Why Exit via Acquisition Is Essential to Entrepreneurial Investment

By: Devin Reilly, D. Daniel Sokol & David Toniatti (CLS Blue Sky Blog)

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…