And the Winner Is--acquired: Entrepreneurship as a Contest with Acquisition as the Prize

And the Winner Is--Acquired: Entrepreneurship as a Contest with Acquisition as the Prize R&D incentives of new entrants to a market may be shaped by the prospects of being acquired by an incumbent. In this paper, we analyze a two-stage innovation game between one incumbent and a large number of entrants. In the first stage, firms compete to develop innovations of high quality. They do so by choosing, at equal cost, the success probability of their R&D approach, where a lower probability goes along with a higher value in case of success— that is, a more radical innovation. In the second stage, successful entrants bid to be acquired by the incumbent. We assume that entrants cannot survive on their own, so being acquired amounts to a ‘prize’ in a contest. We identify an equilibrium in which the incumbent chooses the least radical project. Entrants pick projects of pairwise different success probabilities, and the larger the number of entrants, the more radical the most radical project becomes. Under certain conditions, we can show uniqueness of this equilibrium and robustness to changes in the timing of the game. Generally, entrants tend to choose more radical R&D approaches than the incumbent and are more likely to generate the highest value innovation. Thus, the need of entrants to be acquired yields yet another explanation, beyond cannibalization and organizational issues, of why radical innovations tend to come from entrants rather than from incumbents. We illustrate our theoretical findings by a qualitative empirical study of the Electronic Design Automation Industry, and derive implications for research and management. JEL Classification: L13, L26, L86 and O31