Samu Happonen How the innovation should be valued? The relationship between the target’s R&D intensity and the premium payment in European technology-based public M&As from 2000 to 2022. Vaasa 2024 School of Accounting and Finance Master’s thesis in Finance Master’s Degree Program in Finance 2 UNIVERSITY OF VAASA School of Accounting and Finance Author: Samu Happonen Title of the Thesis: How the innovation should be valued? The relationship between the target’s R&D intensity and the premium payment in European technology-based public M&As from 2000 to 2022. Degree: Master of Science in Economics and Business Administration Programme: Master’s Degree Program in Finance Supervisor: Janne Äijö Year: 2024 Pages: 108 ABSTRACT: The objective of the thesis is to investigate the relationship between the target’s R&D intensity and the premium payment in European technology public M&As. The purpose is to deepen the understanding on the value relevance of the R&D investments in the M&A process, the infor- mation asymmetry dynamics regarding these R&D investments, and how these factors influence the M&A premium paid for the target firm. The thesis utilizes the R&D intensity of the target firm as a proxy for innovativeness, further being analyzed from the perspective of R&D to market value, R&D to net sales, and R&D growth rate. To investigate insider trading effect around R&D intensive targets, the thesis analyzes the relationships four weeks, one week, and one day prior to the announcement. The data sample includes a total of 203 public European M&As of technology firms from 2000 to 2022. By the utilization of the OLS regression analysis, the thesis finds that all three R&D intensity proxies of the target firm have a positive relationship with the M&A premium. However, contrary to U.S.- based studies, the results for these R&D proxies are not statistically significant. Thus, between the three R&D proxies, R&D intensity based on net sales one day prior to the announcement emerges as the most relevant explanatory factor for analyzing the changes in the M&A premium. This is evidenced by its relatively high coefficient of 53.54 and a t-statistic of 1.56, which ap- proaches the critical t-value of 1.65, corresponding to the 0.10 significance level. On average, public European technology firms pay 39.87-44.22 percent premium excess to the share price of the target firm, which is higher compared to other more conservative sectors. Comparing M&A premium four week and one week prior to the announcement to one day prior to the announcement, M&A premium decreases -4.35 and -4.60 percent, respectively. As tar- get’s R&D intensity increases, increases the probability for insider trading effect and target’s ability to achieve higher M&A premiums. In addition, the high expected M&A premium increases firm’s incentives to harness innovativeness, further increasing the attractiveness among poten- tial acquirers and execute EXIT through M&A transaction. The results are apt to enhance ac- quirer’s rational decision-making, reduce managerial hubris around hard-to-value R&D assets, and decrease the total proportion of information asymmetry in the public stock market. KEYWORDS: Mergers and acquisition, M&A, M&A premium, research and development, R&D, innovation, information asymmetry, insider trading 3 VAASAN YLIOPISTO Laskentatoimen ja rahoituksen akateeminen yksikkö Tekijä: Samu Happonen Tutkielman nimi: Kuinka innovaatiota tulisi arvostaa? Kohdeyrityksen T&K-intensi- teetin ja preemion maksun välinen suhde eurooppalaisissa tekno- logiapohjaisissa julkisissa yritysjärjestelyissä vuosina 2000–2022. Tutkinto: Kauppatieteiden maisteri Oppiaine: Rahoitus Työn ohjaaja: Janne Äijö Vuosi: 2024 Sivumäärä: 108 ABSTRAKTI: Opinnäytetyön tavoitteena on tutkia kohdeyrityksen T&K-intensiteetin ja preemion maksun suhdetta Euroopan teknologisissa julkisissa yritysjärjestelyissä. Tarkoituksena on syventää ym- märrystä T&K-investointien arvorelevanssista yritysjärjestelyprosessissa, kyseisiin T&K-inves- tointeihin liittyvästä tiedon epäsymmetriasta ja siitä, miten nämä tekijät vaikuttavat lopulta koh- deyrityksestä maksettavaan yritysjärjestelypreemioon. Opinnäytetyössä hyödynnetään kohdeyrityksen T&K-intensiteettiä innovatiivisuuden mittarina, jota analysoidaan niin T&K markkina-arvoon, T&K bruttokatteeseen, että T&K kasvunopeuden näkökulmasta. Tutkiakseen sisäpiirikaupan vaikutusta T&K-intensiivisten kohdeyrityksien kes- kuudessa, opinnäytetyössä analysoidaan suhteita neljä viikkoa, yksi viikko ja yksi päivä ennen julkista yritysjärjestelyilmoitusta. Aineisto sisältää yhteensä 203 julkista eurooppalaista teknolo- giayritysten yritysjärjestelyä vuosina 2000–2022. OLS-regressioanalyysiä hyödyntäen opinnäy- tetyö löytää, että kaikilla kohdeyrityksen T&K-intensiteetin mittareilla on positiivinen suhde yri- tysjärjestelypreemiolla kanssa. Toisin kuin yhdysvaltalaisissa tutkimuksissa, T&K-intensiteetti mittarien tulokset eivät kuitenkaan ole tilastollisesti merkitseviä. Kuitenkin kaikkien kolmen T&K-intensiteetti mittarien kesken, T&K bruttokatteeseen yksi päivä ennen julkista yritysjärjes- telyilmoitusta osoittautuu relevanteimmaksi selittäväksi tekijäksi yritysjärjestelypreemion ana- lysoinnissa. Tämä perustuu sen suhteellisen korkeaan 53.54 kertoimeen ja 1.56 t-arvoon, joka lähestyy kriittistä 1.65 t-arvoa, mikä vastaa 0.10 tilastollista merkitsevyystasoa. Julkiset eurooppalaiset teknologiayritykset maksavat keskimäärin 39.87–44.22 prosentin pree- miota yli kohdeyrityksen osakkeen hinnan, mikä on korkeampi verrattuna muihin konservatiivi- sempiin sektoreihin. M&A preemio laskee -4.35 ja -4.60 prosenttia, kun verrataan neljää viikkoa ja yhtä viikkoa yhteen päivään ennen julkista yritysjärjestelyilmoitusta. Kohdeyrityksen T&K-in- tensiteetin kasvaessa sisäpiirikaupan vaikutuksen todennäköisyys ja kohdeyrityksen kyky saa- vuttaa korkeampia preemioita yritysjärjestelypreemion valossa kasvaa. Lisäksi odotettu korkea yritysjärjestelypreemio lisää yrityksen kannustimia edistää innovatiivisuuttaan edelleen, mikä li- sää entisestään houkuttelevuutta mahdollisten ostajayrityksien keskuudessa ja kohdeyrityksen johdon EXIT mahdollisuutta yritysjärjestelyn kautta. Tulokset ovat omiaan edistämään ostajayri- tyksen rationaalista päätöksentekoa, vähentämään johdon yli-itsevarmuutta T&K investointien ympärillä ja pienentämään tiedon epäsymmetrian kokonaisosuutta julkisilla osakemarkkinoilla. AVAINSANAT: Fuusiot ja yritysostot, yritysjärjestelyt, yritysjärjestelypreemio, tutkimus ja kehi- tys, T&K, innovaatio, tiedon epäsymmetria, sisäpiirikaupat 4 Table of Contents 1 Introduction 8 1.1 Background and motivation 10 1.2 Literature review 11 1.3 Purpose of the study 16 1.4 Hypotheses 17 1.5 Contribution 18 2 Mergers and acquisitions 20 2.1 The basic concepts of M&A 21 2.1.1 The definition of M&A 21 2.1.2 The M&A process 22 2.1.3 The market waves of M&A 24 2.2 Types of M&A transactions 25 2.2.1 Horizontal transaction 25 2.2.2 Vertical transaction 26 2.2.3 Conglomerate transaction 26 2.2.4 Domestic and cross-border transaction 27 2.3 Types of M&A financing 28 2.4 Types of M&A acquirers 30 2.4.1 Financial acquirer 30 2.4.2 Strategic acquirer 31 2.4.3 Friendly and hostile takeover 31 2.5 M&A valuation 32 2.5.1 Valuation of a target firm 32 2.5.2 Valuation of synergy 34 2.5.3 M&A value creation 35 2.6 Competition law in Europe 38 3 Innovation through R&D 40 3.1 Innovation 40 3.1.1 Innovation input and output 41 5 3.1.2 Innovation waves 42 3.1.3 Innovation in Europe 44 3.2 R&D as a proxy for innovation 45 4 Theoretical framework 46 4.1 Neoclassical theory 46 4.2 Sell-side motives 48 4.3 Behavioral theories 49 4.3.1 Winner’s curse and managerial hubris 50 4.3.2 Agency theory 50 4.3.3 Market mis-valuation theory 51 4.4 Macro-economic theories 52 4.5 Acquiring innovation through M&A 53 4.5.1 Pre-M&A causalities for R&D and M&A 55 4.5.2 Post-M&A causalities for R&D and M&A 57 5 Data 60 5.1 Collecting the data 60 5.2 Improving the data 60 5.3 The final data sample 62 5.4 Variables 66 5.4.1 Dependent variables 66 5.4.2 Indepentent variables 67 5.4.3 Control variables 69 6 Methodology 72 6.1 Ordinary Least Squares method (OLS) 72 7 Results 74 7.1 M&A premium and R&D to market value 75 7.2 M&A premium and R&D to net sales 78 7.3 M&A premium and R&D growth rate 82 8 Discussion 87 6 8.1 Discussion on M&A premium and R&D intensity 87 8.1.1 Discussion on M&A premium and R&D intensity results 89 8.1.2 Discussion on information asymmetry in R&D intensive firms 90 8.1.3 Discussion on implications for M&A parties 92 8.2 Limitations 96 8.3 Future research 97 9 Conclusion 99 References 102 7 Figures Figure 1 The relationship between the premium and acquirer’s abnormal returns in M&A transaction (Diaz et al., 2009). 9 Figure 2. Growth and ROIC drive value (Koller et al., 2011) 36 Figure 3. Drivers for long-term innovation (Hargroves et al., 2005). 43 Figure 4. M&A transactions in the final data sample. 63 Figure 5. Annual average target market value and M&A premium four weeks prior to announcement. 64 Figure 6. Annual average target market value and excess M&A premium four weeks prior to announcement. 65 Figure 7. Annual average ratio of target market value and excess M&A premium four weeks prior to announcement. 66 Tables Table 1 M&A in Europe: Domestic vs. Cross-border from 2003 to 2022 (Aventic- Advisors.com, 2023). 28 Table 2. The M&A valuation model developed by the author, influence by Damodaran (2002) and Arzac (2005). The table presents positive NPV investment. 34 Table 3. The improvement of the data. 61 Table 4. Descriptive statistics for the target firm-specific data. 62 Table 5. Descriptive statistic for the M&A transaction data. 62 Table 6. R&D intensity based on market value, net sales and R&D growth. 69 Table 7. The summarization of control variables. 70 Table 8. Descriptive statistics for control variables. 71 Table 9. M&A premium and R&D intensity based on market value. 76 Table 10. M&A premium and R&D intensity based on net sales 80 Table 11. M&A premium and R&D intensity based on R&D growth rate. 84 8 1 Introduction Mergers and acquisitions (M&A) are a vital part of any healthy economy and more im- portantly, a major way for companies to provide returns to their owners and investors. M&A transaction generally include one company – an acquiring company – that pur- chases the assets or shares of a target company. Due to the potential for high share- holder returns, M&As make a highly attractive way for entrepreneurs and owners to cap- italize on the value created in a company (Sherman et al. 2016). The absolute objective for M&A is to create value for the organizations involved and their shareholders, and this value creation can be born in various ways. Still, M&As are large and complex financial transactions, and they often involve various challenges in achieving the desired eco- nomic benefits. Interestingly, Bruner (2005) states that M&A is a loser’s game with only a 20 percent success rate. Due to the complexity of the M&A process, generally both transaction parties have team of full variety of M&A professionals, including managers, attorneys, accountants, and investment bankers. Both parties conduct due diligence and valuation analysis of prime candidates, and proceed to initial negotiations (Sherman et al., 2006). Generally, one of the most critical decisions of the M&A transaction is the final transaction price. Due to information asymmetry between transaction parties, there can be hard pinpoints in ne- gotiating the fair valuation range for the target company. Difficulties arise not from rela- tively easily evaluated tangible assets e.g., plants, properties, and equipments, but ra- ther from evaluation on more intangible assets such as intellectual property, research & development projects, or patents. In general, companies are investing to research & development (R&D) to increase their potential to generate higher cash inflows in the future. In theory, these investments in R&D should increase the valuation of the company, if the initial investments yield higher returns than the company’s cost of capital. Still in the context of M&As, investments in R&D involve uncertainty and information asymmetry, which can create widely varying opinions on the valuation of the target company. Thus Laamanen (2007) states that 9 acquirers are paying higher premiums on R&D-intensive firms, and Lin and Wang (2016) states that high R&D capacity relative to firm valuation makes R&D-intensive firms at- tractive M&A targets. R&D affects the company’s operations and future cash flows in many different ways, which makes R&D an interesting variable from the point of view of M&A valuation. The success of an M&A in not purely based on the obtained future profits, but rather completing the M&A process at a price that is not greater than the obtained profits. For the shareholders of the target company to be willing to sell their holdings to the acquir- ing company, the acquirer generally offers a premium in the M&A transaction. M&A pre- mium, the bid price above the market value of the share price of the target company, can be seen as one of the most critical factors when considering the post-M&A obtained profits of the acquiring and target shareholders. Prior literature show that he premium has a positive influence on the abnormal returns obtained by the shareholders of the target company. Thus, the relationship between the premium and acquirers’ abnormal returns in M&A can be presented as quadratic relationship (Diaz et al., 2009). Figure 1 The relationship between the premium and acquirer’s abnormal returns in M&A transaction (Diaz et al., 2009). 10 Diaz et al. (2009) suggest that the market can consider the higher premiums being an indication for greater future earnings, which supports the synergy hypotheses. The point A reflects the situation where the premium increases higher than the discounted future cash flows of the M&A transaction, and the M&A transaction results in net negative out- come for shareholders of the acquiring company (Diaz et al., 2009). When overpayment hypothesis becomes dominant against synergy hypothesis, there is a probability that the acquiring company has been estimated the value of the target company’s assets inaccu- rately. 1.1 Background and motivation If the target company is examined homogeneously, the R&D factor can be valued through traditional investment or option pricing models. The key is to assess whether R&D will generate more cash flows in the future, given the initial investments, work ef- fort and time spent on it. In the case of publicly listed companies, the valuation of com- pany’s R&Ds depends on the consensus of the stock market. However, if the probability of a potential company takeover is added to the equation, the R&D factor can be valued differently. In the context of M&A, the target company’s R&D can be valued higher if it is considered to have a high synergistic value for the business of the acquiring company. More specifically, Bena and Li (2014) find that on average acquiring companies have large patent portfolios and low R&D expenses, while target firms have high R&D expenses and slow growth in patent output. In addition, any technological overlap between M&A par- ties has a positive effect on takeover probability, and this effect decreases when M&A parties overlap in same product markets. Interestingly, when the acquiring and target company have technological linkage pre-M&A, more patents are produced post-M&A. Authors conclude that synergies obtained from combining innovation capabilities are important drivers for engaging M&A. In addition to rational factors, M&As are affected by irrational factors, the so-called be- havioral finance. Behavioral finance theories affecting to M&As are examined in the 11 chapter 2.5.4, but this thesis more strongly supports the rational decision-making prac- tices in M&A process. R&D is an information-sensitive asset, and its valuation is relatively more challenging than a valuation of a tangible asset. If the acquirer understands the relationship between the R&D and the M&A premium, can the acquirer argue the tender price more effectively. In contrast, if R&D is found to have a positive relationship with the M&A premium, it can increase the incentives of many, especially small companies, to invest in R&D and achieve higher innovativeness. 1.2 Literature review In the realm of prior accounting and finance literature, the link between R&D expendi- tures and subsequent future financial benefits has long been a subject of inquiry and skepticism. The late 90s’ prevailing believe for a relationship between R&D costs and future financial benefits is reflected by the lack of relevant and statistically significant studies. However, Lev and Sougiannis (1996), in their seminal work published in the Jour- nal of Accounting and Economics, challenged this conventional view. Their research is the first research to systematically explore and identify a significant and economically meaningful association between R&D expenditures and subsequent earnings for a di- verse set of R&D-intense firms. In addition to founding a relationship between R&D ex- penses and earnings, they introduce the concept of firm-specific R&D capital and its im- pact on stock prices and returns. The study by Lev and Sougiannis (1996) marked a pivotal departure from the long-stand- ing notion that failed to recognize the value-relevance of R&D capitalization. Their study not only address the issues of reliability and objectivity in R&D capitalization but also demonstrates the potential market inefficiency and additional market risk factor associ- ated with R&D capital, thereby challenging the foundation of prior accounting standards. The pivotal findings of Lev and Sougiannis (1996) laid the groundwork for a more nu- anced understanding of the economic implications of R&D expenditures in future’s fi- nance and accounting research. 12 In regards of this thesis, the research by Laamanen (2007) is used as a main reference study, and this thesis aims to continue to examine the relationship between the M&A premium and R&D investments of a target company. Several prior studies argue that paying high premium is value destroying for the shareholders of the acquiring company, and that paying high premiums is an indication of low-quality decision-making policies. The payment of the premium has been seen as an overpayment that exceeds the bene- fits created by the synergies from the M&A. On average, acquirers are paying 20 – 30 percent premium over the market price of the target, but more specially in U.S., the premium payment is presented to be 30 – 50 percent. The premium payment is higher for technology-based firms, and higher premiums are not shown to be due to managerial hubris or high competition for targets. Briefly, Hayward et al. (1997) suggest that mana- gerial hubris leads to the manager’s overconfidence, exaggerated self-confidence, in their skills to achieve calculated synergies and the willingness to pay a higher premium in M&As. Laamanen (2007) suggests that technology firm’s increasing cash outflow from the prior R&D assets increases the information asymmetry in the public stock market, further re- sulting higher variance between the potential M&A valuations and stock market partici- pants. Generally, a potential acquirer that is ready to pay the highest M&A premium over the target shares wins the tender competition, in which case a higher variance of the M&A premiums is apt to increase target’s bargaining power during the negotiation phase, further the increasing the probability of yielding higher M&A profits. Still, prior literature suggests that stock market heavily discounts R&D intensive firms until they yield tangible cash inflows, indicating a strong emphasize on traditional financial analysis for the tar- gets. Still, the author suggests that acquirers engaging M&A with the technology firm with high R&D intensity indicate a more favorable view on target’s risky R&D assets, fur- ther suggesting that M&A acquirers value the target’s accumulated R&Ds higher than the public stock market. 13 Laamanen (2007) states that acquirers engaging in M&A with a technology-based target and paying higher premium does not result in negative abnormal returns. Abnormal re- turns are seen to be more strongly related to the homogenous valuation of the target company, being independent from the premium payment. One of the main findings is that the R&D investment-to-market ratios and R&D growth rate have a statistically sig- nificant positive relationship to paid premium by acquirers. Acquirer paying high premi- ums can be justified, when target firm’s resources are difficult to value by the stock mar- ket, and acquirer can achieve private synergistic benefits due to the accumulated R&D investments of the target company. Donelson and Resutek (2012) argue that the R&D premium primarly increases from ele- ments of R&D firm’s realized returns that are not directly linked to their R&D expendi- tures. More specifically, these excess returns are part of a broader value and growth anomaly. Althought R&D investments are influence positively to future earnings, the R&D investment policies of firms do not influence the earning forecasts made by inves- tors and analyst. The result suggest that the firm would have no incentives to aim to increase its share valuation based on increasing R&D investments. In contrast, a later study by Lin et al. (2016) presents that high R&D intensity firms achieve higher stock market returns. These dynamics are based on increased M&A attractiveness due to higher R&D intensity and growth multiples, further increasing the sensitivity and a posi- tive fluctuation of the stock. Interestingly, Aboody and Lev (2000) examine the relationship between information asymmetry, firm’s R&D expenses and insider gains, using R&D intensity as a proxy for private information. The topic is relevant due to high uncertainty regarding the M&A transaction, as R&D expenses of firms creates challenges for public market valuing the transactions. Aboody and Lev (2000) construct a robust dataset from insider trading in- formation, covering the period from 1985 to 1997 in the U.S. The methodological ap- proach involves building portfolios based on R&D activities and insider transactions, ex- amining regression analyses, and performing various robustness tests. 14 Aboody and Lev (2000) find that insider gains are significantly larger for R&D-intensive firms compared to non-R&D firms. Additionally, investors react more strongly to insider trading in R&D firms, further indicating information asymmetry and increased difficulty in valuing these firms publicly. Authors highlight the importance of R&D expenses as a critical factor in valuing and pricing a firm, emphasizing challenges associated with infor- mation disclosure and the potential for capitalizing on insider information in the pres- ence of heightened information asymmetry. In the context of M&As, this information can contribute to fluctuations in M&A premiums as acquirers are challenged under un- certainties assessing the value of a target firm. A study by Cheng et al. (2016) supports these findings by showing that in a M&A trans- action, a target with higher information asymmetry is significantly and positively related to a higher bid premium compared to a more transparent target firm. Moreover, there is a positive relationship between the information asymmetry of the target and the ac- quirer’s announcement abnormal returns. The investors of the acquiring company react positively to the announcement of opaquer target firm, furthermore, suggesting that the investors reward the acquiring company efficiently resolving a target firm’s valuation un- der high information asymmetry. These relationships are persistent for all payment methods of the M&A transaction. Although the thesis mainly investigates R&D invest- ments and the effect of asymmetric information on the premium paid for the target firm, the study by Cheng et al. (2016) reflects the relevance of asymmetric information in the M&A transaction and valuations itself. In a study by Chan et al. (2001) authors do not only examine the valuation of the R&D investments in the U.S. stock market, but also its relationship to returns volatility. The topic is relevant to the thesis, as it investigates how the stock market success to evaluate R&D intensive firms and how uncertainty in R&D affects return volatility. This is crucial for understanding additional aspects influencing the pricing and valuation of M&A trans- action, especially the valuation of the target firm. 15 Chan et al. (2001) utilizes daily stock market data from AMEX, NYSE, and Nasdaq, cover- ing the period from 1975 to 1995 in the U.S. By ranking stock based on R&D expenses and facilitating them to portfolios, and examine the performance of these portfolios, authors aim to find patterns related to R&D-to-sales and R&D-to-market value dynamics. The multifactor regression model is used to investigate if excess returns from R&D-in- tensive stocks reflect risk differentials. Additionally, the research explores the association between R&D-intensive and return volatility cross-sectional regression analysis. Chan et al. (2001) results indicate that while there is interestingly no strong evidence supporting an association between R&D spending and future stock performance, R&D intensity is significantly associated with share’s return volatility. The finding has a direct implication for M&A transaction, suggesting that the lack of comprehensive accounting information on intangible assets like R&D can contribute to increased volatility for inves- tors. Additionally, firms with high R&D intensity are shown to have beaten-down stocks. Hence, for potential acquirers in need of R&D capacity to generate growth, high R&D capacity relative to firm valuation makes R&D-intensive firms attractive takeover targets. For the thesis, a more recent and geographically relevant study by Mataigne et al. (2017) investigates the impact of R&D investments by targets on the acquisition premium con- tingent upon the acquirer’s financing choices. Examining the hand-collected data sample of 407 listed European transactions, authors find that, on average, target firms with R&D investments experience a 15.8 percent higher premium compared to targets with no R&D investments. The findings are in line with Laamanen (2007) and supports the evi- dence for potential synergies in a wide range of industries. Interestingly, the relationship is shown to be negative if the M&A transaction is financed with debt. These finding sug- gest the discretion of the acquiring company’s management is stiffened in the decision- making process, mainly due to elevated interest cost and stronger monitoring by debt holders. 16 1.3 Purpose of the study Through prior relevant research and European data sample from technology firm’s M&A between 2000 to 2022, this thesis investigates is there a relationship between the R&D intensity of the target firm and the premium paid in the M&A transaction. The purpose of the study is to expand the understanding on value relevance of the R&D investments in the M&A process, the information asymmetry regarding these R&D investments, and does these factors influence the premium paid for the target company. The research topic is essential, given that the premium payment constitutes a significant element in a M&A transaction, and the premium paid has direct value implications for both M&A par- ties involved in the transaction. The findings of the thesis have value relevance both for the acquirer and the target com- pany in the M&A process. By the deeper understanding on how R&D assets, which are relatively challenging to value compared to more tangible assets, should be valued, an acquirer can evaluate the more accurate valuation of the target company. If the acquirer benefits from the R&D investments made by the target firm, the higher premium pay- ment can be justified by the shareholders of the acquiring firm. However, this thesis significantly benefits the target companies. If R&D investments have a value relevance in the M&A process, it is apt to increase the incentives to engage in R&D activities by technology companies, furthermore, increasing the potential to achieve higher future cash flows. If there is a significant and positive relationship be- tween R&D investments and the premium paid in the M&A transaction, it provides an attractive EXIT strategy for smaller and agile technology firms in the form of M&A. As a whole, the thesis contributes to the ability of M&A parties and the stock market to un- derstand more efficiently, how the innovativeness of the target firms should be valued, and what are the justifications for exceed premium on the current share price of the target firm. 17 1.4 Hypotheses The main purpose of examining innovation in the light of R&D investments is discussed more deeply in chapter three. Nonetheless, it is imperative to adopt a multifaceted ap- proach towards examining R&D from different aspects. By examining R&D through three different empirical hypotheses, the thesis can unveil the intricate interrelations within the market dynamics. To expand the understanding of value relevance of the R&D in- vestments in the M&A process and to continue Laamanen (2007) seminal work, the the- sis examines the following empirical hypotheses: H1: “The target’s R&D-to-market value has a positive relationship with the premium paid in European technology-based public M&A” H2: “The target’s R&D-to-net sales has a positive relationship with the premium paid in European technology-based public M&A” H3: “The target’s R&D growth rate has a positive relationship with the premium paid European technology-based public M&A” The null hypothesis is rejected and vice-versa alternative hypothesis is accepted if the p- value is less than a statistical significance level of 0.05. If the studied p-value is less than 0.05, in practice this indicates that there is a statistically significant relationship between the studied variables, the observations are more than two standard deviations away from the median and the results can be generalized to a wider entity. If the p-value is over 0.05, accepting the null hypothesis means that there is no statistically significant relationship between the studied variables. Therefore, the thesis poses the following statistical hypotheses; 𝐻0: 𝛽𝑅&𝐷 𝑝𝑟𝑜𝑥𝑦 ≤ 0 𝐻1: 𝛽𝑅&𝐷 𝑝𝑟𝑜𝑥𝑦 > 0 18 Laamanen (2007) argues that the information asymmetry in the market is expected to increase due to firm’s higher R&D capital and R&D growth rate, further leading to under- valuation by the stock market. The undervaluation is rationalizable through reduced cash flows, but these firm-specific accumulated R&D investments can yield potential private benefits for M&A acquirer. Therefore, investigating R&D-to-market value can unveil in- teresting and significant empirical findings. Laamanen (2007) finds that as the sales revenue of a target firm increases, the stock market reaction at the time of the M&A weakens. In addition, using R&D-to-net sales ratio can create problems in growing firms, which has not yet accomplished to turn these R&D investments to cash inflows. Still as a counterargument, Li and Wang (2016) find that takeover probability is not related to innovation efficiency, further suggesting that innovation efficiency premium should not be related to takeover probability. Some firms can try to capitalize the target firm’s poorly managed R&D investments. Finally, R&D growth rate is an interesting factor as it eliminates the absolute measures of the firm size but enables to investigate growing R&D intensity of the target. Aboody and Lev (2000) find that insider trading increases as the R&D intensity of the firm in- creases, and Laamanen (2007) finds significant relationship between the R&D growth rate and the M&A premium paid. Therefore, R&D changes can be argued to play im- portant role in the context of M&A transaction, suggesting higher insider trading, accu- mulating firm-specific private benefits, and potential EXIT strategy for the target firm. 1.5 Contribution The prior relevant literature finds the critical relationship between R&D expenditures and future financial benefits. Lev and Sougiannis (1996) establishes a significant relation- ship between the R&D expenses and future earnings for R&D-intensive firms, introduc- ing the concept of firm-specific R&D capital and exposing market inefficiencies. The piv- otal study for the thesis by Laamanen (2007) finds that uncertainty around cash flows from R&D investments created information asymmetry, further affecting the valuation 19 of the target firm in the M&A process. Author reveals that acquirers paying higher pre- miums experience no negative abnormal returns, and R&D investment-to-market ratios and R&D growth rates correlate positively to the M&A premium. Additionally, Lin and Wang (2016) highlight the likelihood of high R&D firms becoming takeover targets. Interestingly, the study by Mataigne et al. (2017) produce a geographically relevant per- spective, showing that target firms with R&D investments achieve higher premiums in the context of the European M&A transactions. Still, the data from 1997 to 2010 does not consider the significant importance of technology firms in the global markets, major financial crises and a period of zero interest rates, further increasing R&D investments with debt financing, and decreasing the discount rate of R&D and M&A investments. In addition, the data includes firms in varying sectors, further limiting the comparability of the results to the M&A premium of R&D intensive technology firms. Examining the rela- tionship between R&D and M&A exclusively in the M&A of technology firms is important, as a significant proportion of R&D investments are conducted in the technology sector in order to achieve innovation edge in highly competitive markets. This thesis aims to contribute updated findings for the relationship between R&D inten- sity and M&A premiums in public technology companies in Europe from 2000 to 2022. The majority of the prior relevant studies in the field focus on the dynamics of the U.S. market (Lev et al. 1995; Aboody et al. 2000; Chan et al. 2001; Laamanen, 2007; Cheng et al. 2016; Lin et al. 2016), and this thesis fills a gap in the European research field. More- over, the thesis offers updates findings from 2000 to 2022, as the study by Laamanen (2007) contributes the period from 1989 to 1999. The thesis attributes to prior literature by generating multidisciplinary findings on the value relevance of R&D assets, infor- mation asymmetry and insider trading effect related to these R&D assets, and how these factors ultimately influence the M&A premium paid for the target firm. 20 2 Mergers and acquisitions This chapter undertakes a thorough investigation of M&As, the main purpose being to establish a robust foundation for comprehending the intricacies of this vital corporate action. Firstly, the section 2.1 provides an understanding of the fundamental compo- nents of M&A process and waves. The section 2.2 investigates different types of M&A transactions since the nature of the M&A can have significant affects to the M&A process and the final transaction price. The section 2.3 examines varying financial options avail- able to firms engaging in M&As, and how different financial methods affects to the M&A transaction. Then, the section 2.4 introduces different types of M&A acquirers, further deepening the understanding of varying organizational structures and objectives associ- ated with these transactions. Especially in the context of technology-based M&A, it is important to distinguish how the strategic and financial acquirer aim to utilize the ac- quired assets of the target company. After the investigation of the M&A itself, the thesis examines the most essential motives for engaging in M&A transaction based on the prior relevant literature. The section 2.5 emphasizes the potential growth and synergy opportunities for acquiring company and highlight the main sell-side motives of the target. Interestingly, the section 2.5.4 of the thesis examines the most relevant behavioral finance theories influencing the M&As. Although a M&A should be based on a rational decision that maximizes the value of the company’s shareholders, prior literature has observed how different behavioral biases affect the decision-making process of company’s managers. Additionally, the section 2.6 and 2.7 examines what is the premium payment and M&A valuation, further deepening the understanding how the premium payment can be justified by the shareholders of the company, based on the valuation in the M&A process. The chapter concludes recognizing the significant impact of EU-level competition legis- lation and how it affects to the M&A deals. Examining the competition law of an individ- ual EU member state is not relevant for the thesis, as it is more important to investigate the minimum requirements set by EU law, so that a M&A transaction within the EU 21 internal market can be proceeded successfully. The analysis of the chapter two creates the required foundation for the subsequent investigation of the interconnectedness be- tween M&A and the R&D intensity of the target firm. 2.1 The basic concepts of M&A The terms merger and acquisition are often used in general and academic discussions as synonyms. Although, mergers and acquisitions have their own technical nature, authors often do not distinguish the terms. In this study, terms are identified as they are pre- sented in “Mergers and acquisitions from A to Z” by Sherman, A., and Hart, M. (2006) and in “Investment valuation” by Damodaran A. (2002). 2.1.1 The definition of M&A A merger is a combination of two or more companies in which the assets and liabilities of the selling company(s) assets and liabilities are absorbed by the buying company (Sherman et al., 2006). As a result of the transaction, the target company is fully liqui- dated. In a merger, the board of directors of two companies agrees to combine. Direc- tors seek stockholder approval for the combination, and in most cases, over 50 percent of the target and bidding company shareholders must agree to complete the merger. In a specific manner, a merger can also be called a consolidation, where both selling and buying companies are liquidated and converted into a new security of the new company. After the two companies' consolidation, both the acquiring and the target company stockholders receive stocks in the new company (Damodaran, 2002). Mergers and buyouts have their structural differences. Firstly, buyouts do not cause a consolidation of two separate companies, unlike mergers. Instead, a group of investors acquires the target company, which may include changes in the management of the company, and usually, the target company becomes a private company. Two established buyouts are managerial buyouts (MBO) and leveraged buyouts (LBO). The MBO com- pany is acquired by its own management. On the other hand, LBOs are financialized heavily by debt, and its commonly accepted by the small relative debt ratio of the target 22 company (Damodaran, 2002). Of the two, LBOs are studied more extensively in prior literature. This thesis will later examine how the debt structure of companies and the use of debt as a payment method affects the premium. The acquisition is purchasing an asset such as a plant, a division, or even the entire com- pany. An acquisition typically has a more explicit definition of transaction sides as a buyer and a target. In the acquisition process, the buyer purchases the assets or shares of the target company. The term acquisition is often called a takeover because after the transaction majority of the target company's shares, and voting rights are transferred to the control of the buying company. In addition, the commonly used term "reverse take- over" means an acquisition where the acquiring company is smaller than the target com- pany (Immonen, 2018). Reverse-takeover ordinarily arises when a private company ac- quires a publicly traded company. 2.1.2 The M&A process Depending on the incentive of a buyer company, buyers can be defined as financial buy- ers and strategic buyers (Arzac, 2005). In both cases, the end objective is to achieve ex- ceeding value, yet the value creation method differs. Strategic buyers are companies that are seeking synergy effects by acquiring or merging with another company. Nowa- days, M&As are increasingly strategically motivated as the strategic buyer can achieve synergies such as entering new markets, adding new product lines, or increasing distri- bution reach (Sherman et al., 2006). Moreover, strategic buyer value creation theories are discussed in detail in section 3.1. Financial buyers are big individual investors or institutions, commonly private equity (PE) funds or venture capital funds, which support a target company with financing new pro- jects or taking the business to a new level. During the transitory buyout period, manage- ment attempts to improve operations, and the financial buyer seeks to transfer the own- ership of the company to a more permanent owner (Arzac, 2005). 23 There is a big difference in activity policy between financial institutions. Most institu- tional investors are passive, including many mutual and pension funds, which will sell the ownership if the development of the business is not at the desired level. Some hedge funds, private equity, and venture capital companies are more active owners seeking potential ways to develop company operations (Damodaran, 2011). Therefore, financial buyers are seeking the value of control, which is generated by changing the way the company is run. The investors consider that value can be created by running the target company more efficiently compared to the current way of managing the company (Dam- odaran, 2005). Both acquiring and selling sides can approach the M&A transaction. Motivations to sell the company may have been long-lasting when management has done an exact plan and preparation on maximizing the future transaction's value. A company can also face a sudden, surprising change in competitive or financial factors, which motivates the owners to sell the company in fast phase. The most common personal level reasons are the death or illness of an owner, retirement, a partner "cashes out" due to dispute or divorce, or incompetence to lead the business further. In addition, reasons can be stra- tegic level reasons such as relocation of the business, company or whole management being ready to move towards different opportunities, insufficient diversification of own- ership, or the company being undercapitalized and needing funding to achieve the next strategic step (Sherman, A., and Hart, M. 2006). The main objective of a selling process is preparation, regardless of the motivations that led to selling. The selling company needs to identify the financial and structural goals of the transaction, make a coherent selling plan, and understand the dynamics of the sell- ing process with potential buyers. Same time as the seller prepares information consid- ering past operating performance and valuable assets, it is important to turn the stones to reveal possible "transaction turnoffs," such as potential legal or financial obstacles. Finally, after drafting an offering memorandum, processing corporate housekeeping matters, and planning of transparent communication manner with 24 buyers, the seller is ready for the M&A process (Sherman, A., and Hart, M. 2006). Simi- larly, as in the acquisition process, higher quality preparation of the target indicates a higher probability of attracting better buyers and creates a possibility for higher value creation in the selling process. 2.1.3 The market waves of M&A Managers are incentivized to make their companies grow, to which M&A activities are essential (Jensen, 1976). M&As are a vital part of any healthy economy and an important way for companies to pursue returns for shareholders. M&As have had various roles in corporate history, ranging from “greed is good,” referring to a hostile takeover strategy, to nowadays trend to use M&As for external growth and industry consolidation (Sher- man, A., and Hart, M. 2006). Prior literature recognizes that global M&A activity comes in waves and is influenced by the overall mood of the current economic cycle. The main reasons underlying the M&A waves are changes in the regulatory environment, industrial or technology shocks, cap- ital market expansions, and incentives to expand business operations to new cross- bor- der markets (Martynova et al., 2008). Even though the individual M&A waves differ from each other, common characteristics are found. Interestingly, all prior M&A waves ended as the stock market collapsed. Rhodes-Kropf, Robinson, and Vishnwanathan (2005) find evidence that temporary com- pany-specific and industry-specific fluctuations in the share price are significant drivers in acquisition activity. The overvaluation of acquiring companies triggers M&A activity, and merger activity spikes when expected growth opportunities are high (Martynova et al., 2008). To conclude the complexity of M&A activity analysis, Brealey and Myers (1991) suggest that takeover waves are one of the ten unexplained puzzles in financial economics. 25 2.2 Types of M&A transactions Briefly, the prior literature recognizes three main types of M&A transactions as horizon- tal, vertical, and conglomerate M&A. It is important to understand how these M&A types differ from each other in order to further understand the motivations behind these M&As. For example, in the technology sector, a company can aim to improve its competitive advantage by acquiring its competitor, acquiring a supplier to enhance op- erations or acquire external expertise from a firm operating in different industry. Importantly, in nowadays globalized economy, this section introduces the difference be- tween the domestic and cross-border M&A transactions. An investigation into variations in market dynamics, cultural integration, and heightened risks intrinsic to cross-border M&As serves to further elucidate distinctions in valuations and motivations specific to the cross-border M&As. 2.2.1 Horizontal transaction Rozen-Bakher (2017) states that horizontal M&As involve a combination of two firms that compete in the same market. The main motivations to engage in horizontal M&A is to enhance market power and cost efficiencies. Firstly, due to reduction of potential ri- vals in the same market, horizontal M&A increase the market power of combined entity, further allowing for strategic pricing decisions that contributes to heightened profits and market value. Secondly, even in the absence of cost savings, the performance of merging firms improves if a larger entity possesses lower marginal costs, primarily due to price increases. Interestingly, horizontal M&As facilitate resource sharing and the transfer of employees and assets, further leading to reduction in total operating costs. Prior literature argues that related M&As carry lower risks compared to unrelated M&As, as management is familiar with the industry where the target firm is operating (Rozen-Bakher, 2017). How- ever, it is relevant to highlight that if the merger company misuses its increased market power or the M&A itself is narrowing the competition within the industry, there is a 26 possibility of an obstacle to the creation of horizontal M&A. Especially, in technology industries where only a few firms manufacture a certain product, either the lack of rele- vant competitors or the monopolization of product manufacturing can create an obsta- cle for potential horizontal M&A. 2.2.2 Vertical transaction Rozen-Bakher (2017) states that vertical M&As involve firms in a buyer-seller relation- ship, which are characterized by upstream and downstream transactions. Contrary to horizontal M&As, vertical counterparts have fewer target firm choices, often limited to a singular option fulfilling acquisition criteria. The main motivations for vertical transac- tions are enhanced market access, operational synergies, and improved efficiency through combined product or service flow. Interestingly, competitive parity within verti- cal M&As can strengthen bargaining positions, but asymmetry may diminish combined profits. In the context of technological M&As, firms with intricate and innovative pro- cesses, can strategically utilize vertical integration to enhance efficiency in R&D and com- petitive edge. 2.2.3 Conglomerate transaction Where horizontal and vertical M&A allow acquisition of firms operating in the same mar- ket or in the same supply chain, conglomerate M&As combine firms which manufactures unrelated products. The main motivations for conglomerate M&As are market diversifi- cation and the potential to enter new geographic markets. Yet, prior literature recognizes challenges in conglomerate M&As due to complex integration process of two unrelated product or services, further hindering the realization of synergy benefits. Additionally, significant differences in markets, products, and geographic locations can create obsta- cles during the M&A integration process, further limiting the ability to reduce operating costs and generate future profits (Rozen-Bakher, 2017). The study by Hagedoorn and Duysters (200) supports the argument that conglomerate M&As experience less success- ful M&As compared to prior mentioned horizontal and vertical M&As. Authors find, that 27 the strategic and organizational fit between firms involved in technological M&A have an important role in enhancing the technological performance of the combined firm. 2.2.4 Domestic and cross-border transaction Marek (2018) introduces that cross-border M&A is an illustrative term for any transac- tion in assets between two companies located in two different countries. In the past few decades, globalization has accelerated the trend for companies to achieve external growth by cross-border M&As. Due to deregulation, trade liberalization, and privatiza- tion, European cross-border M&As have experienced rapid growth since the mid-1990s, significantly impacting the direction and magnitude of global foreign direct investment (FDI) flows. More specifically, Drazdou (Aventic-Advisors.com, 2023) article investigating M&A activ- ities in European Union, illustrates how companies are engaging in domestic and cross- border M&As. Although domestic M&As are dominating in European M&A activity, cross-border M&As achieved 47 percent of total deal volume in 2022. Overall, cross-bor- der M&As transactions are averaging 40 percent of total M&A volume over the 20-year period. Highly relevant for the thesis, the following table 1 illustrates the development of European domestic and cross-border M&As from 2003 to 2022. 28 Table 1 M&A in Europe: Domestic vs. Cross-border from 2003 to 2022 (Aventic-Advi- sors.com, 2023). Marek (2018) investigates the cross-border M&A activity in European Union countries, discovering the main motives behind these unique transactions. The main motivating factors include the synergy motive for economic benefits, the agency motive to further enhance shareholder value and achieve an access to new markets rapidly, and the diver- sification motive as a business-expansion strategy. Additional motives are shown to be restructuring possibilities, prevention of asset losses, and efficient resource allocation. In the context of technology-based transactions, cross-border M&As present a strategic avenue for firms encountering challenges in achieving independent technological devel- opment within their domestic markets. This is particularly relevant for high R&D-inten- sive firms, as cross-border M&As provide the opportunity to broaden their knowledge base, facilitating the acceleration of ongoing or new R&D indicatives, fostering innova- tion, and further enhancing competitive advantage. 2.3 Types of M&A financing After a buying side has found the right target company to buy, evaluated the target com- pany, and negotiated the transaction price, it is time to decide how the transaction is financed. Commonly, the transaction is financed by three different methods (Sherman, 29 A., and Hart, M. 2006; Damodaran, 2002). Cash is the simplest method to finance a trans- action. This method is available for companies that have accumulated a high proportion of cash prior to the transaction or increased the proportion of debt to finance the trans- action (LBOs). Furthermore, acquiring company can finance the transaction with its shares in a stock-swap deal. This method transfers the ownership of the target company and enables the shareholders of the target company to benefit from the growth of the acquiring company. Stock-swap negotiations focus strongly on the implemented ex- change ratio of stocks. Lastly, the mixed transaction can be financed partly with cash and stock-swaps. The payment method is a two-sided decision that is purely motivated by the incentives of transaction parties. If the financial markets value companies incorrectly, managers can use this asymmetry of the market to their advantage. At least, in theory, investors should be able to choose between different securities, and prices should at any point of time “fully reflect” the available information, known as “the efficient market hypothe- sis” (Fama, 1970). The efficient market hypothesis divides market stages into three forms. Firstly, the strong form is where the individual investors or group have monopo- listic access to any information affecting the stock price. The second semi-strong form reflects all public information about the markets. Lastly, the weak form of the market only consists of historical data from stock and returns. In conclusion, when the level of information in the markets is low, a higher level of misvalued M&As is created. This statement can be supported by the prior study by Shleifer and Vishny (2003), which created a model to demonstrate that relatively overvalued acquirers frequently make acquisitions compared to target companies. In addition, stock acquisitions are explicitly used in transactions where the acquiring company believes its stock price to decline and aspires to make these future negative returns less negative. On the other hand, the fre- quency of cash payments increases when the valuations in the market are low. More precisely, a study by Rhodes-Kropf, Robinson, and Vishnwanathan (2005) shows that in intense merger markets, stock-financed transactions are common and can be motivated by the overvaluation of the stock. On average, cash acquirers are less overvalued than 30 stock acquirers. Certainly, shareholders of the target company should be aware of the possibility of overvaluation if the acquiring company suggests pursuing the transaction with its stocks (Damodaran, 2002). 2.4 Types of M&A acquirers Two distinct buyer approaches to M&A process can be defined as strategic acquirer and financial acquirer (Bragg, 2008). In both instances, the absolute objective of the buying company is to create exceeding value, still the value creation method differs. This thesis places a particular emphasis on strategic M&As due to the crucial influence of the tar- get’s R&D investments on the assessment of valuation and the subsequent success of the merger. 2.4.1 Financial acquirer A financial acquirer engages in a M&A process with the primary objective of holding the acquired company temporarily, anticipating value appreciation over time, and subse- quently selling it for profit (Bragg, 2008). Typical financial acquirers are big institutional investors, private equity (PE) funds, or venture capital funds, which support a manage- ment of the target firm with new projects and aims to lead the firm towards more prof- itable growth. Due to this transitory period, management attempts to improve opera- tions, and initial financial buyer seeks to transfer the ownership to more permanent owner (Arzac, 2005). If the financial acquirer possesses pertinent technical know-how, the substantial premi- ums offered by financial acquirers can be rationally justified. This justification is based on the acquirer’s capacity to contribute to the continued advancement of the target company’s R&D investments. Considering Bragg’s (2008) perspective, it can be suggested that the influence of technical knowledge within financial acquirers is comparatively lim- ited when juxtaposed with strategic acquirers. This is attributable to the inherent con- strains faced by financial acquirers as synergies can be realized only by strategic acquirers, not by financial acquirers. 31 2.4.2 Strategic acquirer Strategic buyers are companies that are seeking synergy effects by acquiring or merging with another company. Nowadays, M&As are increasingly strategically motivated as the strategic buyer can achieve synergies such as entering new markets, adding new product lines, or increasing distribution reach (Sherman et al., 2006). Bragg (2008) suggests that a strategic buyer is willing to pay higher premium for the target company, exceeding the average amount a financial buyer offers. This higher valuation is justified due to strategic acquirer’s incentive to retain and develop the most valuable components of the target entity while discarding the less essential components. The strategic acquirer’s capability to execute this strategy is based on its extensive un- derstanding of the relevant industry, as well as a profound understanding of the target company’s products, intellectual property, R&D investments, and operational processes. In the light of this thesis, strategic acquirers are in a more interesting position than fi- nancial acquirers, as strategic acquirers are expected to achieve higher synergistic bene- fits from target’s R&D investments than financial acquirers. Interestingly, Mneijja et al. (2010) find that on average European financial buyers pay from 16 percent to 24 percent lower premiums compared to strategic buyers. 2.4.3 Friendly and hostile takeover The acquisition can be identified as a friendly or hostile takeover. In a friendly takeover, the target company's managers are incentivized to accept the acquisition. Involved par- ties perform due diligence, negotiate transaction price and other deal-specific terms. In a hostile takeover, the management of the target company is not willing to be acquired, and management is usually forced to take action to prevent the acquisition (Damodaran, 2011). Companies are increasingly using "value consultants" to assist them in restruc- turing, increasing value, and avoiding being taken hostilely over (Damodaran, 2002). In contrast to a friendly takeover, the bidder side does not negotiate with the management of the target company but instead makes a tender offer directly to the shareholders. 32 Although, the nature of a takeover can change rapidly in mid-acquisition from friendly to hostile and vice versa (Miller et al., 2017). 2.5 M&A valuation The determination of the transaction price holds critical significance within the context of M&A deal, as it delineates whether the transaction generates exceeding value or leads to value destruction for the acquiring company’s shareholders. In typical M&A transac- tion, the acquirer customarily offers a premium above the current market value of a pub- licly traded target company’s shares, incentivizing shareholders of the target company to tender their shares. As articulated by Arzac (2005), this premium denotes an excess payment beyond the value enhancement already reflected in the target’s pre-acquisition share price. This section is vital for the thesis, as it creates foundation on how the valuation of a target company and the final M&A deal price itself is determined. As this thesis delves into the relationship between the target R&D intensity and the premium payment, it is therefore necessary to understand why the premium is paid above the target company’s pre-acquisition share price and what are its drivers. In addition, this section examines different valuation techniques to introduce varying methods of evaluating the fair price of the target assets. 2.5.1 Valuation of a target firm In the acquisition process, the valuation of the target company does not fundamentally differ from the valuation of companies in general. To begin with, status quo valuation should be calculated or so-called "stand-alone" valuation, where only the target com- pany is valuated with existing investing, financial, and dividend policies. This status quo valuation builds the base value of the transaction price, in which future control, operat- ing, and financial premiums are added. To calculate the status quo value for the target company, there are three commonly used methods; the discounted cash flow method, the method of multiples, and the asset valuation method (Damodaran, 2002). 33 The discounted cash flow (DCF) method estimates the company's intrinsic value based on its fundamentals. The DCF model is built by discounting the future cash flows of the company, and its strength underlies counting in the company-specific information. The weakness of the DCF model is that the model cannot effectively value non-profitable companies or private companies with short historical data (Damodaran, 2002). Despite DCF method is highly common among practitioners, it can introduce challenges in valu- ing newly established R&D-intensive targets, as these investments have not yet pro- gressed to generate growing future cash flow for the company. Furthermore, even if the R&D investments are taken into account in the expected future cash flows, it is challenge to define the actual increasing effect of the R&D investments on these future cash flows. The method of multiples compares the relations of common variables of the company, such as price/earnings, price/book, and price/sales ratio, to its competitors. The method's strength is to disclose which company is potentially under or overvalued com- pared to its competitors in different market situations. Even if the model can identify a relatively undervalued company, the weakness of the model is its inability to recognize the valuation of the market in general (Damodaran, 2002). The efficacy of the method of multiples lies in its ability to interpret whether a target’s R&D investments are valued more favorably than those of its counterparts within a set of comparison companies. When the financial metrics of two companies are aligning closely, the method of multi- ples can be used to reveal the market perception regarding a specific target’s potential to leverage its R&D investments more efficiently than its competitors in the future. Finally, the asset valuation method accepts that the value of the asset can be greater than the present value of the expected cash flows on the occurrence or nonoccurrence of an event. The asset valuation method is generally used to evaluate options but can also be used to evaluate "optionlike" assets. For example, the method will help evaluate smaller innovative companies with intangible assets whose value is not yet realized in the balance sheet (Damodaran, 2002). In other words, when the probability of generat- ing future cash flows from the target’s R&D investments depends highly on other 34 developments in the market, if investors expect such developments to occur, it is apt to indirectly increase the valuation of these R&D investments. 2.5.2 Valuation of synergy Calculating the status quo value of a target company is a relatively straightforward pro- cess, yet complexity increases when future deal synergies are estimated. Calculating syn- ergies holds certain risks, as synergies can occur in a different size or period than ex- pected. All these changing factors must be considered in valuation and discount the es- timated future earnings. Prior literature does not have a consensus on whether the val- uation of synergies is too complex a process to operate. However, possible guidelines are found if visible synergies can be transferred into financial numbers. Arzac (2005) sug- gests calculating sensitivity, scenario analyses, and estimating the probabilities for dif- ferent scenarios. Valuating synergies more comprehensively, sensitivity analysis should always be calculated as estimates of the worst, neutral and best-case scenarios. Table 2. The M&A valuation model developed by the author, influence by Damodaran (2002) and Arzac (2005). The table presents positive NPV investment. 35 The table 1 states that transaction price should always be between “status quo“ and “status quo + total synergies” (Arzac, 2005). The difference between the “status quo + total synergies” of the strategic and financial buyer is that only the control premium mat- ters for financial buyers. Big investors, private equity, and venture capital companies are willing to pay large premiums over the market price to control the companies because they assume they can manage the company more efficiently compared to current man- agement. Rationally, control synergy is greater for an inefficiently managed company, and a hypothetically “perfectly” managed company should have zero control synergy. Interestingly, Dutordoir (2010) studies the period of 1995-2008 and finds that 54 percent of M&A premium payments exceed the estimated synergies. These M&A transactions achieve so-called negative net present value (NPV). If the investment generates higher returns than its costs, it receives a positive NPV. Thus, M&As significantly impact a com- pany and its shareholders, and management should only accept the M&As that generate higher returns than shareholders could earn themselves (Brealey, 2011). An example of positive NPV investment is demonstrated in the table 2. It is imperative to highlight from Dutordoir (2010) that it does not take a stand on what is the quantum of premium paid in the M&A per se. What holds greater centrality is the acquirer’s deliberate or inadvertent willingness to opt for a decision wherein it commits to pay a premium for the target exceeding the expected synergies. In other words, the relatively high premium payment does not exclusively signal a decline in the value of the acquiring company’s shareholder, expected that the synergy benefits from the target company is greater than the premium. 2.5.3 M&A value creation Companies create value for their owners by investing cash now to generate more cash in the future. The amount of value created is the difference between investments made and future cash inflows, which are adjusted by the discount rate and riskiness of future 36 cash flows. The company’s return on invested capital (ROIC), revenue growth, and ability to sustain both over time determine future cash flows of the company and ultimately drive value creation for the owners. Although, earnings and cashflows are regularly cor- related, too heavy concentration on earnings often leads companies astray (Koller et al., 2011). These doctrines in question are not only limited to companies’ internal invest- ments, but to all engaged investments, including M&As. Figure 2. Growth and ROIC drive value (Koller et al., 2011) Growth, ROIC, and cash flows are tightly linked. For any level of growth, value always increases with improvements in ROIC. However, the matter is different with growth. When ROIC is high, faster growth increases value, but when ROIC is low, faster growth decreases the value. The ultimate creation or destruction of value is determined by whether the return on capital is greater or less than the company's cost of capital (Koller et al., 2011). Understanding the impact of a company's ROIC, revenue growth, cash flows, and cost of capital on the company's value strongly influence value creation calculations such as net present value (NPV) and discounted cash flow (DCF) model. For example, when management is aware of the company's ability to create value as a result of the M&A deal, it can use varying valuation techniques to define the threshold value for pre- mium payment and avoid the destruction of shareholder value. According to a highly recognizable phrase referring to the time value of money, a dollar today is worth more than a dollar tomorrow. Practitioners’ most used investment criteria to optimize the time value of money are net present value (NPV), internal rate of return 37 (IRR), and the payback rule (Dai et al., 2022). NPV calculates the present value of the cash flows generated by the investment and divides them by the cost of the investment, i.e., the applied discount rate. Therefore, the investment with the highest positive NPV should be accepted. One of the core advantages of the NPV method is its ability to in- clude most of the risks and costs inside the calculations. However, NPV can face difficul- ties due to future uncertainties and recognizing the required time for obtaining the esti- mated cash inflows. IRR is the discount rate that produces zero NPV for the investment. The most relatively profitable investment should be accepted, and the rate of return should be higher than the company’s opportunity cost of capital. If the IRR is lower than the discount rate, the investment generates a negative NPV and should not be accepted. As NPVs do, IRR does not consider the size of the investment, and generally, IRR prefers short-term invest- ments over long-term investments. Lastly, the payback rule measures how long investors need to wait until the investment covers its initial costs. The company sets a cutoff date for the investment to cover its expenses. Applying the payback rule further, the discount payback period discounts future cash flows to present value and compares whether the NPV is positive before the cutoff date (Dai et al., 2022). According to a Finnish-based study by Wang (2021), in 1984, 57.7 percent of companies considered IRR as the primary indicator, while only 2.5 percent utilized NPV. By 2004, IRR was still the leading indicator, but 52.1 percent of analyzed publicly listed companies reported NPV to be either their primary or secondary decision rule for investment. Kang et al. (2018) investigates how firm’s methods for evaluating M&As are influenced by two socio-political determinants identified in the behavioral theory of the firm. Au- thors analyses the roles of uncertainty and controversy in influencing valuation tech- niques such as net present value (NPV), internal rate of return (IRR), valuation multiples, leveraged buy-out (LBO) valuations, and relative valuations like EBITDA multiples. The results indicate that the higher uncertainty around the target firm enhance focused fi- nancial analysis, while controversy drives decision-makers to prioritize the role of 38 negotiation and coalition-building to achieve their M&A objectives. Authors identifies four distinct M&A valuation approaches, which can be utilized under varying uncertainty and controversy levels. Moreover, desktop valuation emphasizes traditional financial analysis, capability design incorporates scenario planning and goal-setting, issue list flags potential conflicting objectives, and finally storytelling aims to create persuasive narra- tives for the transaction. Especially when the have high R&D intensity, the ability of fi- nancial advisors to yield higher premiums in emphasized through scenario planning and attractive story telling. A financial economist can be prone to under-emphasize the ben- efits of incorporating behavioral explanations in activities such as M&A assessment, and scholars with higher organizational focus underestimate the role of financial analysis. Valuation models can be used as guidance and provide a benchmark for acquisition pric- ing. However, from time to time only part of the premium can be calculated and justified using valuation models. It is necessary to recognize that intangible and, in some cases, emotional factors will significantly influence the final price (Thomas, 2016). 2.6 Competition law in Europe Before delving into the investigation of R&D as a proxy for target innovativeness, this thesis scrutinizes the pertinent legislative environment that impacts M&A transactions within the Europe. The primary emphasis in the examination of relevant legislation does not include precise rule or article-based legal interpretation, rather it aims to enhance comprehension of the mechanism that both prohibit and facilitate the initiation of M&A transactions within the Europe. Investigating the relevant legislation is important, as it limits the emergence of M&As that could be successfully rationalized on financial grounds. As R&D-intensive firms often operate in sectors with significant innovation and technology, they can experience heightened regulatory reviews to ensure that proposed M&A do not unduly limit competition or stifle innovation. In the EU, the main legal instrument for the merger control of concentrations between undertakings is the Council Regulation (EC) No 139/2004. It establishes the European 39 Commission as the authority responsible for reviewing and approving or prohibiting M&As that have a significant impact on competition within the EU. In addition, the EU’s antitrust rules including the Articles 101 and 102 of the Treaty on the Functioning of the European Union (TFEU) apply to M&As. TFEU Article 101 prohibits agreements, decisions, and practices that may harm compe- tition in the EU internal market, including price-fixing and market sharing-practices. Yet, exceptions exist for agreements that contribute to economic progress, benefit consum- ers, and do not impose unnecessary restrictions on competition. In practical terms, while a M&A between two R&D-intensive technology firms might typically raise concerns about restricting competition, it could be permissible under TFEU Article 101 if the M&A ensures consumers receive a fair share of the resulting benefits. In contrast, TFEU Article 102 prohibits the abuse of a dominant market position within the EU internal market or a substantial part of it if it may impact trade between member states. More specifically, the abuse of a dominant market position includes actions as imposing unfair prices, limiting production or markets to harm customers, applying un- equal conditions to similar transactions, and requiring unrelated supplementary obliga- tions for contract acceptance. While a M&A deal may be initially permitted under TFEU Article 101, it could later be prohibited under TFEU Article 102 if the merger entity en- gages in abusive practices that harm competition and consumers through its dominant market position. 40 3 Innovation through R&D As this thesis aims to contribute updated findings for the relationship between R&D in- tensity and M&A premiums in public technology companies in Europe from 2000 to 2022, it is important to investigate the strategies employed by firms to enhance their innova- tiveness through R&D. Section 3.1 examines what is innovation and why is it important. Section 3.1.1 investigates innovation from the perspective of innovation input and out- put. Section 3.1.2 Briefly deepens the understanding of historical and current innovation waves. Relevant for the scope of this thesis, section 3.1.3 examines the development and factors affecting the innovation in the Europe. Finally, section 3.2 rationalizes the utilization of R&D as a proxy for company’s innovativeness. 3.1 Innovation In the dynamic landscape of business, innovation stands as a pivotal force, enhancing competitive advantage and increasing sustainable growth. Yet, prior literature lacks sin- gular, universally accepted definition for innovation. Furthermore, this reflects the mul- tifaceted nature of innovation, suggesting not only technological possibilities but also novel approaches to processes, products, services, and business models. As this thesis delves into the essence of innovation, it becomes increasingly evident that comprehend- ing and leveraging innovation are paramount for businesses navigating in continually evolving competitive markets. An article authored by McKinsey and Company (2022) posits that innovation is a system- atic practice involving the development and marketing of breakthrough products and services for adoption by customers. The survey within the article reveals that despite over 80 percent of executives ranking innovativeness among their firm’s top three prior- ities, less than 10 percent express satisfaction with their actual innovative performance. While high proportion of companies seek to be innovative, McKinsey and Company in- vestigated assessing the innovation proficiency of 183 companies, comparing it against a proprietary database of economic profit, where economic profit is calculated as the 41 total profit minus the cost of capital. The results emphasize the significance of innova- tiveness, indicating that successful innovation yield economic profits 2.4 times higher than those achieved by other companies. 3.1.1 Innovation input and output Innovation is a fundamental factor for the growth and development of an individual com- pany, further accelerating the economic growth of the specific area. However, the thesis leads to the question that if the innovativeness of companies is highly valued, how should innovation be invested or how should it be quantified. Kijek et al. (2010) suggest that in order to increase the innovation performance, the firm must be efficient in trans- forming the innovation inputs into innovation outputs. Consequently, authors recognize the importance of innovation efficiency as a part of firm’s innovation policy and conduct canonical correlation analysis to investigate the innovation input and output relationship in the group of 22 EU member states. In the light of Rose et al. (2009), Kijek et al. (2010) present that innovation metrics are evolving through four generations. Firstly, the most dominant generation metric for in- novation is a linear concept of innovation focusing on inputs as R&D investments. R&D expenditures are crucial for creating a formal process to further create value-adding knowledge within the firm, but the use of R&D as an input does not exhaustively identify all forms of innovation. Key disadvantages are that R&D does not reflect the actual out- put efficiency and R&D strategies can vary based on the firm’s strategy or sector. There- fore, accounting firm’s science and technology (S&T) activities and highly skilled human resources is highly recognized method to proxy innovation more effectively. The ra- tionale for identifying human capital as a company’s input is based on the fact that com- panies can use human capital to develop new communication and information technol- ogies and methods in ways, which are not reflected in accounting R&D expenses per se. For the outputs, the third-generation metrics gives emphasis to a more comprehensive away of innovation indicators and indexes derived from surveys and the amalgamation 42 of publicly accessible data sources. Additionally, fourth generation metric is based on a knowledge-based networked economy, what has its own ad hoc nature and are the sub- ject of measurement. While these relatively discretionary used output data sources sup- port to deepen the knowledge of the company’s level of innovation, the most frequently implemented output evaluation method in prior literature is patent counts. The strength of investigating patents is the information access to public data sources, what guarantees a relatively robust continuity for research. On the other hand, there are major differ- ences between patents in terms of their actual business value, and a significant propor- tion of innovation do not result in patent protection. Authors conclude that the most pertinent gauge of the commercial success of innovation lies in the proportion of overall revenue attributable to novel and substantially enhanced products (Kijek et al., 2010). 3.1.2 Innovation waves Investigating innovation waves in the light of technology-based M&As is crucial due to their pivotal role in shaping organizational trajectories amidst evolving competitive land- scapes. Across centuries, firms have navigated diverse development paths influenced by shifts in competitive environments and their responses. A brief examination of these economic transformations facilitates an understanding of the intricate interplay between innovation and the economy, particularly in delineating the reliability of research results across distinct phases of innovation waves. In practice, the discernible presence of an innovation wave within the economic landscape increases a rationale wherein firms ex- hibit willingness to offer higher premiums to align themselves with the forefront of in- novation, further developing their competitive edge in the market. On the other hand, it is justified to argue that if there were no clear macroeconomic innovation wave in the market, firm’s R&D investments would increasingly focus on company-specific objects, rather than directions of general macroeconomic innovation. The figure by Hargroves and Smith (2005) provides a significant illustration of historical innovation waves, offering insights into the evolutionary trajectory of varying innovation trends in the market landscape. The development of innovation has continued ever since 43 the first industrial revolution in the 19th century, and it can interpret that innovation waves are emerging more and more dynamically. Of particular relevance to this thesis is the fifth wave, characterized by pivotal breakthroughs in technological investments, sig- nifying a paradigmatic shift in organizational strategies and competitive dynamics. Figure 3. Drivers for long-term innovation (Hargroves et al., 2005). Currently, the focus of contemporary discourse gravitates toward the sixth wave of inno- vation. The sixth wave is characterized by pronounced emphasis on sustainability devel- opment and fostering enduring growth. As firms increasingly prioritize environmental and social factors in their decision-making, technology-intensive M&As plays a significant role in driving sustainability-driven innovation. These transactions enable firms to access competitive technologies and expertise, further facilitating the development and imple- mentation of sustainable solutions. The pursuit of sustainable growth objectives can serve as a catalyst for strategic collaborations and partnerships within the technology sector, fostering synergies and enhancing competitive edge in the dynamic marketplace. 44 3.1.3 Innovation in Europe Within the context of this thesis, it is crucial to briefly investigate the evolutionary tra- jectory of innovation within the European Economic Area (EEA), discerning pivotal trends inherent to its development. The European innovation scoreboard (2023) authored by European commission suggest that bold policies and increased investments towards R&D are necessary to contribute to the success of Europe’s digital and green transfor- mation. The scoreboard suggests that Europe favorable environment for innovation in- vestments, and the innovation performance in Europe is increased 8,5 percent between 2016 to 2023. The main external factors impacting on innovation performance in Europe includes Russian invasion, the resulting energy crises, and the high inflation period. In addition, the analysis of Covid-19 shows that the pandemic has a negative impact on innovation expenditures, innovative sales, and venture capital expenditures since 2020. The European innovation scoreboard (2023) shows that South Korea is the most innova- tive country in the world. Additionally, Australia, Canada, and the U.S. have an innovation performance lead over the EU. Compared to 2016, performance for the EU has improved most in SME innovators due to strong performance in product and business process de- velopment. Additionally, the linkages and collaboration efforts between innovating firms has strong increase, further suggesting solid M&A market. Also, there is a solid increase trend in government support for business R&D. The performance for the EU declined most in human resources due to strong decline in doctoral graduates and intellectual assets due to a decline in both patent applications and design applications. These find- ings support the use of R&D as a proxy for innovation, instead of innovation outputs such as patents and design applications. Interestingly, 2021 data shows that even R&D ex- penditures in the business sector increased 6.3 percent in EU, the GDP has increased stronger with 7,7 percent, suggesting a decline in R&D intensity for the EU. The score- board indicate that large enterprises account for almost 80 percent of EU business R&D expenditures. 45 3.2 R&D as a proxy for innovation To continue Laamanen (2007) seminal work, this thesis uses firm’s R&D expenditures to capture the relationship between the target firm’s innovativene actions and the M&A premium paid. Although R&D expenditures do not cover all forms of innovation in the company, the prior literature suggest R&D as the main indicator of innovation input. In addition, under IRFS, GAAP and other relevant accounting principles, firms are obligated to account the necessary yearly R&D expenditures as incurred, which ensures the conti- nuity of future research of the same quality. Based on the European innovation scorecard (2023), European industries characterized by medium-high and high technological intensities exhibit increased levels of R&D ex- penditure, alongside a heightened propensity for patent applications and a greater prev- alence of innovative firms. The presence of increased levels of R&D further bolsters the robustness of the study findings, underlining the significance of R&D expenditure as a pivotal determinant in investigating the dynamics within the context of technological M&As. 46 4 Theoretical framework Following an exploration of the M&A process and business innovativeness, it is pertinent to delve into the theoretical framework that prior literature has examined concerning M&A and R&D. Firstly, this chapter investigates the leading neoclassical theory of M&A and emerging behavioral theories that also offers insight into the rationale behind the substantial premiums associated with M&A transactions. Additionally, the chapter briefly investigates relevant macroeconomic theories, which are particularly relevant to cross-border M&A activities and R&D endeavors. Furthermore, this chapter addresses the motivations underlying the acquisition of R&D assets both prior to and following M&A transactions, further deepening the understanding the relationships between M&A activities and R&D investments. 4.1 Neoclassical theory The neoclassical theory presents M&A as a synergy-driven investment in which the value of the combined company is higher than the value of independent companies. Similarly, the value creation theory is one of the earliest theories to explain why companies seek M&A transactions. At its core, two separate companies can achieve more than they could themselves, referring to synergy creation with the “1 + 1 > 2” formula (Zhang, 2019). The neoclassical theory is strongly based on the synergy hypothesis by Bradley, Desai, and Kim (1988), which explains the emergence of M&As with operational syner- gies, economies of scale, and benefits in the form of economic scope. Combining two separate companies makes it possible to achieve advantages that are not possible to attain as individual companies. With the greater turbulence of the economic environment, neoclassical theory suggests that companies have more incentive to pur- sue M&A, which enables the company to adapt more quickly compared to internal or- ganic growth (Ahern et al., 2007). In line with neoclassical theory, Damodaran (2005) states that synergy is the additional value generated by combining two companies, cre- ating opportunities that would not be available to these companies operating 47 independently. Synergies can be categorized mainly into two separate groups operating and financial synergies. Damodaran suggests synergies are the most widely used and misused rationalizer in M&As. Operating synergies allow a company to increase its operating income from existing as- sets and increase growth. Operating synergies are created with economies of scale, higher pricing power, a combination of different functional strengths, and higher growth in a new or existing market. Generally, economies of scale and higher pricing power oc- cur after horizontal M&A due to a reduced competition environment and the higher market share of the combined company. Using combined competition advantages, shared distribution network, and prior brand name recognition, the new company can pursue new market opportunities, which it could not achieve before the M&A (Damo- daran, 2005). Financial synergies produce higher cash flows and a lower cost of capital. Financial syn- ergies can occur in the form of increased debt capacity, tax benefits, diversification, and higher efficiency of capital spending. If a company with high-return projects (with limited cash) and excess cash (with limited project opportunities) company pursues M&A, the combined company can expect to yield higher-value projects. Value creation occurs when excess cash can be invested in new high-returning projects, and the future cash flows of the combined company can become more stable and predictable, which creates higher debt capacity. In addition, the profitable company can create tax benefits if it ac- quires a money-losing company, as the acquiring company can use the net operating losses of the latter to reduce its tax burden. Finally, there can be potential diversification benefits for some private or closely held companies. In the sample of 264 large mergers, a “value line” forecasts average M&A synergy gains to be 10.03 percent for the combined equity of the merging company. The estimates show that only 1.64 percent in additional value is from financial synergies, and the rest, 8.38 percent, is from operating synergies. This distribution is explained by those 48 operating synergies that arise in higher-focused mergers, while tax savings contribute a significant fraction of the gains in diversifying mergers. The main driver for operational synergies is cutbacks in investment expenditures rather than increasing the company’s operating profits (Devos, 2010). Also, Damodaran (2005) suggests that cost-saving mer- gers are more likely to deliver estimated synergies than mergers were estimated syner- gies weights toward growth synergies. Prior literature also recognizes strategic and managerial synergies. Strategic synergies are the additional real options a target company brings to a new combined company. The company's value includes both cash flows and strategic capital, such as intellectual and human capital, that includes plans and the “know-how” of turning these plans prof- itable. These new real options can be seen as “the new possibilities to create synergies” in the future and can take a long period to emerge (Collan et al., 2009). Moreover, man- agerial synergies can be generated by acquiring a target company with inefficient man- agement performance. The objective of the acquiring company is to discipline the inef- ficient management of the target company and renovate non-value- maximizing opera- tional strategies (Martin et al., 1991). To summarize, as neoclassical theory presents M&A as a synergy-driven phenomenon, there can be various ways to create excess value by combining two companies. Synergies occur mainly as operating and financial synergies, and operational synergies are shown to generate the highest proportion of the excess value. Nonetheless, the more critical issue relates to evaluating this potential synergy and determining how much to pay for the synergy (Damodaran, 2005). 4.2 Sell-side motives Both acquiring and selling sides can approach the M&A transaction. Motivations to sell the company may have been long-lasting when management has done an exact plan and preparation on maximizing the future transaction's value. A company can also face a sudden, surprising change in competitive or financial factors, which motivates the 49 owners to sell the company in fast phase. The most common personal level reasons are the death or illness of an owner, retirement, a partner "cashes out" due to dispute or divorce, or incompetence to lead the business further. In addition, reasons can be stra- tegic level reasons such as relocation of the business, company or whole management being ready to move towards different opportunities, insufficient diversification of own- ership, or the company being undercapitalized and needing funding to achieve the next strategic step (Sherman, A., and Hart, M. 2006). The main objective of a selling process is preparation, regardless of the motivations that led to selling. The selling company needs to identify the financial and structural goals of the transaction, make a coherent selling plan, and understand the dynamics of the selling process with potential buyers. Same time as the seller prepares information considering past operating performance and valuable assets, it is important to turn the stones to reveal possible "transaction turnoffs," such as potential legal or financial obstacles. Fi- nally, after drafting an offering memorandum, processing corporate housekeeping mat- ters, and planning of transparent communication manner with buyers, the seller is ready for the M&A process (Sherman, A., and Hart, M. 2006). Similarly, as in the acquisition process, higher quality preparation of the target indicates a higher probability of attract- ing better buyers and creates a possibility for higher value creation in the selling process. 4.3 Behavioral theories Financial theories present that the goal of the company is to maximize its shareholder value. Nonetheless, managers can have individual drivers and motivation to pursue M&A transactions, even if the transaction would not benefit the shareholders. Asaoka (2019) finds that the human errors and biases of the managers often result in failure and impairment loss, leading to a risk of overvaluation of the target company. By under- standing the role of emotion and psychology, more effective decision-making can be secured in M&A transactions, leading to higher value creation for the acquiring compa- ny's shareholders. 50 4.3.1 Winner’s curse and managerial hubris Ahern and Weston (2007) present the winners' curse theory, as many bidders around a highly uncertain target company, causing a wide range of bids. As a result, the highest bid rationally wins, which frequently causes the winner to overpay in relation to the fair value of the target company. The winning bidder is "cursed" in the sense of the over- payment. Roll (1986) presents the empirical evidence supported by psychologists that individuals do not always produce rational choices in an uncertain environment, and the overcon- fidence and arrogance of the managers are remarkable motivators for engaging the deal through. The winner's curse theory is linked closely with the managerial hubris theory because many acquisitions are motivated by the managers' mistakes and pursued with- out future synergy gains (Berkovitch et al., 1993). In addition, Roll (1986) suggests that some managers have only a few or fewer possibilities to engage in M&A in their whole career, which can motivate them to convince themselves that the valuation is correct, and the market does not fully reflect the total economic value of the combined com- pany. Winner's curse and managerial hubris theories have a long history in the literature on M&A auctions and are undeniably one of the biggest motivators to pursue the M&A transaction. 4.3.2 Agency theory The agency theory, also known as the principal-agent problem, is an interest conflict between the principal (shareholder) and agents (managers) (Ross et al., 2010). As a re- sult of the conflict, two types of agency costs are born, indirect and direct agency costs. Indirect agency cost reflects, for example, a situation where shareholders want manag- ers to pursue profitable M&A, but managers do not use the opportunity. Direct agency cost can take two forms, the first being corporate expenditure, which benefits managers at the cost of the shareholders. Second, agency costs are expenses from monitoring management actions. Jensen and Meckling (1976) investigate that in some situations, it will pay the agent to expend resources which will gua