In Silicon Valley, the most important thing to think about when starting a company is how you’re going to end it. The venture capital funding model that dominates the tech industry is focused on the “exit strategy”—the ways funders and founders can cash out their investment.
Today, that focus is preventing disruptive competition, cementing tech monopolies, driving companies to shelve innovations, and undermining the promise of Silicon Valley.
While in common lore the exit strategy is an initial public offering, in practice IPOs are increasingly rare. Most companies that succeed instead exit the market by merging with an existing firm. Venture capitalists and founders paid in stock don’t want to build a business for the long term. They want to cash out, preferably as soon as possible.
But public offerings increasingly take too long for venture capitalists to complete this change in ownership. Once one year faster than acquisitions, time to exit by IPO is now one to two years longer, per our research. Venture capitalists generally expect to make 12-20% year on the money they invest across all the startups they fund. The easiest way to do that is to sell the company.
Innovative startups are especially likely to be acquired by the dominant firm in the market, particularly when they are venture funded. Incumbents are the most eager and best able to understand how an upstart could eat their lunch—far before others can see the upstart’s value. Even assuming others see that value, incumbents are the most willing to pay for it, even if—perhaps especially if—they plan to shut the upstart down. The incumbent wants to hold onto its sales in a monopoly market, continuing to sell units at higher prices while avoiding further investment in quality and innovation. Taking over a challenger means that the incumbent won’t face competition.
Today, more than nine in 10 exiting venture-backed firms sell out to other firms, according to our research. Once thought to spur competition, venture capital may in fact cement incumbency.
This focus on exit, particularly exit by acquisition, is destroying the promise of Silicon Valley. Imagine if the titans of industry a century ago (or even a generation ago) were interested not in growing their businesses, but in cashing out as quickly as possible. We wouldn’t have most of the industries we have today.
Silicon Valley’s focus on the exit strategy leads to concentration in the tech industry, reinforcing the power of dominant firms. It short-circuits the development of truly disruptive new technologies that have historically displaced incumbents in innovative industries. And because incumbents often buy startups only to shut them down, intentionally or not, it means that the public loses access to many of the most promising new technologies Silicon Valley has developed.
It helps explain why the normal cycle of new companies driving out old monopolies seems to have stalled in the tech industry, where we found that the main incumbents are all at least 15 years old—an eternity in Internet time.
That has sparked concern among the public and presidential candidates from both parties. It has even surprised scholars normally sure the market can solve its own problems. Some argue that antitrust should break up big firms. Others think we should declare that parts of those firms—such as their data—be considered essential to competition and made available to others.
But those are blunt instruments; breaking up a Facebook or a Google may do more harm than good. Worse, those advocating breakup or regulation are fighting the last war. Trying to dislodge an entrenched monopoly by regulating it or breaking it up is hard and uncertain work. And it misses the bigger picture: Historically, a new company has always come out of nowhere and disrupted that monopoly. It is that disruption we have lost and need to get back.
In the paper we published late last year in SSRN, we suggest a number of ways to break the cycle of acquisition by incumbents, including both carrots and sticks. We can offer carrots to encourage innovative startups to stay in the market. We can also change venture capitalists’ incentives, offering them ways to cash out without selling out.
IPOs require extensive, expensive legal diligence that can take a year or more. Even after this process finishes and some shares start trading, securities law and private contracts typically “lock up” venture capital shares for six or more months. Public policy and practical concerns also make it hard to sell shares to financial owners outside the public markets. We should change tax and securities laws so that IPOs or secondary market sales are easier and mergers more difficult. As a result, we will encourage free-standing businesses to keep operating.
But those carrots need to be coupled with sticks. We should change the antitrust laws to focus on who is acquiring startups. Right now it’s too easy for incumbents to buy startups that might challenge them. Mergers beneath $200 million in value are no longer reviewed by the antitrust agencies. And when larger acquisitions do trigger review, the government rarely takes an anti-merger position.
Antitrust agencies should be much more skeptical of incumbents buying startups. We should presumptively ban incumbent monopolists from acquiring competitive startups, something the Clayton Act already gives regulators the power to do. But we should also worry about companies buying startups that don’t directly compete but that offer a possible platform for making the existing market obsolete. So antitrust agencies should also aggressively investigate mergers in complementary industries, like Facebook’s acquisition of WhatsApp or Google’s purchase of DoubleClick, even if the companies aren’t yet direct competitors at the time of the purchase.
These solutions won’t alone fix the problem of today’s entrenched tech monopolies. But they will allow the next generation of companies that might displace the tech giants to make it to market.
Silicon Valley changed the world. And it did so because founders and venture capitalists wanted to win tomorrow’s markets, not sell out to those who had already won yesterday’s. We should make sure founders and venture capitalists keep incumbents on their feet and don’t tire of the chase. And that means venture capitalists and tech companies must—as Steve Jobs urged Stanford’s graduating class in 2005—“stay hungry.”
Mark A. Lemley is the William H. Neukom professor at Stanford Law School.
Andrew McCreary is a student at Stanford Law School.
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