we propose that cost and resource-based theorists is relatively new the joint effect among two or more resources will be given perceived differences in several key dimen- more strongly associated with the creation of fi rm sions (i.e., unit of analysis, theoretical question, wealth, since both the super additive effect as etc.). While Madhok (2002) offers several compel- well (as the relative bargaining power of the input ling reasons why we should more closely consider provider) can be better accounted for. the overlap between the two theories, Foss and Foss Implications for RBT: costs versus revenues. (2005) argue that the minimization of transaction There is some debate among resource-based costs is a primary route for value creation in fi rms.

Conversely, Mayer and Salomon (2006) testing both investment in a particular asset, the combination of transaction cost and resource-based logics, fi nd bounded rationality and opportunism in exchange support for the notion that the relative quality of the processes tends to limit the temporal scope of fi rm’s technological capabilities affect the type of contractual arrangement between organizational governance arrangements implemented by the fi rm stakeholders. Stated differently, when input provid- even in the face of contractual hazards. The impli- ers cannot reliably predict the future, they do not cation is that researchers must more carefully con- attempt to, but rather develop shorter-term contracts sider the impact of resource heterogeneity on fi rm that account for things they can predict. The chal- governance decisions (which typically is the domain lenge, however, with this approach among young of transaction costs economics). technology-based ventures is that equity stakes are While we concur that resource-based logic has often granted early in the lifecycle of the venture. much to gain from a more explicit link between RBT So, although recent articles utilize a real-options rea- and TCE, we suggest that this link is most relevant soning to explain the staging of capital infusions (Li, for particular types of resources (i.e., specialized 2008), the equity stake in most cases has already resources). On the issue of cospecialized resource been predetermined. (For example, a VC fi rm pro- combinations, however, both frameworks need addi- viding a $2 million investment for a 40 percent tional development to better model the value cre- equity stake paid out in fi ve installments as the ation process. By applying and extending the factor venture reaches key milestones). By implication, payments and resource bargaining models devel- further codevelopment of real options logic with the oped by Lippman and Rumelt (2003a; 2003b), along factor payments/bargaining perspectives we outline with other core developments in RBT, we provide here might reveal a stronger contractual arrangement an alternative framework for thinking about the between a venture and input providers where equity complementary issues of rent appropriation and stakes are granted over time as the marginal produc- wealth creation and how the development of tivity of key resources becomes more apparent. In cospecialized resources bundles can simultaneously all likelihood, the reason equity stakes are granted control bargaining costs while generating surplus the way they typically are is because input providers revenues. are supplying specialized resources and are, there- Implications for real options theory in RBT. fore, able to extract higher factor payments based on Regarding the issue of resource valuation, the use of their unilateral bargaining position. real options theory has recently gained traction as a framework for modeling resource investment deci- Practical implications sions under uncertainty (McGrath, 1997; Folta and Miller, 2002). According to McGrath (1997), real The emphasis on ex post bargaining does raise options approaches are a preferred mode of invest- several interesting issues regarding the current state ing in resource development when the process is of practice in stakeholder bargaining in entrepre- highly uncertain but the commitment required from neurial ventures. First, whereas Lippman and Rumelt input providers is substantial. In this type of setting, (2003b) focus on the need for stakeholders to engage the strength of an options-based decision process, in ex post bargaining over the fair allocation of the McGrath (1997) suggests, is that input providers can surplus revenues, we draw attention back to the need assess the value of the investment at different stages for stakeholders to bargain over factor payments to to determine whether subsequent investment is war- ensure that each resource receives full payment to ranted. By implication, sequential investment deci- match its marginal product. Then, once full factor sions where capital is allocated over time based on payments are made, theory suggests the ex post bar- the variance of the option value allows input provid- gaining process should determine how to allocate ers to reassess the merits of particular resource the surplus revenues. By implication, the allocation development projects without having to invest the of revenues should proceed in two stages: fi rst, capital all at once. Thereby they do not run the risk allocate the portion of revenues linked to individual of losing the entire investment if the development factor payments, and second, divide up surplus process encounters insurmountable obstacles. revenues. In similar fashion, Magill and Quinzii (2002) The challenge is that many key stakeholders often propose that when incomplete markets provide forgo initial factor payments to minimize the cash unreliable pricing signals regarding the value of an outfl ows from early-stage ventures for an increased

Copyright © 2009 Strategic Management Society Strat. Entrepreneurship J., 2: 339–355 (2008) DOI: 10.1002/sej Factor Payments, Bargaining, and Firm Wealth 353 share of the surplus revenues. For example, recent are the most relevant where property rights are work by Wasserman (2006) reports that among IPO- incomplete. stage fi rms, founder entrepreneurs typically earn, on Lastly, one of the key assumptions we make in average, $25,000 less than nonfounder managers. the article—consistent with Makowski and Ostroy’s This suggests founders are commanding lower up- (1995; 2001) reformulation of perfect competition in front factor payments in exchange for higher residual neoclassical theory—is that input providers will returns over the long run. Furthermore, underwriters inevitably seek to bid up factor payments to achieve and venture capitalists appear to band together to an equilibrium with the marginal productivity of increase IPO underpricing, thereby extracting exces- each resource. We do not assume, however, that this sive rents from the fi rm (Arthurs et al., 2008). In this process is predictably linear or that the input pro- situation, the standard agency model is fl ipped, vider can always perfectly assess the true marginal because corporate insiders (i.e., the entrepreneur) productivity of their supplied input. In fact, an actually must work to protect the fi rm from important extension of this study would be a more excessive rent appropriation by external capital in-depth analysis of this bargaining process to providers. confi rm the tendency of input providers to seek such More broadly, this situation refl ects our earlier a factor payment equilibrium. Toward this end, observation that when key stakeholders extract rents Blyler and Coff (2003) argue that because of the payable for the use of undervalued resources (here, self-serving biases common in decision making, underpricing of the fi rm), they do so at the expense market actors may, in fact, overvalue their contribu- of other key stakeholders. In the situation described tions, thereby attempting to extract higher factor above, the entrepreneurs managing IPO-stage fi rms payments. An alternative perspective—consistent are extracting lower factor payments than would be with prospect theory—would be that when resources warranted by their marginal contribution to reve- are cospecialized, factor providers would be reticent nues, in exchange for a greater share of the venture’s to attempt to bid up factor payments because they future net cash fl ows. However, the VCs and under- would not want to endanger the super additive gains writers are banding together to extract excessive derived from the development of cospecialized rents that far exceed their marginal products. These resource bundles. As such, until future research issues suggest that both academics and practitioners confi rms the relevance of such a process, it should must work to redesign the standard contract in early be noted that this assumption is a baseline condition stage technology-based ventures to ensure these of the propositions we develop in this study. markets are more effi cient at distributing both the equitable factor payments and surplus revenues. ACKNOWLEDGEMENTS

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