Several proposals in the House and Senate are aimed at substantially curbing M&A (Mergers and Acquisitions) activity as part of changes focused on antitrust. In a recent study, titled “Mergers, Antitrust, and the Interplay of Entrepreneurial Activity and the Investments That Fund it”, we shed light on the possible implications to startup-driven innovation, in general, and the VC ecosystem, in particular. To that end, the study advances a number of empirical observations about the role and significance of M&A for startups and the VCs that back them.
Why does exit via merger matter to entrepreneurship? The ability to realize returns on their investment and effort, commonly referred to as “exit from entrepreneurial ventures,” is important for both investors and founders. Without the ability to exit, neither founders nor investors will be able to reap the gains of the appreciation in the valuation of the business. Entrepreneurial exits are largely a function of acquisitions rather than IPOs (Initial Public Offerings). A close look at “exit” events since the Great Recession reveals an overall growth in the number of events over the past fifteen years, partially reflecting the overall increase in investment activity during the period. Moreover, the number of Mergers & Acquisitions significantly outnumbers that of IPOs each year. In any given year, there are at least fivefold more M&A events than there are IPOs.
Going public is the realm of fewer, larger companies. The number of IPOs grew dramatically up to the year 2000, yet the number of companies going public every year has dropped after the dot-com bubble burst and has remained low ever since in relative terms. The study reviews several reasons for the marked change in the frequency and nature of IPOs (i.e., realizing synergies of scale and scope in the Internet age, Sarbanes-Oxley Act of 2002, SEC Regulation FD, and 2003 Global Settlement), as well as the dramatic recent expansion in “public” exits in the form of Special Purpose Acquisition Companies (SPACs).
Moreover, the age of companies at IPO also changed post-2000. Whereas the average age of a company at IPO was, on average, eight years during the period leading up to the year 2000, the average age is usually over ten years for post-2000 IPOs. A corollary observation is that the successful scale behind many of the innovators that have gone public traces back to active M&A activity. Consider Airbnb, which debuted on the NASDAQ on December 10, 2020; the company engaged in over a dozen acquisitions of companies in related spaces during the decade leading to its IPO. Another example is Unity Software, which acquired over a dozen companies prior to its September 2020 IPO, including the $53M acquisition of Artomatix (March 2020) and $25M acquisition of Multiplay (November 2017). Similarly, Palantir engaged in about a half dozen acquisitions prior to its September 2020 IPO. Snowflake also acquired Numeracy (March 2019) and CryptoNumerics (July 2020) prior to its IPO (September 2020).
Acquisitions are common across a wide range of valuations. Not only do acquisitions account for the larger number of liquidity events, but they also cover a wide range of exits at low and medium valuations. Over the past 15 years, M&A deals over $500M have been a rare minority and most M&A exits are at a lower sub $100M valuation. A related observation is that the time from first VC to exit is shorter under the M&A route. The median time to exit stands at less than 5 years for M&A in comparison to 6 years or more for exits via IPO.
Maintaining the health of the entrepreneurial ecosystem is important. We have presented the discussion of liquidity events, with a focus on M&A activity, through the lens of founders, customers, and their ability to deliver and benefit from consistent innovation. As this is an important topic, one should carefully take stock of multiple issues that are at play, including some that may have received less attention to date. The focus of the current discussion is on the entrepreneurial ventures being acquired and the viability of their innovation. Below, we highlight a related view that has received less attention to date. It has to do with the health of the VC model as a whole, shifting attention for the specific ventures that are to be acquired and taking the broader view of the VC firms that funded those ventures and the firms’ ability to back other innovative ventures. This hurts a number of traditional LPs investing in venture capital funds such as public pensions and universities, which use venture capital investment to increase the returns on their assets.
Implications: M&A and First-Time Funds.
The observations mentioned above carry several implications for the health of the VC ecosystem. We highlight one possible implication below and invite you to read the full study for a discussion on additional implications.
The majority of first-time VC funds are small. Data from 2006 onwards reveals that the median fund size for first-time VCs is in the sub-$50M range. Building on the observations above, it becomes clear that a single M&A deal represents a sizable return for a first-time fund. Moreover, the time to an exit event is usually faster under the M&A track (in comparison to IPO track). Taken together, these observations suggest that the viability of first-time funds is particularly sensitive to the market for sub $100M M&As. One or two M&A deals can make a substantial contribution to the compensation of a first-time fund. Crucially, it also plays an instrumental role in the longevity of the VC firm by allowing it to successfully raise follow-on funds.
We emphasize the implications for first-time funds because of the role they play in impact investments and introducing diversity to VC ranks. Many first-time funds are raised by investors with more diverse backgrounds. Moreover, the new cadre of investors make it their mission to support founders with diverse backgrounds. As a result, smaller new funds often pursue innovation in sectors or geographies that have been neglected in the past. Taken together, these figures suggest that M&A plays a crucial role in the health of the VC ecosystem. This may be particularly so for first-time funds where the time and ability to execute a median-sized M&A can unlock the ability to raise a follow-on fund and further advance diversity and inclusion in the entrepreneurial ecosystem.
To conclude, recent regulatory proposals are aimed at addressing antitrust concerns. We call attention to the potential implications to the viability of the VC ecosystem and the innovative startups it supports. It has the potential to dramatically affect M&A-exit opportunities for founders and VC investors. As a result, it may decrease the number of new VC funds and could impact social-based investing relating to sustainability and diversity which play a large role in many first-time funds’ investment decisions.
Gary Dushnitsky is an Associate Professor at the London Business School.
D. Daniel Sokol is a Professor at the USC Gould School of Law and Affiliate Professor at the USC Marshall School of Business.
This post is adapted from their paper, “Mergers, Antitrust, and the Interplay of Entrepreneurial Activity and the Investments That Fund it”, available on SSRN.
 M&A information sourced from Pitchbook.
2 To calculate the returns for a specific deal, one requires information on the equity stakes of the VC fund.