Optimal merger policy with financially constrained start-ups

Acquisition of potential competitors has become a big issue in all industries. In the digital economy alone, hundreds of start-ups have been bought in the last few years by incumbents such as Alphabet, Amazon, Apple, Facebook and Microsoft.  However, only a handful of such cases were investigated by Antitrust Authorities (in most countries a merger can go ahead only if approved by them), and none was challenged. 

In the Barcelona GSE Working Paper No. 1197, “Shelving or Developing? The Acquisition of Potential Competitors under Financial Constraints,” Chiara Fumagalli, Massimo Motta and Emanuele Tarantino investigate the possible anti- and pro-competitive effects of acquisitions of potential competitors and study the optimal policy an antitrust authority should follow when dealing with such acquisitions.

A model of start-up acquisitions

The paper introduces a model where an Antitrust Authority (AA) decides its merger policy at the beginning of the game; and the two companies, an incumbent, and a start-up. The start-up owns a project that, if developed, can give rise to a product which will compete with the incumbent. Since it has not enough financial assets to pay for the cost of the project, the start-up would need external funding. However, because of moral hazard, the start-up may be financially constrained: if its assets are not large enough, it will not obtain external funds and will not be able to develop the project, even though profitable in expected terms.  The incumbent can decide to acquire the start-up at an early stage, before project development (acquisition of a potential competitor), or at a later stage, after the start-up secures funding (if it manages to) and develops successfully (acquisition of an actual competitor). When the incumbent takes this decision, it does not observe the assets of the start-up. Following an early acquisition, the incumbent could develop the project itself (it is assumed to have enough resources to pay entirely for the cost of the project) or shelve it. Acquisitions are conditional on the AA’s approval — a decision that the AA takes on the basis of the standard it has chosen at the start of the game.

Compared with the traditional analysis of horizontal mergers, the acquisitions of potential competitors trigger an additional trade-off. On the one hand, the authors show that these acquisitions may in some cases be welfare detrimental because they may lead to the suppression of projects that the start-up would have developed if independent (“killer acquisitions”), or to the suppression of ex-post competition. On the other hand, due to the presence of financial constraints, early acquisitions may also increase the chance that the innovation reaches the market by allowing the incumbent to develop a project that the start-up would fail to develop independently. Furthermore, the authors identify another pro-competitive effect which arises from acquisitions of actual competitors: the anticipation that a late takeover will occur alleviates the start-up’s financial constraints (because outside investors expect that the incumbent will take over the start-up’s financial obligations) and may enable the start-up to finance a project that would be denied funding otherwise. Thus, through this channel, the chance that the innovation reaches the market increases. 

Implications for an optimal merger policy

This novel framework highlights that acquisitions of start-ups by incumbents generate trade-offs that may not be trivial. The authors then study the AA’s optimal policy towards takeovers of potential competitors. 

One may think that, in order to take advantage of the pro-competitive effect of early takeovers, a merger policy should be lenient towards acquisitions of potential competitors. The authors show that this purpose is, instead, achieved by a strict merger policy. This policy commits to block any late takeover (that is, mergers with actual competitors), and to block early takeovers (that is, mergers with potential competitors), unless the incumbent formulates offers takeover price that only financially constrained start-ups would accept (recall that the incumbent does not observe the start-up’s assets when it formulates the takeover bid). Such a merger policy has a beneficial selection effect, for it pushes the incumbent towards early takeovers of credit-constrained start-ups, thereby removing the inefficiency caused by financial constraints and making the development of the innovation more likely.  This strict policy effectively amounts to a policy whereby the AA screens mergers according to the value of the transaction, authorising those that are below a certain threshold. In this respect, the authors contribute to a discussion about takeover prices possibly signalling anti-competitive mergers.

By prohibiting late takeovers, a strict merger policy precludes the start-up’s financial constraints from being alleviated and the other pro-competitive effect to be taken advantage of. Indeed, expecting that the start-up financial obligations will be taken over by the better endowed incumbent firm, investors are more willing to lend in the first place. The authors show that, because of the latter effect, in certain circumstances a more lenient merger policy which allows for the acquisition of committed entrants, may be optimal. The authors identify a number of conditions that have to be satisfied simultaneously for this to be the case. They include the presence of severe financial imperfections so that late takeovers have a pronounced ex-ante effect on the chance that the start-up obtains funding from investors and hence the innovation could materialise. When all such conditions do not simultaneously apply, the optimal policy is the strict merger policy described above.

Finally, note that the paper focuses on the asymmetry of financial resources between the incumbent and a start-up as the mechanism which may leads to pro-competitive effects of the takeovers, but the same reasoning could apply more generally to situations in which the incumbent may have other resources, such as managerial skills or market opportunities, that the start-up lacks.