Start-up founders who have worked countless hours and taken minimal pay to launch their companies understandably look forward to the big payday that comes with an IPO or a sale. So do venture capital or angel investors who risked millions to back a fledging enterprise that could very well go under.

But a study by experts from Wharton and INSEAD shows that IPOs and acquisitions actually dampen a start-up’s innovative spirit — which is often the very reason why it is appealing to investors or a new corporate owner in the first place. Instead of driving start-ups to step up their level of innovation, public scrutiny turns out to have the opposite effect, according to the recent paper, “Entrepreneurial Exits and Innovation,” by Wharton management professor David Hsu and Vikas A. Aggarwal, a professor of entrepreneurship and family enterprise at INSEAD. The study is slated for publication in the journal Management Science.

The researchers find that the level of innovation is highest among privately held start-ups and lowest in businesses that go public, while acquired companies fall somewhere in between. Hsu and Aggarwal discovered that pivotal to this ordering of innovation outcomes is the level of public scrutiny the company gets rather than the degree to which key players are leaving the company.

When a company goes public, it has to make regular disclosures to the SEC that range from quarterly earnings and stock and debt offerings to other material events such as executive departures or important drug discoveries that must receive regulatory approval. Moreover, the company will get many more shareholders after an IPO and typically attract a following from Wall Street analysts.

When many eyes are watching, a publicly held start-up feels more pressure to perform, especially since it has to report to shareholders every quarter. Financial results and product innovations help drive the stock price so there is an inclination to choose projects with a faster payoff to the detriment of long-term innovation. “You will have a shift in the types of projects you select,” Aggarwal says. “In a public setting, you have a much lower ability to take on riskier projects; you lower your tolerance for failure.”

“If you can stay private, you feel free to experiment more. No one’s going to find out whether what you’re trying to do is successful or less successful. You can aim for the fences more.” –David Hsu

A start-up that stays private, however, can have the luxury of innovating without the constant pressure to show short-term results. That is critical because important innovations often take time to develop and require more experimentation. They also tend to yield higher returns in the long run than more certain investment activities. “If you can stay private, you feel free to experiment more,” Hsu notes. “No one is going to find out whether what you’re trying to do is successful or less successful. You can aim for the fences more.”

Down for the Count

For their paper, Aggarwal and Hsu studied the performance of 476 U.S.-based biotechnology companies with venture capital funding that were founded between 1980 and 2000, tracking them until the end of 2006. The sample includes more than 15,400 patents and nearly 45,800 forward citations (future patents referencing those of the innovator). The authors discovered that after an IPO, both the quality and quantity of innovation, as measured by patent citations and patent applications, drop. “If managers know that they will have to report project status on a regular basis, they may be incentivized to select projects that are more likely to yield steady progress,” they write.

Hsu and Aggarwal also point out that not all IPOs have the same effect on innovation. They find that the negative impact on innovation is most pronounced on start-ups with a number of early-stage projects in the pipeline that are also closely watched and highly scrutinized by analysts. “That’s when you suffer the most in innovation outcomes,” Hsu says. “You do much worse than the average IPO.”

While well-known innovators with a rabid analyst following, such as Apple and Google, are publicly held, Aggarwal argues that the firms could have been even more innovative if they had stayed private. Moreover, their level of innovation was often greater before their IPOs than after going public. “Many of the most prominent innovators did the lion’s share of their innovation under private ownership,” he notes.

Aggarwal points out that Facebook’s leadership actually preferred not to go public, but they were pushed in that direction because the SEC mandates that companies with 500 or more stakeholders, among other requirements, must file reports regularly. “Technical reasons forced the company to go public,” he says. Had it stayed private, Facebook “would likely have had the luxury to be more innovative.”

Hsu points to audio equipment maker Bose as an example of an innovative, closely held company. Founder Amar Bose, who died in July at the age of 83, eschewed the IPO path to stay private. In an interview with Discover magazine in 2004, he said going public “would have destroyed everything.” Bose, an MIT professor, said he visited about half a dozen companies in the Boston area founded by MIT faculty that had gone public. “Every one of those CEOs said, ‘If only we had known the consequences, we never would have gone public. We are spending two-thirds of our time on image building to keep the stock price up.'”

In a July 12 obituary, The New York Times reported that Bose “focused relentlessly on acoustic engineering innovation. His speakers, though expensive, earned a reputation for bringing concert-hall-quality audio into the home.” The story went on to say that by refusing to go public, “Dr. Bose was able to pursue risky long-term research, such as noise-canceling headphones and an innovative suspension system for cars, without the pressures of quarterly earnings.”

The M&A Option

When it comes to a merger or acquisition, the impact on a start-up is mixed, according to the researchers. While the quality of innovation drops, quantity actually increases — i.e., a start-up files more patent applications, but gets fewer patent citations after being bought. Researchers usually cite other patents as the foundation for their own tests. The more citations a patent gets, the more influential it is.

“[Start-ups] have a choice. If they are looking to build an innovative company in the long run, they need to think more carefully about the implications for innovation.” –Vikas A. Aggarwal

Why does an acquisition spur the start-up to crank out more patents but experience a drop in citations? Again, it comes down to scrutiny, Hsu and Aggarwal say. When a start-up becomes a subsidiary or division of a larger company, its managers want to impress the new owners. One way to do that is to file more patents. But they also tend to choose projects that show results more quickly to satisfy the new owner. That means managers will be less willing to fund innovative projects because the payoff is further away. Thus, innovation quality — and with it, citations — decline.

Hsu and Aggarwal also found out that the make-up of the start-up’s buyer has an impact on innovation as well. A publicly held buyer will elicit lower innovation quality from a start-up than a private acquirer, again because of the level of public scrutiny. In addition, if there is greater technology overlap between the buyer and the start-up, innovation quality suffers more than if there are fewer similarities.

One reason: If the buyer purchases a start-up that is in a similar business, the tendency is to merge the company into existing operations. That means there could be too many people in the company now doing the same thing, and the threat of layoffs loom. Thus, managers in the start-up will seek to impress the new owners in order to keep their jobs, Hsu says. One way to do that is to boost short-term results at the expense of innovation in the long term.

Show Me the Money

So where does that leave a start-up in need of capital? Entrepreneurs have been willing to give up the ability to operate under the radar in exchange for liquidity and the other benefits of a public offering, the authors note. As a public company, they can raise funds by issuing stock or bonds to fund expansion, research and other capital needs. But Hsu and Aggarwal say there are other ways to raise financing without giving up privacy.

For instance, a firm could seek to be acquired by a private company, which has a less harmful impact on innovation than a public parent, Hsu notes. Once the buyer succeeds in getting the start-up, it has to ensure that incentives and buffers are in place to keep the innovative spirit intact. The new parent firm should try to incubate the start-up, spin it off as a separate unit, set it up as a separate, private unit, or insulate the company in some way, Hsu suggests.

Start-ups also could form partnerships with big corporations that can fund their operations, Hsu says. Biotech firms could ally with bigger rivals such as Merck and Pfizer, which may fund research and development in exchange for marketing rights. “We found that if you want to maximize your chances of radical breakthrough work, you have to have some kind of insulation from outside pressure,” he adds.

Another option is for start-ups to seek private equity investors in order to preserve privacy, Aggarwal says. When the owners are ready to exit, they can sell their stake to another private investor to preserve innovation quality. “There’s value in continuing private ownership,” he notes.

The bottom line is that start-ups should not rush into an IPO because they are seeking to cash out quickly or find financing through the capital markets. Doing so will have a deleterious effect on innovation in the long term. “They have a choice,” Aggarwal says. “If they are looking to build an innovative company in the long run, they need to think more carefully about the implications for innovation.”