Start‐up acquisitions, strategic R&D, and the entrant's and incumbent's direction of innovation

Abstract An entrant and an incumbent allocate their research funds across a rival and a non‐rival market. The prospect of an acquisition distorts both players' incentives to allocate funding. Allowing for acquisitions may improve both players' innovation direction and consumer surplus. Under conditions, the incumbent, anticipating monopolization rents in the rival market, moves R&D towards that market. This “incumbency for buyout” effect lowers the rents the entrant obtains from the contestable market, which gives it incentives to move R&D resources away from the rival market. Such strategic interaction in the R&D market has implications for the assessment of start‐up acquisitions.