Last month, the online chat startup Discord halted accepting bids for a potential acquisition. Suitors included Microsoft, which had offered to acquire the company at least $10 billion. Instead, Discord’s management decided to remain independent and explore options for a future initial public offering (IPO). While this episode might seem like just another day in the tech industry, it highlights an important public policy issue facing startups—and the future of the tech industry.
As startups experience high growth, they often face two choices. Founders can decide to sell their company and use the proceeds to start another company or pursue another project. Alternatively, companies can stay independent and seek further financing through loans or an initial public offering. However, strict regulations restrict entrepreneurs’ ability to pursue either option, and thus act as a barrier to entrepreneurial dynamism and innovation. As policy makers consider how to maintain a favorable regulatory environment for America’s tech companies, they should consider expanding the financing and exit options for high-growth startups such as Discord.
Policy makers might believe that every founder wants his or her company to be the next Google or Facebook, but that is often not the case. Many entrepreneurs want their companies to become valuable enough for market incumbents like Alphabet and Microsoft to acquire them at a high price. According to a survey by Engine, a research and advocacy organization, 90 percent of startup exits between 2008 and 2018 involved acquisition by another company (the remaining 10 percent were through IPO).
However, the recently increased antitrust scrutiny of tech acquisitions means that founders often experience difficulties selling their startups to established tech companies. Whereas Discord could have pursued negotiations with several Big Tech companies—such as Alphabet, Apple, and Facebook—Microsoft was the only major player to bid for it. Given recent developments in the regulatory environment, that should not be surprising.
Recent antitrust lawsuits against Facebook and Google by the Department of Justice, the Federal Trade Commission, and several state attorneys general are likely to make other Big Tech companies more reluctant to attract further scrutiny by pursuing acquisitions. That means less competition for buyouts among major companies, which translates into potentially lower offer prices for startups.
Startups need access to financing to offer new services, hire new employees, and expand business operations. However, the 2008 Dodd-Frank Act has made it more difficult for small businesses to secure financing from banks—especially as financial institutions seek to avoid increased risk by lending to startups. And while venture capital (VC) is becoming an essential source of business financing, VC funding remains out of reach for many startups.
As my CEI colleague Iain Murray points out, access to financing remains especially difficult for small businesses in rural areas. For instance, new startups based in Pennsylvania and Montana are likely to experience greater difficulty in securing funding than San Francisco- and New York-based firms—even if their business plans are excellent. Likewise, while companies in sectors like payment systems and artificial intelligence find it relatively easy to secure funding, startups in less tech-intensive sectors face more difficulties in obtaining financing.
Finally, instead of selling, founders can decide to remain independent, offer equity stakes via initial public offering, and publicly list their company. Yet, the choices available for tech companies that want to remain independent and seek alternative financing options remain limited.
The tightening of rules surrounding public listing means that IPOs have become cumbersome and expensive. Costly underwriting fees, legal fees, and Sarbanes-Oxley compliance costs (including reporting and disclosure requirements) mean that IPOs remain out of reach for most tech companies.
According to PricewaterhouseCoopers, an IPO for a company with less than $100 million in annual revenue costs between $2.6 million and $13.4 million—plus $1 to $2 million per year in compliance costs for running a public company. As a result, many tech companies are deciding to wait until they have much more revenue before going public—and many might not even be profitable yet.
Despite the potential of direct listings as an alternative to IPOs, it remains relatively uncommon. While companies such as Slack and Spotify are examples of successful direct listings, current regulations prevent companies from raising money from underwriters through direct listings. Special purpose acquisition vehicles (SPACs) have great potential for startups, but the associated costs remain expensive. Furthermore, new proposed legislation—such as Sen. John Kennedy’s (R-LA) SPAC bill—could increase compliance costs for certain SPACs.
Despite the difficulties that startups face in selling their company and receiving funding, policy makers continue to ignore such challenges. Instead, the policy conversation in Washington appears to be increasingly focused on the largest companies. While Big Tech companies are undoubtedly crucial to the U.S. economy, their slowing rate of innovation means that policy makers need to improve the regulatory environment for startups that can spearhead innovations. Expanding financing options for tech firms and making it easier to raise money through IPOs and SPACs should be top priorities to that end.