How Do Start-up Acquisitions Affect the Direction of Innovation?

A start-up engages in an investment portfolio problem by choosing how much to invest in a ‘non-rival’ project and a ‘rival’ project that threatens an incumbent. Anticipating its acquisition, the start-up distorts its investment portfolio in order to raise acquisition rents. This may improve or worsen the direction of innovation and consumer surplus. The bigger the difference in social surplus appropriability across the two projects, the more likely it is that the direction of innovation improves and consumers benefit from an acquisition. These results also hold if the acquirer takes over the research facilities of the start-up.