Many lawmakers are eager to rein in the power of the largest tech companies: Amazon, Apple, Facebook and Google.
But some of their proposals could actually hurt the smaller companies they’re meant to protect, venture capitalists warned CNBC.
VCs are particularly concerned about efforts in Congress to restrict mergers and acquisitions by dominant platforms. Some of those proposals would work by shifting the burden of proof onto those firms in merger cases to show their deals would not harm competition.
While proponents argue such bills would prevent so-called killer acquisitions where big companies scoop up potential rivals before they can grow — Facebook’s $1 billion acquisition of Instagram is a common example — tech investors say they’re more concerned with how the bills could squash the buying market for start-ups and discourage further innovation.
Of course, venture capitalists and the groups that represent them have an interest in maintaining a relatively easy route to exiting their investments. A trade group representing VCs, the National Venture Capital Association, counts venture arms of several Big Tech firms among its members. (Comcast, the owner of CNBC parent company NBCUniversal, is also a member.)
But their concerns highlight how changes to antitrust law will have an impact far beyond the largest companies and how smaller players may have to adjust if they’re passed.
Why start-ups get acquired
When venture capitalists invest in a start-up, their goal is to make a large return on their spend. While most start-ups fail, VCs bank on the minority having large enough exits to justify their rest of their investments.
An exit can occur through one of two means: through an acquisition or by going public. When either of these events occurs, investors are able to recoup at least some of their money, and in the best case scenario, reap major windfalls.
About ten times as many start-ups exit through acquisitions as through going public, according to the NVCA. Venture capitalists say that number shows just how important it is to keep the merger path clear.
The top five tech firms aren’t the only ones scooping up tech deals. Amazon, Apple, Facebook, Google and Microsoft have accounted for about 4.5% of the value of all tech deals in the U.S. since 2010, according to public data compiled by Dealogic.
Reform advocates have pointed to some acquisitions, like that of Instagram by Facebook, as examples of companies selling before they have the chance to become standalone rivals to larger firms. But VCs say that’s often not the case.
“They all think they could be public companies one day, but the realities are, it’s not realistic for most of these companies to achieve the size and scale to survive the public markets as of today,” said Michael Brown, general partner at Battery Ventures.
While going public is a often the goal, VCs say it can be impractical for start-ups for various reasons.
First, some start-ups may simply not have a product or service that works long-term as a standalone business. That doesn’t mean their technology or talent isn’t valuable, but just means it could be most successful within a larger business.
Kate Mitchell, co-founder and partner at Scale Venture Partners, gave the example of a company called Pavilion Technologies that made predictive technology for manufacturers and agriculture, which sold to manufacturing company Rockwell Automation in 2007.
“That’s a company that just couldn’t get to escape velocity,” she said of Pavilion. “Because they were selling globally to large plants, we couldn’t figure out how to sell the technology cost effectively.”
It was still a useful technology, but needed the infrastructure of a larger business to accelerate further, she said. After Rockwell acquired it, it became incorporated into its offerings and several employees stayed for years.
Sometimes, she said, an acquisition is a last resort before bankruptcy, and at least helps investors get some of their money back.
“It is better that they’re sold for even 80 cents on the dollar than that they go bankrupt,” she said.
In addition, going public can be difficult. The IPO process is expensive and VCs said that small cap companies often struggle on the public market in part because of the lack of analyst coverage of such businesses.
Clate Mask, co-founder and CEO of venture-funded email marketing and sales platform Keap, said greater merger restrictions on the largest companies would likely “change the calculus” for start-ups. But the shift would not be between getting and acquired and going public. Instead, he said, it could make entrepreneurs think harder about whether to raise venture funding at all.
“When you have capital behind you, you can think and operate differently,” he said, adding that entrepreneurs can take more risks with that backing.
Loss of investment and innovation
Several VCs told CNBC they were worried about the trickle-down effect that merger restrictions on the largest firms would have on the entire entrepreneurial ecosystem.
Their fear is that if companies no longer have enough viable exit paths, institutional investors that back VCs — like endowments and pension funds — will shift their money elsewhere. In turn, VCs will have fewer funds to dole out to entrepreneurs, who may see less reason to take the risk of starting a new company.
The ultimate concern is for a loss of innovation, they say, which is exactly what lawmakers are hoping to fend off with merger restrictions on the largest buyers.
“If you restrict the potential to generate exciting rewards and returns from investment, entrepreneurs could find other things to do with their time,” said Patricia Nakache, general partner at Trinity Ventures.
Nakache said placing restrictions on the largest tech firms’ ability to make acquisitions could actually discourage entrepreneurs from building companies that compete with their core businesses. That’s because many entrepreneurs like having a back-up plan incorporating possible acquirers if they can’t go public. With greater uncertainty about whether the Big Tech companies could be potential buyers, they may seek to build businesses outside of the largest players’ core offerings, she said.
VCs also warned that without the biggest players in the mix, sale prices for start-ups would drop significantly.
But outside the industry, some believe these concerns won’t be as bad as VCs fear.
“These sorts of laws, if they work as intended, you’re going to have a more competitive marketplace generally, so there’s going to be more potential buyers,” said Michael Kades, director of markets and competition policy at the non-profit Washington Center for Equitable Growth. “I get it if you’re at the VC today, what you’re concerned about is the next couple of years or what your company can get, but increasing the number of potential buyers for firms … also means that there’s still a very thriving market for these sorts of acquisitions, just not by dominant firms.”
Bhaskar Chakravorti, dean of global business at Tufts University’s Fletcher School, said while venture capitalists are probably right that acquisition prices could slide under new merger restrictions, entrepreneurs will still have a drive to innovate.
“Ultimately people are going to adapt and yes, some of the valuations, some of the bidding may be stunted. Some of the acquisitions may go for ten, 20% less,” he said. “But ultimately, I don’t think it’s going to make that much of a difference because entrepreneurs are going to go after ideas, they’re going to build them, they’re going to put together teams, and venture money needs a place to invest.”
Kades agreed that good ideas will still likely get funding even if the largest firms can’t bid on them or would have a harder time completing an acquisition. Restricting mergers from those companies is about “trying to limit the anticompetitive premium,” he said.
Shifting capital
VCs are also concerned the new rules could accelerate the shift of venture investment outside the U.S.
Mitchell said while other countries including Canada have been adding incentives for entrepreneurs to come and stay in their borders, regulations under consideration in the U.S. will push them away.
“We would be making it difficult just at a time when everyone else is trying to make it attractive” to be an entrepreneur in their country, she said.
According to the NVCA, the U.S. has seen its share of global venture capital fall from 84% to 52% in the last 15 years. That’s why lawmakers shouldn’t rest on their laurels that U.S. venture capital can keep up with the rest of the world under new arduous regulations, VCs contend.
But Chakravorti disagreed the merger laws would push investment outside the U.S., as many alternatives are worse.
“There are very few alternative locations,” he said. Exits in China would come with heightened scrutiny, and Europe is known for a more heavy-handed approach on business regulation.
Still, Brown said, should stricter merger laws pass, he would have to consider casting a wider net for potential buyers when it comes time to exit an investment. That could include more international buyers than he’d otherwise consider.
Nakache said should merger reforms pass, she may consider investing more heavily in start-ups whose potential acquirers wouldn’t be impacted by the laws. For example, if enterprise platforms like Salesforce or Oracle didn’t meet the threshold for stricter merger enforcement, VCs might shift spending from areas like search and social media to software as a service.
Open to some reforms
Some of the VCs interviewed by CNBC felt existing antitrust laws were adequate, but others acknowledged that reforms outside of mergers could be beneficial.
Restrictions on platforms leveraging data they collect to compete with businesses that rely on them is one example that could help level the playing field if done correctly, Nakache suggested.
Mitchell said the most helpful change would be to create more consistency in enforcement of the antitrust laws, particularly from one administration to the next.
Mask, the Keap CEO, said he’s not opposed to Congress taking some action to curb Big Tech companies’ power, but that most entrepreneurs recognize those firms overall “are good for the ecosystem.”
“Those Big Tech companies are helpful in driving a lot of the momentum of the overall sector,” he said. “And I think to have them broken up in some kind of extreme aggressive way I’m not sure is a great thing either.”
