In new research, Wentian Zhang finds that a reduction in antitrust enforcement causes venture capitalists to significantly decrease their investments in startups, leading to fewer startups going public and diminished innovation.

Venture capital and startups backed by VCs are important contributors to the economy. According to Will Gornall and Ilya Strebulaev, around half of public firms in the United States founded within the past 50 years were financed by a VC fund in their early stage, defined as the first three stages of a company’s development comprising seed, start-up, and early-growth funding. However, these startups are vulnerable to the anticompetitive conduct of large firms. For example, some large firms drive competitor startups out of business by selling competing products below cost, i.e., predatory pricing (e.g., Wal-Mart Stores, Inc. v. American Drugs, Inc.). Other large firms acquire startups and then terminate the development of the startups’ innovations to preempt future competition, also known as killer acquisitions (see Colleen Cunningham, Florian Ederer, and Song Ma).

Antitrust laws endeavor to prevent these anticompetitive behaviors, and recently, we have seen antitrust enforcement intensify in the U.S. In December 2022, the Federal Trade Commission sued Microsoft over its acquisition of Activision for allegedly harming competition in the gaming industry. Shortly thereafter, in January 2023, the Department of Justice Antitrust Division filed its second lawsuit against Google in just over two years, seeking to break up Google’s online advertising business. These major antitrust cases against tech giants have caused VC investors to debate if this more intense antitrust enforcement will help or harm startup formation and success. Some VCs express concerns that more intense antitrust enforcement will deter large firms from acquiring startups, thus stifling an important pathway for VC exit, the major incentive to initial startup backing. Other VCs suggest that stronger enforcement will level the playing field and enhance startups’ chances of survival against established large firms. Therefore, how antitrust enforcement actually affects VC investments in startups is an important empirical question.

In my new working paper, “The Effect of Antitrust Enforcement on Venture Capital Investments,” I answer this question by estimating how regional VC-investment levels changed in response to the DOJ Antitrust Division closing four of its seven field offices in 2013, thus reducing scrutiny and enforcement in those regions. I find that annual VC investments in a startup decreased by around $683,000 on average across the five years after the antitrust office closures, or about 17% less than the average  VC investment in a startup before the 2013 office closures. This decrease was driven by fewer VC investors participating in each round of financing and investors making smaller investments on average. The effect is abrupt and persistent, with no signs that levels of VC startup investments were fluctuating significantly before the office closures in 2013.

By comparing the change in VC investments in startups near closed antitrust offices with the investments in startups near remaining offices, I was able to disentangle the effect of lower antitrust enforcement from the baseline dynamic of VC investments around the antitrust office closures event. In addition, the findings cannot be explained by concurrent events such as local economy changes, since there’s no evidence of any shifts in local GDP coinciding with the antitrust office closures in 2013.

Additional tests show that VC-backed startups located in areas less protected by the antitrust division have a lower chance of successful VC exits. These startups also produced around 17% fewer patents after local antitrust office closures. This is because they received less financial support from VC investors and thus were hindered from investing in risky R&D projects. These results imply long-term negative effects of lower antitrust protection on innovation and the development of VC-backed startups.

In addition to finding that the office closures reduced additional rounds of VC investment in startups and startup innovation, I also find that the number of new startups backed by VCs dropped by around 10%. This result indicates that VCs decided to initiate fewer investments in new startups located in areas less policed by antitrust, which accounts for the profound impacts of antitrust enforcement on the local product market competition, employment, and thus macroeconomy, as pointed out by Tania Babina, Simcha Barkai, Jessica Jeffers, Ezra Karger, and Ekaterina Volkova.

Why does the reduction in antitrust enforcement negatively affect startups and VC-financing decisions? With lower antitrust enforcement, large firms that see the startups as future competitors are more likely to strangle their growth and success, such as by predatory pricing or exclusionary acts to monopolize the product market. Considering the heightened failure risks, VCs reduce their startup investments. To verify this hypothesis, I compared how the office closures impacted startups in more concentrated markets versus those in more competitive markets, with industry concentration measured by the Herfindahl–Hirschman index (HHI). Presumably, large firms in more concentrated markets command the market power and funds to effectively use anticompetitive tools to stifle startup growth. Indeed, it turns out that startups in more concentrated industries were harmed more by the office closures. Specifically, startups in more concentrated industries experienced on average a $1.1 million decline in annual VC investments, which accounts for 22% of annual VC investments in a startup in those industries before the office closures. In comparison, the effect of office closures on startups in more competitive industries was insignificant.

In summary, the results in my paper show that the reduction in antitrust enforcement leads to a decrease in VC investments and harms startup innovation and development in the long run. The negative effect is stronger for startups in more concentrated industries where anticompetitive practices by large firms are more frequent. These results indicate that local antitrust enforcement is important in promoting competition and innovation by protecting startups from abuse by large firms with high market power.

Author’s Disclosure: The author has no conflicts of interest to disclose.

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