Unintended Consequence in a Blanket M&A Rule
The FTC hearings are shining a spotlight on our current competition enforcement regime, finding both challenges and opportunities. As the FTC continues its self-examination, many are looking for the “low hanging fruit” of policy changes that can have an immediate positive impact. One suggestion that some have rallied around are adopting a bright-line bar or at least moratorium of mergers and acquisitions (“M&A”) involving a large tech company buying a startup. The stated goal of such policy, preventing tech companies from removing sources of future competition, has some merit. But several participants in the FTC hearings, including venture capital funders, have identified significant risks in such an approach to achieve that goal.
The simple explanation that tech firms engage in acquisitions to protect themselves from future competition might not accurately explain what is happening in tech M&A activity. A closer look is necessary, especially before adopting broad bright-line rules. In his book “Economics for the Common Good”, Nobel Prize-winning economist Jean Tirole points to economics as being a useful tool for identifying the unintended consequences of seemingly useful policies. Tirole explains that we often look at the direct effects of a policy and stop there, “[y]et secondary or indirect effects can easily make a well-intentioned policy toxic.” It is these same indirect effects that we must consider when discussing bright line M&A rules in the tech industry.
While there may indeed be some defensive acquisitions in the tech industry, a risk not exclusive to tech, there are also significant benefits that could be lost in a blanket rule. The concerns about bright-line bar to tech M&A falls roughly into four categories:
- M&A provides incentives for innovators to form startups and venture capital to fund them.
- Bigger tech companies have the expertise and technology that startups might need to be viable long term.
- Some startups might not by long-term viable on their own.
- Startups may need new management to successfully transition into later stages of a company’s growth cycle.
This post will explain each in turn.
Incentives to Start and Fund a Startup
There have been some recent changes in the way venture capital invests in tech startups. Evidence suggests that the number of deals is down but the amount invested is up. Additionally, investments are coming later in the life of a startup. Matt Schruers wrote about this evidence and conflicting conclusions that have been drawn from it. However, one thing that was made clear at the FTC hearings is that some venture capital funders rely on M&A and initial public offerings in order to justify their investments. Scott Kupor, from venture capital firm Andreessen Horowitz, said that bigger companies purchasing startups is helpful to the startup community because it provides an exit ramp for venture capital funding and allows them to recycle investments.
Professor Daniel Sokol examined this in his recent paper “Vertical Mergers and Entrepreneurial Exit.” Sokol examined empirical scholarship in the strategic management literature, and found that exit through M&A is critical for both founders and funders. The expected reward for most venture capital funds and some founders is found in scaling a venture to exit. This exit is increasingly an M&A event due to initial public stock offerings trending down since the passage of the Sarbanes Oxley Act.
The Need For Big Problem Solvers
Professor Steven Tadelis explained another issue at a recent FTC panel: being a startup is risky. Tadelis stated that the most common reasons for startup failure is bad product, insufficient funding, or poor execution. Tadelis stated that more startups fail to poor execution than you would think, and that acquisitions by established firms can really help with this. Sokol states this another way: startups tend to be better than established firms in innovation due to increased bureaucracy but larger firms are better at process innovation. This means that an established firm may have a better chance of executing an idea than the startup would.
One example of this may be Pebble, a pioneering smartwatch startup that pushed the development of smartwatch technology. Pebble was the first to market and proved consumer interest in smartwatch products, but ran into many problems while trying to establish themselves as a hardware company. Sources said that Pebble had problems paying suppliers, had insufficient funding, faced a smaller market than predicted, and had trouble competing once new products entered. Pebble tried to find a buyer, but it was too late. The company was ultimately acquired by Fitbit at fire sale prices.
At a recent FTC panel, Sokol stated that the field of management science examined the Facebook/Instagram deal and found it to be an example of the opposite. Their conclusions were that Facebook played a significant role in growing Instagram to the company that it is today. This success may not have been realized without the support of an established company that knew how to take a social media company to profitability.
The Troubles With Monetizing a Startup
A related problem to the need for big problem solvers is the need for a startup to eventually make money. Tech companies have been known for following an “eyeballs first, monetize later” strategy that relies on continual investment and debt to pay bills while growing. The slower a company is to monetize, the more wary investors and lenders get in continuing to provide the necessary funds. In many cases, a big-pocketed acquirer is needed to not only make good on debts and expenses, but to also provide the ability to turn a profit. This can be done by making the acquired product into a feature that increases the profitability of an existing platform, or by providing the know-how and technologies needed to develop a successful monetization strategy.
Google’s acquisition of YouTube may be an example of this. YouTube was a fast growing company when Google acquired it in 2006, but it was not earning enough to justify its huge expenses and it had substantial legal risks on top of that. This was a tricky problem because YouTube requires significant computer processing and internet bandwidth to serve its customers. Meanwhile, no one had really tackled the problem of monetizing such diverse content (both in quality and length) for streaming over the internet. Google is still working on monetization strategies to this day, and there have been mixed reports on when (if ever) YouTube achieved profitability. However, what is certain is that the acquisition not only let YouTube continue to pay its bills, access to Google’s technology and monetization know-how has been instrumental in developing YouTube into what it is today.
The Importance of Management
Studies have found a positive correlation between replacing startup founders with experienced executives and performance. While this need not be done through M&A activity, founder replacement is an additional benefit of acquisition. The cause of this increased performance is not clear in the empirical research, but there are theories.
Startup founders are not always the right people to manage a company as it transitions into maturity. Founding a company rewards a set certain set of skills — like risk-taking, quick pivoting of strategies, and rapid innovation — that are not necessarily appropriate for managing a company that has reached maturity. There are also personalities and corporate cultures that are better suited to young scrappy companies than companies that need to assure stockholders of continued stability. It’s not hard to think of large personalities that are better suited for the excitement of serial startup creation rather than settling in to the necessary tedium of corporate management. Ironically, the same characteristic that makes disruptive innovation difficult for larger companies is often what is necessary to carry a company past its startup phase — bureaucracy.
There is, of course, another possibility not covered in this post: that a particular nascent firm could grow into a true challenger to today’s platforms. Sorting these companies from those that will eventually need an acquirer to make good on their innovations will be a challenge for our antitrust enforcement agencies. Hopefully the current hearings will provide insight on what evidence is important in distinguishing the two. However, it is incorrect to present a bright-line rule barring tech M&A as a low-risk way to take immediate action. Such intervention could harm innovation and even competition. We will need to dig in further in our future debates to identify more suitable policies that can reduce harms in under-enforcement without creating avoidable harms in over-enforcement.