M&A is the new R&D

-- by guest blogger Julie Meyer

Meyer is the CEO of Ariadne Capital, a London-based investment and advisory firm focusing on new media, software and communications services.

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 by corporate enterprises. It's a win-win: the startups get the resources to scale; the corporations expand the way they grow new products and services.

Through their corporate development units, most large companies operate a mixed economy where they balance the greater certainty of organic growth and its longer time horizon with the benefits of inorganic growth, namely an earlier starter position, and probably a more excellent innovation.

There has been a lot written about how much value destruction can happen when a business is acquired. Some would argue that if you’re clear about what drives the value, then acquisitions create value when they improve long term cash flows. The time frame is important here for assessing the improvement of cash flows, but so are the additional strategic value drivers and elements above and beyond financial value.

Most of the time, start-ups are not bought only for their present or future financial value. That’s part of it, but there’s more. Acquisitions are increasingly a form of R&D.

Good entrepreneurs have the greatest insight into how a particular market is developing, as they are in the “eye of the tornado” and are dealing with markets dynamics real-time. Entrepreneurs also think differently. They see things that others don’t. They feel compelled to make things happen because something doesn’t exist which should. Sometimes that’s blind faith, which leads to catastrophe. More frequently however, that’s great insight which is harnessed into a step change in how an industry operates. If a company acquires that asset -- the entrepreneur’s insight and innovation -- then they can lead in that industry breakthrough. Time and time again, we see that the benefits of market disruption and dislocation accrue to the Nr 1 and 2  players who embrace it. Otherwise said, the disrupter will be acquired by the entity they most disrupt, and embracing the disruption can be very value-enhancing.

Part of why corporates buy startups is to add fresh DNA to the corporate gene pool and introduce new ways of thinking into how they operate. Sometimes there is massive organ rejection by the body, but there have been hugely successful acquisitions. In the best of these, the startup culture has positively affected the corporate culture as well. The EMAP acquisition of WGSN has worked exceptionally well. WGSN is a Bloomberg service for the fashion and style business which was acquired by EMAP in October 2005 for £140 m. WGSN’s business has doubled since then.

So is the buyer typically disadvantaged in an M&A process? Pretty much, one has to conclude, as the information asymmetry is such that there is a fundamental disequilibrium. The best way to offset this is to "date" before getting married. Not surprisingly, some of the healthiest acquisitions have stemmed from successful business development leading to the larger company wanting to own the startup. The longer and better you understand the asset, the better you can assess its value.      

There are other ways to get some of the right and new DNA in your firm if you are running an established enterprise. Acquiring firms will always carry the risk of information asymmetry. Google apparently acquired YouTube in 5 days. It’s easy to look at the price (1.65 billion USD) and the timeframe and see how that worked in the founders of YouTube’s favor. Increasingly, smart corporates like Skype and Google are investing themselves directly into startups in order to continue to learn about markets. Recently they both co-invested in European WiFi network FON.

In summary, it’s important to stay radically open to small change which indicates that major disruptions are happening in the market. You can become obsolete faster than you know. Partnering, investing and acquiring have always been part of the corporate toolkit, but derivatives of each, and blended models, and an overall speed in the market mean that a corporate executive can never take anything for granted –- neither his current market position, nor his next year’s forecasts.