Bridge Building in Venture Capital-Backed Acquisitions
Executive Summary — The acquisition of new capabilities through the purchase of small venture capital-backed start-ups is a strategy that has been employed by many large technology firms including Cisco, Microsoft, Google, and EMC. Young venture capital-backed companies, for their part, often develop innovative technologies that can be exploited by existing technology companies. The value inherent in these start-ups is typically tied up in the intellectual property or human capital that has been developed during the early stages of the company's life. The opportunity to acquire valuable intangible assets, however, is balanced by the difficulty in assessing the value of the underlying assets. Unlike purchasing companies with substantial operating profits and a long track record of sales, the ability to fully assess the prospects of intangible assets is subject to substantial asymmetric information and uncertainty. This paper explores mechanisms for limiting the asymmetric information that potentially plagues the acquisition of young venture capital-backed companies. The results also shed light on the value that venture capitalists add to their portfolio companies as well as to companies in their venture capital network. Key concepts include:
- In the bridge-building alternative presented here, the personal relationship between the two firms is critical to conveying value-relevant information about both the target and the acquiring firm.
- The venture capital investor link between the acquirer and the target has a strong effect on how the purchase transaction is structured, how the market reacts to the announcement of the acquisition, and how the acquirer performs in the stock market in the long run.
- Recruitment of management and the identification of first-time customers may be improved through bridge building networks that the venture capitalist creates.
- Bridge building may be important in relationships with service providers and strategic partners.
We compare three potential mechanisms for alleviating the asymmetric information between the public acquirers and private venture capital-backed targets. First, because venture capitalists repeatedly sell their portfolio companies through acquisitions, venture capitalists may be able to certify the quality of the assets that an outside party is buying because they are "staking their reputation" on not selling overvalued assets. Second, personal and professional relationships may "bridge" the asymmetric information. This bridge may be particularly strong if both firms were financed by the same venture capital firm. Third, geographic proximity may also reduce the asymmetric information between a target and an acquiring firm. In a sample of 1,083 acquisitions of venture capital-backed private companies from 1976 and 2001, we find strong evidence that venture capital firms can form a bridge between acquiring firms and target firms that reduces asymmetric information associated with the transaction. Acquisition announcement period returns are more positive for acquisitions in which both the target and the acquirer are financed by the same venture capital firm. Similarly, we find that having a common investor increases both the likelihood that a transaction will be all stock as well as the fraction of stock in the overall acquisition payment. Targets that are concerned that the acquirer is potentially overvalued may be less willing to accept stock in an acquisition. A common investor can reduce this uncertainty about overvaluation. Hence, our evidence shows that the bridge runs in both directions. In addition, an acquisition is more likely to take place when there is a common venture capital investor linking the acquirer and the target. Finally, we show that long-run post-acquisition abnormal returns are higher for the acquiring firms when the target and the acquirer share a common venture capital investor.