Venture capital: an ecosystem under threat?

Corporate merger and acquisition (M&A) activity is rarely far from the news, but that is not to say that the subject is always well understood. Contested takeovers make for lively copy, as do the “mega-mergers” that can be presented as blatant empire-building and a search for monopoly profits.

Far less coverage is devoted to the critically important role that M&A plays in the ecology of venture capital, the source of the funds that power new, pioneering businesses of the type that have put the United States at the cutting edge of commercial and technological innovation.

Put simply, M&A increasingly provides the mechanism whereby venture capitalists (VCs) are rewarded for their investment, as are the founders of the business concerned. Those who have taken all the risks are paid a premium by the acquiring company over their original stake.

It is this prospect of a profitable “exit strategy” that is the key incentive for the VCs to invest in the first place. Therefore, it follows that anything making such exit acquisitions more difficult or less likely will diminish this incentive, and, all things being equal, reduce the flow of VCs’ funds to new businesses.

Our research has examined the potential effect of a proposed anti-trust legislation before the US Senate on the delicate entrepreneurial ecosystem, with special reference to VCs. These effects could be felt particularly keenly among the smaller, first-time VC funds which not only provide valuable investment in new enterprises but play a central role in making both investors and investee firms more diverse and inclusive than would otherwise have been the case.

We shall examine more closely the ecology of venture capital shortly. First, to understand where any negative effects from the proposed changes to anti-trust law may arise, it is necessary to look at the existing principles underlying the law and the new proposals.

Under the present system, it is for the government, in objecting to a merger or acquisition, to show that, if it goes ahead, it is likely substantially to lessen competition in the market concerned. In other words, the initial burden is on the government to prove the proposed acquisition would be anti-competitive.

Most mergers could be caught

Should it clear this initial hurdle, the defendants have an opportunity to assert that the authorities have inaccurately assessed the likely effect on competition, perhaps by failing to appreciate potential business efficiencies arising from the transaction or maybe by over-stating the anti-competitive harms that would result from the proposed deal.

If the defendants are successful, the burden of proof switches back to the authorities.

Now, two separate bills are in front of the upper house, introduced respectively by Senator Amy Klobuchar and Senator Josh Hawley. Both would markedly change the operation of anti-trust law as it has been practised for decades.

Senator Klobuchar’s proposals would replace the requirement for the government to show that there would be a substantial lessening of competition if the merger or acquisition went ahead with a criterion that the government needs to show only that there was an appreciable risk of materially lessening competition, “materially” being defined as anything above the trivial de minimis level that is beneath the interest of the law.

Under this definition, most mergers, we believe, would seem likely to be caught.

Furthermore, while details remain subject to constant negotiation, there have been suggestions that, for a large number of mergers and acquisitions, the burden of proof may be shifted to the companies concerned, putting the onus on them to overcome a presumption that the deal was not anti-competitive.

This last category has obvious implications for the ability of founders and investors in young companies to reap the rewards of their efforts by an exit through acquisition.

No payday?

Suggested aspects of Senator Hawley’s proposals, again subject to constant negotiation, would be of equal concern to the VC sector and the firms in which it invests. These could inhibit acquisition by highly-capitalised companies and by “Dominant digital firms”.

If enacted, there has to be a likelihood that such legislative changes would have a chilling effect on M&A activity of all types, large deals and small, across all industries. But it is in the VC eco-system that the new cold climate would be felt especially keenly.

To understand why, we need to understand the central role that M&A plays in allowing founders and investors to reap the rewards of their efforts and their risk-taking respectively. The legacy of the dot-com bubble of the Nineties is that many still mentally connect exit strategies with IPOs, thanks to strong memories of such madcap flotations as Netscape in the US and lastminute.com in the UK.

But while the number of IPOs showed dramatic growth up to the bursting of the dot-com bubble in 2000, there followed a vertiginous plunge. More recently, the numbers have recovered, but M&A continues to account for the vast majority of exits. Furthermore, the average age of a company at the point of its IPO has risen from eight years in the period leading up to 2000, since which time it is now ten years.

Clearly, the IPO route has become less attractive for younger businesses. Why is this? Possible explanations have been voiced by scholars and practitioners, which include the more burdensome compliance costs imposed on publicly-traded firms by the 2002 Sarbanes-Oxley Act, itself a response to the dot-com crash. Such overheads are, almost by definition, especially onerous for small firms.

Another possible explanation, noted by prior work, would highlight the decline in the number of underwriters providing analysis of smaller businesses.

Many firms still use the IPO model to trigger the “liquidity event” at which investors and founders have, in effect, their payday, and it is the case that the average IPO involves larger sums than the average acquisition. However, the decline in overall IPO activity has made the acquisition route of increasing prominence in the entrepreneurial landscape.

Ripple effects

Another driver of M&A as the preferred exit route for so many VCs is the shorter time-horizon involved in the firm concerned reaching the stage for an acquisition as opposed to length of time needed to be ready for an IPO. This is particularly the case in relation to first-time VC funds.

Because of their smaller size, the viability of first-time funds is particularly sensitive to changes in the market for M&A deals of below $100 million. Just one or two deals can make a significant contribution to the track record of a first-time fund which, in turn, increase the chances of the fund being able to raise follow-on investment.

But it is especially so in the case of first-time funds given that, in recent years, a new generation of funds has been founded with by talented investors who are often of diverse background. Moreover, many new funds focus on diversity and inclusion as increasing numbers of investors seek opportunities to support founders of diverse backgrounds.

The result of all this is that the smaller, newer funds frequently look for the chance to invest in innovative companies working in locations or sectors that have been neglected in the past. Nobody, we suggest, would actively wish to threaten such inclusion and diversity efforts, but proposed legislation may well do so inadvertently.

M&A is part of a delicate VC mechanism that relies on a balance of incentives between acquiror and acquired. Larger companies have many reasons to acquire a smaller firm. One would be that an all-out acquisition would generate efficiencies for the acquiror that could not be achieved with arrangements stopping short of this, such as strategic alliances or joint ventures. Another would arise when the smaller firm represents a strategic complement to the larger one, leading to reduced transaction costs and other benefits.

Further benefits may arise from knowledge transfer, better co-ordination of investment and synergies in terms of research and development. A final incentive would be the ability to meet competitive threats from other larger firms through acquiring a relevant business, a quicker way of adding new products or features than starting from scratch, in-house.

For the market as a whole, an M&A event sends value signals that can be incorporated into the pricing of future deals.

Our research suggests all concerned should pause and think through the less recognised ripple effects of the proposed legislation, in particular, the risk of shutting down an extremely important part of the US venture capital industry.

Gary Dushnitsky is Associate Professor of Strategy and Entrepreneurship at London Business School.

• Download the academic paper this article is based on, by Dr Dushnitsky and his co-author D. Daniel Sokol, here: ‘Mergers, antitrust, and the interplay of entrepreneurial activity and the investments that fund it’