In the paper, R&D and the Incentives for Merger and Acquisition Activity, written by Gordon Phillips (professor of finance at the University of Southern California) and Alexei Zhdanov (professor at the University of Lausanne and the Swiss finance Institute), the difference between large and small firms incentives to innovate during M&A activity as well as whether M&A activity promotes or hinders innovative activity is evaluated. R&D and innovation decreases have been documented in previous literature when larger firms acquire a company. In this paper, the authors use recent information pertaining to premerger R&D activity to support why larger firms should not stifle innovation. They demonstrate how a merger can stimulate R&D activity in smaller firms.
What is reflected in this paper is that smaller firms are encouraged to be more innovative during an active acquisition market. Generally, pre-merger, smaller firms increase their R&D to become more attractive acquisition targets. After the acquisition, innovation decreases or completely dies. They point out how the acquiring company should continue the R&D as an exit through a strategic sale.
Larger firms need to determine whether to innovate themselves or acquire smaller firms that have successful innovations. Larger firms can typically conduct R&D in-house, but if they outsource the R&D investment to smaller firms, they can then acquire those that successfully innovated. Acquiring a firm with successful innovation is a more conducive path, for larger firms, to obtaining the innovation than innovating itself.
This effect is illustrated in theory or reticle models and rigorous empirical tests are provided. New empirical predictions regarding pro-cyclicality of R&D investments as they relate to firm size, is sex the potential acquisitions on R&D, banks of R&D to industry structure, and effects of bargaining power and asset liquidation on smaller firms R&D decisions are depicted. The authors provide strong evidence supporting their predictions. They found that small firms have more R&D activity in merger and acquisition intensive industries; R&D investments are pro cyclical specifically for smaller firms; and smaller firms sell out more during industry booms.
They use Google as an example. In 2010, Google acquired 48 smaller firms six years after it went public. Add that to the 60 acquisitions over the previous five years in the company acquired a total of 108 smaller companies after its initial public offering. Of all the acquisitions that Google made, three of them were smaller search engine companies which Google bought for their technology assets and patents. Each of these companies offered additional features in their search engines that Google now incorporates into its search capabilities. The company’s purchased were Outride, Kaltix, and Orion.
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