Patent Protection, Startup Takeovers, and Open Innovation

Abstract Open innovation largely relies on startup innovators transferring their R&D to incumbent firms. Yet, such innovators are at a disadvantage when faced with incumbents holding patent portfolios, raising the question why do such Lilliputian firms choose to innovate? In view of this, we study the impact of patent protection on the innovation incentives of startup firms in a dynamic model where an incumbent faces a sequence of potential startups and the incumbent’s chance of winning an infringement lawsuit increases with the size of its patent portfolio. It is shown that open innovation–style takeover deals generate extra benefits for the incumbent via its enhanced future bargaining positions, a part of which accrues to the current startup as an increased bargaining share, justifying R&D activity that would not have taken place otherwise.