If You Don’t Think Today’s Tech Giants Are Vicious, Just Ask Venture Capitalists

Silicon Valley today resembles the deepest part of the jungle known as the triple canopy, where tall trees block out all the light and nothing can grow on the ground. Who knows how many good businesses are not funded because of the fear of the tech monopolies?

 

 

It is normal for big companies to throw shade on their competitors, and this metaphor applies in Silicon Valley, as well.

 

As we were researching our book, The Myth of Capitalism, a venture capitalist told us that the tech economy had now turned into a jungle. The metaphor of predators and prey made sense to us, but he was much more specific. Silicon Valley today resembles the deepest part of the jungle known as the triple canopy, where tall trees block out all the light and nothing can grow on the ground. Today, very little sunlight reaches the startups. Most city dwellers think it is impossible to walk through jungles because of how dense they are, but that is only partly true. Deep in the rainforests there is a unique structure of several vertical layers of trees, each forming a canopy. The top canopy goes up to 130 feet above the forest floor. Almost all the wildlife lives in the canopy; many animals live high in the trees and never set foot on the ground below in their entire lives. Once you get inside the heart of the jungle in the triple canopy, almost nothing grows on the ground. Only 2 percent of sunlight reaches the ground after getting through all the leaves. All that is left on the floor is a thin layer of fallen leaves and branches that very quickly decomposes.

 

American soldiers were very familiar with the triple canopy in the Vietnam jungle. The humidity down below was a stifling 95 percent, exhausting men and rotting clothing. Almost nothing could survive for long underneath. The Ho Chi Minh Trail itself was in the triple-canopy jungle, which made it almost impossible for helicopters and planes to see through the trees and support US troops below. The response of the Department of Defense was to dump 19 million gallons of herbicide that poisoned the land. Between Google, Amazon, Apple, Facebook, and Microsoft, they have collectively bought over 436 companies and startups in the past 10 years, and regulators have not challenged any of them. In 2017 alone, they spent over $31.6 billion on acquisitions. Most small companies now do not expect to succeed on their own and their only goal is the “exit” to one of the big tech companies before they are crushed.

 

The threat of unlimited losses against a big player is reason enough for startups to sell to the incumbents. The retailer Diapers.com initially rejected Amazon’s efforts to acquire it. In response, Amazon responded by slashing its own diaper prices in a clear effort at predatory pricing. The executives at Diapers.com calculated that, based on the cost of diapers from Procter & Gamble and shipping costs, Amazon was going to lose $100 million in one quarter merely in diapers. As a startup that needed venture capital funding, there was no way they could raise that amount of capital in order to compete with Amazon. In the end, Amazon made them an offer they could not refuse.

 

It would appear irrational for Amazon to sell diapers at a loss, but Amazon is not a normal company. In their book Matchmakers, David Evans and Richard Schmalensee have pointed out that, “Traditional economics holds, for example, that it’s never profitable to sell products at less than cost. The new multisided economics shows that even paying some customers rather than charging them anything can be profitable in theory and often is in practice.”1)David S. Evans and Richard Schmalensee, Matchmakers: The New Economics of Multisided Platforms  (Harvard Business Review Press, 2016). Kindle Edition, locations 322–323. Given the winner take all dynamics of being a platform company, Amazon will happily sell diapers at a loss if it can get more buyers and sellers interacting on its platform. Either the upstarts sell out to the bigger company, or they get ruthlessly crushed. Most founders have little choice when facing bigger players but to sell. Some founders do, like Instagram and WhatsApp did to Facebook. The ones that do not accept an offer they can’t refuse face brutal competition: their innovations are copied, they face patent lawsuits, and their top talent is poached.

 

The tech giants love startups, but in the same way that lions love feasting on lifeless carcasses of gazelles. Either they provide innovations the giants can’t come up with in-house, or they pay a toll to the big tech companies for the pleasure of using their infrastructure. There is perhaps no better example of this dynamic than what has happened to Snap, the company that makes the disappearing messaging app Snapchat. Although it is one of the most innovative consumer-focused internet companies, it has been battered by the giants. Snap raised $3.4 billion in one of the biggest Initial Public Offerings in years. After failing to buy Snap when it was a rapidly growing startup, Facebook repeatedly copied and cloned its key innovations for Instagram, another startup that Facebook bought. Snap shares are languishing below its IPO price, another road kill of the tech giants, and funding may be harder to come by for the next David to challenge a Goliath.

 

The tech giants love startups, but in the same way that lions love feasting on lifeless carcasses of gazelles.

 

But Facebook isn’t the only giant feeding off Snap’s carcass. In January, Snap signed a cloud-hosting deal with Google. Snap agreed to pay Google $400 million a year for the next five years, which is about half its yearly revenue.

 

Startups that receive venture capital funding from the tech giants learn things the hard way. Jonathan Frankel was ecstatic when Amazon’s venture capital group invested $5.6m into his startup Nucleus, a startup that focused on communication and video. A year later, however, Frankel was furious. Amazon launched its latest voice-controlled device, the Echo Show, a clone of the Nucleus product. As he told Recode, “they want to sell more detergent; we actually want to help families communicate easier.”

 

While the technical costs of building an online service are cheaper than ever, it has never been harder for startups to succeed. Online platforms control the essential infrastructure on which their rivals depend. The big tech companies run server clouds, app stores, ad networks, have venture firms, and they control the backbone of the Internet.

 

Startups spend hundreds of millions of dollars of advertising on Facebook and Google to get their product in front of potential users. They need Apple and Google’s approval to appear in the app stores. They pay Google and Amazon for their servers and pipes. Much like the medieval European peasants, the startups pay robber barons to cross their roads, hoping they will not be attacked along the way. Google is so far ahead of competitors that no companies have even entered Google’s search market since 2008. No venture capital group will ever fund a search engine.

 

Much like the medieval European peasants, the startups pay robber barons to cross their roads, hoping they will not be attacked along the way.

 

 

Google’s scale is staggering and impossible to comprehend, as much of its technology is still a highly guarded secret. To put things in perspective, if Google were not a search engine, it would be considered one of the top three internet service providers in the world, based on its ownership of fiber-optic cables. Google has dozens of data centers scattered around the world, with at least 12 located in the United States.  One of the largest Google data centers in Oregon is approximately the size of two American football fields, with cooling towers four stories tall. Google has invested $30 billion in infrastructure over the past three years on cables connecting its cloud data centers. There is simply no way any startup can compete with that level of capital spending.

 

It is not only Google that controls the fabled information superhighways that everyone’s data passes through. Increasingly, the big internet monopolies are building and own the world’s fiber-optic cables. Google and Facebook partnered to lay the first 8,000-mile cable that directly connects Los Angeles to Hong Kong. Facebook and Microsoft announced they would be building the Marea cable, which will offer speeds of 160 terabytes per second across the Atlantic. They own the pipes of the utility on which others will have to pay tolls.

 

If you don’t think today’s companies are vicious, just ask venture capitalists. In the words of Benedict Evans, a venture capitalist, Google, Facebook, and Amazon are “aggressive street fighters. All of these companies have the benefit of 20 years more history – they saw what happened to Microsoft” and they won’t let it happen to them.

 

“If you provide great content in one of these categories that is lucrative to Google, and seen as potentially threatening, they will snuff you out,” said Jeremy Stoppelman, cofounder and CEO of  Yelp. “They will make you disappear. They will bury you.”

 

The situation is very much like the late 1990s when it was widely known that venture capital funds wouldn’t fund you if you were going to go into an area where Microsoft was involved. If a new product or program interfered with Microsoft’s objectives, Microsoft employees would use language like ‘let’s go “knife the baby,”’ as a metaphor for killing off the small competitor.

 

Today, the same thing is happening again. Albert Wenger, a managing partner at Union Square Ventures states, “The scale of these companies and their impact on what can be funded, and what can succeed, is massive.” Wenger noted that many investors simply refuse to fund businesses that are in the “kill zone.”

 

Who knows how many good businesses are not funded because of the fear of the tech monopolies? As Stoppelman told 60 Minutes in an interview, “If I were starting out today, I would have no shot of building Yelp.” Today’s giants have created an ecosystem that enriches themselves even when they don’t think of the best ideas first. For the biggest tech firms, competing against startups has become a one-way bet.

 

[Excerpted from The Myth of Capitalism: Monopolies and the Death of Competition by Jonathan Tepper and Denise Hearn. Reprinted with permission by the authors.]

 

For more on Silicon Valley and competition, watch Luigi Zingales in conversation with Yelp CEO Jeremy Stoppelman and Financial Times journalist Hannah Kuchler:

 

 

Disclaimer: The ProMarket blog is dedicated to discussing how competition tends to be subverted by special interests. The posts represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty. For more information, please visit ProMarket Blog Policy

References   [ + ]

1. David S. Evans and Richard Schmalensee, Matchmakers: The New Economics of Multisided Platforms  (Harvard Business Review Press, 2016). Kindle Edition, locations 322–323.