Venture Predation

Uber once seemed poised to revolutionize urban transportation. Instead of hailing a cab in the street, you could order a ride on a mobile app. Uber’s fares were surprisingly cheap—often much cheaper than taxis. Yet drivers seemed to be making more with Uber than they could by driving a cab. Uber’s low fares attracted riders, and its relatively high pay attracted drivers. Uber grew quickly, taking market share from taxi companies, and forcing some into bankruptcy. It seemed that Uber had found cost efficiencies that had eluded hidebound taxi companies. But in hindsight it has become clear that Uber’s low fares and comparatively attractive driver pay were made possible only by massive venture capital subsidies. From the start, Uber racked up heavy losses. In the past few years, Uber fares have increased steadily, but the company still has not reached sustainable profitability. If its business model never added up, how did Uber come to dominate the market for urban transportation? Venture predation.

Predatory pricing is a strategy that firms use to suppress competition. The predator’s prey are its competitors. The predator aims to drive them out of the market. The strategy has two steps. First, the predator prices its product below its own costs, losing money, but attracting more customers and increasing its market share. Unable to tolerate the losses necessary to compete, the prey exit the market. Second, once the predator dominates the market, it raises its prices to supracompetitive levels, generating monopoly profits that let it recoup the cost of predation.

Predatory pricing violates the antitrust laws. In the mid-twentieth century, it was common for plaintiffs to prevail on predatory pricing claims. But starting in the 1970s, the law began to change under the influence of Chicago School economists, who argued that predatory pricing was irrational. These scholars pointed out that predators should lose more from predation than their prey because of their greater market share. They also argued that predation would only exclude the prey temporarily. The prey could withdraw from the market during predation, take out a loan, and re-enter when the predator raised its prices. And even if the old prey never returned, the predator’s supracompetitive prices should entice new firms to enter.

The Supreme Court gradually embraced the Chicago School critique. In 1986, the Court stated that “predatory pricing schemes are rarely tried, and even more rarely successful.” Then in 1993, the Court held that the plaintiff in a predatory pricing case must prove that the defendant not only priced below its cost but also had a “reasonable prospect” or a “dangerous probability” of recouping its losses. This test has proved nearly impossible for plaintiffs to satisfy.

More recently, though, post-Chicago School economists have shown that predatory pricing can be rational when firms have imperfect information. For example, a predator might create the false impression that it has achieved a new efficiency and then sharply lower its prices, leading the prey to believe it has been outcompeted on the merits. Or a predator might convince the prey’s lenders that the predator has lower costs, so the prey cannot get a loan to ride out the price war. A predator can also price below its costs in one market or at one point in time to develop a reputation that deters rivals from competing with it elsewhere or later. The post-Chicago School models are now widely accepted, but it has proven difficult to identify firms employing these strategies in the real world.

We think real world examples can be found in Silicon Valley. In a forthcoming article, we describe a new predatory pricing strategy we call venture predation. The strategy has three steps. First, venture capitalists (VCs) provide a startup—the “venture predator”—with cash for predation. Second, the venture predator uses that cash to price its goods or services below cost, grab market share, and drive its rivals out of the market. Third, once the venture predator dominates the market, its VCs—and often its founders—cash out by selling their shares to investors who believe that the company can recoup the costs of predation.

Like velociraptors, venture predators’ size belies their strength. VCs are strongly motivated to fund predation because their investment model requires them to pursue high-risk, high-reward strategies. Most startups fail, so VCs need one or two of their portfolio companies to grow exponentially to offset those losses. Venture predation can fuel rapid, exponential growth. Venture predators also benefit from the secrecy afforded to private companies. Founders and VCs can freely discuss strategy in confidential meetings. And because they do not have to disclose their financial statements, venture predators can obscure their cost structures, which makes it easier to mislead their rivals and their rivals’ lenders into thinking they have been outcompeted on the merits.

The most important innovation of venture predation is that the VCs who fund it and the founders who implement it can profit even if the predator never recoups the costs of predation. They just need to convince whoever buys their shares—an acquiror or subsequent investors—that the predator might eventually recoup its costs. Uber illustrates this point. During its IPO roadshow, Uber’s executives told investors that, even though the company was losing billions each year, they expected it would earn an adjusted profit margin of 25% after “competitive pressures” subsided. Those profits have yet to materialize. But for its VCs, Uber was a smashing success. Benchmark, the VC firm which led Uber’s Series A, generated a $5.8 billion return on an $11 million investment. To other VCs, Uber looks like a model to emulate. In the article, we show how two other venture-backed startups, WeWork and Bird, have followed Uber’s venture predation playbook.

Venture predation has real social costs. If a venture predator is able to raise its prices to a supracompetitive level, it harms consumers who pay those prices. And even if the predator is never able to raise its prices above the competitive level, it can still harm consumers by reducing their choices and depriving them of product innovations that excluded rivals or thwarted new entrants would have developed. Venture predation also distorts the price signal and leads to economically irrational decisions. Taxi drivers who thought they could make more driving for Uber—and did not realize that Uber’s pay was inflated by unsustainable subsidies—are now stuck with car loans they cannot afford. Most importantly, venture predation misallocates capital. The billions of dollars that VCs squandered on predatory pricing could have funded advances in socially valuable technologies.

We consider two kinds of interventions to deter venture predation. First, we argue that courts should reform antitrust law, either by eliminating the recoupment requirement or by letting plaintiffs satisfy it by showing that investors bought shares in a venture predator with an expectation that it would recoup its losses. At a minimum, venture predation casts serious doubt on the Supreme Court’s claim that predatory pricing is “rarely tried.” Second, we argue that requiring large, private companies to make financial disclosures—which the SEC is reportedly considering—would help expose venture predators earlier and provide their competitors with the information they need to fight back.

Download the complete paper here.