Technological innovation and Acquisitions
Xinlei Zhao[1]
Department of Finance
Kent State University
Kent, OH 44242
330.672.1213
September 2007
Abstract:
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I examine firms’ make-or-buy decision in the context of mergers and acquisitions via an investigation of the relation between technological innovation and acquisition activities. I find that firms engaging in acquisition activities are less innovative and have experienced declines in technological innovation during the years prior to the bid. Among the bidders, the relatively more innovative ones are less likely to complete a deal, suggesting that these bidders may feel less pressure. Further, although experiencing less decline in innovation output than bidders that cancel the deals, bidders that complete the deals still trail non-bidding firms in technological innovation during the three years after the acquisitions. This finding suggests that buying-innovation can only partially alleviate the internal innovation deficiency problem.
Keywords: patents, citations, innovation, Coase Theorem, make-or-buy, R&D
JEL Classification: G34
1
1. Introduction
This paper examines firms’ make-or-buy decision in the context of mergers and acquisitions. This question is one of the fundamental questions in modern economics and it goes back as far as Coase (1937). Coase argues that the make-or-buy decision depends on the environments in which firms perform relative to the market. Obtaining goods or services via the market entails a number of transaction costs, including searching and information costs, bargaining costs, and contract enforcement costs, etc. Because of the additional costs in the external market, the Coase Theorem argues that firms are formed to produce goods or services more cheaply internally. This theorem also implies that firms resort to the external market only when they are not able to internally produce the goods or service as efficiently in the market. This argument has been reintroduced into economics by Williamson (1975); it has been more thoroughly developed by Klein, Crawford, and Alchian (1978), Grossman and Hart (1986) and others. However, empirically proving this theory is difficult. Some studies have tried to shed light on this theory by examine how firm boundaries or asset ownership affect its behavior (for example, Baker and Hubbard (1993) and Mullainathan and Scharfstein (2001)). Another stream of literature directly examines this theory in the context of mergers and acquisitions (for example, Higgins and Rodriguez (2006)).
This paper belongs to the second stream of literature. If the Coase Theorem sufficiently describes a firm’s make-or-buy decision, firms with successful internal innovation are more likely to rely on internal growth and less likely to participate in the acquisition market. Consequently, firms would be more likely to engage in acquisition activities following a lack of success in their internal innovation efforts. Higgins and Rodriguez (2006) find some evidence in support of this buying-innovation prediction in the pharmaceutical industry. However, their work is limited to one industry and it is not clear whether the findings can be generalized to other industries and to different types of deals.
My study contributes to this literature in four ways. First, I examine firms’ make-or-buy decisions across industries and over time. In contrast, the prior studies have been limited to specific industries, such as the trucking industry (Baker and Hubbard (1993)), the vinyl chloride monomer (VCM) industry (Mullainathan and Scharfstein (2001)), or the pharmaceutical industry (Higgins and Rodriguez (2006)).
Second, I examine the role innovation plays in the likelihood of deal completion, which has not been investigated before. The Coase Theorem implies that, among the firms involved in acquisition activities, the less innovative firms should be more likely to complete a deal.
Third, an important question that has yet to be thoroughly investigated in the existing literature is whether buying-innovation is detrimental to internal innovation and whether it can fully make up for the lack of success in internal innovation. I try to answer this question by examining changes in innovation output following a completed acquisition and a failed acquisition.
Finally, this paper uses citation data as a measure of innovation output quality. Prior studies usually draw conclusions based on R&D expenditure (a measure of innovation input), or patent counts (a measure of innovation output quantity). However, neither of these measures is able to sufficiently describe the true technological innovation level of a firm.
This study uses a sample of 1,053 acquisitions during the period of 1984-1997. I combine this sample with the NBER patent data set created by Hall, Jaffe, and Trajtenberg (2001). I find that, controlling for other firm characteristics, the number of patents of the bidders is comparable to that of the non-bidding firms. However, bidders have significantly fewer citation counts to their patents, and they have also lagged behind in terms of citation growth in the past three years. This finding suggests that bidders are as innovation-oriented, but the quality of their innovation is deficient, so they attempt to acquire quality and innovation skills externally. The likelihood of deal completion is negatively associated with the citation counts prior to the bid, suggesting that bidders with relatively higher-impact innovations in the past are more confident with their own research productivity and feel less pressure to complete the deal.
Further, acquisitions do not seem to stifle technological innovation since bidders that complete the deals experience less decline in innovation output than those that cancel the deals. On the other hand, bidders completing the deals still lag behind non-bidding firms during the three years after deal completion. This finding suggests that buying-innovation can only partially alleviate the internal innovation deficiency problem. In addition, I find that less innovative bidders experience more increases in innovation after the acquisitions are completed.
These results hold among both diversifying and non-diversifying deals, among bidders from more innovative industries and during the sub-periods of 1980s and 1990s. Therefore, the findings indeed confirm that the make-or-buy decision is determined by whether a firm performs better than the market or not. The findings here also suggest that what motivates the make-or-buy decision is the innovation output quality, not innovation input (R&D) or innovation output quantity (patent counts), further highlighting the value of citation data. On the other hand, although acquisitions do not stifle technological innovation, they can only partially make up for the internal deficiency. In other words, my findings suggest that firms should rely primarily on internal innovation success rather than on acquisitions in the external market.
My study also contributes to the mergers and acquisitions literature. Theory has suggested many possible answers to the question of why acquisitions occur: efficiency-related, market power, disciplining, agency costs, and diversification. However, data have not strongly supported any one of these views as consistently explaining a significant portion of acquisition activities over time. My paper sheds insight on the motivations of acquisitions by examining the quantity and quality of technological innovation on the bidder side, and my evidence suggests that buying-innovation is one reason why firms merge.
The plan of the paper is as follows. I review the literature on the role of technological innovation in acquisition and develop my hypotheses in the next section. Section 3 describes the sample and variables, and provides descriptive statistics. Section 4 examines how technological innovation affects a firm’s takeover decisions, and Section 5 studies post-acquisition innovation. Section 6 discusses some additional investigations, and Section 7 concludes.
2. Role of technological innovation in Acquisitions and Hypothesis Development
Acquisition activities and technological innovation each has a large impact on economic activity, and technological innovation has often been mentioned as one of the justifications for mergers and acquisitions (for example, Chesbrough (2003)). Yet, there is surprisingly little empirical study on the interaction between the two. Typical studies of the efficacy of acquisitions focus on operating synergies and performance post-acquisition, or announcement return and long-term returns.[2] My current paper tries to fill the void in the literature by investigating the interaction between technological innovation and acquisitions.
Earlier studies investigating the role technological innovation plays in acquisition activities usually relies on R&D expenditure. However, R&D expenditure is an input to innovation, not the output. On the other hand, patents are innovation output and have long been recognized as a very rich and potentially fruitful source of data for the study of innovation and technological change (see Griliches (1990) for an excellent review of the literature on patents). In particular, patent data include citations to previous patents and to the scientific literature, allowing researchers to create indicators of the “importance” of individual patents and cope with the enormous heterogeneity in the “value” of patents.[3] Past research has shown that citations as a whole do provide useful information about the generation of future technological impact of a given invention (Trajtenberg (1990), and Hall, Jaffe, and Trajtenberg (2005)).[4]
Prior Literature
Hall (1990) uses data on R&D to examine the impact of acquisitions on industrial research and development. She finds evidence of declines in R&D intensity as measured by the ratio of R&D to sales after acquisition, but the declines are statistically insignificant. Hall (1999) extends her earlier work by stratifying potential bidders based on their propensity to acquire. She finds that firms with a high acquiring propensity that actually make an acquisition have a significantly higher increase in their R&D. Hall concludes that the overall finding of no impact obscures some real heterogeneity across firms.
Hitt et al. (1991) examine the effect of acquisitions on R&D inputs (firm R&D/sales adjusted for industry average) and outputs (patents/sales), based on a sample of 191 firms from 29 industries from the period 1970 - 1986. They examine the seven-year window around the merger completion. They find that acquisitions have a significant and negative effect on R&D intensity, and diversifying acquisitions negatively affect patent intensity. However, this study needs to be updated, since technological innovation really took off in the past two decades and more sophisticated statistical methods are now available. Further, this study draws conclusions based on R&D and patent, measures that are not able to fully capture innovation quality.
Hagedoorn and Duysters (2000) focus on a single, high-tech industry to examine the effect of acquisitions on the technological performance of the combined firms, as measured by the number of patents. They conclude that acquisitions can contribute to increases in innovative activities if there is both the organizational and strategic fit of the companies involved in these mergers. They measure “fit” using the SIC codes, the patent classification codes, R&D intensity, and firm size.
Higgins and Rodriguez (2006) examine the performance of 160 pharmaceutical acquisitions from 1994 to 2001. They find that firms experiencing declines in internal productivity are more likely to engage in an outsourcing-type acquisition in an effort to replenish their research pipelines. They document post-acquisition improvement in three performance measures: positive announcement period returns, significantly positive changes in both the research pipeline and sales (the year of acquisition versus the year after). Besides the fact that this study is limited to one specific industry, it is also unclear whether the documented improvement can be attributed to better innovation success post acquisitions. For example, the improved research pipeline can result from the additional drug candidates acquired from the target, which does not necessarily indicate an improvement in innovation output. Therefore, the above study still leaves unaddressed the question whether acquisitions (or a lack of acquisition) affect technological innovation.
My Hypotheses
This study examines the interaction between technological innovation and acquisition across firms and over time. If the Coase Theorem provides a good description of a firm’s make-or-buy decision, then bidders facing a decline in the success of internal innovation efforts would attempt to buy continued innovation externally. I call this the buying-innovation hypothesis. This hypothesis has the following predictions.
1) Less innovative firms are more likely to engage in acquisition activities.
2) Among the bidders, the relatively less innovative firms are more likely to complete a deal because they feel more pressure to do so, while more innovative firms are less likely to complete a deal.
The buying-innovation hypothesis does not have clear predictions on the post-acquisition innovation levels, which can be affected by many other factors. One factor is the strategic fit, which plays an ambiguous role in the Coase Theorem. Post-acquisition innovation could increase if there are economies of scale in R&D activities. On the other hand, acquisition activities can be affected by agency costs such as the integration problem and post–acquisition innovation could also show a significant decline as a result.[5]
Therefore, whether technological innovation increases or decreases following a successful acquisition is an interesting empirical question. An answer to this question is important to the make-or-buy decision because it can shed light on whether the ‘buy’ decision adds value or not, and whether the ‘buy’ decision can fully make up for internal innovation deficiency.
3. Sample Formation, Variable Construction, and Sample Overview
My empirical design is to relate the quantity and quality of technological innovation to takeover decisions and to explore the impact of takeover from a technological perspective.
Sample Formation
To form the sample of acquisitions, I begin with all announced (both completed and cancelled) US acquisitions with announcement dates between January 1, 1984 and December 31, 1997 as identified from the Mergers and Acquisitions database of the Securities Data Company (SDC).[6] I identify all deals where the bidder is a public firm and the form of deal was coded as a merger, an acquisition of majority interest, or an acquisition of assets. I require that the transaction value be no less than 1 million.[7] Further, I only retain an acquisition if the bidder owns less than 50 percent of the target prior to the bid and is seeking to own greater than 50 percent of the target. For completed deals, I require that the bidder owns more than 90 percent of the target after the deal completion. These filters yield 10,457 deals.
To clearly delineate the effect of each acquisition on innovation and reduce the risk of contamination, I only include isolated acquisitions, i.e., those acquisitions that do not overlap when a sample firm makes multiple acquisitions. More specifically, I only keep the first bid by the same bidder within a three-year window. Note that this three-year time frame is chosen because I also compute changes in patent/citation counts over the same three-year window both before and after the acquisition. This filter yields 4,269 deals.