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Why Small Firms Sell Out

Acquisition by Big Tech is an exit strategy born of bad regulation.

Among some conservatives’ main complaints about Big Tech is the way it acquires smaller competitors, stopping them from displacing them like Facebook displaced MySpace. The practice has become so all-encompassing, the argument goes, that it undermines competition and requires strong antitrust action, perhaps unwinding some previous acquisitions in the process.

On the surface, this argument might make intuitive sense. A closer look reveals that the acquisitions strategy is a response to a pair of dilemmas, one genuine, the other wholly artificial, created by regulatory policy. Before breaking out the antitrust machete, we should consider whether a scalpel can improve the situation.

The first dilemma, which was explored by the renowned late Harvard professor Clayton Christensen, concerns how big firms innovate. Big firms by nature become less innovative as they grow. They become good at what they do, but the gains from innovation become smaller over time. Internal norms and procedures become set in stone, leading to the “not invented here” problem whereby managers react with suspicion to ideas from outside the organization.

What this means is that large, once innovative firms can appear to do everything right and still not see the disruption coming. The dilemma is that firms must choose between paying attention to their existing audience or to opportunities that will disrupt their existing business. They can be damned either way. Concentrate on refining your product and catering to your core audience can lead you to design the very best buggy whip just as the automobile appears.

On the other hand, diversification for its own sake can doom a company just as much. When Yahoo realized Google was offering better search and email products, it tried video streaming, job matching, and other new products. All failed. And remember the Amazon Fire phone? So does Jeff Bezos.

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In the early 1990s, I studied for an MBA at Imperial College in London. One of the professors had just returned from a trip to the U.S. to advise Kodak on business strategy. He had told the company to pay attention to “still imaging,” the precursor to digital photography, which he thought could kill the business. He was right, of course. But why did the Kodak executives not see it? Probably because they were more concerned with beating emerging rival Fujifilm. They believed that Kodak’s position as market leader in film would transition naturally to still imaging and similar technologies. An effort to secure the new market for digital cameras in the 2000s paid off for a while, but then the iPhone came along. A late pivot to home printing was not enough to stave off bankruptcy. Kodak’s disruption was complete despite an attempt to move with the times and some genuinely innovative approaches.

Today’s Big Tech firms are acutely aware of this dilemma. Facebook, for instance, did not invent social media, but it was able to disrupt MySpace and other early social networks by, as Mark Zuckerberg famously put it, moving fast and breaking things. Amazon disrupted book selling and has since moved on to retail in general (though it does not dominate the broader retail sector, which still largely comprises brick-and-mortar stores).

Their solution to the dilemma is to try both approaches, to continually improve on the main product and grow that product’s audience while diversifying and trying new things. For example, Amazon realized that the computing power it needed to power its retail business could be a product in itself and created Amazon Web Services.

The tech giants seem well aware that the main source of potential disruption, and also potential growth, is outside the firm. That is why they constantly keep an eye open for new ideas from others and buy them up. Facebook bought an upstart photo filtering app called Instagram and turned it into a global social media business that in many ways competes with its main product.

The acquisitions do not always pan out. Amazon bought diapers.com but, despite putting a great deal of resources into it, failed to disrupt the diapers market dominated by grocery stores. (Amazon has been accused of having bought diapers.com in order to kill it, but that was not the case.)

The innovator’s dilemma explains why large tech firms want to buy up smaller firms. These companies are like Carroll’s Red Queen: “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” If they wanted to stay still, they would buy up firms and kill them off. But acquisitions enable them to keep running. That means they invest in new ideas, which benefits all consumers.

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There is another dilemma, which I call the Entrepreneur’s Dilemma. Every for-profit entrepreneur wants to see his or her idea succeed and make money. In the past, the path to success was clear. You borrow seed money from relatives or the bank (or, in the case of Google’s founders, max out your credit cards) and then go on to build a company that gets financing to pay back investors, issuing additional stock and going public on a stock exchange. Traditionally, you could go public quite early, allowing you and your investors to share in your company’s growth. Home Depot, for instance, went public when it owned only four stores.

However, increasingly stringent financial regulation, which was initially aimed at preventing another Enron scandal and then at preventing banks from making overly risky loans, has broken that model. Borrowing seed money is now more difficult. Bank lending to startups and small businesses shrank by 20 percent after the financial crisis because of new regulations. Moreover, the complexity of going public has increased so much that even successful companies delay their IPOs until they have grown huge; see Uber and Facebook. This makes the entrepreneur much more reliant on angel investors and venture capitalists.

Investors, however, want to see a guaranteed return. Therefore, they will look for an exit strategy in the business plan. The easiest exit strategy for a tech entrepreneur is to sell the idea to a Big Tech firm.

That is the dilemma: endure the slings and arrows of financial regulation or sell out and lose control of the idea. It is telling how bad the regulation must be that so many entrepreneurs choose the latter option. Financial regulation has made the American dream of growing your own business to household-word status nigh impossible for most entrepreneurs.

So, if things seem out of balance, that’s because regulators have made it that way. If we are to restore the old model of competition and disruption and make the innovator’s dilemma a source of risk again, then rather than using the blunt edge of antitrust, we should first reform financial regulation using a fine scalpel. Policy makers simply need to make access to capital and investment easier for entrepreneurs. If we do that, then the chances that Facebook will go the way of MySpace will be much higher.

Iain Murray is a senior fellow at the Competitive Enterprise Institute.

This article was supported by the Ewing Marion Kauffman Foundation. The contents of this publication are solely the responsibility of the authors.

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