INNOVATION DRIVEN ACQUISITIONS OF HIGH-TECH START-UPS: NEW INSIGHTS FROM THE INCENTIVE AND

COMPETENCE PERSPECTIVES

Massimo G. Colombo, Politecnico di Milano

CAMBRIDGE, March 2009CAMBRIDGE, March 2009

The acquisition of high-tech start-ups 2

• Surge of interest in the M&A literature on the acquisition of high-tech start-ups (Bloningen and Taylor 2000, Desyllas and Huighes 2008).

• Key element of the external technology sourcing strategies of large established firms (Kale and Puranam 2004).

• The post-acquisition reorganization process (Jemison and Sitkin 1986, Haspelagh and Jemison 1991) crucially influences the innovation impact of these acquisitions.

• Focus of the extant literature on the dichotomy between structural separation and structural integration.

• Less attention to non-structural (i.e. behavioral) aspects, with a few exceptions (Ranft and Lord 2002, Graebner 2004).

The acquisition of high-tech start-ups 3

• Aim of the paper: Focus attention on a particular aspect of the post-

acquisition reorganization process: should decision authority over the post-acquisition innovation activity of the acquired start-ups :

• delegated to the acquired key inventors; • or centralized within the acquiring firm?

Management of high human capital individuals: key aspect of the post-acquisition reorganization process.

New insights from combining:• Arguments inspired by the competence-based

perspective;• Arguments rooted in the economics of organizational

design (Colombo and Delmastro 2008) relating to individual incentives.

The acquisition of high-tech start-ups 4

• Theoretical model which predicts under which circumstances delegation is more effective than centralization.

• Testable propositions relating to: The direct effect on the effectiveness of delegation of the type

of acquisition:

• explorative or exploitative. The interaction effect between the type of acquisition (either

explorative or exploitative) and:• The technological relatedness between the acquiring and

acquired firms;

• The establishment of prior alliances between them;

• The prior acquisition experience of the acquiring firm.

The extant empirical literature: Stylized facts 5

• The innovation impact of the acquisition of high-tech start-ups often is disappointing: Poor post-acquisition innovation output of the acquired inventors

(Kapor and Lim 2007); Departure of star scientists and engineers (Ernst and Vitt 2000).

• Moderating effect of the structural integration of the acquired start-up as opposed to structural separation: structural integration generally damages post-acquisition innovation

output (Paruchuri et al. 2006, Kapor and Lim 2007); Stronger negative effect if:

• the acquired firm is in explorative stage (Puranam et al. 2006); • the acquirer use the acquired start-up as a source of ongoing innovations

(Puranam and Srikanth 2007); Smaller negative effect if the acquiring firm has greater acquisition

experience (Puranham and Srikanth 2007).

The extant empirical literature: stylized facts 6

• Structural integration is more likely (Puranam et al. 2008): with strong interdependencies between the acquiring and acquired

firms; when the combining firms lack “common ground” (i.e. operate in

different technological areas)

• The negative effect of structural integration are not uniform across individual inventors (Paruchuri et al. 2006): inventors that suffer the most are: those with divergent technological expertise from the one of

the acquiring firm; those that rely more on co-authorship.

Open issues 7

• Need to go beyond structural aspects of the post-acquisition reorganization (Haspelagh and Jemison 1991, Pablo 1994, Larsson and Finkelstein 1999, Ranft and Lord 2002, Zollo and Sing 2004).

• Importance of managerial aspects: delegation of decision authority.

• Structural separation and delegation of decision authority are (almost) independent aspects: structural separation is compatible with centralization of decisions (and viceversa).

• Need to take into consideration the longitudinal dimension of post-acquisition reorganization: Timing of reorganization decisions; Sunk costs and path-dependency.

The traditional view of the incentive perspective 8

• Property rights theory (Aghion and Tirole 1994):

The acquisition of a high-tech start-up involves a change in the allocation of property rights;

The acquirer gains control over the post-acquisition innovation activity of the acquired start-up;

Acquired innovative entrepreneurs become salaried employees and have no ex-post bargaining power;

They lack appropriate incentives to make relation-specific investments;

If the relation-specific investments of acquired entrepreneurs are important for innovation: Negative effect on innovation

The traditional view of the incentive perspective 9

• Traditional agency theory (Holmstrom 1989):

The acquisition of a high-tech start-ups by a (generally larger ) firm generates agency costs: Negative effect on innovation

Hidden action problems inherent in innovation activity become more severe and are a source of diseconomies of scale in R&D (Zenger 1994):

• Free rider problems in team production as agents’ individual effort is difficult to monitor;

• Indirect monitoring quite inefficient;

• Externality in innovation activity: the incentives of the acquired innovators are disaligned with those of the acquiring firm;

Hidden information problems in the early post-acquisition period: difficult to identify who are the acquired key inventors.

New insights from recent developments in the incentive perspective

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• Innovation activity is modeled as a multi-task agency relation: the acquiring firm does not know in which task (R&D project) the acquired key inventors are most productive.

• The acquired key inventors possess specific knowledge on local technological matters (Jensen and Meckling 1992).

• This specific knowledge is based on “soft” information (i.e. non-verifiable from third party): room for strategic communication (Dessein 2002, Marino and Matsousaka 2005, Friebel and Raith 2007, Alonso et al. 2008, Dessein et al. 2008).

• The acquired key inventors enjoy private benefits (Aghion and Tirole 1997) in performing R&D activity (“taste for science”).

• Key dilemma: If acquired key inventors are in charge of selection of R&D projects, the project they

chose is likely to diverge from the one the acquiring firm would chose should it have the same information set;

if the acquiring firm is in charge the selected R&D project may not be the optimal one because of lack of relevant information.

New insights from recent developments in the incentive perspective

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• Need to elicit implementation effort from the acquired key inventors, which is complementary to good decision in R&D project selection (Raith 2004, Van den Steen 2006).

• Technological uncertainty in R&D activity: it magnifies the information advantage of the acquired key inventors (Zabonjiik 1996, Prendergast 2002, Baker and Jorgensen 2003, Raith 2004).

• The greater the “combination potential” of the acquisition, the greater the marginal product of the effort of the acquired key inventors, the more important effective R&D project selection (Raith 2004).

• Externality problem: Need to coordinate decisions relating to the post-acquisition innovation activity of the acquired start-up with the other operations of the acquired firm: lack of coordination generates bad performance; locally optimal decisions need not to be optimal for the acquiring firm:

trade-off between high-powered local incentives and firm-level incentives (Stein 2002, Alonso et al. 2008, Dessein 2008).

New insights from recent developments in the incentive perspective

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• For the acquiring firm it is important: With delegation of decision authority to the acquired key inventors: to

deter choice of low pay-off projects (Baker et al. 1992); With centralization of decision auhtority: to enforce orders (Marino et

al. 2006); difficult with star scientists:• They are difficult to replace if they decide to leave (Ranft and Lord 2000,

2002);

• They can easily find a new job.

• Different priors between the acquired key inventors and the acquiring firm (Zabonjik 2002, Van den Sten 2006, 2007): with centralization of decision authority the acquired key inventors have low

incentives to provide effort if they think that acquiring firm’s managers take bad decisions.

With delegation, the provision of high-powered incentives to acquired key inventors makes problems rising form divergence of decisions even worse.

The benefits and costs of delegation of decision authority to the acquired key inventors: a synthesis

The benefits of delegation The costs of delegation

Use of the specific knowledge possessed by the acquired inventors in “local” decisions. More important if there is high technological uncertainty.

Selection of projects with great private benefits, but limited pay-off. It can be alleviated through use of high-powered incentives.

Avoid distortion from strategic communication of “soft” information upward the corporate ladder.

High-powered incentives are costly if performance measures are noisy.

Elicit implementation effort from the acquired key inventors, especially if they have strong beliefs that diverge from the ones of the acquiring firm

High-powered incentives are counterproductive if biases in project selection are driven by the strong beliefs of the acquired key inventors.

Avoid problems arising from the acquired key inventors’ disobedience of (supposedly wrong) orders.

Lack of coordination of decisions with and neglect of externality on the other operations of the acquiring firm. It can be alleviated through use of balanced incentives.

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Factors favoring/hindering the delegation of decision authority to the acquired key inventors

Explorative motives: direct positive effect on the delegation of decision authority

Exploitative motives: direct positive effect on the centralization of decision authority

Key role of the specific knowledge of the acquired key inventors for effective decision making.

Limited role of the specific knowledge of the acquired key inventors for effective decision making.

Tacit, non verifiable nature of the acquired key inventors’ specific knowledge, based on “soft” info.

Codified, articulated nature of (most of) the acquired key inventors’ specific knowledge, that is (largely) based on “hard” info.

Information advantage of acquired key inventors amplified due to high technological uncertainty

Limited extent of technological uncertainty.

Strong beliefs of the acquired key inventors that are likely to diverge from those of the acquiring firm

Convergence of beliefs.

Limited need for coordination of the decisions relevant to the post-innovation activity of the acquired start-up with the other operations of the acquiring firm.

Need for close coordination of the decisions relating to the post-acquisition innovation activity of the acquired start-up with the other operations of the acquiring firm.

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The role of technological relatedness, prior alliances, and prior acquisition experience

Explorative acquisitions Exploitative acquisitionsTech. relatedness

Positive influence on delegation Positive influence on centralization

Greater combination potential, because of the greater absorptive capacity of the acquiring firm.

Greater need for close coordination of the innovation activity of the start-up with the other operations of the acquirer

Smaller hidden information problems in identifying acquired key inventors

Greater monitoring ability

Greater ability of designing non-noisy innovation performance measures

Prior alliances

Positive influence on delegation

Smaller hidden information problems in identifying acquired key inventors

Biases in project selection more predictable.

Greater positive influence with low technological relatedness

Prior acquisition experience

Positive influence on delegation if prior acquisitions were exploration driven

Positive influence on centralization if prior acquisitions were exploitation driven

Learning by doing effect in explorative acquisitions.

Learning by doing effect in exploitative acquisitions.

Greater positive influence with low technological relatedness

Greater positive influence with low technological relatedness

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Delegation or centralization of decision authority: A synthesis

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