A closer look at merger and start-up data suggests it’s a cultivation zone
Earlier this month, the Federal Trade Commission (FTC) issued special orders to Google, Amazon, Apple, Facebook, and Microsoft to provide information on transactions the companies completed between 2010 and 2019. Under a law known as the Hart–Scott–Rodino Antitrust Improvements Act of 1976 (HSR), companies are only required to notify the FTC and the Department of Justice (DoJ) about acquisitions above a certain size threshold. The FTC is collecting information on deals that fell below this line using its authority to study market operations. As FTC Chair Joseph Simons told reporters in a conference call, “This is for a research and policy project,” not for enforcement action.
This collection effort comes on the heels of criticism by antitrust scholars, members of Congress, and investment experts that the floor set by HSR allows large tech companies to skirt antitrust scrutiny. In an official statement, the Commission explained that the query is part of a larger project to “deepen its understanding of large technology firms’ acquisition activity,” and to explore “whether large tech companies are making potentially anticompetitive acquisitions of nascent or potential competitors that fall below HSR filing thresholds and therefore do not need to be reported to the antitrust agencies.” At the end of this process, the FTC will release a report that could spur Congress to reform the antitrust regime. While policymakers at all levels of government should be concerned about impediments to innovation, a drastic overhaul of antitrust laws isn’t currently needed.
The kill zone
The first time anyone heard that the Washington Post was going to acquire the Washington Herald in 1954 came after the deal had been completed. Both parties kept the news secret under tight secrecy and were able to merge operations with little pushback. By the 1960s and into the 1970s, companies were learning the advantages of this strategy. As William J. Baer, a former director of the Bureau of Competition at the FTC, explained, there are “strong incentives for speedily and surreptitiously consummating suspect mergers,” because it is difficult to unwind a consummated merger or acquisition after it has been completed. In reaction to a number of these “midnight mergers,” as they were called, Congress passed the Hart–Scott–Rodino Antitrust Improvements Act of 1976, which required companies to notify authorities if the total assets of the target company rose above a certain threshold. As of 2020, that number is $94 million.
In the past decade, the five companies have completed hundreds of deals that fall under this line. Venture capitalists (VC) are now wondering aloud whether more acquisitions should undergo review by governmental agencies, dubbing the effect “the kill zone.” Not only are tech companies acquiring startups to kill potential rivals in this framing, but their mere presence has killed any appetite for investors to fund a competitor. Some chart the decline in startups and initial public offerings (IPOs) directly to the rise of digital companies like Apple, Google, and Amazon. At a DOJ antitrust workshop on the topic, investor Paul Arnold made a case for the existence of kill zones. Large platforms have the data and the users, he argued, so “It’s a really hard barrier to overcome, and sometimes there’s an answer, but often it will kill things.” To Arnold, these advantages and the kill zone should be of concern to antitrust authorities.
The vast majority of acquisitions by large tech companies are made either for the tech or the talent of the target company, not to stifle a future competitor. Both parties benefit from these deals. Startups often have great ideas but lack the technical and marketing resources to bring a product to a wider audience. Large companies, on the other hand, have the resources and consumer base for a new product but often lack innovative ideas. Yet, the true benefactors of these deals are consumers who can now choose an innovative product that may not have existed otherwise.
Google’s acquisition of Android in 2005 serves as one example. Today, the deal seems like a smart move, but at the time Eric Schmidt was uncertain where the company would fit into Google. He was skeptical of the purchase which was orchestrated by Larry Page and Sergey Brin. Both Page and Brin had a vision for mobile and acquired Android, which had no viable product in 2005 and put Android’s Andy Rubin and Rich Miner at key places within the company. With Google’s resources on its side and the talent gained in the deal, Android launched and has since become the largest mobile operating system, a clear win for consumers.
Facebook’s acquisition of Instagram also offers a similar lesson. Supported by the engineers at Facebook, Instagram upgraded its backend and got access to Facebook’s ad platform, both of which helped the company to consistently grow its revenues and user base. In contrast, the primary competitor to Instagram, Snapchat, has struggled on its own. Snapchat’s parent company, Snap, went public in March of 2017 and built its own advertising platform to compete with the likes of Facebook and Google. While its fortunes have changed, Snap had lackluster revenues for years, causing the company to lay off personnel and reorganize. The company launched Spectacles, a pair of sunglasses embedded with a camera, that flopped. An app redesign in 2018 sparked a backlash, and almost 2 percent of its users dropped out. Even today, the stock sits below its initial IPO price. While Instagram doesn’t have independence, it boasts over a billion monthly active users compared to Snapchat’s 360 million.
For startups, going public isn’t a sure path to success. Companies typically sign away 4 to 7 percent of their gross proceeds to an investment bank to sell shares of the stock. They also tend to incur an additional $4.2 million in costs to go through the process of getting listed. On top of this, a company will have to fork over another $1 to $2 million for federal compliance every year. Most IPOs perform worse than the overall market.
Corporate management has also tended to shift towards acquisition because it is a more sure bet. Using data of US firms from 1990 to 2012, economists have found that companies with financial analysts tend to cut research and development expenses, invest in corporate venture capital, and buy more startups. As the authors of one study concluded, “financial analysts encourage firms to make more efficient investments related to innovation, which increases their future patents and citations and influences the novelty of their innovations.” In other words, as a company matures and formalizes its financial processes, that company will shift its innovative strategy by spending less money on internal research and development and more money on buying innovative companies.
The evidence for a kill zone is far from conclusive in the investment space as well. Last year, the total number of VC deals reached a new high, and the total dollar value of these deals came in as the second-largest behind 2018. Moreover, 2018 might be considered an outlier, since the Chinese fintech firm Ant Financial raised an unheard of $14 billion, SoftBank dumped $3 billion into WeWork, and the owner of TikTok got another $3 billion.
Sophisticated commentators will point out that investment is occurring, but not in the industry niches where large firms have an advantage. Google faced a similar environment when it was trying to get off the ground in the late 1990s. Ram Shriram, one of the earliest investors in Google, recently recalled that “I went up and down Sand Hill and could not get a single VC to get a check at the time. The reason? They said search was taken.” Michael Moritz, another early investor in Google, confirmed Shriram’s sentiment and continued by explaining that, “Companies start off with a very narrow focus, and they do one small thing very well, and then they become the best at it, and then they gradually expand.”
Picking out successful companies in the tech sector isn’t easy. In a study on expert evaluations of companies, “experts can differentiate among early-stage ventures on the grounds of quality beyond the explicit venture and entrepreneur characteristics contained in the written summaries.” But these appraisals only work for hardware, energy, life sciences, and medical devices. Experts had a difficult time selecting successful companies in consumer products, consumer web and mobile, and enterprise software sectors, the spaces where the large tech companies dominate.
Declining startups and lifecycles
While big tech companies are sometimes blamed for declines in new businesses, the Nobel winning economist Robert Lucas predicted a pattern would emerge back in 1978. Over a long time horizon, people were getting smarter and more capable, Lucas explained, and those improvements were showing up in wage increases. In the future, working at a firm would get incentivized over starting a company since people would likely be more productive when working together. Entrepreneurs would decline as a portion of the economy, while industries with higher productivity would likely see bigger firms come into existence.
The patterns that Lucas laid out have since been confirmed in a range of settings. Employment within large firms tends to grow over time as a country gets wealthier. Research into American manufacturing from 1850 to 1880 reveals this pattern, as does research for Canada, Germany, Indonesia, Japan, South Korea, and Thailand. When the World Bank Group first compiled national data in the Entrepreneurship Survey, it too found an inverse relationship between entrepreneurship rates and Gross Domestic Product (GDP). The size of firms also grows as a country becomes wealthier. As economist Markus Poschke noted, “richer countries thus feature fewer, larger firms, with a firm size distribution that is more dispersed and more skewed.”
Finally, it could be that the industries where big tech companies reside are at a different stage of the innovation lifecycle. Innovation tends to follow a consistent pattern. In the beginning, a product tends to be pioneered by a few firms, but as it grows, entrants arise to compete. During the initial growth stage, consumer preferences tend to be unstable, which helps to promote product innovation and entry. But as the industry matures, products become standardized, and firms tend to shift their focus to managerial practices. Eventually, the industry shakes out, firms fail, and the industry consolidates around a few players. Search, and social media are over 30 years old at this point, which suggests that these industries might be shifting into their mature stages.
The vast majority of acquisitions aren’t to stop competitors, but to buy innovative ideas and talent, which has the end effect of being pro-consumer. Moreover, in 2019, VC investments had a record-breaking year. Policymakers, as well as leadership at the FTC and the DOJ, are justified in taking a closer look at the impact of large firms on innovation. Still, the evidence of a kill zone in the tech industry is thin.