How Patents Affect VCs’ Funding Decisions? — Case of Early Stage Ventures — Patent Effect

*This blog post is the first part of a series on how patents affect VCs’ funding decisions. In the following series, we will look at impact of patents on receiving VC funding for startups located in US, Europe and Turkey respectively with case analysis.

Startups are always on the lookout for market opportunities to expand their scope of impact in the market and build a successful company. There are a number of ways of developing such a strategy: technological innovation, building a blue ocean, focusing on customer experience, differentiation and low-cost approach, internationalization etc. In order to carry out these scaling-up strategies, startups need resources, i.e., funding. Funding options basically consist of VCs, CVCs, angel investors, government support and incentives. For startups to be qualified to obtain such funding depends on commercialization potential, business model, financial turnover rate, technology, management skills, technical capability, innovation potential, feasibility, go-to-market strategy and IP value. Patents are strong indicators that show the product has a unique value and a solid R&D background. They are a direct outcome of the inventive process, and more specifically of those inventions which are expected to have a commercial impact. They are considered as an appropriate indicator for capturing the proprietary and competitive dimension of technological change.[1] Even though, as mentioned before, there are various reasons why funding authorities choose to invest in a startup, this article will focus on the effect of patents on funding decisions, particularly of VCs. Thus, patent information will be taken as statistical indicators to show to what extent they affect the investment decisions of VCs.

Entrepreneurs have to convince potential investors on the growth potential of their company. Since the quality of the venture is not directly observable, external parties base their decisions on tangible assets. Thus, VCs rely on quality characteristics to approximate a start-up’s quality before making investment decisions. In our case, the role of patents will be taken as quality signals for VC funding. Another study shows that VCs value patents more than angel investors, which suggests that startups interested in raising venture capital might anticipate VCs’ preferences and be more likely to patent than those targeting angel investors.[2]

Kauffman Firm Survey (2013) reports that only 8.8% of high-tech startups, which are those that most likely to try to raise VC funding, have patents. (Among non-high-tech startups, the fraction is reported lower at 2.2%.) VCs tend to provide financing over several financing rounds. In this way, VCs try to eliminate information asymmetries regarding the startup’s performance and potential. Patents have both a signaling and a protection function: VCs view patents as a quality signal in terms of firm’s technological advancement and innovation capabilities. In a study carried out by Zhou et al, it is argued that start-ups that filed at least one patent prior to applying for VC funding obtained a 51.7% higher amount of VC funding than did start-ups that did not file.[3]

Among other factors that affect the likelihood of receiving VC funding for early stage ventures, patents constitute a solid reference point especially in the case of inexperienced entrepreneurs. In a further study on US startups, it is also shown that the approval of a startup’s first patent application increases its likelihood of raising venture capital (VC) funding in the following three years by 3.5 percentage points — a 59% increase relative to the unconditional probability of raising VC funding.[4]

In the case of seed and/or early stage European biotechnology startups, we see that the time lapse between applying for a patent and receiving VC funding is shorter. Having at least one patent application reduces the time to the first VC investment by 76%.[5]

Patents convey important information on a startup’s technological capability and innovation potential in due diligence processes. Faced with resource constraints, startups need to do a trade-off between pursuing patent grants or investing in additional applications. When making such trade-off, startups burn a lot of cash in the litigation process. Even if the startup has the adequate resources for the process, there still is a time risk. Startups can’t defend against patent infringement until the patent is granted, thus patents become pure cost in the application period. As for the other side of the medallion, patents ease market-entry conditions for startups in terms of commercial value and protection against rivals. Also, by reducing information asymmetries, VCs make use of patents in order to learn about the start-up’s technology and commercial potential.

[1] Archibugi and Pianta, Measuring Technological Change Through Patents and Innovation Surveys, Elsevier Advanced Technology, 1996

[2] Conti, Annamaria, Marie Thursby, and Frank T. Rothaermel, “Show Me the Right Stuff: Signals for High–Tech Startups,” Journal of Economics and Management Strategy, 22 (2013), 341–364.

[3] Zhou et al., Patents, Trademarks, and Their Complementarity in Venture Capital Funding, Technovation 47, 2016, pp. 14–22

[4] Farre-Mensa et al., Do Patens Facilitate Entrepreneurs’ Access to Venture Capital?, 2016

[5] Haeussler, C. et al., To Be Financed or Not… — The Role of Patents for Venture Capital Financing, Discussion Paper №09–003, Centre for European Economic Research, ftp://ftp.zew.de/pub/zew-docs/dp/dp09003.pdf

Originally published at blog.patenteffect.com on May 11, 2018.