Investors in tech start-ups are keenly attuned to their exit strategy when they obtain most (or all) of their return on investment. Significantly, most start-ups never intend to reach full scale; instead, they develop many innovations with the specific intent to sell out (a “liquidity event”) to well-established firms that can exploit value-creating network effects.

Yet this market reality seems to be an inconvenient truth to members of the progressive Neo-Brandeisian school of antitrust. Neo-Brandeisians apparently believe that small firms should always be brought up to scale, providing (in their view) much-needed competition to incumbent firms in concentrated markets. For this reason, over the last several years, there have been a variety of proposals to increase antitrust scrutiny and regulation of the tech sector to raise barriers to the acquisition of nascent firms by established platforms.

For example, in the last Congress, the Subcommittee on Antitrust, Commercial and Administrative Law of the Committee on the Judiciary released a Majority Staff Report entitled Investigation of Competition in Digital Markets (Democratic Majority Staff Report), which viewed the acquisition of small innovative companies by larger platforms as a primary competitive problem in digital markets. To limit such acquisitions, the Democratic Majority Staff Report argued for “the creation of a statutory presumption that a market share of 30% or more constitutes a rebuttable presumption of dominance by a seller, and a market share of 25% or more constitutes a rebuttable presumption of dominance by a buyer.” Similarly, a 2019 report from the Stigler Center of the University of Chicago suggested that all mergers “between dominant firms and substantial competitors or uniquely likely future competitors should be presumed to be unlawful, subject to rebuttal by defendants.” Other progressive politicians, such as Senator Elizabeth Warren and Representative Alexandria Ocasio-Cortez, have echoed these sentiments. These proposed presumptions imply that combinations involving firms with larger market shares always reduce competition from emerging technologies and disincentivize innovation, and are therefore inherently anticompetitive.

Although legislation has yet to be enacted to codify such proposals, the Biden administration—which has adopted a full-throated embrace of the Neo-Brandeisian School—has launched efforts to restrict small firm acquisitions by incumbent players in digital markets by administrative fiat.

For example, in December 2023, the Department of Justice (DOJ) and the Federal Trade Commission (FTC) revised their Merger Guidelines to codify their Neo-Brandeisian view of antitrust enforcement. According to Guideline 4, the DOJ and FTC believe that “mergers can violate the law when they eliminate a potential entrant in a concentrated market.” To determine whether to bring an enforcement action, the DOJ and FTC state that they will look at both objective and subjective evidence. Looking at objective evidence is entirely legitimate, but assigning equal weight to subjective evidence is problematic as it allows the enforcement agencies to pursue their biases.

And the Biden administration certainly has its Neo-Brandeisian biases. As the new Merger Guidelines state:

because concentrated markets often lack robust competition, the loss of even an attenuated source of competition such as a potential entrant may substantially lessen competition in such markets. Moreover, because the Agencies seek to prevent threats to competition in their incipiency, the likelihood of potential entry that could establish that a merger’s effect “may be” to substantially lessen competition will generally not equal the likelihood of entry that would rebut a demonstrated risk that competition may be substantially lessened.”

The Biden administration’s efforts to restrict acquisitions of start-ups in digital markets undoubtedly have economic consequences. After all, such restraints may alter the timing of an investor’s exit, affecting the incentives for innovation. How will firms respond?

To help answer this question, in a 2021 paper entitled Innovation, Exit, and Restrictions on Tech Mergers and Acquisitions, the Phoenix Center’s economists modeled the effects of potential limitations/prohibitions of small firm acquisitions by “dominant” firms in digital markets. Using a three-stage game with three actors (the innovator, a dominant platform, and a non-dominant platform), they scrutinized the decisions of innovators and technology platforms both with and without a statutory restraint on acquisitions by large platforms.

Central to their theoretical argument was the assumption that under the Democratic Majority Staff Report’s recommended amendments to the Clayton Act (and similar constraints offered by others), a dominant digital platform may acquire an innovation early in its development—prior to the public availability of the innovation—to avoid triggering antitrust review, such as by acquiring the human resources (or other assets) necessary for the innovation’s development. They showed that restrictions on acquisitions by the large platforms will adversely affect investments in innovations and alter the innovator’s exit strategy, incentivizing innovators to transfer their innovations to dominant firms in even earlier stages to avoid antitrust scrutiny. These prohibitions may encourage innovators to choose this early exit strategy despite it being inefficient (absent rules against acquisition), and they will additionally drive more in-house innovation at the big firms and produce less external innovation. Similarly, the authors showed that efforts to block later-stage acquisitions will likely reduce the returns on innovation, thus reducing technological advancement in the industry.

Their analysis proved prescient.

For example, in January 2024, Amazon was forced to abandon its $1.4 billion acquisition of robot vacuum maker iRobot after the European Commission informed the parties that it intended to challenge the acquisition. The FTC quickly claimed credit for blocking the deal. Shortly thereafter, iRobot announced that it was going to lay off about thirty-one percent of its workforce and slash its R&D budget. Yet despite this loss of capital, jobs, and innovation, progressive policymakers were thrilled with this outcome.

More recently, on March 20, 2024, Stratechery published an article entitled Microsoft and Inflection AI, Inflection Oddities, The Acquisition That Isn’t, reporting on the “bizarre” arrangement between Microsoft and artificial intelligence start-up Inflection AI. Combing through press reports, Stratechery discovered that rather than buy Inflection outright, Microsoft entered into an arrangement whereby, among other things, it would hire the bulk of Inflection’s staff and would enter into a licensing agreement for Inflection’s technology, which would be available for sale on Microsoft’s Azure platform. Yet even though this arrangement left Inflection as a “shell of its former self,” shortly thereafter the company was nonetheless able to raise an additional $1.4 billion dollars. Noting that “[e]verything about this is weird,” Stratechery concluded that “this is an acquisition in everything but name, just in the most convoluted way possible; the FTC can pat itself on the back . . . while Microsoft probably pays less than they might have otherwise.”

In the end, both the Phoenix Center’s analysis and the Microsoft/Inflection deal remind us once again of the immutable economic maxim: firms are not passive recipients of regulation. Despite the Biden administration’s hostility towards small firm acquisitions by incumbent players, such transactions will continue—just earlier in the innovation sequence and for less value than if the government allowed the transaction to occur at the most efficient time. In the meantime, as the iRobot case demonstrates, for those transactions that do not adapt to the current hostile antitrust environment, innovation and jobs are likely to suffer in digital markets.

Note from the Editor: The Federalist Society takes no positions on particular legal and public policy matters. Any expressions of opinion are those of the author. We welcome responses to the views presented here. To join the debate, please email us at [email protected].