No Exit: A Threat to Venture Capital, Entrepreneurship, and Innovation

By Devin Reilly, D. Daniel Sokol & David Toniatti¹

In the revised “Digital Markets Strategy” published in February 2021, the UK’s Competition and Markets Authority (“CMA”) claimed that the overarching goal of the recently-created Digital Markets Unit (“DMU”) was to “deliver a step-change in the regulation and oversight of competition in digital markets and in turn drive dynamic innovation”² (emphasis added).

Indeed, the UK (and London in particular), is well-established as one of the leading locations for innovative start-ups, especially those backed by venture capital (“VC”) funds. This leadership stems not only from London’s traditional role as a global financial center, but also from the UK’s supportive regulatory environment, the presence of a vigorous network of academic research and access to highly trained human capital.

These advantages combine to make the UK and London a hub for VC, which in turn serves as a powerful engine of innovation. The continuous cycle of investment, development, exit, and reinvestment driven by VC funding helps to create and maintain a dynamic, diverse, and highly competitive marketplace as the research and development (“R&D”) profile of start-ups complements that of existing larger companies due to a different risk profile and different type of innovation targeted.

These dynamics highlight the beneficial role that acquisitions of smaller, entrepreneurial firms by larger, more mature businesses play in the economy, particularly in driving innovation. Consequently, any rule-making or other regulatory action that disrupts or becomes a drag on this cycle may actually threaten competition, and thereby undermine the CMA’s own good intentions. In particular, recent proposals in the UK aimed at heightening scrutiny of virtually all acquisitions — including both horizontal and non-horizontal mergers — by large companies will almost certainly make exit strategies more costly or difficult for entrepreneurs and their VC backers, especially in the digital industry. Given the incentives embedded in the VC ecosystem, this would run the risk of disrupting the VC investment cycle and undercutting its associated benefits.

In this blog post, based on our recent article, we will focus on the critical role that exit via acquisition plays in providing incentives for VC investment and entrepreneurship in the UK and globally, which in turn create the type of dynamic innovation that the CMA has set as its goal.³

Venture Capital Often Goes Where Corporate R&D Won’t

For decades, the VC ecosystem has been an important stimulator of entrepreneurship and innovation, providing funding for early-stage ventures that may not be appropriate for the risk profiles of larger corporations. Large firms face pressure to generate returns on invested capital, which can disincentivize them from engaging in risky enterprises or meaningfully investing in new ideas. In addition, larger firms have more stakeholders and oversight compared to entrepreneurs. As a result, decisions at larger firms may face increased scrutiny, and investing in unproven ideas may not be consistent with managerial incentives.

The VC business model, on the other hand, is custom-built for taking exactly the kinds of risks that larger, more established businesses try to avoid. Risk-taking is an inherent component of a VC fund’s investment strategy, in which many bets are made in anticipation that only a few will pay off.⁴

In fact, if we take patent activity and quality as a proxy for innovation, some academic studies suggest that a dollar of VC may be nearly three times more valuable than a dollar of corporate R&D. For example, VC funding accounted for less than 3 percent of U.S. corporate R&D from 1983-1992, but researchers estimated that it was responsible for around 8 percent of U.S. patents over this period.⁵ In addition, a recent study of U.S. firms’ patenting outcomes found that VC-backed firms were between two and three times more likely to have “higher quality” patents, as measured by citations, originality, and other factors.⁶

The VC Cycle of Investment, Innovation, Growth, and Reinvestment Is Also Important for Competition

The VC business model is not built for the long haul. VC firms typically raise closed-end funds from institutional and wealthy individual investors through a limited partnership. They then invest those funds in young, privately held, high-growth firms, commonly in exchange for an equity stake.⁷

For several years following their investment in a smaller company, venture capitalists typically work with the founders of the company to grow the venture and help market, improve, or scale a potentially useful product or service. The goal of many of these founders, and of their investing VC funds, is to realize the return on their investment either by selling the venture to a corporate acquirer or, less frequently, through an initial public offering (“IPO”).⁸

Ventures that are acquired by a larger firm benefit from the competencies of larger firms. In particular, larger firms do well with routinized processes that come with scale and thus often are better equipped to enact incremental change rather than radical innovation.⁹ Larger firms can then employ these comparative advantages to help smaller firms scale more efficiently.¹⁰ Consumers may also benefit from having greater access to a broader range of products and more diverse sources of innovation than would otherwise be feasible.

At the end of the VC investment cycle, successful firms typically seek to raise follow-on funds from investors to begin a whole new cycle of investment in other younger, smaller firms.¹¹ In this way, serial entrepreneurs, such as the UK’s Alex Chesterman, often not only find success with their maiden ventures, but then are incentivized to pursue new opportunities after their first wins.¹²

Using this model, VC funding has made important contributions to such key technological innovations as mainframe computing in the 1960s; personal computing in the late 1970s; biotechnology in the 1980s; internet and e-commerce in the 1990s; “smart” mobile communications technologies and cloud computing in the 2000s; and several novel products and business models in the 2010s, including mobile apps, fintech, software as a service and “sharing economy” platforms.¹³

Attractive Exit Opportunities Are Key for Sustaining the Venture Capital Ecosystem

In the dynamic and fast-paced VC ecosystem, exit opportunities, and in particular exits via acquisition, are the critical drivers of entrepreneurship and innovation.¹⁴ The end game for most investors in VC funds is realizing the return on their investment through what is commonly referred to as “exit from entrepreneurial ventures.”

Forms of exit include acquisitions, IPOs — either directly or through special purpose acquisition company (SPAC) listings — and buyouts. However, in recent years traditional IPOs have been on the decline, as investors increasingly seek to avoid the significantly higher costs and complexity involved. Instead, investors and entrepreneurs have been turning more to exit via acquisition by large companies and, at least in the United States, through SPACs in the form of “de-SPAC transactions.”¹⁵

In the UK, the importance of exit via acquisition continues to grow.¹⁶ In a recent survey of UK start-up founders and executives, for example, 58 percent cited acquisition as the long-term goal for their company, compared to 18 percent whose goal was an IPO.¹⁷ In another study of 1,545 British start-ups that raised equity in 2011, 226 companies had been acquired by 2019 while only 32 companies had exited via an IPO.¹⁸

In addition, a survey of investors focused on UK start-ups from the Coalition for a Digital Economy (“Coadec”) found that 90 percent of investors identified the ability of start-ups to be acquired as “very important” for the success of the tech start-up ecosystem, with the remaining 10 percent identifying it as “somewhat important.”¹⁹ Similarly, 23 percent of investors stated that a “significant restriction” on the ability to exit would lead them to stop investing in UK start-ups, with an additional 50 percent stating that they would “significantly reduce” their investments.²⁰

Exit through acquisition thus is central to the ability to maintain the dynamic cycle of VC investment. But the economic and competitive benefits do not stop there. These exits also create “multiplier” effects by stimulating further entrepreneurship and associated innovation, leading to additional societal benefits such as job creation, increased standard of living and overall economic growth.²¹

In addition, studies in Europe and the U.S. have found that VC stimulates post-deal innovation within the acquiring company.²² Acquired firms are more likely to generate spin-offs than non-acquired firms,²³ and employees of high-growth and VC-backed acquired firms are more likely to return to the start-up sector than employees who had been hired previously at the acquiring firm.²⁴

The UK Must be Able to Protect Its Role as an Important Locus of Innovation

The UK enjoys a sizable advantage over other European countries in terms of levels and recent growth in VC investment in various sectors. Across industries, the global volume of VC investments has increased significantly over the last decade. But VC investment within Europe is highly concentrated in a limited number of countries, and the UK leads the field by a wide margin.

Compared to two of Europe’s other strongest economies and start-up hubs, Germany and France, the UK has been consistently outperforming its closest rivals in venture capital invested in tech for the past five years.²⁵ Additionally, UK’s tech-related VC investments in 2020 (US$15.0 billion) were slightly larger than the total across the rest of Europe, excluding Germany and France (US$14.8 billion).²⁶ The UK also accounts for a disproportionate share of unicorns (companies reaching a valuation of US$1 billion or more) in Europe.²⁷

In recent years, venture capitalists in London have continued to be more successful in attracting significant funds than those in other European hubs.²⁸ London-based firms raised US$7.8 billion in 2020, which is over five times higher than in Berlin, six times higher than in Paris and 11 times higher than in Amsterdam.²⁹

When Considering Regulatory Changes Intended to Protect Competition, Regulators Must Tread Cautiously to Avoid Unintended Consequences

The benefits that the UK enjoys from a vibrant entrepreneurial ecosystem should not simply be assumed. The UK has witnessed a flurry of proposed changes to merger review policies in the past year that may reduce exit opportunities for entrepreneurs and VC investors and threaten the UK’s position as the VC hub for Europe. Research indicates that VC activity is affected by laws that impact the viability of exit opportunities. For example, the implementation of antitakeover laws in the United States that made acquisition more difficult led to a decrease in subsequent VC investment.³⁰

The VC community in the UK has sensed the changing tide. A 2020 survey by the British Business Bank reported that 77 percent of VC fund managers felt that the availability of exit opportunities had worsened since 2019 and 41 percent viewed the current market for successful exits as “poor” or “very poor.”³¹

These proposed changes not only put at risk the welfare of VC managers, but also potentially harm consumers, who benefit from the innovation that these acquisitions generate and from the incentives that motivate entrepreneurs to create new products and services that attract VC investors and acquiring firms. Moreover, the changes may curb the growth of VC investments in areas outside of London and negatively impact geographic and demographic diversity in the UK economy.

Ultimately, it will be critical for the UK to pursue policies that buttress its strengths as a center for entrepreneurship and avoid compounding existing challenges, especially in its post-EU future. Neither the UK nor the CMA is alone in wrestling with these questions. Antitrust regulators around the world have been proposing changes to merger review policies and enforcement strategies designed to heighten scrutiny on a broad class of transactions. As they do so, they should make sure they tread cautiously to avoid the unintended and potentially anticompetitive consequences of disrupting the VC ecosystem.

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1 D. Daniel Sokol is a professor at the USC Gould School of Law and the USC Marshall School of Business, as well as a Senior Advisor at White & Case, LLP. Devin Reilly & David Toniatti are economists at Analysis Group, Inc. The Computer and Communications Industry Association (“CCIA”) provided financial support for the original paper on which this post is based. Devin Reilly & David Toniatti have provided consulting support to technology companies in various matters. All opinions are our own.

2 “The CMA’s Digital Markets Strategy,” CMA, February 2021, p. 7, available at https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/959399/Digital_Markets_Strategy.pdf.

3 “The CMA’s Digital Markets Strategy,” CMA, February 2021, p. 7, available at https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/959399/Digital_Markets_Strategy.pdf.

4 Deborah Gage, “The Venture Capital Secret: 3 Out of 4 Start-Ups Fail,” Wall Street Journal, September 20, 2012, available at https://www.wsj.com/articles/SB10000872396390443720204578004980476429190.

5 Samuel Kortum & Josh Lerner, Assessing the Contribution of Venture Capital on Innovation, 31 RAND JOURNAL OF ECONOMICS, 674–692 (2000).

6 Sabrina T. Howell et al., How Resilient is Venture-Backed Innovation? Evidence from Four Decades of U.S. Patenting, National Bureau of Economic Research (NBER) Working Paper No. 27150 (May 2020).

7 Bronwyn H. Hall & Josh Lerner, The Financing of R&D and Innovation, 1 HANDBOOK OF THE ECONOMICS OF INNOVATION, 609-639 (2010); Gary Dushnitsky & D. Daniel Sokol, Mergers, Antitrust, and the Interplay of Entrepreneurial Activity and the Investments That Fund It, USC Law Legal Studies Paper No. 21-35 (June 2021).

8 Bronwyn H. Hall & Josh Lerner, The Financing of R&D and Innovation, 1 HANDBOOK OF THE ECONOMICS OF INNOVATION, 609-639 (2010); “2020 Global Startup Outlook,” Silicon Valley Bank, 2020, p. 7, available at https://www.svb.com/globalassets/library/uploadedfiles/content/trends_and_insights/reports/startup_outlook_report/suo_global_report_2020-final.pdf.

9 Gary Dushnitsky & Michael J. Lenox, When do Firms Undertake R&D by Investing in New Ventures? 26 STRATEGIC MANAGEMENT JOURNAL, 948–949 (2005) (“[E]ntrepreneurial ventures are likely to be the source of highly valuable and innovative ideas.”).

10 Gary Dushnitsky & D. Daniel Sokol, Mergers, Antitrust, and the Interplay of Entrepreneurial Activity and the Investments That Fund It, USC Law Legal Studies Paper No. 21-35 (June 2021); Marc Goedhart, Tim Koller & David Wessels, “The six types of successful acquisitions,” McKinsey & Company, 2017, available at https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-six-types-of-successful-acquisitions.

11 Paul A. Gompers, Grandstanding in the venture capital industry, 42 JOURNAL OF FINANCIAL ECONOMICS, 133-156 (1996).

12 Alex Chesterman founded Zoopla, a property listing website and one of the UK’s first unicorns that was sold for £2.2 billion in September 2018. He also founded a marketplace for used cars, Cazoo, in 2018 and announced a £30 million funding round for Cazoo in December 2018. “Overview of UK’s Top Serial Entrepreneurs,” Beauhurst Blog, March 19, 2019, available at https://www.beauhurst.com/blog/successful-serial-entrepreneurs/; “Zoopla founder Alex Chesterman to launch used car sales platform,” AM Online, December 12, 2018, available at https://www.am-online.com/news/dealer-news/2018/12/12/zoopla-founder-alex-chesterman-to-launch-used-car-sales-platform.

13 Josh Lerner & Ramana Nanda, Venture Capital’s Role in Financing Innovation: What We Know and How Much We Still Need to Learn, 34 JOURNAL OF ECONOMIC PERSPECTIVES, 237-261 (2020); “Recalling Apple’s VC-Funded Past,” PitchBook, September 14, 2012, available at https://pitchbook.com/newsletter/recalling-apples-vc-funded-past.

14 Gary Dushnitsky & D. Daniel Sokol, Mergers, Antitrust, and the Interplay of Entrepreneurial Activity and the Investments That Fund It, USC Law Legal Studies Paper No. 21-35 (June 2021).

15 Until very recently, SPACs in the UK have not been common. Vanya Damyanova & Rehan Ahman, “Changes to UK SPAC rules open door for more listings,” S&P Global Market Intelligence, September 15, 2021, available at https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/changes-to-uk-spac-rules-open-door-for-more-listings-66199184.

16 Richard T. Harrison & Colin M. Mason, Venture Capital 20 years on: reflections on the evolution of a field, 21 VENTURE CAPITAL, 1-34 (2019).

17 “2020 Global Startup Outlook,” Silicon Valley Bank, 2020, p. 7, available at https://www.svb.com/globalassets/library/uploadedfiles/content/trends_and_insights/reports/startup_outlook_report/suo_global_report_2020-final.pdf.

18 “We tracked every startup that raised venture capital in 2011,” Beauhurst Blog, May 23, 2019, available at https://www.beauhurst.com/blog/startups-of-yesteryear-2019-update/.

19 “The Digital Markets Unit: On the Side of Startups? An Investor Perspective,” Coadec, September 2021, pp. 2, 16-17, available at https://coadec.com/wp-content/uploads/2021/09/On-the-Side-of-Startups_-1.pdf.

20 “The Digital Markets Unit: On the Side of Startups? An Investor Perspective,” Coadec, September 2021, pp. 16-17, available at https://coadec.com/wp-content/uploads/2021/09/On-the-Side-of-Startups_-1.pdf.

21 David Ahlstrom, Innovation and Growth: How Business Contributes to Society, 24 ACADEMY OF MANAGEMENT PERSPECTIVES, 10-23 (2010).

22 Ana Faria & Natália Barbosa, Does Venture Capital Really Foster Innovation? 122 ECONOMICS LETTERS, 129-131 (2014); Samuel Kortum & Josh Lerner, Assessing the Contribution of Venture Capital on Innovation, 31 RAND JOURNAL OF ECONOMICS, 674–692 (2000); Shai Bernstein et al., The Impact of Venture Capital Monitoring, 71 THE JOURNAL OF FINANCE, 1591-1622 (2016).

23 Steven Klepper & Sally Sleeper, Entry by Spinoffs, 51 MANAGEMENT SCIENCE, 1291–1306 (2005).

24 J. Daniel Kim, Startup Acquisitions as a Hiring Strategy: Worker Choice and Turnover, SSRN Scholarly Paper ID 3252784 (March 2020); Weiyi Ng & Toby Stuart, Acquihired: Retained or Turned Over? SSRN Scholarly Paper ID 3461723 (September 2019).

25 “UK Tech Ecosystem update,” Dealroom, December 2020, p. 4, available at https://dealroom.co/uploaded/2020/12/End-of-year-2020-Tech-Nation-Dealroom.pdf?x20197.

26 “UK Tech Ecosystem update,” Dealroom, December 2020, p. 4, available at https://dealroom.co/uploaded/2020/12/End-of-year-2020-Tech-Nation-Dealroom.pdf?x20197.

27 “UK Tech Ecosystem update,” Dealroom, December 2020, p. 10, available at https://dealroom.co/uploaded/2020/12/End-of-year-2020-Tech-Nation-Dealroom.pdf?x20197.

28 While London constitutes a significant share of VC investment in the UK, there is geographic diversity in VC activity and entrepreneurship. See Report Section V.

29 “London: Europe’s global tech city,” Dealroom, January 14, 2021, p. 8, available at https://dealroom.co/uploaded/2021/01/dealroom-london-jan-21-1610614703.pdf?x20197.

30 Gordon M. Phillips & Alexei Zhdanov, Venture Capital Investments and Merger and Acquisition Activity Around the World, NBER Working Paper No. 24082 (November 2017).

31 “UK Venture Capital Financial Returns 2020,” British Business Bank, November 12, 2020, p. 32, available at https://www.british-business-bank.co.uk/wp-content/uploads/2020/11/BBB-VC-Returns-Report-2020-FINAL-1.pdf.