The Race of Unicorns: Startup Acquisitions Before IPO to Signal Company Quality

Abstract

Assets are reallocated less efficiently through mergers and acquisitions (M&As) between private firms compared to the public ones. I develop a theoretical framework to explain how information imperfections inhibit efficiency gains through private acquisitions. Two startups of different qualities are seeking initial public offerings (IPOs) for costly real options and can acquire each other before IPO. Investors initially cannot distinguish their qualities but can observe whether an acquisition occurred. I show that efficiency loss in private acquisitions is not generated by the quality of the acquirer, but rather due to a lower probability of completing deals. Furthermore, undertaking acquisitions before IPO generates a positive signal about firm quality during stock issuance. Lastly, I document empirical evidence in support of this signaling effect.