Antitrust regulators around the world, including in the UK, have recently proposed changes to merger review policies and enforcement strategies that have implications for how acquisitions of start-ups are investigated and evaluated. These changes will likely lead to heightened scrutiny—and increased costs and longer reviews—for many acquisitions, including horizontal and vertical mergers. In evaluating the merits of such changes, it is critical to take into account the important role that exit via acquisition plays in providing incentives for venture capital (VC) investment and entrepreneurship, and more broadly in driving dynamic innovation—one of the stated goals of the UK’s Competition and Markets Authority (CMA). In our article, The Importance of Exit via Acquisition to Venture Capital, Entrepreneurship, and Innovation, we provide context and analysis in evaluating the effects of such proposed rule changes, with a focus on the UK.
First, our article provides an overview of the VC ecosystem and the link between VC investments and innovation. Second, the article identifies consumer benefits that acquisitions by large companies of younger, smaller companies can provide and highlights the beneficial role that acquisitions of smaller firms by larger firms play in the economy, particularly in driving innovation. Third, the article describes the context of VC investment in the UK, including the UK’s favorable, yet fragile, position as a VC hub for continental Europe. Finally, the article provides background on the recent push for more geographic and ethnic diversity in VC investing in the UK, important context given the negative impact that rule changes might have on newer VC investments.
Venture Capital is Often a Complement to, not a Substitute for, Corporate R&D
We begin our paper by noting that VC investing is complementary to R&D within companies. For decades, the VC ecosystem has been an important stimulator of entrepreneurship and innovation, providing funding for early-stage ventures that may not be appropriate for the risk profiles of larger corporations. Large firms face pressure to generate returns on invested capital, which can dissuade them from engaging in risky enterprises or investing meaningfully in new ideas. In addition, larger firms are often subject to more scrutiny from stakeholders and regulators, and investing in unproven ideas may not be consistent with managerial incentives.
The VC business model, on the other hand, is custom-built for taking exactly the kinds of risks that larger, more established businesses try to avoid. Risk-taking is an inherent component of a VC fund’s investment strategy, in which many bets are made in anticipation that only a few will pay off.
In fact, if we take patent activity and quality as a proxy for innovation, some academic studies suggest that a dollar of VC investment may be nearly three times more valuable than a dollar of corporate R&D. Indeed, VC-backed firms were between two and three times more likely to have “higher quality” patents, as measured by citations, originality, and other factors.
The Cycle of VC Investment, Exit, and Reinvestment Matters for Competition
The VC business model is not built for the long haul. VC firms typically raise closed-end funds from institutional and wealthy individual investors through a limited partnership. They then invest those funds in young, privately held, high-growth firms, commonly in exchange for an equity stake.
For several years following their investment in a smaller company, venture capitalists typically work with the founders of the company to grow the venture and help market, improve, or scale a potentially useful product or service. The goal of many of these founders, and of their investing VC funds, is to realize the return on their investment either by selling the venture to a corporate acquirer or, less frequently, through an initial public offering (IPO).
Ventures that are acquired by a larger firm benefit from the competencies of larger firms. In particular, larger firms do well with routinized processes that come with scale and thus often are better equipped to implement incremental change rather than radical innovation. Larger firms can then employ these comparative advantages to help smaller firms scale more efficiently. Consumers may also benefit from having greater access to a broader range of products and more diverse sources of innovation than would otherwise be feasible.
At the end of the VC investment cycle, successful firms typically seek to raise follow-on funds from investors to begin a new cycle of investment in other younger, smaller firms. In this way, serial entrepreneurs often find success with their maiden ventures, giving them an incentive to pursue new opportunities after their first wins.
VC Investors and Entrepreneurs Need Exit Opportunities
In the VC ecosystem, exit opportunities, and especially exits via acquisition, are the critical drivers of entrepreneurship and innovation. The end game for most VC investors is realizing the return on their investment through what is commonly referred to as “exit from entrepreneurial ventures.”
In the UK, the importance of exit from entrepreneurial ventures via acquisition continues to grow. In a recent survey of UK start-up founders and executives, for example, 58 percent cited acquisition as the long-term goal for their company, compared with 18 percent whose goal was an IPO. In another study of 1,545 British start-ups that raised equity in 2011, 226 companies had been acquired by 2019 while only 32 companies had exited via an IPO. Another survey of investors focused on UK start-ups found that 90 percent of investors identified the ability of start-ups to be acquired as “very important” for the success of the tech start-up ecosystem, with the remaining 10 percent identifying it as “somewhat important.” Similarly, 23 percent of investors stated that a “significant restriction” on the ability to exit would lead them to stop investing in UK start-ups, with an additional 50 percent stating that they would “significantly reduce” their investments. Exit via acquisition thus is central to the ability to maintain the dynamic cycle of VC investment, particularly given that IPOs are far less common and typically only feasible for the largest ventures.
Exits via acquisition also create multiplier effects by stimulating further entrepreneurship and associated innovation, leading to more jobs, higher standards of living, and overall economic growth. In addition, studies in Europe and the U.S. have found that VC investment stimulates post-deal innovation within the acquiring company. Acquired firms are more likely to generate spin-offs than non-acquired firms, and employees of high-growth and VC-backed acquired firms are more likely to return to the start-up sector than employees who had been hired previously at the acquiring firm.
Keeping the UK Relevant in Innovation
Ultimately, it will be critical for the UK to pursue policies that buttress its strengths as a center for entrepreneurship and avoid compounding existing challenges, especially in its post-EU future. Neither the UK nor its CMA are alone in wrestling with these questions. Antitrust regulators around the world have been proposing changes to merger review policies and enforcement strategies designed to heighten scrutiny on a broad class of transactions. As they do so, they should be careful to avoid the unintended and potentially anticompetitive consequences of disrupting the VC ecosystem.
This post comes to us from Devin Reilly at the consulting firm Analysis Group, D. Daniel Sokol at USC’s Gould School of Law and Marshall School of Business, and David Toniatti, also at Analysis Group. It is based on their working paper, “The Importance of Exit via Acquisition to Venture Capital, Entrepreneurship, and Innovation,” which received funding from the Computer and Communications Industry Association and is available here. Reilly and Toniatti have provided consulting support to technology companies in various matters. Sokol also serves as a senior adviser to White & Case, LLP, where he has worked for both industry associations and companies on technology antitrust-related issues and other issues.