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Entrepreneurial Efficiencies and Vertical Mergers: Q&A with Prof. D. Daniel Sokol

· August 1, 2018

According to D. Daniel Sokol, Professor of Law at the University of Florida College of Law and Senior Of Counsel at Wilson Sonsini Goodrich & Rosati, an overly strong negative inference on the competitive effects surrounding vertical mergers can stifle innovation and business formation in startup companies.

In his latest paper, Professor Sokol provides a general overview of how procompetitive vertical merger policies are beneficial in enforcing the role of antitrust policy and promoting competition and innovation. This paper also explores how an effective vertical merger policy can support entrepreneurial exit for founders and venture capitalists.

DisCo spoke with Professor Sokol to discuss the paper, and we summarize that conversation in this blog post. We recommend reading his full paper (available here) for more detail on the topics we discussed in our Q&A session.

DisCo: Should regulators view vertical merger policy as the only factor or one of a series of factors that could lead to a chilling effect in entrepreneurial behavior?

Sokol: Antitrust is one of a number of factors that can support or harm entrepreneurship.  Other issues include access to: capital, high skilled workers (including immigrants), an entrepreneurial ecosystem, and other factors such as tax and regulatory policies.  However, antitrust law, particularly with regard to a vertical acquisition of a startup firm by a larger tech firm (e.g., pharma, devices, online platform, hardware, financial services), impacts the ability of founders and entrepreneurs to exit the market.  IPOs are infrequent compared to the late 1990s. As such, vertical acquisition is the typical exit strategy. Many business models are specifically built with this sort of exit in mind.

Antitrust enforcement against vertical mergers except in clear instances of anti-competitive harm threatens the primary form of exit by founders and entrepreneurs and their ability to reap the rewards of a successful investment.  The overall empirical literature across fields suggests that most vertical mergers are pro-competitive and the presumptions regarding anti-competitive harm are (and should be) different than cases of horizontal mergers, where harm is more likely.  Unfortunately, there are some populists who would abandon economic effects and decide merger policy based on other indeterminate factors. Such an alternative approach would threaten entrepreneurship and innovation.

DisCo: In your view, how should a court determine when to intervene in vertical mergers? What facts justify intervention? What other factors should the court consider besides the economic factors?

Sokol: Let me be clear – courts should only look to economic factors specific to the particular case in before them.  Nothing else matters. Because of a paucity of vertical merger cases, there is not much guidance. Worse, the DOJ Non-Horizontal Merger Guidelines (1984) have never been withdrawn.  The Guidelines and the assumptions therein are relics of an earlier era and neither reflect current practice nor the direction in which law should change.  Regardless of what one thinks of the merits of the AT&T case, it is terrible that Judge Leon cited to these Guidelines as authority for his opinion.

In many ways, this question misses the point.  It is very rare that a vertical merger case will be litigated.  Most of the action is before the antitrust agencies. Most vertical mergers present no competitive concerns.  A smaller number may reflect some concern but these concerns often can be addressed through a consent. It is a very rare case where a vertical merger will be challenged in court.  Indeed, AT&T was the first vertical merger challenge in decades.  This is not by accident.

DisCo: When forming a ruleset to govern vertical mergers where should those rules come from? Would the FTC be better suited to form those rules (if they were granted rulemaking authority) or should it be left to Congress?

Sokol: Currently, the rules of the game are mostly informal and based on practice by repeat players before the agency.  Some additional formal guidance (potentially including Guidelines) offers more transparency and improves business decision-making by firms.  Much of the justification in Section 1 of the 2010 Horizontal Merger Guidelines are equally applicable to the vertical context, which “describe the principal analytical techniques and the main types of evidence on which the Agencies usually rely”.

DisCo: In the paper you mention that large firms tend to become less innovative in product innovation once they reach a certain size and level of complexity, and need to acquire smaller firms in order to stay competitive. Can you provide more detail on why it is necessary for them to acquire smaller firms, and how these acquisitions could benefit the incentives for new players to innovate?

Sokol: Nobel Laureate and antitrust economist [Oliver E.] Williamson was one of the first (although origins go back as far potentially to the 1920s and [Univ. of Chicago Prof. Frank] Knight) to introduce the idea of diseconomies of scale.  One aspect to that concept is that large organizations become bureaucratic.  The start-up culture of fast paced innovation becomes more difficult in such circumstances.  Decision-making is also slower in large organizations, as anyone in a multi-national company, law firm or economics consulting firm knows firsthand (one need not be a techie or a university professor to understand how frustrating bureaucracy can be).  However, larger firms have some advantages. One such advantage is that they are very good at process innovation.

There are a number of industries where acquisition of vertical firms has been fundamental to growth strategy.  In pharma and devices, one might argue that Pfizer and Medtronic are nothing other than private equity shops that happen to have a good supply chain, distribution system and marketing team.  Similarly firms like 3M, Microsoft, Cisco, Intel, Apple, Oracle, PayPal, Google, Alibaba, Tencent, Facebook, and Amazon are constantly looking for startups to acquire to help them develop their next big breakthrough.  Sometimes the collaboration is short of merger. However, there are circumstances in which a merger is necessary to achieve the strongest efficiencies.

DisCo: To conclude, if readers only take away one observation from your paper about vertical mergers what would it be?

Sokol: We should be cautious about tinkering with vertical merger policy.  A system that changes the presumptions before agencies and courts that does not think through the competitive effects of vertical mergers threatens to create not merely bad antitrust policy but to harm the entrepreneurial ecosystem more broadly.

Competition

Some, if not all of society’s most useful innovations are the byproduct of competition. In fact, although it may sound counterintuitive, innovation often flourishes when an incumbent is threatened by a new entrant because the threat of losing users to the competition drives product improvement. The Internet and the products and companies it has enabled are no exception; companies need to constantly stay on their toes, as the next startup is ready to knock them down with a better product.