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The Race for Education Tech Heats Up

November 1, 2011: 8:59 AM ET

The education industry’s top firms are rushing to secure their future, even if it means partnering with a startup that it would have acquired outright in the past. The latest deal between Pearson and startup Knewton is a case in point.

By Scott Olster, editor, FORTUNE

FORTUNE — Selling out, cashing in and calling it a day seems to be many startup founders’ dream these days. And in a shaky market, who can really blame them?

New York-based Knewton is hanging tough. The online learning company announced on Tuesday that it is pairing up with Pearson to add its adaptive learning technology to all of the publisher’s online courses, starting with its college-level programs.

Instead of selling itself, Knewton has entered into an agreement with the industry giant, which might otherwise have been an acquirer. The deal is just the latest sign that some startups are holding their own with the industry’s heavyweights as the market for new educational technology heats up.

Knewton uses an algorithm to track how students learn, tailoring courses incrementally based on a student’s individual strengths and weaknesses. The system is intended to grow more intelligent as more students use it, much like Google’s (GOOG) search results.

Pearson’s close to 9 million college-age digital students will work within Knewton’s system, creating a massive amount of coveted data on how student learn online. Pearson will get semi-exclusive access to Knewton’s adaptive learning technology. And Knewton, which recently raised $33 million in venture capital funding in a round led by Pearson and Founders Fund, will get a share of proceeds based on the number of Pearson’s (PSO) online students. “Pearson is a network effect wrapped up in a bow,” says Jose Ferreira, Knewton’s founder and CEO.

Demand for online education is exploding. The global market for online learning at schools and businesses is expected to grow from $32.1 billion in 2010 to approximately $50 billion by 2015. And Pearson is far from the only player that’s fighting for a piece of that growth. News Corp (NWS) purchased a 90% stake in Brooklyn-based Wireless Generation for $360 million last November. Apollo Group (APOL) purchased Carnegie Learning Technology, an adaptive learning company, in a $75 million deal this past August. And companies like NBCUniversal and even Disney (DIS) have begun to dip their toes into the online learning business.

Pearson is certainly no stranger to buying the competition. It has completed six acquisitions this year so far, according to investment banking firm Berkery Noyes. The publisher acquired Baltimore-based virtual school provider Connections Education in a $400 million cash deal in September. And in January, the company acquired a $127 million 76% stake in TutorVista, an online learning startup based in Bangalore, India.

According to Berkery Noyes, there has been a total of $7.8 billion worth of mergers and acquisitions activity in the education industry so far this year, up from $6.3 billion for 2010. “There’s a bit of a land grab going on,” says Tucker. “Folks like Pearson are buying and investing in everything in sight because they are seeing legacy businesses disappear.”

It wasn’t always like this. Unlike journalism and music for example, education has been the one part of the media world that has, more or less, kept digital disruption at bay. The industry’s primary business partners — school systems and universities, the so-called formal market – are notoriously slow to change. Deeply entrenched business ties with the major publishing companies don’t hurt either.

Smaller firms have traditionally had a hard time making much impact. “Startups have historically not even tried to take on the formal market. It’s not that likely you are going to get a school district to work with you. It really limits growth,” Ferreira says.

That has begun to change as tablet computers make their way to classrooms and college campuses and as web-based education resources outside traditional textbook publishing become increasingly available. Now, the industry’s top firms are rushing to secure their future — even if it means partnering with a startup that it would have acquired outright in the past.

Why not create a similar product in-house? After all, Peason, which reported a total of $1.4 billion in free cash flow in 2010, already offers similar features in its widely used MyLab and Mastering software. “When you have a group like Knewton, focused on doing one thing and one thing well, it’s hard for Pearson to replicate,” says Greg Tobin, president of the higher education math division at Pearson Education. “You could say that we could do the same thing, but it sure as heck would take us a lot longer.”

That puts firms like Knewton in a good position to bargain. With major backing and a first tier partner, the question is whether Knewton can mobilize quickly enough to meet demand. “We are overwhelmed,” admits Knewton’s Ferreira. “We’re 70 people now and I think we’ll grow to 150, maybe 200 by the end of next year.”

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