Corporate Innovations and Mergers and Acquisitions

It has long been argued that synergies are key drivers of mergers and acquisitions (M&As), and that many
M&As occur due to technology reasons. However, there is little direct evidence of whether and how
synergies in the technology space drive individual firms decisions to participate in M&As, and of how they
affect merger outcomes. In our paper, Corporate Innovations and Mergers and Acquisitions, forthcoming in
the Journal of Finance, we first examine the relation between characteristics of corporate innovation
activities and whether a firm becomes an acquirer or a target firm. We then study whether technological
overlap between firm pairs affects transaction incidence. Finally, using a sample of bids withdrawn due to
reasons exogenous to innovation as a control sample, we estimate the effect of a merger on future
innovation output when there is pre-merger technological overlap between merging firms. Our large and
unique patent-merger data set over the period 1984 to 2006 allows us to construct targeted measures of
innovation output and technological overlap, extending the analysis of Hoberg and Phillips (2010) in
product markets.

The merger of Pharmacia & Upjohn and Monsanto, creating Pharmacia Corporation, in 2000 illustrates
how synergies in the technology space trigger transactions. Both companies were active in the market for
prescription pharmaceuticals, but in different therapeutic areas; their products were mostly
complementary. A merger motive of both companies was for each to obtain access to the others
technological assets and skills. Monsantos most successful product (Celebrex) used a novel
technological platform known as Cox-2-specific inhibitors; the merger allowed Pharmacia & Upjohn access
to this technology. Similarly, Pharmacia & Upjohn had strong expertise in biotechnology (genomics) based
on large biotech proteins, which had not been adopted by Monsanto in its small chemicals prior to the
merger. The mergers most important technological consequence was the creation of a critical mass
allowing for expanded in-house clinical research, the typical scale of R&D projects increased, while the
lead time of research decreased. Other important consequences were the improvement of existing
technological competencies, and the merged company gaining access to a much broader network of
research institutes.

This example highlights a number of key features of merger transactions that we study. First, merger
participants pursue related R&D activities prior to the acquisition. Second, certain technologies of one
party appear valuable to the other party and vice versa, triggering the transaction. Third, improvement in
post-merger innovation output occurs through technological synergy. To understand whether this example
represents a general pattern underlying M&As, we investigate the following research questions. How are
firms innovation activities related to transaction incidence? Do merger participants possess related
technologies prior to the transaction? Does the presence of pre- merger technological overlap affect post-
merger innovation output? Assuming that acquirers and target firms are active in technological innovation,
we expect that parties with interfirm linkages in the technology space are more likely to form merger pairs.
We also conjecture that transactions with pre-merger overlapping technologies result in an improvement in
innovation output post-merger. The central idea guiding our analysis is that synergies obtained from
combining corporate innovation activities are an important driver of M&As.

To examine the role of corporate innovations in M&As, we compile an economy-wide patent- merger data
set, and develop measures that capture firms innovation output and potential synergistic gains stemming
from technological overlap between merger participants. We first show that both acquirers and target firms
are active in technological innovation, but with different characteristics. Firms with large patent portfolios
and low R&D expenses are more likely to become acquirers, while firms with high R&D expenses and
slow growth in patentable innovation output are more likely to become target firms.

We next find that the presence of technological overlap between two firms innovation activities, as
captured by the proximity of patent portfolios, shared knowledge bases, and mutual citations of patent
portfolios, has a significant effect on the probability of a merger pair formation. This finding provides direct
firm pair-level evidence in support of the synergy perspective of M&As.

Furthermore, we show that when firms overlap in terms of both product markets and technological
innovation, the positive effect of technological overlap on the likelihood of a merger pair formation is
reduced for firm pairs that also overlap in product markets.

Finally, we use a quasi-experiment, involving bids withdrawn due to reasons exogenous to the innovation
activities of either the acquirer or the target firm, to estimate the treatment effect of a merger on post-
merger innovation output. Following Seru (2010), we argue that the assignment of deals into the treatment
sample (i.e., completed deals) versus the control sample (i.e., bids withdrawn due to reasons exogenous
to innovation) can be treated as random. As such, any selection concerns are differenced out by
comparing firms innovation output in the treatment sample, pre- and post- merger, with that in the control
sample. We show that the presence of pre-merger technological overlap between merging firms leads to a
significant improvement in the combined firms post- merger innovation output.

In summary, our results highlight the ex-ante selection effects of corporate innovation activities on
transaction incidence and merger pairing, as well as the ex-post treatment effect of a merger on firms
innovation output.