Venture capital is a $234 billion industry in the U.S. and $709 billion globally. The massive sector is celebrated for shepherding in tech giants like Meta and Amazon. But new research suggests that some of the biggest Silicon Valley darlings like Uber succeeded because of an illegal pricing strategy that is creating perverse incentives and stifling innovation.
Lawyers Matt Wansley and Sam Weinstein, colleagues at the Yeshiva University’s Cardozo School of Law, investigate it in a new research paper entitled “Venture Predation.”
“It reduces choice. It reduces innovation. You’re knocking out competitors who might come up with more efficient business models,” Weinstein told Fortune. “Uber doesn’t have a more efficient business model. It prevailed through burning cash, not through being better.”
Predatory pricing is hard to prove
Predatory pricing is when a predator (a “deep-pocketed corporation with a large market share,” Wansley and Weinstein write) lowers its prices in order to squash competition and take control of the market. That’s why you could easily afford an Uber during its early years, or how Amazon undercut essentially every bookseller in America.
Initially, the predator loses money since it is selling below its costs. But once the competitors have run out of business and fled the market, the predator raises its prices so high that they would be unsustainable in a normal market—and recoups its losses.
Predatory pricing is a type of anticompetitive practice and violates antitrust laws, which are intended to ensure a fair and free market.
Take Walmart, for example. In 1993, the now-leading Fortune 500 company lowered its prices for drugstore products at one of its stores in Conway, Ark. The prices were so low that it was driving local drugstores out of business. Walmart was found guilty for predatory pricing and was ordered to pay nearly $300,000 in damages to the local stores.
But a group of economists, called the Chicago School, said that predatory pricing is irrational and rarely tried.
The argument goes like this: Companies engaging in predatory pricing will suffer the brunt of the loss because of their larger market share. Cutting prices only pushes out competition temporarily, and even if the old competition never returns, then new competition should be able to enter the market and undercut the predator’s higher prices.
The elusive problem corrects itself, they argued.
But now it’s nearly impossible to prove predatory pricing in court, as the Chicago School influenced two key Supreme Court cases.
In Matsushita Electric Industry v. Zenith Radio, 1986, the court stated that “predatory pricing schemes are rarely tried, and even more rarely successful.” Seven years later, in Brooke Group v. Brown & Williamson Tobacco, 1993, the court established a test to prove predation: The plaintiff must prove that the defendant priced below its cost and had a “reasonable prospect” or “dangerous probability” of recouping its losses.
It’s been 30 years since Brooke Group and no plaintiff has won since.
New name, same game
Enter the venture capitalists.
Wansley and Weinstein argue that one particular strategy used by venture firms challenges the “rarely tried” argument. They’re calling it “venture predation.”
Venture predation is a three step strategy. First, venture capitalists load up a startup (the “venture predator”) with money. Next, the startup uses its stockpiles of cash to price its goods and services below cost, eliminate competition, and rapidly seize market share.
Then, once the startup has a dominant market share, the venture capitalists, and often the startup founders, cash out through an acquisition or initial public offering by selling their shares to investors who believe the startup can recoup the costs of predation.
The key point here is that cutting prices below cost is unsustainable for a company. It delays reaching profitability. But if you’re a venture capitalist, it doesn’t matter.
“They just need to create the impression of future profitability, so they can sell their shares at an attractive price,” Wansley and Weinstein write.
For instance, Uber, one of the main examples in their research, raised $24 billion from investors and used some of the cash to subsidize cheaper fares for riders and higher pay for drivers, quickly driving taxis out of the market. But Uber never had a superior product or cost efficiency, according to the authors, and in order to maintain its market share against Lyft and other ride-hailing services, it had to maintain its low prices.
“In each of the three years before its IPO, Uber racked up losses of $3 billion or more,” the authors write. “Uber reassured investors by explaining that once it became dominant, it would be able to raise its prices and recoup its losses.”
To this day, Uber still hasn’t turned a profit. But for the venture firms that cashed out with the IPO, it doesn’t matter.
Benchmark, the venture firm that led Uber’s Series A funding round, put $12 million into the startup and generated a $5.8 billion return.
“That’s one of the best investments in history, and it was predatory pricing,” Wansley told Insider.
Venture capitalists’ motivation to engage in predation comes from what is known as a power law. Most of the startups in the portfolios of venture firms will fail or only see modest growth. So to offset those losses, the returns must come from the rare, explosive startup successes.
The unpredictable likelihood of seeing returns “makes VCs focused on upside potential and relatively insensitive to downside risk,” the authors write. “They seek out startups with the potential for rapid, exponential growth and push them to take risks to realize that potential.”
Harm to innovation
Wansley and Weinstein argue that there is a tremendous social cost to venture predation. Among those costs is the harm to innovation.
By misallocating capital towards anticompetitive practices rather than socially-beneficial and productive products, venture capitalists—who often claim to help founders transform society through innovation—are actually stifling innovation.
Venture predation is just plain “wasteful,” Wansley told Fortune.
“If a company is not profitable, then you have to ask, is social value being created? And if social value is created trying to develop a technology and it just never really works, that’s okay because there’s still important learning done there,” Wansley said. “But if there was never any real technology to begin with, we question whether it’s creating any value.”
This harms the consumer, too, by reducing choice and raising prices. And in turn, the lack of market competition results in lower-quality products.
To be sure, Wansley and Weinstein don’t believe that every venture firm is actively engaging in predation. In fact, they think it’s relatively rare and that this is a “recent development.” After all, a lot of things have to go right for venture predation to work at Uber’s degree of success.
Still, it can be a tempting “fallback strategy,” Wansley said.
“I don’t think most VCs come into an investment thinking ‘we’re gonna win with predatory pricing.’ But I think once they have an investment where it seems like there’s some growth potential, and they know that consumers are very sensitive to cost, then all of a sudden, predatory pricing looks attractive,” he added.
Wansley’s and Weinstein’s insight could transform the assessment of predatory pricing cases in the courts. Their research may also discourage venture predation outright.
“Once VCs or late stage investors become convinced that there’s some serious chance that even if their company does well that they’re gonna face a predatory pricing case, then we think we can deter the strategy,” Wansley said.