UNEQUAL INTERNATIONAL STRATEGIC ALLIANCES IN THE BIOTECHNOLOGY INDUSTRY

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UNEQUAL INTERNATIONAL

STRATEGIC ALLIANCES IN

THE BIOTECHNOLOGY INDUSTRY

IS THERE A PANACEA FOR SME’S?

Name:

Mirthe Marije Wallinga

Date:

January 2008

Institution:

University of Groningen

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IN THE BIOTECHNOLOGY INDUSTRY

IS THERE A PANACEA FOR SME’S? JANUARY 2008

Author: Mirthe Marije Wallinga

Student number: 1326724

Telephone number: +31 6 15 350 713 Email address: m.m.wallinga@student.rug.nl

Faculty of Management and Organization Master Strategy and Innovation

Supervisors: Dr. G. Gemser Dr. T.J.B.M. Postma Website: www.rug.nl/feb Telephone number: +31 50 363 3453 Bioclear BV. Supervisor: Drs. S. Keuning Website: www.bioclear.nl Telephone number: +31 50 571 8455 Talentproject Supervisor: Drs. M. Jongsma Website: www.talentproject.nl Telephone number: +31 50 363 8840

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VALUE APPROPRIATION FROM INTERNATIONAL STRATEGIC ALLIANCES

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ACKNOWLEDGEMENTS

IT IS GOOD TO HAVE AN END TO JOURNEY TOWARD BUT IT IS THE JOURNEY THAT MATTERS, IN THE END

Ernest Hemingway (1898-1961)

My journey from student to graduate has come to an end. Some people like to argue that this journey has taken me too long, other emphasize that this journey is something that should be enjoyed as long as possible. I like to think that my journey has ended at just the right moment in time.

For support during the last hurdle I had to overcome, I owe my gratitude to supervisors from various different fields. My internship at Bioclear would not have been possible without the guidance of my in-company supervisors drs. S. Keuning and drs. M. Henssen and all my other great colleagues at Bioclear. I would like to thank Dr. G. Gemser, my first supervisor from the University of Groningen, for help with the theoretical and methodological side of this thesis, for giving me the opportunity to present my thesis during the course ‘Capturing value from Innovation’ and for her overall confidence in me. I would also like to thank dr. R. Lageveen for allowing me to conduct some interviews with people from IQ Corporation and my second university supervisor dr. T. Postma for giving me feedback.

As this is the end of my journey, I would also like to thank some people that have made it possible for me to experience to this journey to the fullest. First of all, my mom and dad, who did not only made it financially possible to study in the Netherlands and in Austria but who also supported me during doubts about my choices, doubts about my future, doubts about my internship, all those horrible doubts. My brother, who made me strive for the best results possible, although he thinks that this has only been the case the other way around. My dear friends, who were there for drinks and dancing, long conversations about the world, trips to Christmas markets, sushi making, New Year’s Eve parties, ice cubs in Vienna, Las Vegas in Moraira, chupitos in Bilbao, penguins in Marseille and all those other fabulous distractions.

And last, but certainly not least, I have to thank my darling. You offer me a shoulder to cry on, arms to sleep in, an opinion to challenge me, breakfasts and songs in the morning, supporting words whenever I feel insecure and a future that excites me. You have been there throughout this journey and when I think about my future journeys, the only thing I know for sure is that I want you to be there with me.

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ABSTRACT

In this explorative research, the focus is put on the international strategic alliances in the biotechnology industry in the Netherlands. An attempt is made to get a clear view of the formal and informal means of protection that SME’s use to appropriate value from an international strategic alliance with a larger partner. The formal means of protection that play a significant role in this realm include the usage of standard contracts, both classical and relational, licensing contracts, patents and trademarks. The informal means of protection that are being discussed include complementary assets, trade secrets, human resources and alliance processes and reputation and trust. The usage of either more formal or more informal is linked to various contextual variables. These contextual variables include having a larger partner, the existence of prior ties, the specific end-date of an alliance, the cultural difference between the two alliance partners and the strategic intent with which a company enters into a specific alliance.

A number of interviews have been held with people from two different Dutch biotechnology companies that are involved in various international strategic alliances with different partners. The main findings show that in case of inequality in size, reliance on more formal means of protection leads to more value appropriation by the SME. However, prior ties and cultural homogeneity increase the usage of informal means of protection in order to ensure optimal value appropriation. The findings of this research lead to 5 interesting propositions, which could be ground for further research. Furthermore, future research could include the effectiveness of the different formal and informal means of protection, the changing environmental and the notion of a company’s internal culture.

KEYWORDS:

INTERNATIONAL STRATEGIC ALLIANCES VALUE APPROPRIATION

SME’S (small and medium sized enterprises)

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VALUE APPROPRIATION FROM INTERNATIONAL STRATEGIC ALLIANCES 5

INDEX

ACKNOWLEDGEMENTS... 3 ABSTRACT ... 4 INDEX ... 5 1 INTRODUCTION... 7 2 THEORETICAL FRAMEWORK ... 11

2.1 REASONS FOR ENTERING INTO A STRATEGIC ALLIANCE ... 11

2.2 APPROPRIATION OF VALUE IN ALLIANCES AND THE DEGREE OF SUCCESS.. 12

2.3 KNOWLEDGE PROTECTION IN AN ALLIANCE ... 13

2.4 FORMAL MEANS OF PROTECTION ... 16

2.4.1 PATENTS... 16

2.4.2 TRADEMARKS... 18

2.4.3 CONTRACTS ... 19

2.5 INFORMAL MEANS OF PROTECTION... 21

2.5.1 COMPLEMENTARY ASSETS... 21

2.5.2 TRADE SECRETS... 22

2.5.3 HUMAN RESOURCES AND ALLIANCE PROCESSES... 23

2.5.4 REPUTATION AND TRUST... 25

3 ADDING CONSTRUCTS AND SUB QUESTIONS ... 28

3.1 LARGER PARTNER ... 28

3.1.1 Sub question 1 ... 29

3.2 TIME-DIMENSION ... 29

3.2.1 Sub question 2a... 31

3.2.2 Sub question 2b ... 31

3.3 CULTURAL ASYMMETRY... 32

3.3.1 Sub question 3 ... 32

3.4 PURPOSE OF THE ALLIANCE OR STRATEGIC INTENT ... 33

3.4.1 Sub question 4 ... 34

4 RESEARCH METHODOLOGY ... 35

4.1 CASE SELECTION... 35

4.2 DATA COLLECTION ... 39

4.3 DATA ANALYSIS... 43

4.4 COMPANY DESCRIPTION BIOCLEAR... 44

4.5 COMPANY DESCRIPTION IQ ... 44

5 RESULTS ... 46

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5.2 MODUS OPERANDI IQ CORPORATION ... 47

5.3 INTERVIEW RESULTS ... 48

5.3.1 MEANS OF PROTECTION ... 49

5.3.2 LARGER PARTNER ... 54

5.3.3 TIME DIMENSION ... 57

5.3.4 CULTURAL ASYMMETRY ... 59

5.3.5 EXPLOITATION VERSUS EXPLORATION ... 62

6 DISCUSSION ... 64

6.1 CONCLUSION SUB QUESTIONS ... 64

6.2 THEORETICAL IMPLICATIONS AND FURTHER RESEARCH ... 68

6.3 MANAGERIAL IMPLICATIONS... 70

6.4 LIMITATIONS... 71

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1 INTRODUCTION

The last two decades, the rate of strategic alliances has increased dramatically, particularly in international markets. In some industries, strategic alliances are no longer seen as a strategic choice but as a competitive necessity (Parkhe, 1993). In most cases, the formation of an alliance offers both partners the opportunity to gain significant benefits. Firms can for instance obtain access to a new and wide geographical market by overcoming barriers of entry, share hazardous research and development projects or pool together complementary assets and resources. But these potential benefits have to be seen in the light of the complexity of managing an alliance. Following Parkhe (1993), alliances can be characterized by ‘inherent instability arising from uncertainty regarding a partner’s future behaviour and the absence of a higher authority to ensure compliance’. This means that managing an alliance is a difficult job as mutual cooperation is desirable but not automatically chosen over self-interest (Koza & Lewin, 2000) The failure rate of alliances is therefore much higher than the failure rate for single firms (Das & Teng, 2000).

Many scholars have made attempts to present a framework to structure the alliance in such a way that the odds of success are raised. Different industries have been explored including firms of all sizes, different alliance structures and alliance governance mechanisms. In this thesis, I would like to focus on a specific industry namely the Dutch biotechnology industry. This industry consists of the development, manufacturing and marketing of products based on advanced biotechnology research. It should however be noted that the biotechnology sector entails much more than gene technology, which is an often used synonym in English. The Dutch government defines biotechnology as “the toolbox of techniques and processes that are available for analysing biological life and which can be used to create better products and processes for the industrial, agrarian and environmental applications”1.

The biotechnology market in the Netherlands is small but the government is showing its support and the environment is favourable for private investments in this sector (Datamonitor, 2005). In many respects, biotechnology is not strictly speaking an industry but merely a set of technologies that can potentially transform various fields i.e. pharmaceuticals, agriculture and even waste disposal (Powell et al, 1996).

This industry is interesting for various different reasons. First of all, strategic alliances are present in all kinds of different industries but especially prevalent in the biotechnology industry (Roijakkers & Hagedoorn, 2003). Secondly, the products developed in this industry have the potential to change our

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8 society in a positive way by improving health care or creating a cleaner, safer environment. As the awareness of society with regard to the environment increases, this industry is becoming significantly more important.

Biotechnology is a young, science-based field, which can also be characterized by its high degree of technology intensiveness within the industry and the fact that state-of-the-art research and technological know-how are critical to the competitive success of firms (Roijakkers & Hagedoorn, 2003). Most of the products firms in this industry offer to their clients however are not just technical. The technological solution has to be combined with the tacit knowledge of the highly trained staff to offer a complete package. Therefore, the firms in this industry are highly vulnerable when entering into a strategic alliance. However, strategic alliances are ubiquitous in this industry because of the fact that firms can benefit greatly when complementary assets are pooled together to generate, develop and commercialise new biotechnology products (Arora & Gambardella, 1990). Furthermore, when a regime of rapid technological development is present, research breakthroughs are widely distributed and no single firm has all the internal capabilities necessary for success. The need for strategic alliances in this ‘industry’ therefore is prevalent but on the other hand, the intensive research and development investments that are made by the specific companies must be protected and maximum return should be appropriated from these investments (Kesan, 2000).

After having identified the particularly ‘industry’ that is of interest for this research, a short remark must be made with regard to the size of the firms that are entering into an alliance. As identified by Arora & Gambardella (1990), three types of agents are involved in innovations in biotechnology namely the universities, small/medium sized research-intensive firms, or so-called New Biotechnology Firms (NBF’s), and large established chemical and pharmaceutical firms. These three players possess complementary assets that can be used to produce new biotechnology products or processes. Therefore, a wide range of opportunities exists for collaboration among them.

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9 critical knowledge. Finally, the time line between the scientific discovery and the commercialisation is long, sometimes taking up to 15 years (Khilji et al., 2006).

As can be imagined, the options for SME’s in general to appropriate value from an alliance differ from those of large established firms for different reasons. For example, small firms do not have the strong reputation many larger firms have and therefore less negotiation power. In addition, the capital position of a smaller firm, in general, is not so advantageous as the capital position of a larger firm and therefore the acquisition of an alliance partner to gain complementary assets is usually not possible. These reasons make it interesting to see how small or medium sized firms can ensure appropriability from an alliance with a larger partner, a so-called unequal alliance.

The final remark I would like to make in regard to defining the boundaries of this research is the notion of ‘internationality’. As was mentioned earlier, the rate of strategic alliances has increased dramatically, particularly in international markets. Furthermore, the number of joint ventures formed between firms from different countries has increased dramatically (Hambrick et al., 2001). International joint ventures can help a firm to cope with the trend of globalisation by using the foreign partner as source of leverage for it’s own resources (Makino and Beamish, 1999). For these reasons, it is interesting to add this contingency to the discussion and focus on the appropriation of value from an international alliance.

Combining my choice of industry, geographical area, firm size and the notion of inequality, the following research question will be the focal point of this thesis:

HOW CAN SME’s IN THE BIOTECHNOLOGY INDUSTRY IN THE NETHERLANDS APPROPRIATE VALUE FROM AN UNEQUAL INTERNATIONAL STRATEGIC

ALLIANCE?

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10 means of protection cover complementary assets, trade secrets, human resources and alliances

processes and reputation and trust.

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2 THEORETICAL FRAMEWORK

The various types of external collaboration range from equity joint ventures to R&D partnerships to collaborative manufacturing. Gulati (1998) defines strategic alliances as voluntary arrangements between firms involving exchange, sharing or co-developing of products, technologies or services. Nooteboom makes the distinction between equity and non-equity alliances (1999). Equity alliances refer for instance to joint ventures where a novel firm is created under shared ownership of the partner firms. A joint venture provides an intermediate position between a non-equity alliance and full integration, which is the case with a merger or acquisition of another company. Non-equity alliances include a wide variety of cooperation forms, including franchising, contractual cooperation in research, licensing, dealerships, consortia for building products etc. For the sake of this thesis, I would like to adopt the definition of Gulati (1998) and add that strategic alliances in this case only consist of non-equity agreements as defined by Nooteboom (1999).

2.1 REASONS FOR ENTERING INTO A STRATEGIC ALLIANCE

In any specific case, a firm is likely to have multiple reasons for entering an alliance. Usually, alliances are designed to allow partners to share risks and resources, gain knowledge and obtain access to markets. Reasons for entering into a strategic alliance can be classified by the usage of a number of different theories. One of these theories is drawn from the work of March (1991) who makes the distinction between exploration and exploitation as stages in organisational learning. In his work, the exploitation phase refers to the deepening of existing capabilities and to incremental improvements in efficiency. This phase includes terms like refinement, choice, production, efficiency, selection, implementation and execution. The strategic intent in this phase is to obtain extra income and incremental improvement from the elaboration of existing capabilities and assets. The exploration phase refers to experimenting with new assets and new capabilities. This includes terms such as search, variation, risk taking, experimentation, play, flexibility, discovery and innovation. The strategic intent in this phase is to discover new opportunities for the firm.

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12 De Man (2006) mentions five features that drive the importance of strategic alliances in our modern-day world. The first important factor is increasing competition, which asks for continuous cost reduction, which can be facilitated by the economies of scale and scope accomplished by entering into a strategic alliance. Internationalisation and liberalization also have facilitated the significance of strategic alliances, as companies often prefer to expand to a foreign market using a local partner. Thirdly, the need for offering individually adapted and custom-made solutions to the customer has become increasingly important in almost every market which can, in most cases, only be accomplished by working together. Especially in the IT and biotechnology, the rapid technological development has also caused a significant increase in importance regarding alliance formation. For most companies, it is simply not possible to keep up with all the technological developments on their own which makes shared development of new technologies a viable option. Finally, the growing theoretical base with regard to the management of alliances has facilitated the knowledge in companies about alliances.

2.2 APPROPRIATION OF VALUE IN ALLIANCES AND THE DEGREE OF SUCCESS It is difficult to assess the degree of success of strategic alliances, as it depends on the benefits gained by both partners as a consequence of the alliance. Therefore, before entering into the realm of success, a distinction should be made between various different constructs including value creation and value appropriation, which includes value protection and value capture (Mol et al, 2005).

Value creation, as stated by Bowman and Ambrosini (2000), can be seen as the contribution to the utility of the final good to the end consumer. In the case of a strategic alliance, value is created by the partnering of two firms and the final product the alliance can offer to the customer. Various complications arise with regard to valuation of the added value of partners in an alliance. These complications occur due to five different characteristics:

• the alliance combines items which are not tradable and of which valuation is difficult;

• the relative contribution of each of the partners is difficult to estimate;

• checking your partner’s costs and benefits is difficult because of the fact that things happen outside the relationship as well;

• the relative value of each contribution is hard to predict and can change over time;

• partners do not always share every detail with regard to the value they are hoping to

appropriate from the alliance. (Doz & Hamel, 1999).

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13 way, a firm tries to prevent competitive imitation of its created value, which is called value protection (Mol et al, 2005). Various means of protection are present to be used to prevent competitive imitation. These means can either be formal, like institutionalised monopolies such as patents and copyrights, or be non-formal, such as causal ambiguity, the threat of loss of reputational capital or economies of scale. Capturing value is also mainly associated with the vertical dimension of the value system and depends on the bargaining power in relation to the neighbouring stages (Mol et al, 2005).

Firms have different expectations of alliances and these expectations affect their evaluation of the success. They usually also have different notions of how much value appropriation is appropriate in the specific alliance. Tidd et al. (2005) noted that firms must learn to design alliances with other firms rather than pursue ad hoc relationships. Partners should specify mutual expectations and agree on a business plan. Failure of the alliance, however hard to define, is mostly a result from the lack of design and strategic divergence but on the other hand, success is mostly related to operational and people-related factors (Tidd et al., 2005). Factor analysis conducted among 135 German firms confirms that people-related factors are more important than either the economical or operational issues but managers often put greater effort into the harder issues, like technical and operational, than the softer but more important people issues (Tidd et al., 2005). One study of alliances among high-technology firms found that more than half the problems that occurred during the first year of the alliance are related to the relationship and not strategic or operational factors. The most common problems were poor communication and conflicts due to the national and corporate culture. Therefore, this thesis will, alongside the different formal and informal ways of protecting knowledge, focus on the softer issues influencing the degree of value appropriation in an alliance.

2.3 KNOWLEDGE PROTECTION IN AN ALLIANCE

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14 This is particularly true for the biotechnology industry, where the range of scientific and intellectual skills, needed to force a research breakthrough, often far exceeds the capabilities of any single organization (Powell et al, 1996). In the pre-invention phase, alliances are difficult to manage because of the absence of a tangible product and there is a high failure rate due to the cautious approach most companies adopt. In the post-discovery phase, the knowledge protection issue arises (Khilji et al, 2006). This can be illustrated by a quote of the CEO of a small biotechnology firm in Maryland, one of the participants in a research by Khilji et al. (2006):

“… now we have (developed) a product, we are in this netherworld of having an incredible discovery that you want to talk about but can’t because its value lies in the secret; if you told it you have lost it”.

Therefore, a long-term challenge for many firms is to engage in an alliance and to protect its core competencies or knowledge and capabilities that are essential to its competitive position in the market place (Norman, 2001).

Critical knowledge or capabilities must be protected from knowledge spill over in at least two respects. First, there is knowledge that is relevant to the alliance directly. A firm must decide which knowledge must remain within its private domain and how to ensure that this knowledge is protected. Secondly, there is the danger of indirect sharing of information and capabilities (Norman, 2001). For example, a member of the partner firm could gain access to information through physical presence in the partner firm and reading the message board, on which critical information is posted.

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15 the importance of reputation and trust is discussed by for instance Nooteboom (1994) and Gemser and Wijnberg (2001).

Using the terms ‘informal’ and ‘formal’, the different protection mechanisms can best be summed up into these different categorisations. This distinction has also been made in the research of Gemser and Wijnberg (2001), where they emphasise the importance of reputational sanctions that are imposed by the market to not engage in imitative behaviour. The following framework combines the different means of protection, which will al be discussed in the following paragraphs:

Table 2-1: Framework formal and informal means of protection

As can be seen in the framework, different terms have been grouped together to give a more general overview. ‘Trade secrets’ as stated by Teece (1986) and ‘secrecy’ as stated by Levin (1987) have been grouped together under the second point of the informal means of protection. ‘Human resources’ and ‘alliance processes’ as stated by Norman (2001) have also been grouped together as there is some kind of overlap between these two points. Some overlap does also exist when we look at trade secrets and human resources and alliances processes and when we look at human resources and alliance processes and reputation and trust. This overlap will be discussed in the appropriate paragraph.

The dominant design paradigm, discussed by Teece (1986) and referring to two stages in the technological evolution within an industry, is not included in this framework. It is less important in the realm of profiting from strategic alliances and opens up another research field which is to extensive to elaborate on in this thesis. It could however be an interesting point for further research into this subject

Informal means of protection Formal means of protection

(1) Complementary

assets

Teece (1986) (1) Standard contracts

(both classical and

relational) and licensing contracts

Reuer & Arino (2007),

Hagedoorn & Hesse

(2007), Arora (1995).

(2) Trade secrets Teece (1986) & Levin

(1987)

(2) Patents Arora (2004), Arora

(1995), Teece (1986)

(3) Human resources and alliance processes

Norman (2001) (3) Trademarks Ramello & Silva (2006)

(4) Reputation (both

competence and

goodwill) and trust

(both competence and goodwill)

Gemser & Wijnberg

(2001), Nooteboom

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16 2.4 FORMAL MEANS OF PROTECTION

Alliances fall somewhere between arm’s-length market transactions and full vertical integration. In arm’s length transactions, the parties of an alliance remain independent while simultaneously cooperation, coordination and information sharing occurs. Like a marriage, the partners in an alliance rely on norms of trust and reciprocity and sometimes govern their relationship by formal means (Besanko, 2000). As the biotechnology is a knowledge-based industry, intellectual property protection is very relevant while the inventions are susceptible to free riding (Kesan, 2000) and the main function of the industry is research and development, which makes its primary asset intellectual property. Various legal mechanisms are available to protect the inventions and the knowledge. These mechanisms include contractual mechanisms, patents and trademarks (Norman, 2001). The different mechanisms can be used either bilaterally or unilaterally. Most firms use mechanisms, which are devised and implemented for the firm’s use only, called unilaterally. Bilateral mechanisms are put in place by mutual compliance by two firms (Norman, 2001).

2.4.1 PATENTS

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17 mentioned purposes are not mutually exclusive and the lines between the different frameworks can sometimes become blurry (Mazzoleni & Nelson, 1998).

For an invention to obtain a patent, it must be useful, new and non-obvious. In the biotechnology industry, the utility is also often subject to discussion. This stems from the fact that merely the speculation of utility is not enough to obtain a patent. One of the main reasons for this it that to allow protection of an invention when the specific utility is still unknown, too broad a field would be monopolized. Therefore, the utility of the invention must be substantial and disclosed specifically in the patent application (Kesan, 2000).

In the realm of alliances between biotechnology firms, patents can be useful in two ways. First, a patent can serve as an input for an alliance, when the technique used in the alliance is protected by a legal patent. This can create an advantage for the firm that owns the patent, as it is more difficult for the partner firm to appropriate an inappropriate amount of value derived from the patent. Secondly, a patent can be an output of an exploration alliances entered into by two firms. When the exploration has led to the shared development of a new technique, patent protection can be obtained to exclude others from using this newly developed technique. One of the pitfalls in this situation can be that the parties did not stipulate upfront how to deal with such a patent and disagree on the usage once the technique can be patented. Therefore in the contract phase, attention should be paid to these kinds of issues.

Norman (2001) mentions that a patent holder may pursue legal remedies that prevent unauthorised parties from using or selling the product or process. Teece (1986) however notes that patents offer considerable protection to new chemical products and rather simple inventions but in the case of process innovations, patents are rather ineffective protection mechanisms. In most cases, once an invention is out in the open, it can easily be invented around at modest costs. This view is shared by Kesan (2000), who mentions that a patent never offers a true monopoly because substitute products, without infringing, can always compete with the patented product.

Solely relying on patent protection can make a company especially vulnerable, as it can never cover all the categories of competitively sensitive knowledge (Norman, 2001). There are two basic types of violation of patents, namely direct and indirect violation. The former consists of someone other than the patent owner or licensee who is making use of the patented invention, without legal permission to do so. Indirect infringement includes the sale of an item which can only be used in the patented invention and when somebody asks somebody else to infringe (Kesan, 2000).

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18 levels of protection in different countries (Kesan, 2000). There is much disagreement worldwide about the type of protection that should be offered to biotechnology but steps are being taken to harmonize this difference.

A patent does not necessarily give the inventor a true monopoly as noninfringing substitute products can always compete with the originally patented product. Levin (1987) brought up the idea that the mere existence of a patent, or any legal protection does not say anything about the efficiency in a competitive environment. Kesan (2000) notes that a patented product can only receive a monopoly position if it is commercially superior. He also makes the remark that there never is a true monopoly because a monopoly only causes exclusion of others and not necessarily the exploitation by the owner. Therefore, the overall effectiveness of patent protection can be questioned, also in the biotechnology industry.

2.4.2 TRADEMARKS

Trademarks have the function of promoting the creation of new information and thereby facilitation of the consumer’s choice and averting opportunistic behaviour from the part of producers. It is a commercial device that has been used long before the establishment of intellectual property as a specific legal category (Ramello, 2006).

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2.4.3 CONTRACTS

Contracts define the conditions of an exchange. Partners in an alliance can use a contract to state their mutual rights and obligations and establish the scope of the collaboration. It can also lay constraints in the realm of external obligations, for instance the limited disclosure of information to third parties or a firm’s claim on intellectual property (Reuer & Ariño, 2007). Greater contractual safeguards are necessary when the risk of opportunistic behaviour increases. When excessive governance mechanisms are used for relatively simple transactions, it leads to unnecessary inefficiencies, whereas the opposite leads to exposure to exchange risks (Reuer & Ariño, 2007). Examples of violations of a contract include the alliance partner establishing itself as a direct competitor by using inappropriately acquired information to make its on product or disclosing protected alliance information to outside parties (Norman, 2001).

In an ideal world, a complete contract would be written down and signed by the two parties in the alliance to eliminate opportunistic behaviour. A complete contract would stipulate each party’s responsibilities and rights in every contingency during the transaction. This way, neither party can exploit the other’s weaknesses. The requirements for a complete contract are difficult to fulfil. First of all, the parties must be able to state all relevant situations and agree on the set of actions these situations impose. The partners must also be able to state what entails satisfactory performance and how this performance can be measured. Finally, the contract needs to be enforceable. These features mean that the contract must be formed bilaterally and that a third outside party must be able to observe the actions taken by both parties. An incomplete contract does not specify every contingency with its rights, responsibilities and actions. This might be the case when it is truly impossible to stipulate all relevant contingencies, which is true for almost every real-world contract (Besanko, 2000). The three

factors that prevent contracts from being complete are bounded rationality2, difficulties specifying or

measuring performance3 and asymmetric information4.

Licensing contracts are a specific form of contracts, which involve the transfer of intellectual property by law, usually in the form of a patent (Hagedoorn & Hesen, 2007). Licensing is a mean to overcome the shortcomings both patents protection and trade secrets offer as to the protection of knowledge (Choi et al., 2004). Unlike other forms of partnerships, licensing involves only a unilateral enforce

2

Bounded rationality: refers to the limited capacity of individuals to process information, to deal with information and pursue rational goals. The bounded rational parties cannot contemplate every incident that may arise and therefore cannot produce complete contracts (Besanko, 2000).

3

Difficulties specifying or measuring performance: Often, parties are not able to specify each party’s responsibilities and rights in words. Therefore language in contracts often very vague and open-ended. A second problem is that performance may be ambiguous and hard to measure (Besanko, 2000).

4

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20 mechanism of protection. This entails a one-way flow of technical knowledge (the patent) and tacit knowledge (the instructions) from the licensor to the licensee in return for compensation. This type of action involves risk allocation to either the licensee or licensor rather than risk sharing, which makes a classical contracting approach more suitable for this type of contract.

In general, the licensor faces a low degree of uncertainty due to the patent protection and the licensee has informational disadvantage in regard to the true value of the asset he key problem affecting licensing transactions lies in the query whether or not a licensee is willing to pay without being able to verify the quality of the invention. On the other hand, once the inventor has disclosed the invention, the potential licensee has little incentive to pay for it. This is why a licensing agreements needs to be drafted to ensure the fair treatment of intellectual property for both the licensor and the licensee (Choi et al., 2004).

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21 2.5 INFORMAL MEANS OF PROTECTION

As has been noted before, using patents as a mean of protection can only ward off the competition for a limited period of time as the competitors can eventually innovate around the original patent (Teece, 1986). Some of the informal means of protection, like controlling the complementary assets in a specific area like marketing or distribution, might be a more effective strategy to stay ahead of competition (Teece, 1986). Aside from controlling complementary assets, various other informal means of protection can also be a substitute or addition to the use of formal means (Norman, 2001).

2.5.1 COMPLEMENTARY ASSETS

In order for an innovation to be commercialized successfully, the technical know-how underlying the innovation must be sold or utilized in the market in combination with other capabilities or assets (Teece, 1986). The available technological knowledge has to be combined with knowledge of the market in which one is operating to successfully introduce and distribute the product (Roijakkers & Hagedoorn, 2003). There are various options how to obtain the complementary assets a company needs for this successful commercialization. At one extreme, one could integrate all complementary assets but in most cases, this is unnecessary and extremely expensive (Teece, 1986). This option is almost impossible for small or medium size companies, as their capital position does not allow full integration. Furthermore, as the biotechnology industry is an industry in which technological development evolves rapidly and research breakthroughs are broadly distributed, no single firm can integrate all internal capabilities necessary for success (Powel et al., 1996; Teece, 1986). On the other extreme, an innovator could try to access all complementary assets through contractual relations. These contracts can be adequate but in some cases expose the innovator to various hazards and dependencies, as is discussed earlier. In between these extremes, there is an array of intermediate possibilities.

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22 Arora (1996) made an attempt to link the usage of complementary assets to the usage of a licensing contract by creating a mean of protection with both formal and informal aspects. He conducted a research into contracting for tacit knowledge, which can also be called licensing. He proposed that the transfer of tacit knowledge requires face-to-face contact and while some of the knowledge within the licensor firm is formalized, much of its knowledge is based on the experience about the process in practice. Contracting for this tacit know-how is difficult, as a third party such as a court cannot observe the good. Consequently, arm’s length contracts for tacit knowledge impose great moral hazards. For instance, the licensor can choice to only limitedly share information with the licensee or to not disclose trade secrets. Given this possible danger, the licensee prefers to make the largest payment after the satisfactory assistance has been received. On the other hand, as much of the know-how is tacit, it cannot be unlearned by the licensee once it is out in the open. This imposes a danger to the licensor as the licensee could refuse to pay the full amount that was agreed upon after receiving the know-how.

One of the solutions Arora (1996) proposed is the bundling of complementary inputs. The licensor has the option to link the transfer and payment for know-how to a complementary input (of which the transfer is not difficult to monitor). The licensor can promise to transfer the know-how and allow the licensee to make part of the payment after the know-how is provided. If the licensee chooses not to make this payment, the licensor can choose to dishonor the contract and withdraw from providing the complementary input. From the point of view of the licensor, it is important to make sure that the benefit of having the know-how and the complementary input is greater than the second period payment, to encourage the licensee to make the payment. In his research, Arora (1996) distinguishes three complementary inputs namely patent rights, commissioning of plant and equipment, which can also be used in any form of combination. To discuss for example the possibility to bundle equipment with know-how, it is easy to imagine that machinery and equipment is property of the licensor and that it can be used as a complementary asset to be supplied to the licensee. Patents can also be complementary to know-how, as they relate to the formalized and explicit components of the technology. It should be noted that, when seeing patents as complementary, licensing transaction can also occur without the licensor having the patent rights. Following Anton and Yao (1994), an invention can also be protected only through secrecy.

2.5.2 TRADE SECRETS

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23 technical solutions are developed that need to be combined with the tacit knowledge of highly trained staff members in order to make the technique work. As the technique cannot be operated without the accompanied knowledge, keeping the knowledge secret could be an interesting option for firms to make sure that the optimal amount of value is appropriated.

Trade secrets protection is available for inventions that are used in business, that give the user an advantage over the competition, that have some element that separates them from everyday knowledge and that have been kept confidential (Kesan, 2000). There are no requirements to using this type of protection but there is also no possibility to protection your innovation against someone else exploiting it through for instance reverse engineering (Kesan, 2000).

Various problems arise when trying to keep the underlying technology a secret. First problem is how to offer a product to the public and at the same time disguising the underlying features. Common practice seems that only chemical formulas and industrial-commercial processes can be protected by trade secrets (Teece, 1997). Especially in the biotechnology industry, where techniques come with a vast amount of knowledge that is needed to work with these techniques, disclosing the product to the public, or to an alliance partner, is a huge challenge. Most firms are not equipped to make sure that only a certain amount of knowledge leaks out to the public or are not aware of the consequences it has for the company if critical knowledge and capabilities of the firm are also available to every competitor.

Continuing on this path, in an alliance with a partner firm, how do you instruct your own staff not to give away critical knowledge and capabilities to the alliance partner? A firm entering into an alliance is facing what can be called a ‘boundary paradox’, when trying to protect the core competencies or knowledge that is essential to its competitive position and simultaneously cooperating in an alliance where knowledge needs to be shared (Norman, 2001). The challenge in making sure that your personnel keeps your company’s secrets secret lies in the effective organization of human resources and alliance processes, which is discussed in the next paragraph. Herein immediately lies the overlap between trade secrets and human resources and alliance processes as the latter are needed to enforce the former.

2.5.3 HUMAN RESOURCES AND ALLIANCE PROCESSES

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24 entering into international strategic alliances, the distinction between top management and alliance management is not so apparent. Small biotechnology firms are an ideal type of modern entrepreneurial companies and are, in terms of their organizational setting and culture, quite different from the standard companies one might find in more traditional industries. These small biotechnology firms tend to be more driven by scientific discoveries and not only by common profit seeking. The fairly academic and professional culture within these companies driven by innovation and loosely organized with informal and non-hierarchical structures is set apart from more traditional companies (Roijakkers & Hagedoorn, 2003). This non-hierarchical component makes the distinction between the different types of management more lateral and a bit blurry (Delerue, 2004).

However, the main conclusions that Norman (2001) draws, concerning the human processes can be transferred to this specific type of research object. These conclusions include the emphasis managers must place on identifying its own core capabilities and the degree of information that can be transferred. Furthermore, the management must create awareness among the workforce and educate them in how to protect the critical knowledge. This view is shared by Spekman et al (1996) when they discuss the importance of vision, values and voice.

Appointment of an alliance information manager (AIM), who is responsible for monitoring, surveillance and consulting in case of vagueness, is also one of the things that can be done to prevent information spillover. But all these actions are useless if a company does not recognize the fact that information leakages frequently depend on the choices an individual employee makes in daily alliance work (Norman, 2001).

Alliance processes are involved with the processes that determine how the work is done and how people interact. In an alliance situation, these processes are vital and these processes must be controlled in such a way to ensure that critical information and capabilities are not shared with the partner. Two types of processes have been characterized by Norman (2001) including the processes that need to be protected and the processes that ensure that this protection occurs. These protection

processes can focus on the information flow, ranging from the deployment of a single gatekeeper5 to

deploying several communication stars6. De Man (2006) also refers to the importance of good

communication for effective alliance management and puts an emphasis on multiple points of contact a firm can have to get in touch with its partner. He also refers to the term ‘linking pins’, which indicates that a person who works in the alliance and at the same time has a position in the internal management structure of one of the partners. This option however is not very feasible for a SME as

5

A gatekeeper keeps the information flow centred. This is a cautious approach that may inhibit the partner to gain enough information to successfully imitate complex capabilities but can also slow down the cooperation process and create less synergy. Term was first used by Lewin (1947).

6

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25 these kind of firms do not have the manpower to make sure that every alliances is led by an internal manager. A firm could also focus on the access of information, by limiting the partner to access both facilities and non-alliance employees (Norman, 2001).

2.5.4 REPUTATION AND TRUST

The use of reputational capital as an informal mechanism to protect oneself against imitation, and thereby assurance of appropriation, has been discussed by Gemser and Wijnberg (2001) in their research into the Dutch and Italian design furniture industry. This mechanism cannot be institutionally enforced, as is the case with all informal mechanisms. Alternatively, the incentive to not engage in imitation lies in the reputational sanctions that can be imposed by various players in the market First issue of concern however is how to define a reputation in the field of biotechnology and how this reputation can be of relevance in the realm of strategic alliances.

In their research concerning the resource-based view on strategic alliance formation, Eisenhardt and Bird Schoonhoven (1996) point out that besides from strategic factors, social factors also play an important role in alliance formation. Especially in entrepreneurial firms, which is one of the characteristics of the biotechnology industry, a strong social position is important. The resource-based theory also mentions that a positive reputation is a valuable intangible asset that can allow a firm to establish sustainable competitive advantage (Barney, 1991). Related to transaction cost theory, a positive reputation can reduce the cost for searching and monitoring a specific partner (Saxton, 1997). Regarding game theory, a positive reputation is an indication that the holder of that reputation will not collect the payoff of the interaction (Parkhe, 1993). Podolny (1994) argues that, besides direct interpersonal contact, status and reputation enhance the probability of cooperation. These qualities are signals for skill and trustworthiness of a potential partner and therefore facilitate cooperation.

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26 goodwill should not be confused with its reputation for competence. The former, they cite, is related to low relational risk and the latter helps to reduce performance risk.

Related to risk is trust, which can also be viewed as a multidimensional concept. A widely accepted manner of making a distinction between different types of trust has been made by Nooteboom (1996). He makes the distinction between the partner’s ability to perform according to the agreements, which is also known as competence trust, and a partner’s intention to do so (goodwill trust). In his book Nooteboom (1994) clearly states that a distinction should be made between trusting someone will be competent and trusting someone has good intentions.

Using these different opinions combining the connotations of risk, trust and reputation, shared by Podolny (1994), Eisenhardt and Bird Schoonhoven (1996) and Das and Teng (2001), one could conclude that there are two types of reputation; the first one regarding the perception of the technical skills by potential partners, performance reputation, and the second one regarding the trustworthiness of a firm relating to being a good partner in alliances. The latter relates to the degree of trust one has in ones partner, and more specifically to the degree of goodwill. Delerue (2004) also mentions that the confidence of economic actors not follows from the predictability of outcomes but from the belief in the goodwill of others, which confirms the previous statement. For the relevance of this thesis, both reputations should be seen in the light of the perception of potential partners and not of customers or other stakeholders.

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27 Non-equity partnerships, like a strategic alliance, are included in the research of Hagedoorn and Hesen (2007). In these types of partnerships, property rights and profit allocation are not automatically accounted for and cannot solely be derived from a formal contract. This lack of ownership structure encourages the need for a range of other contractual safeguards. On the other hand, flexibility is needed to encourage the sustainability of these long-term partnerships. This flexibility cannot be found in the classical contracting perspective, whereas the relational contracting perspective also attributes attention to the relationship as it evolves. Relational contracting replaces discreteness and presentation by relational norms like reputation and trust.

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28

3 ADDING CONSTRUCTS AND SUB QUESTIONS

The usage of formal or informal means of protection varies greatly between different alliance types (Reuer & Ariño, 2007). In this thesis, I would like to focus on SME’s entering into an international strategic alliance with a larger partner, a so-called unequal alliance, for reasons discussed in the introduction. Therefore, all other types of firms in different industries and entering into different cooperation forms are not taken into account when discussing the influence of other characteristics on the usage of formal or informal means of protection for value appropriation. I would like to start by connecting partner asymmetry in size to the usage of more formal means of protection.

3.1 LARGER PARTNER

In general, it is considered that small firms are less formalised, more flexible, more innovative and more laterally organized than larger firms (Delerue, 2004). In an alliance between an SME and a larger firm, the asymmetry in size can cause numerous difficulties regarding the value that the SME can appropriate from the alliance. Bleeke and Ernst (1995) have suggested that the stronger partner in an alliance often has a hidden agenda regarding taking over the weaker partner, which makes alliances between unequal partners unlikely to be successful. Das and Teng (2001) therefore conclude that a smaller firm is weaker and more vulnerable to opportunistic behaviour of the partner. A larger company in addition has more scope, access to a wider market, more suppliers, more political influence, etc. Consequently, a larger company also has more room for opportunism. On the other hand, a larger firm can be expected to have more to lose when jeopardising its favourable reputation and its actions are more transparent to other companies in the industry. But fact remains that the large company has more options for opportunism and has therefore a favourable position over the smaller company in the alliance (Nooteboom, 1994). Therefore, it can be concluded that the smaller party in the alliances needs to rely more on formal protection mechanisms, and specific classical contracting and licensing agreements, to defy the opportunism the larger party could display in the future.

In additional to the threat of opportunistic behaviour, partner asymmetries can also lead to different expectations about equal treatment. A fair reward system is essential in making alliances successful and when partner asymmetries are considerable, the weaker party will tend to perceive that it is being exploited. When the weaker party in the alliance displays a lack of trust towards the stronger party, this stronger party consequently also feels less secure about the alliance (Das & Teng, 2001).

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29 The first sub question for my research therefore is:

3.1.1 Sub question 1

For optimal value appropriation, do SME’s in the biotechnology industry entering into strategic alliances with a larger partner (unequal alliance) rely dominantly on the formal means of protection?

This first sub question will serve as the basis for this research and is also a guideline for the following sub questions. I would like to continue with proposing some situations in which the reliance on formal means of protection may not be the best option and SME’s could benefit from choosing to rely more on informal means of protection. These situations include the influence of the time-dimension, the influence of cultural asymmetry and the purpose of the alliance.

3.2 TIME-DIMENSION

Various relational characteristics are important when discussing the dimensions and determinants of contractual complexity. These relational characteristics include the existence of prior ties and the duration of an alliance and open-ended versus alliances with a specific end date. These characteristics all have something to do with what can be called the time-dimension. I would like to start by addressing the influence of prior ties on the usage of either formal or informal means of protection and continue by shedding a light on the influence of a specific end date of the relationship.

Before starting the discussion on the influence of prior ties on appropriation from an alliance, a short remark must be made with regard to the definition of construct. For this research, having prior ties with an alliance partner can also indicate that the alliance has had a long duration. Alliance partners who have been engaged in an alliance for a longer period of time consequently have prior ties towards each other and the mechanisms that arise between partners with prior ties also arise when partners have been engaged in collaboration for a long period of time.

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30 cooperation and thereby lowering the perception of relational risk is not unrealistic (Das & Teng, 2000).

Reuer and Ariño (2007) add to the statements made by their colleagues by claiming that prior relations only have an influence on the less strict coordination provisions and not so much on the more stringent enforcement provisions. They stipulate that prior alliance contact only generates more intra-organizational routines, which makes the coordination processes smoother and generally breeds trust. Prior ties between organizations can lead to the development of inter-organizational routines for monitoring and collaboration. These routines offer the partners a better understanding of each other’s culture, management systems and so forth (Reuer and Ariño, 2007). The empirical research they conducted did not provide significant support for the hypothesis formed with regard to the influence of prior ties.

Norman (2002) makes a summary of the points of view of different authors, stating that higher levels of trust result in actions such as the reduction of formal contracts, less detailed agreements, fewer actions to safeguard knowledge and monitor partner behaviour and greater information exchange. One of the researches that concluded this was one conducted by Ring and Van de Ven (1994). Basing their results solely on theoretical evidence, they concluded that prior ties lead to higher levels of trust between the partners and increases the efficiency of the development of the relationship. Therefore, a greater reliance on goodwill decreases transaction costs and increases flexibility because the need for a legal document is perceived as being lower. Norman’s own research into this field (2002) does provides us with a hypothesis that was tested empirically as she sent out a survey to various firms in the public and private sector specialized in microelectronics, computers and telecommunications. However, she did not find substantial empirical support to conclude that firms with prior ties will employ less strict knowledge protection mechanisms so no empirical evidence is present in this realm.

Furthermore, Gulati (1998) claims that firms in ongoing interaction might not only learn about their partners but also develop a sense of trust around other norms. He did find empirical evidence to support this claim as he found a positive relationship between the number of prior ties and the increased trust between partners. For the purpose of this thesis, I would like to follow the claims of Gulati (1998) and Das and Teng (2000) and conclude that prior ties breed a sense of trust between the partners and surrounding other norms which indicates that reliance on informal means of protection is more likely to occur.

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31 more informational provisions concerning the monitoring and adaptation of the alliance (Reuer & Ariño, 2007). The thoughts of Reuer and Ariño (2007) show some similarities to the distinction made between classical and relational contracting of Hesen and Hagedoorn (2007), which was discussed earlier. In this realm, the enforcement provisions fit in the classical approach of contracting and the informational provisions show similarities with the relational contracting approach.

Reuer and Ariño (2007) found that open-ended relationships, relationships without a specific end date, involve more potential future gains than a time-bound relationship would, which protect against opportunistic behaviour of the partner by capturing more proximate gains. Combined with the fact that the specific end date of an alliance means that one can better anticipate on the future and therefore specify the rights and duties for all relevant situations, time-bound contracts are more detailed and complex. As all contingencies are easier to predict in time-bound alliances, they tend to rely more on strict enforcement provisions and less on coordination provisions. This could also potentially mean that firms entering into open-ended alliances will find the relational contracting more suitable than the classical contracting approach, as was claimed earlier. This is enforced by the claim of Gulati (1998) that the lower the appropriation concerns are, the less hierarchical the governance structure for organizing the alliance is.

Based on the statements made with regard to the influence of the time-dimension on the usage of either formal or informal means of protection, I would like to start by stating the following sub question:

The fact that the influence of prior ties has already been tested once or twice, does not mean that this sub question is obsolete for this thesis because of the fact that the setting of this research, SME’s in the biotechnology industry entering into an alliance with a bigger partner, could provide us with new information regarding the importance of trust and reputation in alliances in this specific context. Concerning the contract having a specific end-date, I would like to propose:

3.2.1 Sub question 2a

For optimal value appropriation, do SME’s in the biotechnology industry entering into unequal alliances with partners with which they have prior ties or longer relations, rely dominantly on informal means of protection?

3.2.2 Sub question 2b

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32 3.3 CULTURAL ASYMMETRY

Pangarkar and Klein (2001) conducted a research into 2407 alliances formed in the global biotechnology industry and reviewed the influence of cultural similarity between these firms. They concluded that there are two different research streams to be considered when dealing with international alliances.

The first stream argues that cultural distance leads to a lack of trust and higher transaction costs. This is derived from the fact that firms from different countries entering into an alliance agreement can experience magnified uncertainty (Pangarkar & Klein, 2001). This follows from the fact that better and more information is available about domestic partners (Gulati, 1995). Additionally, uncertainties can derive from differing norms about behaviour, greater demand uncertainty, political instability or the different nature of corporate governance systems (Gulati, 1998). Parkhe (1998) adds to this research stream that communicating with a foreign partner is made more difficult due to these uncertainties. Besides from the cultural difference, a difference in language could also add to the uncertainty surrounding an international alliance. An asymmetry in language skills often constraints the transparency between the partners, especially when the knowledge that has to be transferred is highly tacit (Hamel, 1991).

The second stream of research, including Buckley and Casson (1996), argues that cultural homogeneity, in the form of shared beliefs, reduces the transaction costs by avoiding misunderstanding. Furthermore, shared values, including integrity and loyalty, increase the willingness to share knowledge. It should be noted that this stream of research concentrates mostly on the formation of international joint ventures and not so much on strategic alliances (Pangarkar & Klein, 2001), which are of importance for this thesis. For this last reason, I would like to propose that for this thesis, cultural distance increases uncertainty and decreases trust between partners, which makes it more difficult to managing an international alliance in comparison to a domestic alliance or a alliance with a partner from a cultural homogeneous country. The sub question that follows from these statements is:

3.3.1 Sub question 3

For optimal value appropriation, do SME’s in the biotechnology industry entering into unequal international strategic alliances a partner that is culturally homogeneous rely dominantly on informal means of protection?

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33 3.4 PURPOSE OF THE ALLIANCE OR STRATEGIC INTENT

The purpose of the alliance also has an influence on the usage of either more formal or more informal means of protection to assure appropriation. Regarding this subject, Pangarkar and Klein (2001) make the distinction between alliances involving upstream activities and alliances involving downstream activities. In high-tech industries, such as the biotechnology industry, firms often get their competitive advantages from their effectiveness in upstream activities such as R&D. Alliances formed involving upstream activities, such as research and development, involve greater risks and opportunism and suffer from higher transaction costs than alliances involving downstream activities, such as marketing (Pangarkar & Klein, 2001). Another relevant distinction is made by Koza and Lewin (2000) regarding strategic alliances with exploration or exploitation intent. They state that companies with high exploration desire and limited exploitation desire form learning alliances. These alliances can reveal new information about markets, core competencies or new technologies. The critical success factor in these kinds of alliances is the ability of the alliance partners to design, manage and adapt organizational processes to keep the alliance on track. This type of alliance is similar to alliances involving upstream activities like R&D.

Pangarkar and Klein (2001) conclude that, for various different reasons, alliances that undertake R&D can better be structured as an equity based alliance, such as a joint venture, than as a non-equity based alliance, as strategic alliances are defined in this thesis. First of all, the high uncertainty of R&D processes makes it difficult to specify all the issues that may arise upfront. Secondly, the risk and impact of partner opportunism is high in R&D alliances, resulting in a higher need for better protection through alignment. Thirdly, R&D processes often have spill over effects so the division of unanticipated gains can better be handled in quasi-hierarchical alliances. Finally, a successful R&D effort requires a considerable amount of tacit knowledge, which can be better shared in an equity alliance. Additionally, Hamel (1991) stated that R&D alliances are sometimes a cover for inappropriately capturing the partner’s superior technology.

In the realm of a learning alliance, as it was defined by Koza and Lewin (2000), Norman (2002) states that firms with specific learning intent will be more likely to learn. She also stated that the higher the perceived learning intent of the partner, the higher the knowledge protection by the firm.