Is big business threatening your venture capital funded start-up?

Venture capital investors can adopt a number of strategies to strengthen their start-up investments in the face of competition from cashed-up corporates

Competing with well-established multinational corporates can be challenging for any startup businesses, especially when they’re up against the corporate giants’ lethal weapon: cash. Known as the “war chest of competition”, large companies are now sitting on record cash stockpiles. In the US alone, for example, 13 companies in the S&P 500 (mainly tech giants such as Apple, Alphabet and Microsoft) are sitting on cash and investments worth more than US$1 trillion (A$1.43 trillion). In fact, Apple has so much cash (equivalent to 7 per cent of the holdings of all S&P 500 companies) that it is trying to dispense of its cash in capital markets using both dividends and share buybacks.

There are a number of reasons why corporates are hoarding cash. Cash can help these market incumbents finance their strategic responses, for example. And incumbents can also defend their market position by ramping up the competitive pressure on start-ups and other early-stage companies, causing them to fail.

“Anecdotal evidence suggests that large incumbent companies can make entry and growth difficult for start-ups,” says Roham Rezaei, a PhD student in the School of Banking and Finance at UNSW Business School, who is in the final year of his PhD. “For example, incumbents can copy start-ups’ novel ideas and develop similar products. Or they can offer their competing products for free (or at lower prices) to kill the rival start-up.”

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UNSW Business School PhD student Roham Rezaei says economists are worried about the decline of business dynamism and its potential impact on entrepreneurship. Photo: supplied

Elastic (a start-up tech firm in the US) is a good example of this, Mr Rezaei explained. As a budding data management company, the company’s core product was a data analysis tool users had to pay to use. However, Amazon copied the product (and even gave it the same name, Elasticsearch) – and offered it for free. “This severely damaged the start-up’s revenue,” said Mr Rezaei.

Competition: then and now

In framing the research, which was co-authored by UNSW Business School’s Professor Jason Zein and University of Sydney Professor Peter Pham, Mr Rezaei explained that the concept of creative destruction (coined by the Austrian-born economist Joseph Schumpeter) is very intriguing. “His idea is simple: for capitalism to work, markets shall remain competitive. And the condition for that competitiveness is the emergence of creative up-start companies that can challenge incumbent ones. This ensures the introduction of superior, innovative products which improve consumer welfare,” he said.

Read more: Is the party over for early stage VC investment?

There are many examples of this, such as TV streaming services versus traditional TV stations, taxi and ride-sharing apps versus conventional taxis, or the rise of Apple which led to the fall of Nokia. “This is business dynamism: the rise of new up-start companies and the fall of the existing incumbent companies,” explained Mr Rezaei.

Recently, however, he said some economists have become worried about the decline of business dynamism and its potential impact on entrepreneurship. One factor that concerns them is higher barriers to entry – thanks in no small part to cashed-up market incumbents. So what is the market outlook for start-ups, and can they respond to the competitive threat of bigger cashed-up companies?

“Not all start-ups that face the giants were squashed,” Mr Rezaei explained. When high-growth Silicon Valley-based company Zoom was founded in 2011, it was competing directly against Cisco and Adobe, which were developing similar video-calling tools. One year later, Microsoft also became a threat to Zoom when they acquired Skype. “We know this story’s end: Zoom (now a unicorn company) survived and thrived big time. So, what is the difference between VC-backed success stories such as Zoom, which managed to outdo the incumbents and Elastic, which fell prey to Amazon?” he asked.

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When Zoom was founded in 2011, it was competing directly against Cisco and Adobe, and it went on to become a unicorn company. Photo: Shutterstock

This was the focus of Mr Rezaei’s PhD research paper, Patient VCs vs. Deep-Pocketed Incumbents: VC Financing Strategies in the Presence of Competitive Threats, which examines how financing exposes venture capitalist (VC) portfolio companies to competitive threats from industry incumbents and how this affects the dynamics of venture capitalist financing.

Venture capitalists and financing start-ups

Mr Rezaei, who was a runner-up for the 2022 Three Minute Thesis (3MT) Competition Business School Heat for his PhD research, said venture capital investors face a lot of unknowns in the financing of start-ups. “Compared to established businesses, start-ups have less of a track record,” he explained.

“The quality of their management team is usually unknown, and they also have high failure rates. Venture capitalists, nevertheless, have specific tools in their box to alleviate these concerns. Perhaps the most potent one is stage-by-stage financing,” said Mr Rezaei, who explained that venture capital investors rarely provide all the capital the start-up needs upfront for fundraising (as opposed to an equity stake). Instead, they break the investment down into multiple stages (such as multiple seed round series A, series B etc.). Staging provides venture capitalists with the option to terminate further financing in case of poor performance, and he explained that this helps VC funds limit their exposure to high risks associated with startup investment opportunities.

Read more: Seven ways to tell whether a private equity-backed IPO should be avoided

However, a seminal economics theory highlights a trade-off in start-up financing; if investors are very strict in implementing their staging (i.e., the conditionality of financing on performance), they might make the start-up prone to predatory actions from bigger, more-established competitors. “By making a firm’s future funding conditional on performance, staging also incentivises incumbent rivals to prey on start-ups so that they do not meet their milestones. Through product market predation, incumbents can jeopardise the start-up’s chance of receiving further financing,” explained Mr Rezaei.

This theory provides a critical insight, he added: “investors should lower the sensitivity of a firm’s continued financing to its performance in the presence of deep-pocketed rivals,” he said. “Venture capitalists who finance new companies that compete with more deep-pocketed rivals are forced to be more patient and less strict in their financing.”

This insight was corroborated by the research. “When start-ups face deep-pocketed rival incumbents, venture capitalists provide larger amounts of money in each round of financing to the start-up,” said Mr Rezaei. “We also show that if the start-up faces incumbent competitive threats, venture capitalists put less weight on the start-up’s revenue when pricing the round. Revenue is a crucial metric of start-up performance and a component for valuation. Venture capitalists’ lower emphasis on it, in the presence of cash-rich rivals, supports the insight from patience. In other words, venture capitalists do not punish start-ups under tough competition if their revenue is low.”

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Amazon copied the product of start-up rival Elastic, which severely damaged the start-up’s revenue. Photo: Shutterstock

Reducing financing risks for venture capital investment

There are a number of practical implications in the research for start-ups, entrepreneurs and venture capital firms, which can provide more capital to start-ups that face more competitive threats. This capital empowers those start-ups to compete more strongly in the product market and “not be crushed by the giants”. But Mr Rezaei said the flip side of more capital provision is more risk exposure for VC firms – which should carefully assess their appetite for additional risk and VC investments.

However, these risks can be mitigated to some degree. Venture capitalists can substitute the lower conditionality in their financing with more intense monitoring and demanding stricter contracts after examining their business model and going through the due diligence process. “For example, we observe that venture capitalists are more present on the board of directors of such start-ups. Also, they choose start-ups closer to them geographically so they can visit the company and meet the founders and employees (for mentoring, for example) more often. Furthermore, they can demand clauses that protect them against downsides,” said Mr Rezaei.

How start-ups can get their business off the ground

The research also found that larger and more experienced venture capital funds (such as Sequoia Capital) can help start-ups deter predation threats more effectively, from investing in early-stage companies through to the IPO process. “In other words, if you face deep-pocketed rivals as a start-up, you better be backed by deep-pocketed VCs. Larger funds can provide you with more ammunition in the battle against the incumbent, which can pre-emptively deter the threat,” said Mr Rezaei.

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Moreover, the experience of those in the venture capital industry and other investors such as private equity funds, angel investors and accelerators matters too. Through funding similar venture-backed companies in the past, those in the venture capitalist ecosystem accumulate deep expertise, familiarising them with the startup’s product market and business plans. This experience enables venture funds to judge the firm’s long-term promise without relying on current financial metrics (such as revenue or profitability associated with high returns), which the incumbent’s predatory actions can undermine, said Mr Rezaei.

In conclusion, he underscored the importance of patience for venture capital investors financing startups facing competitive threats by larger and cashed-up businesses. “Patient financing contributes to the entry and growth of innovative start-ups, which is essential for the creative destruction that has contributed to the betterment of our lives as consumers,” he said.

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