Out of the Abyss: M&A and IPOs Restart the Innovation Flywheel

Only six weeks ago, many of us were wringing our hands about America’s faltering innovation engine. Investments in VC-backed startups had been plummeting for more than a year and American corporations had been slashing internal longer-term R&D spending for decades. Even the federal government has been investing markedly less on basic science and technical research as a percentage of total economic output.

What a stunning difference 42 days make. Mergers and acquisitions in both the startup and Wall Street worlds have spiked sharply, and the IPO market is showing signs of life. These developments hardly solve the U.S. innovation crisis overnight. They do however serve to re-start the innovation flywheel and strongly suggest that the long-beleaguered venture capital industry is poised to rebound and eventually spark the rebuilding of critically important innovation muscle in other sectors of the economy.

Am I being too bullish? Based on more than two decades of experience in the seed and early stage venture capital with recent exits of $2.2 Billion from M&A transactions, I don’t think so.

Startup “exits” – whether they are M&A or public offerings — are ultimately the lifeblood of venture capital because they allow investors to monetize their past investments and invest in a fresh round of startups. And this leads to a virtuous cycle. Corporations, which have cut back significantly on innovation and venture investing in recent years, begin realizing anew that the markets in which they compete continue to march forward. Sitting on the sidelines if not a viable option and increasingly, they are turning to the venture-backed domain of start-up innovation as an invaluable external R&D arm. Given that major corporations have cur their R & D investments in half over the past 30 years in parallel with the 4X explosion of innovation investment by small companies, we are no doubt standing on the precipice of permanent increase in strategic M & A activity as open innovation continues to take hold.

Here is a quick glance at what has been happening lately. In the venture capital world, Facebook acquired startup FriendFeed in mid-August for a reported $47.5 million. The same week, VMware snapped up SpringSource for $420 million. Shortly thereafter, Intuit announced its $170 million acquisition of Mint.com, a personal finance site. Its lead investor, First Round Capital, said the Mint.com exit generated the highest return of any deal the firm has done. Also in September, Google’s Eric Schmidt announced his plans to acquire one company per month.

On Wall Street, this week alone Xerox announced it would buy Affiliated Computer Services and Abbott Laboratories said it would buy the drug business of Solvay. Last week, Dell acquired Perot Systems. A week before that, Adobe Systems turned heads with the announcement that it planned to buy Internet services firm Omniture for $1.8 billion, its biggest acquisition since the blockbuster purchase of Macromedia Inc. in 2005.

I’m hardly the only one impressed by this activity. Wall Street bankers are saying that the sudden increase in corporate mergers shows a new sense of confidence. “The psychology has changed,” Boon Sim, head of mergers and acquisitions for the Americas at Credit Suisse, told The New York Times in late September. “This is a sign that things have stabilized.”

In addition, the IPO market is re-energizing. Last week, seven companies went public, including electric-car battery maker A123 Systems Inc., marking the biggest week for IPOs since March 2008. Another bright sign is that this year’s few big IPOs have seen their stocks hold well above their IPO prices. This makes venture capitalists more inclined to test the waters and take a startup public. Venture capital-backed OpenTable Inc., for example, is up more than 35 percent from its offering price.

More Silicon Valley IPOs are on the way – assuming markets remain stable. Fortinet, a Sunnyvale computer security firm, and Mirion Technologies, a San Ramon maker of radiation-detection devices, recently joined a growing flurry of pending deals – and the line is growing.

Overall, what both the M&A and public markets are saying is that innovation does not stand still in technology-driven markets. Companies that want to stay competitive must become more aggressive about innovation and growth. Strategic M&A activity, in particular, signals the beginning of a product replenishment cycle.

There is no question that the stage was set for this rebound in activity. Merger and acquisition activity in the VC world and on Wall Street had hit bottom. The value of VC-related M&A tech deals announced in the first half of 2009 was about $58 billion, the lowest level in five years, according to Thomson Reuters. The story was the same with IPOs. In the first half of the year, only six VC-backed companies went public, not much better than 2008, among the worst years on the books. Whether an acquisition or an IPO, a path to liquidity is the essential grease for the venture wheels of innovation.

Just as we saw during the dot-com bust, widespread reports of the death of innovation and the venture capital ecosystem were pre-mature. As with all industries, venture capital is undergoing changes. With increased reliance on M & A exits, at least in the near term, venture managers will be well served to revisit their investment models and adjust their strategies accordingly. And while the market for IPOs regains its footing, successful M & A candidates are likely to play an increasingly important role in the path to liquidity for venture-backed companies.

Robert R. Ackerman, Jr. is the founder and managing director of Allegis Capital (www.allegiscapital.com), a seed and early-stage venture firm headquartered in Palo Alto. Ackerman has worked with more than 50 corporate investment partners over the past 20 years as both a venture capitalist and a startup executive.