Will the courts kill California’s venture capitalist economy?

On Wednesday, a federal appeals court heard oral arguments for and against the Federal Trade Commission’s antitrust case against Microsoft and game developer Activision Blizzard’s announced merger.

Having studied venture capital for over a decade, I believe the court’s decision will have a far broader reach than video games or this one case. Its ruling will either signal that venture capital investing can remain a cornerstone of the United States economy or that the nation’s leading antitrust regulators have a right to pull it back.

Venture capital involves high-touch support for young, innovative, and risky firms. It offers them financing, mentorship, strategic guidance, and network access from some of America’s leading entrepreneurs and companies.

California receives the vast majority of the nation’s venture capital investments. In 2022, it accrued $104 billion of it. The next two runner ups did not even have one-third of that amount.

While most companies that receive venture capital funding fail, others become significant successes. Research I conducted in 2015 showed that three out of the five largest global companies and one-fifth of publicly traded U.S. companies have received venture capital financing.

These numbers have only gone up since then. In a 2021 study I conducted with Will Gornall from the University of British Columbia, we found that venture capital-backed companies account for 41% of total U.S. market capitalization and 62% of U.S. public companies’ research and development spending. Among public companies founded within the last fifty years, venture capital-backed companies accounted for half by quantity, three-quarters by value, and more than 92% of all research and development spending and patent value.

The U.S. venture capital industry is an important ingredient of California’s growth engine. Without it, Apple, Netflix, Airbnb, Zoom, and many other California-based companies would likely have never come to fruition. Our lives would be vastly different.

However, without mergers and acquisitions, California’s venture capital economy cannot function.

For the venture capital industry to thrive, venture capitalists must be able to have successful exits. Exits enable venture capitalists to return money to their investors and raise new funds to invest in the next generation of startups. Even though the most talked about venture capital exits are the venture capital-backed companies that go public, ten or more merge or are acquired for each that goes public. Without a viable option of successful mergers and acquisitions, the venture capital industry will likely come to a halt.

With the proposed Microsoft and Activision merger, the FTC fears the potential of centralizing industry market share. However, by making this and other mergers and acquisitions unviable exit avenues for venture capitalists, the FTC could instead hurt the tens of thousands of entrepreneurs who rely on venture capital investments to get their ideas going.

If venture capitalists know their investments are unlikely to exit via acquisitions, they will develop higher bars for investing.

In fact, in my experience, many venture capitalists often know that acquisitions are the only viable options for many of their portfolio companies. Blocking venture capitalists’ exits will result in less investment, fewer startups, less innovation, and a greater chance of California losing the competitive position it has in fields ranging from healthcare to artificial intelligence.

If venture capitalists cannot ever cash out, as their companies get acquired by more established entities, they will reduce investments throughout the entire economy. We will have not only fewer acquisitions. We will miss on the next Apple, Uber, and Amazon.

A government that can shut down the next Google or Netflix out of fears that mergers and acquisitions can slow industry growth would not be good for California’s economic growth, and it would not be good for its consumers, either. Here’s hoping the appeals court makes the right decision.

Ilya A. Strebulaev is the David S. Lobel Professor of Private Equity at Stanford University and a research associate at the National Bureau of Economic Research. He also is the founder and director of the Stanford GSB Venture Capital Initiative. He is a co-author of “The Venture Mindset,” to be published by Portfolio/Penguin Random House in May 2024.