R&D and the Incentives from Merger and Acquisition Activity

In the paper, R&D and the Incentives from Merger and Acquisition Activity, forthcoming in the Review of Financial Services, my co-author (Alexei Zhdanov of the University of Lausanne and the Swiss Finance Institute) and I examine how the incentives to innovate differ between large and small firms and whether the M&A market hinders or promotes innovative activity. Previous literature has documented that R&D and innovation decreases post-acquisition and has attributed this effect to large firms stifling innovative activity. Using recent data on pre-merger R&D activity, we show that this view is flawed. Rather than large firms stifling R&D by small firms, we show theoretically and empirically how mergers can stimulate R&D activity of small firms. Thus, ex ante R&D rises and then falls naturally after acquisition as the pre-merger stimulus effect wears off.

In fact, we show that an active acquisition market encourages innovation, particularly by small firms in an industry. How does this happen? Successful innovation makes small firms attractive acquisition targets. Small firms increase their R&D to obtain more innovation pre-merger so that they will be attractive acquisition targets. Exit through strategic sales thus becomes an important motivation to continue to spend on R&D.

The trade-off for large firms is between innovating themselves or acquiring small firms that have successfully innovated. Large firms, who can conduct R&D in-house, can optimally outsource R&D investment to small firms and then acquire those that successfully innovate. Acquiring firms that have successfully innovated can be a more-efficient path to obtaining innovation than innovating directly oneself.

We illustrate this effect in a theoretical model and provide rigorous empirical tests. We generate new empirical predictions regarding pro-cyclicality of R&D investments and their relation to firm size, the effect of potential acquisitions on R&D, the link of R&D to industry structure, and the effect of bargaining power and asset liquidity on small firms’ R&D decisions. Our evidence supports these predictions. Small firms do more R&D in merger and acquisition intensive industries. R&D investments are pro-cyclical especially for small firms. Small firms also sell out more during industry booms.

A recent prominent example is Google. Google made 48 acquisitions of smaller firms in 2010, six years after it went public, and 60 acquisitions in the previous five years, for a combined total of 108 acquisitions in the six years post-initial public offering (IPO). (See “Google Cranks Up M&A Machine” Wall Street Journal, March 5, 2011.) Specifically, early in its life, Google bought three smaller search engines for their technology assets and patents. Each of these companies operated search engines with additional features that Google incorporated into its online search capabilities. These purchases include: Outride (see: http://www.google.com/press/pressrel/outride.html), Kaltix (see http://en.wikipedia.org/wiki/Kaltix), and Orion (see: http://searchengineland.com/google-implements-orion-technology-improving-search-refinements-adds-longer-snippets-17038). Another example is Cisco. To extend its networking offerings, Cisco has purchased 16 computer networking companies and five computer security companies since 1999.

We conclude that M&A activity strongly increases firms’ incentives to conduct R&D, but less so for large firms as they may buy smaller firms for their technology to use in their existing business. Competition also increases incentives for firms to conduct R&D, especially for small firms. Public policy implications of our work include the conclusion that if a country passes laws that hinder mergers and acquisitions, small firms will have fewer incentives to conduct R&D, as there will be one less channel for innovators to monetize their R&D expenditures.

The full paper is available for download here.