The Federal Reserve’s actions had follow-on effects in the broader debt and equity markets. Importantly, in the startup world, the recent tightening in capital markets has impacted new investments into startups, which declined by 29 percent between 2021 ($346 billion) and 2022 ($246 billion).
Exit activity similarly declined from 2021 to 2022. VC-backed companies created a total exit value of just $72.9 billion across 1,281 exits in 2022, compared to $768.2 billion across 1,951 exits in 2021, representing a 90 percent decline in total exit value. As exit activity declined, the share of exit value from M&A exits increased substantially (from 14 percent of total exit value in 2021 to forty-seven percent in 2022), while the share from IPOs declined (from 85 percent of exit value in 2021 to 48 percent in 2022). Taken together, these data paint a picture that in weak markets, VC investment gets curtailed and M&A exits become even more important.
As a general matter of industry custom and practice, VCs will seek a corporate buyer for portfolio firms once they believe the firm has little potential to go public. This is an even more salient consideration in currently stressed capital markets; all else equal, given the IPO pathway is challenged at the moment, VCs seeking to maximize the value of their investment will be looking more to corporate buyers—a trend already borne out in the 2022 data cited above.
In short, there are fewer IPO opportunities in the current capital markets environment, which means VCs must rely more on M&A as the means to exit their investments. If regulators make such exits more difficult (e.g., by presuming that any acquisition of a startup by an incumbent is anticompetitive), VCs may invest less going forward, and more startups will either never get funded or will die on the vine at a higher rate. Given the important role VCs play in funding innovative startups, this could have a broader chilling effect on innovation in the economy.
Prohibiting Certain Mergers Would Worsen Expected Exit Outcomes
Devising a plausible “but for” scenario in the absence of a proposed merger is a particularly nuanced exercise when the target is a VC-backed startup. Absent a strategic merger, a VC-backed startup can: i) continue operating as an independent company, ii) go public via an IPO, iii) be acquired by a private equity firm, or iv) fail. Predicting which of these paths a company will take, let alone estimating a company’s counterfactual exit value, is exceedingly difficult. However, removing the M&A option will only decrease expected exit values in our view.
In light of the industry customs and practices discussed in the first section above, it would be inappropriate to assume that, as a general matter, VC investors would continue to extend additional funding to a VC-backed startup if an M&A exit is blocked. There are a number of VC customs and practices that weigh on the likelihood and viability for a VC-backed startup to continue operating as a standalone entity. Specifically:
- VC investment time horizons are limited, and VC firms are not perpetual investors by design. As discussed above, they typically need to exit within ten years or less. Further, few venture-backed startups receive more than four rounds of funding, and it is rare to ultimately exit successfully after a fourth round.
- Early-stage VC firms are looking to hit “home runs,” and their business model does not typically entail extending startup firms a long leash of multiple rounds of financing, nor does it typically entail getting intimately involved with running the business or trying to devise new monetization strategies.
- As noted above, it is rare for VC firms to cross-invest (i.e., if a specific VC fund that backs a startup has exhausted all its dry powder, the fund’s parent firm would be unlikely to make further investments in the startup).
- The different structural preference terms typically associated with late-stage investments have important implications for hypothetical additional funding round(s). For example, liquidation preferences that would likely be associated with such additional investment might imply that the investors would need an even higher exit value down the road to earn positive returns.
In addition to these considerations, stagnant growth can deter investors. If a later-stage target firm has not received funding for many years, it suggests the VC firms that invested in it may not perceive the firm to be relatively successful or likely to go public. For example, if a later-stage target firm has not been able to demonstrate a viable monetization strategy, it may not be a natural candidate for additional investment.
Highlighting the impact of stagnant growth, “down rounds” (rounds of financing in which a startup’s implied valuation is lower than it was as of the prior funding round) have severe implications and consequences. Common stock could potentially be wiped-out with extreme down rounds, and even if not, down rounds raise issues of employee morale and retention, and send negative signals to the market.
In sum, there are several salient considerations regarding VC-backed target firms and the existing VC investment(s) in target firms when assessing what could feasibly happen absent a merger. Depending on the circumstances, it is entirely conceivable that a firm’s VC backers would simply not extend any additional funding.
Absent the opportunity to continue operating as an independent company, VC-backed startups need to successfully exit in order to avoid failing. When assessing an M&A deal with a VC-backed target, one is already dealing with a conditional subset of all VC-backed firms—those that are not perceived to have strong potential to go public. Thus, assertions that an IPO is a possible counterfactual alternative to the proposed merger should be carefully scrutinized. Such concerns are even more salient when capital markets are stressed.
The most plausible counterfactual alternative may be a transaction rather than additional investment from existing investors or an IPO. Of course, every circumstance is unique, but some considerations to bear in mind with alternative transaction counterfactuals include:
- If a viable alternative offer exists, it would likely be at a lower valuation. VCs are interested in maximizing returns for their investors; if it were possible to achieve higher value via an alternative transaction, then profit-maximizing VCs would have taken it.
- Exit options—and the valuation at which exit can be achieved—are dictated by the market. Not all exits are “successful” (e.g., an investment can be sold at a loss or below the investor’s ex ante expected return). There is no guarantee that if a deal falls through, an alternative deal would be able to generate a positive return to the target’s investors/employees.
- A firm may not have other viable exit options and consequently might go out of business absent a challenged merger.
The Importance of VC-Backed Startups to Future Innovation
Foreclosing or reducing the likelihood of certain M&A exits, all else equal, would disincentivize VCs and other early-stage investors from backing future startups. This would make it more difficult for future startups to gain necessary early-stage funding, which in turn could lower employment at (and the number of) startup firms, thereby generally stifling future innovation. Insofar as a downstream effect of such a posture is an increase in “down round” financings for later-stage startups, this too would make working at a startup less attractive to skilled employees, and thereby chill future innovation. In fact, Tiago Prado and Johannes Bauer find empirical evidence of a positive relationship between acquisitions by “Big Tech” companies and VC activity.
The reason for this is basic supply and demand dynamics and the associated incentives that actors in the market face. VCs supply the capital for firms to innovative and their willingness to supply future capital is inextricably tied to the returns they expect to receive upon exit. Supply necessarily varies with expected returns and limiting exit options will reduce expected future returns, thereby reducing the supply of VC capital ex ante.
This issue has been raised by scholars who have studied the VC industry. Gompers and Lerner succinctly summarize the point:
[w]hile exiting is the last phase of the venture capital cycle … it is extremely important to the health of the other parts of the cycle. The need to ultimately exit investments shapes every aspect of the venture capital cycle, from the ability to raise capital to the types of investments that are made.
The authors similarly note:
[t]he long-run demand for venture capital is shaped by forces such as the pace of technological innovation and regulatory change, the presence of liquid and competitive markets (whether for stock offerings or acquisitions) through which investors can exit their investments, and the willingness of highly skilled managers and engineers to work in entrepreneurial environments.
Limiting exit options (or the perceived value of future exits) would also make employment at a VC-backed startup relatively less attractive for skilled employees and innovators. Innovation at tech startups is driven by talent and startups rely heavily on equity compensation (i.e., shares of ownership and stock options in the firm) to attract and retain skilled workers. “Cashing out” such equity requires an exit (e.g., selling shares in the stock market following an IPO or having shares acquired by another firm in an M&A transaction). Limiting future exit options, or increasing the uncertainty about future exit options, would reduce the expected value of equity compensation, which in turn would make it less attractive for skilled employees to join future startups and, all else equal, have a chilling effect on innovation.
In addition, positive efficiency and innovation impacts from a potential acquisition should be robustly assessed. Contrary to the “kill zone” argument advanced by certain commentators, the prospect of an acquisition by an incumbent firm could increase future startup activity, thereby fostering innovation (and potentially increasing competition). For example, the acquisition of a startup by an incumbent firm could increase growth and development of the startup’s product due to the new owner’s greater ability to fund and finance rapid development or greater experience/expertise in a given space. Such an acquisition could also increase the startup’s efficiency and potential profitability via synergies. Consumers could also potentially benefit from greater network effects. For example, while Massimo Motta and Martin Peitz find certain scenarios where acquisitions of startups by tech incumbents could be anticompetitive, the authors also document many scenarios where there are welfare-positive network effects from such acquisitions.
In light of the media attention and regulatory scrutiny on acquisitions of startups, it is important to remember that not all acquisitions, even those by large incumbent firms, are necessarily anticompetitive. Implicitly (or explicitly) presuming otherwise would have adverse consequences for future innovation, as VC-backed firms have accounted for the vast majority of new U.S. public company R&D spending in recent decades, and M&A transactions are a critically important exit option for such firms.
Consequently, when focusing on a specific proposed transaction, deep financial analysis of the target firm and the capital structure of the various rounds of investment by its VC backers, as well as the relevant VC customs and practices and how they would impact purported counterfactual worlds absent a merger, is crucial to understanding all the implications of blocking the transaction.