Is M&A the New R&D?

Big companies can benefit from buying startups when it gives insight into market dynamics and puts them at the leading edge of industry innovation, says Julie Meyer

Something new is happening in the way technology innovations are getting bedded down in the industry. Briefly put, venture capital-backed startups are being acquired much earlier in their development by larger companies that offer entrepreneurs a rapid path to growth and scale. For big corporations, in turn, startups help create a "mixed economy" of innovation, balancing the greater certainty of in-house research and development and organic growth (and its longer time horizon) with an earlier but riskier starting position in emerging technologies.

To be sure, there has been a lot written about how often value is destroyed in acquisitions. It's fair to argue that the measure of successful acquisitions ought to be that they improve long-term cash flows. But it's also important to consider the time frame for cash-flow gains, as well as strategic drivers above and beyond financial value. Strategic value needs to be tied to financial value, but there's more to it than that alone.

Here's why buying startups can pay off, even if they're not immediately accretive to earnings or cash flow. Entrepreneurs, if they're good, have the best insight into how particular markets are developing. They are in the "eye of the storm," dealing every day with how markets are dynamically evolving. Entrepreneurs also think differently. They see things that others don't. They feel compelled to make stuff happen, often simply because they see something that doesn't exist yet—and should. Sometimes that blind faith leads to catastrophe, but more often, entrepreneurial insights eventually turn into step changes in how industries operate.

Value of the Entrepreneurial Class

If a large company acquires an entrepreneur's insight and innovation, it has the opportunity to get ahead of rivals and own the step change. Time and time again we have seen that the benefits of market disruption and dislocation accrue to the first few players who embrace it. Put another way, if a market disrupter is acquired by the entity he or she has the most potential to disrupt—and the acquirer embraces, rather than smothers, the disruption—it can be extremely value-enhancing. Especially compared with the alternative.

Consider the example of Google. Once people referred to it as a search engine, but today it's often called a media firm. Indeed, since going public in 2004, Google (GOOG) has become one of the largest media companies in the world. How did it get there? It entered a crowded market with better technology. Its "unfair" advantage was applying its technology, specifically search algorithms, to the aggregation of audiences. Building an audience is what media firms have always done, but Google did it differently, using different thinking. Entrepreneurial thinking. Imagine what having that technology in-house might have done for some of the firms we now call the "old media."

Part of why companies buy startups is to add such new DNA to their corporate gene pool and introduce a new way of thinking into how they operate. Sometimes there is massive organ rejection by the body, but there have also been hugely successful examples of acquisitions. In the best of these, the startup culture positively affects the parent's corporate culture as well. One example that comes to mind is the 2004 acquisition of WGSN—the Worth Global Style Network—by London-based publisher Emap. WGSN is like the Bloomberg of the fashion industry, an online repository of news, trends, and research. Since Emap bought it for $280 million, WGSN's business has doubled. And Emap has gotten much more Web-savvy. Indeed, Managing Director Dharmash Mistry says WGSN gave Emap a rock-solid new business when Emap was in a rough patch.

Information Asymmetry

Is the buyer typically disadvantaged in such an acquisition? All too often, that's the case. There's usually an information asymmetry because the startup is closer to the ground. The best way to offset this is to "date before getting married." The longer and better companies understand an asset, the better they can value it. Not surprisingly, some of the best acquisitions have occurred when internal corporate business development groups were already part-way toward entering a business or market and then found a startup already there to buy.

Sometimes, though, moving too fast only accentuates the information asymmetry. Google apparently acquired YouTube in just five days. It's easy to look at the price—not to mention the challenges YouTube has run into since—to see how much that worked in favor of YouTube's founders. One way to avoid that problem is to invest early in startups to get insight into their business and market. Last year, for instance, both Google and Skype (EBAY) put money into Fon, a European Wi-Fi network run by serial entrepreneur Martin Varsovsky (see, 2/7/06, "From Hot Spots to Fon Zones?").

The bottom line: Partnering, investing, and mergers and acquisitions always have been part of corporate activity. What's different now is that thanks to globalization and the Internet, small changes can lead quickly to major disruptions in business models and industries. Regular injections of entrepreneurial culture help ward off the risk. Of course, it's not a panacea. Corporate leaders still have to manage R&D and innovation well—not rely solely on acquisitions to do the job. But given how fast things are moving, buying startups is becoming an increasingly important part of the chief executive's toolkit.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE