Antitrust regulators around the world, including in the UK, have recently proposed changes to merger review policies and enforcement strategies that will likely lead to heightened scrutiny—and increased costs and longer reviews—for many acquisitions, including both horizontal and non-horizontal mergers. In evaluating such changes, it is important to consider the context in which many acquisitions occur, and in particular the critical role that exit via acquisition plays in providing incentives for venture capital (VC) investment and entrepreneurship. This ecosystem ultimately is instrumental 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 such context for the effects of these proposed rule changes, with a focus on the UK.
VC Encourages Risk-Taking That Helps Support Innovation
For decades, the venture capital, or VC, ecosystem has stimulated entrepreneurship and innovation by providing funding and other forms of support to early-stage ventures, helping those businesses with market entry or expansion. In this way, VC funds have helped populate markets with many innovative and competitive products or services, taking on the kind of high-risk, high-return projects that larger, more established corporations may shy away from. The UK has been transformed for the better for its leadership in VC based growth outside of North America.
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. Importantly, because VC firms raise closed-end funds with a short shelf life, a successful exit at the end of one investment cycle often leads to a firm seeking follow-on funds that begin a whole new cycle of investment in other young businesses.
By providing support for young, innovative companies, the VC funding cycle has contributed to such key technological innovations as mainframe computing in the 1960s; personal computing in the late 1970s; biotechnology in the 1980s; internet and e-commerce in the 1990s; and ‘smart’ mobile communications technologies and cloud computing in the 2000s. Most recently, VC funding has been behind many novel products and business models introduced into the digital economy, including mobile apps, fintech, software as a service, and ‘sharing economy’ platforms. Indeed, studies in Europe and the US have found that VC stimulates post-deal innovation. The VC engine, built for speed, is a good match for the blindingly rapid and globe-spanning growth of the digital sector.
Exit via Acquisition Creates Incentives for VC Investment and Broader Consumer Benefits
In the dynamic and fast-paced VC ecosystem, exit opportunities, and in particular exits via acquisition, are the critical drivers of entrepreneurship and innovation. The end game for most investors in VC funds is realising the return on their investment through what is commonly referred to as ‘exit from entrepreneurial ventures,’ most often by selling the venture to a corporate acquirer, and less frequently through an initial public offering (IPO), either directly or through special purpose acquisition company (SPAC) listings.
Notably, in recent years traditional IPOs have been on the decline, as investors increasingly seek to avoid the significantly higher costs and complexity involved. Instead, investors and entrepreneurs have been turning more to exit via acquisition by large companies and, at least in the United States, through SPACs in the form of ‘de-SPAC transactions.’
Beyond creating incentives for VC investment, acquisitions of small firms by large firms create multiplier effects that further stimulate innovation. For example, studies have shown that 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. These dynamics highlight how exit via acquisition is an important mechanism by which the entrepreneurial ecosystem continually supports itself and provides ways to continue innovation.
Recent Proposals May Disrupt This Virtuous Cycle and the UK’s Favourable Position as a VC Hub of Europe
In Europe, VC funding is highly concentrated in a limited number of countries, and the UK leads the field by a wide margin. For example, London-based firms raised US$7.8 billion in 2020, which is over five times higher than in Berlin, six times higher than in Paris and 11 times higher than in Amsterdam. The UK and London enjoy this favourable position in the global VC ecosystem due to a number of factors, including its regulatory environment, attractiveness to foreign talent, and a university system that fosters both domestic and foreign talent.
However, despite this thriving environment, proposals from legislators and regulators around the world, aimed at heightening regulatory scrutiny of acquisitions by large companies, threaten to disrupt the dynamic VC investment cycle.
Such proposals will almost certainly make exit strategies more costly or difficult for entrepreneurs and their VC backers, especially in the digital industry. Earlier studies have found that VC activity is affected by laws that impact the viability of exit opportunities. For example, one study found that antitakeover laws in the United States that made acquisition more difficult led to a decrease in subsequent VC investment.
In the UK, where VC activity and acquisitions play an important role in stimulating the country’s economy, threats to the prospect of exit via acquisition remain a central concern. For example, a survey of investors focused on UK start-ups from the Coalition for a Digital Economy (Coadec) found that 90% 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% identifying it as ‘somewhat important.’ Similarly, 23% 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% stating that they would ‘significantly reduce’ their investments.
The vast majority of UK start-ups emphasize the importance of exit via acquisition because few entrepreneurs view alternatives like IPOs as a long-term goal. In a recent survey of UK start-up founders and executives, 58% cited acquisition as the long-term goal for their company, compared to only 18% 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.
Recently, the VC community in the UK has expressed its concern over the changing regulatory tide. A 2020 survey by the British Business Bank reported that 77% of VC fund managers felt that the availability of exit opportunities had worsened since 2019, and 41% viewed the current market for successful exits as ‘poor’ or ‘very poor.’
Ultimately, it will be critical for the UK, as well as regulators in other countries, to pursue policies that buttress its strengths as a centre for entrepreneurship and avoid compounding existing challenges. They should make sure they tread cautiously to avoid the unintended and potentially anticompetitive consequences of disrupting the VC ecosystem.
There may well be serious economic consequences if regulators fail to consider the complex interdependencies of the different roles played by VC firms and acquisitions in the economy’s growth and continued development. In fact, if we take patent activity and quality as a proxy for innovation, some academic studies suggest that a dollar of VC may be nearly three times more valuable than a dollar of corporate R&D. For example, VC funding accounted for less than 3% of US corporate R&D from 1983-1992, but researchers estimated that it was responsible for around 8% of US patents over this period. In addition, a recent study of US firms’ patenting outcomes found that VC-backed firms were between two and three times more likely to have ‘higher quality’ patents, as measured by citations, originality and other factors.
These proposed changes have the potential to harm growth and, ultimately, consumers, who benefit from the innovation that these acquisitions generate and from the incentives that motivate entrepreneurs to create new products and services that attract VC investors and acquiring firms.
Devin Reilly is an Economist (PhD) and Manager at the Analysis Group.
D. Daniel Sokol is Professor of Law and Business at USC’s Gould School of Law and Marshall School of Business, and Senior Adviser to White & Case, LLP.
David Toniatti is an Economist (PhD) and Vice President at the Analysis Group.
The Computer and Communications Industry Association (CCIA) provided financial support for this work.