Is there a kill zone in tech?

Recently, Noah Smith explored an emerging question in tech. Is there a kill zone where new and innovative upstarts are being throttled by the biggest players? He explains,

Facebook commissioned a study by consultant Oliver Wyman that concluded that venture investment in the technology sector wasn’t lower than in other sectors, which led Wyman to conclude that there was no kill zone.

But economist Ian Hathaway noted that looking at the overall technology industry was too broad. Examining three specific industry categories — internet retail, internet software and social/platform software, corresponding to the industries dominated by Amazon, Google and Facebook, respectively — Hathaway found that initial venture-capital financings have declined by much more in the past few years than in comparable industries. That suggests the kill zone is real.

A recent paper by economists Wen Wen and Feng Zhu reaches a similar conclusion. Observing that Google has tended to follow Apple in deciding which mobile-app markets to enter, they assessed whether the threat of potential entry by Google (as measured by Apple’s actions) deters innovation by startups making apps for Google’s Android platform. They conclude that when the threat of the platform owner’s entry is higher, fewer app makers will be interested in offering a product for that particular niche. A 2014 paper by the same authors found similar results for Amazon and third-party merchants using its platform.

So, are American tech companies making it difficult for startups? Perhaps, but there are some other reasons to be skeptical.

First off, the nature of the venture capital market has changed due to the declining costs of computing. Not too long ago, much of a tech company’s Series A and B would be dedicated to buying  server racks and computing power. But with the advent of Amazon Web Services (AWS) and other cloud computing technologies, this need has dried up.

What does this mean for the ecosystem? Ben Thompson explained the impact back in 2015:

In fact, angels have nearly completely replaced venture capital at the seed stage, which means they are the first to form critical relationships with founders. True, this has led to an explosion in new companies far beyond the levels seen previously, which is entirely expected — lower barriers to entry to any market means more total entries — but this has actually made it even more difficult for venture capitalists to invest in seed rounds: most aren’t capable of writing massive numbers of seed checks; the amounts are just too small to justify the effort.

Instead, venture capitalists have gone up-market: firms may claim they invest in Series’ A and B, but those come well after one or possibly two rounds of seed investment; in other words, today’s Series A is yesteryear’s Series C. This, by the way, is the key to understanding the so-called “Series A crunch”: it used to be that Series C was the make-or-break funding round, and in fact it still is — it just has a different name now. Moreover, the fact more companies can get started doesn’t mean that more companies will succeed; venture capitalists just have more companies to choose from.

Research is only now catching up with Thompson’s hunch. In a newly released NBER working paper, economists David Byrne, Carol Corrado, Daniel E. Sichel find that prices for computing, database, and storage services offered by AWS dropped dramatically from 2009 to 2016. As they concluded, “cloud service providers are undertaking large amounts of own-account investment in IT equipment and that some of this investment may not be captured in GDP.”

Second, a decline in startups was predicted by Nobel winning economist Robert Lucas back in 1978. Over time, Lucas surmised, productivity increases will yield wage increases, which in turn will incentivize marginal entrepreneurs to become employees. This will increase productivity at the company, but also increases the size of the firm. Over time, as productivity and wages inch upwards, working at a firm gets incentivized over starting a company. Entrepreneurs as a portion of the economy will thus decline and industries with higher productivity rates will see bigger firms.

Recent analysis of 50 separate national economies confirmed the inverse relationship between entrepreneurship rates and Gross Domestic Product (GDP), which has also been confirmed by the World Bank Group Entrepreneurship Survey as well. Time series analysis also hints at this relationship. Employment within large firms tends to grow over time as a country gets wealthier. Analysis of the Census Business Dynamics Statistics (BDS) illustrates this, as does groundwork conducted in American manufacturing from 1850 to 1880. But the United States isn’t the only country where this relationship can be found. The same trend exists for Canada, Germany, Indonesia, Japan, South Korea, and Thailand.

Moreover, the distribution of firms tends to change as a country becomes wealthier. As economist Markus Poschke noted, “richer countries thus feature fewer, larger firms, with a firm size distribution that is more dispersed and more skewed.” So, it not just the United States that has large firms. Sweden, the Netherlands and Ireland all have large firms, but they too are relatively wealthy by international standards. Productivity goes a long way to explain the distributional changes.

Nicholas Kozeniauskas, a recent minted economist from NYU, also has been working on research showing the skewed nature of entrepreneurism, which adds some depth to this conversation. As he found, the decline in entrepreneurship has been more pronounced for higher education levels. Overall, “an increase in fixed costs explains most of the decline in the aggregate entrepreneurship rate.”

As of right now, I think we should be unsatisfied with the evidence of a kill zone. The research doesn’t point in the same direction. But as new insight comes in, we will need to update, as always.

First published Nov 7, 2018