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Startup Exit Strategies in the New Antitrust Era

Aug. 11, 2021, 8:01 AM

Startups have long relied on mergers and acquisitions as a principal exit strategy to monetize investment in research and development. Combining the innovation of a startup with the scale of an established company can yield synergies that promote returns on investment. The startup, its investors, and employees receive a payout, while the buyer acquires a complementary asset, and the cycle restarts.

This serial entrepreneurship mechanism drives innovation ecosystems in which platform “hubs” regularly support and absorb technologies developed by outside innovators.

This exit-by-M&A pathway has been facilitated by the fact that regulators have generally viewed acquisitions of startups by incumbents as posing little risk to competition. The logic is straightforward.

If an emergent firm represents a small portion of a much larger market, the transaction is unlikely to increase the acquirer’s market power, and hence, consumer harm is unlikely. For dealmakers, this means that startup acquisitions have generally raised little concern over regulatory intervention that would delay or preclude closing.

Hands-Off Regulatory Environment for Tech M&A Is Over

In the U.S., legislators from both parties have urged amending the antitrust laws to constrain the market power attributed to dominant platforms. This expansive approach to antitrust enforcement is reflected in pending legislation that would relax the evidentiary requirements for taking enforcement action under the antitrust laws or, in the merger context, would bar companies’ acquisitions that exceed certain revenue or capitalization thresholds.

Even absent legislative changes, regulators in the U.S., the U.K., and the EU have already adopted the view that large platforms’ acquisitions of small companies raise a high risk of being a “killer acquisition” designed to suppress a competitive threat, rather than to acquire a complementary asset.

Existing research has not yet confirmed the actual incidence of such “predatory” acquisitions as a general phenomenon. In the most influential paper, researchers reported that, in a sample of thousands of acquisitions by pharmaceutical companies, 5% to 7% qualified as “killer acquisitions.”Yet the Israel competition authority examined a sample of acquisitions of local firms during 2014-19 by large foreign firms (a customary monetization pathway in Israel’s startup-driven tech sector) and did not find a single such acquisition.

For practical purposes, these uncertainties do not really matter. What matters is that regulators view the “killer acquisition” scenario as a material risk inherent in any startup acquisition by a large incumbent. This is equivalent to adopting a difficult-to-rebut presumption of competitive harm in the case of any acquisition by a sufficiently large firm. The consequences are already apparent.

In 2019 and 2021, the Federal Trade Commission took action to block acquisitions by Illumina, the world’s leading provider of gene sequencing machines, of two smaller firms with single-digit market shares. The 2019 acquisition of Pacific Biosciences, a gene-sequencing company, was abandoned by Illumina following the agency’s challenge (and a statement of concern by the U.K. competition authority).

The 2021 transaction involves the acquisition of Grail, a cancer blood test maker that Illumina had previously spun off. In July 2021, EU regulators announced that they had opened an investigation into the transaction.

Both transactions illustrate the delays that dealmakers can now expect to encounter in any acquisition undertaken by a sufficiently large firm, irrespective of the size of the target.

Changing Exit Strategies

This global shift in merger review policy is likely to significantly impact deal strategies in the tech economy.

Higher regulatory risk elevates deal uncertainty and requires adjusting termination fees and deal expiration periods for transactions that might have formerly fallen into regulatory “safe zones.” In certain cases, regulatory risk may favor abandoning M&A for exit strategies involving IPOs (or close equivalents) or acquisitions by private equity firms or larger firms in unrelated markets.

While entrepreneurs’ exit strategies are more limited in this regulatory environment, it may have a silver lining for the global innovation economy by inducing certain firms to secure liquidity through an IPO followed by internal growth, rather than “selling out” to an existing platform. (In other cases, however, it may preclude startups from achieving commercial viability, so the net effect is unclear.)

For example, commentators sometimes assert that startups sell “too early” and, as a result, forfeit economic value that could have been captured by bearing the costs and risks of scaling up independently. If regulatory risk in U.S. and European markets complicates monetization strategies through acquisition by a large multinational, then startups’ founders and investors may shift to capture returns through IPOs. In the aggregate, this may result in more emerging firms achieving scale as stand-alone entities rather than as divisions of established players.

There is some evidence that the market has already responded as expected. Data reported by the IVC Research Center shows that, during 2020, the number of acquisitions of Israeli firms fell but the number of IPOs by Israeli firms increased. Israeli companies raised approximately $1.6 billion through IPOs, almost four times the amount raised through IPOs in 2019.

If all public offerings are included, then the total amount increases to $6.96 billion for 2020, as compared to $1.95 billion in 2019. In short: Exit activity has remained robust but has diversified across deal structures.

The current shift in the presumptions that drive merger review necessitates a corresponding shift in the presumptions that drive entrepreneurs’ and investors’ R&D monetization strategies. In the present regulatory climate, exit-by-IPO will sometimes offer a preferred exit strategy with greater deal certainty and faster time-to-completion than exit-by-M&A. Whether the global innovation economy is a winner or loser as a result remains an open question.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

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Jonathan M. Barnett is the Torrey H. Webb Professor of Law at the University of Southern California, Gould School of Law. He is also the author of “Innovators, Firms, and Markets: The Organizational Logic of Intellectual Property.”

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