2014-04-01

Co.Labs

Investors Say Lawbreakers Like Airbnb, Aereo, And Uber Are Increasingly Worth The Legal Bills

Once verboten territory for tech VCs, industries regulated by agencies like FAA, FDA, FTC, and SEC spill hundreds of millions of dollars when disrupted.



Are you a venture capital investor with a portfolio company facing a lawsuit or a political headache? Then welcome to the club. From Airbnb’s escalating skirmishes with the New York Attorney General, to Uber’s showdowns with taxi commissioners in cities around the world, startups seem to be increasingly comfortable—even blasé—when it comes to taking on legal and regulatory risk. And so are their backers.

Asked whether his team at Union Square Ventures has turned down a pitch due to concerns about legal action or regulation, Nick Grossman, general manager for policy and outreach, says: "Not yet."

The standard refrain as to why? "Software is eating the world," the phrase coined by Silicon Valley kingmaker Marc Andreessen that has become industry shorthand for macro trends in technology, business, and society that seem destined to make software triumphant. In other words, investors told me, innovation is outpacing regulation, and sooner or later government will have to answer to the "social energy" of consumers.

That explanation is true to a degree, but it’s a bit too easy—just because industries are being "consumed" by technology, doesn’t mean the startup across the table from you is going to deliver an attractive return. So why are some VCs lining up, checkbooks in hand, to weather the legal storms? The answer is a surprising combination of finance 101 and graduate-level legal and political maneuvering that could have policymakers playing defense for years to come.

Numbers Don’t Lie

Until recently, biotech was the one sector that regularly found fledgling companies embroiled in court battles. It’s no coincidence that biotech was also the one sector that many venture capital firms, even those with wide-lens portfolios, would refuse to consider.

Then, in the last few years, everything changed. The naïvité that colored early interest in the "sharing economy" quickly hardened into something more calculated, as investors realized that when it comes to financing startups with bold, disruptive visions—and significant legal, lobbying, and public relations expenses—the numbers add up.

Let’s do the math. First, a trend that’s old news: The cost of validating a startup idea has dropped dramatically. "You can find out pretty quickly, before the regulators ever show up, whether the idea is succeeding or failing," says Jorge Torres, vice president at Silas Capital. Software costs continue to fall—witness the pricing war between Amazon Web Services and Google’s Cloud Platform—and hardware and biotech startups are benefitting from 3-D printing and other prototyping tools that have made it remarkably cheap to enter a market.

Then comes a second equation. Legal and regulatory risks add major line items to a startup’s budget in the form of billable hours for lawyers, lobbyists, and more, multiplied by the number of cities and states in which the startup operates. It’s counterintuitive, but those expenses can actually make a company more attractive to investors. Why? Because founders need to give up a greater percentage of their ownership in order to pay the bills.

"VCs often like putting more capital to work—it means they can own larger portions of these businesses," says Nick Chirls, CEO of Alphaworks, a new funding platform. "Investors are building [the legal costs] into the capital costs of these companies, and the returns are fantastic."

In essence, lean cost structures undermine investors’ negotiating position, giving founders an edge. The return of capital-intensive businesses has restored a balance of power that’s more favorable to VCs.

Threading The Needle

On all this, investors seem largely aligned. But the industry’s thinking is rapidly evolving on the question of how this new wave of legally dubious startups should go to market—and disagreements are starting to flare.

To understand the emerging approach, you first have to understand the old. Lot18, an e-commerce platform for wine, represents a more traditional strategy for managing regulatory risk: Follow the rules by finding a defensible way to "thread the needle." After a series of fits and starts as it sussed out a business model, Lot18 now has a competitive advantage in having navigated the maze of regulations that govern alcohol sales and distribution and lived to tell the story. Lot18 may look like an online wine store, but as its FAQs make clear: "Lot18 provides access to high-quality, hard-to-find wines at attractive prices [emphasis added]." All sales are final—because Lot18 does not actually sell wine.

At first glance, Aereo—the enfant terrible of streaming video, with a Supreme Court decision pending—appears to be following a similar playbook. Critics describe Aereo as a "Rube Goldberg-like contrivance" closer to the letter than the spirit of copyright law—indeed, Aereo appears to have built its technology from the ground up in order to "thread the needle" in the most provocative way possible. But when I sat down in February with founder and CEO Chet Kanojia, I was surprised to hear him describe a more expansive vision in keeping with recent recent content experiments at Netflix, Amazon, and Maker Studios. "Creative people can't get in front of the consumer because someone at a network controls the gates," Kanojia told me. In the long-term, he said, "a company like Aereo could change the power balance and open doors."

The Aereo of today is far from realizing that vision, but Kanojia appears to be aware of the new model that has captured investors’ imaginations. Just repeat after me: "full-stack."

Full Stack FTW?

"Poetically: almost any vertical regulated by a TLA is ripe for an eventual full stack co IPO."

Andreessen Horowitz partner Balaji Srinivasan tweeted those words recently as part of an extended musing on the nature of "full-stack" startups. Poetry, indeed: It sure sounds nice, but what is Srinivasan talking about, and what does it have to do with legal and regulatory risk?

Let’s do a little textual analysis: To Srinivasan, the best way to build a billion-dollar business, circa 2014, is to go after the end-to-end value chain in industries regulated by "Three Letter Acronym" agencies like the FAA, FDA, or SEC. That means controlling the full product experience and bypassing incumbents at every industry layer. Srinivasan calls out "legacy physical" verticals as areas of particular interest, but that hardly narrows down the list; automobiles, education, hospitality—pretty much everything is fair game.

What Srinivasan doesn’t spell out: "Full-stack," almost by definition, includes regulation. Full-stack startups are attractive because they bypass all incumbents, including regulators, and in so doing are positioned to write the rules of the future in their own image.

If that sounds like a stretch, just take a look at the de facto regulations that are already up and running (often quite effectively) at companies like Airbnb, in which hosts and guests rate one another and report bad behavior. Union Square’s Grossman says the system at Airbnb is "essentially a regulatory scheme, but a trust-based scheme and not a public one. It's a direct affront not only to the incumbent businesses but to the incumbent regulators." The same could be said of new approaches to evaluating credit-worthiness, auto insurance risk, and myriad other applications. The difference with "full-stack" is that a company’s scope of control becomes potentially problematic.

Learning From History

Once upon a time, regulators and incumbents were scoring wins and startups were feeling the pain. Napster, LimeWire—thanks to a spate of copyright infringement lawsuits, some of the most compelling ideas from a decade ago no longer exist. Silicon Valley did learn from those lessons—in very different ways, companies like SoundCloud and Spotify took them to heart—but rightly or wrongly that era feels like a very different chapter than the one we’re in now. For one, the stakes are higher—the consequences of sharing a song are trivial compared to the potential consequences of sharing a car or a home. And what’s more, the new order that startups are creating is far more embedded in our daily lives; as consumer habits and expectations shift, it gets harder and harder to reverse course.

"The Internet is creating new paradigms that were never contemplated when the regulatory regimes were created," says Amish Jani, managing director at FirstMark Capital and an investor in Aereo and Lot18.

Amid this reality it’s easy to hail your next Uber and pity the regulators; the sand is shifting beneath their feet. But headstrong Silicon Valley has its decriers.

"When you have technology risk, team risk, competitive risk—why would you add regulatory risk on top of it?" says Yanev Suissa, who worked in the Bush and Obama administrations before joining the investment team at New Enterprise Associates. "They’re betting on the notion that consumers want this. They’ll get there, but the question is how much time and money and effort and distraction it will take to get there."

At Aereo, Kanojia is sanguine in the face of these obstacles. "In most cases, you don't know where the risk is. It ends up being you were too early, you were too late," he says with a shrug. "The ones that you know are better than the ones you don't know." Kanojia acknowledges that the "legal overhang" has made it more difficult to forge partnerships, but says he has not seen it affect hiring or other areas.

A Way Forward

So here is our new reality: Startups are building self-governing regulatory frameworks based on their own platforms and data, even as they fend off incumbent attacks, and investors are poised to reap the benefits. It seems like it’s about time that Silicon Valley and Washington put their heads together in order to make sure that consumers aren’t left in the lurch.

"If the Valley were to engage a bit more with Washington I think you’d have a regulatory environment and an investment environment that overlapped in a more productive way," Suissa says. "The Valley operates on a thesis of how things should get done. In Washington it’s about what can get done."

Bridging that gap won’t be easy, but it's feasible; many of the components are already in place, if we could find ways to map the data being generated to the definitions and requirements that policymakers have spelled out. Public versus private, professional versus amateur—the new paradigms don’t fit the old categories, but smart use of data can bring the clarity we need.

"There's tremendous value in all the data that these networks are producing. An ideal regulatory approach would make use of that data as much as possible," Grossman says.

Whether policymakers at capitol buildings and city halls agree remains to be seen.

[Image: Flickr user Martin Bowling]




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3 Comments

  • Steven Unger

    Part 3

    Put all of this together and what have you got?

    • airbnb is likely to prevail in "private room" rentals in single-family homes and duplexes. This is the part of airbnb that is innovative and really reflects the "sharing economy".

    • Despite the hype the success of airbnb rentals in multi-family buildings will be limited by complaints from neighbors and landlords.

    • airbnb "entire place" rentals are just like all the other vacation rental websites.

    Investor beware. airbnb is a lodging company as much or more than a tech company. I don't think Tech Venture Capitalists are experts in the lodging industry.

  • Steven Unger

    Part 2

    Insurance is the elephant in the room. Most airbnb hosts do not realize that their homeowner's insurance will not cover damage or liability caused by short-term renters.

    Multi-family buildings are a real problem because the neighbors notice the airbnb rentals and most leases and Homeowner's association prohibit short-term rentals.

    Most working business travelers value consistency and predictability offered by a hotel with a 24-hour front desk, room service, secure parking or cabs at the door. In the end airbnb is not likely to prevail in a big way with business travelers.

  • Steven Unger

    I may be wrong, but I don't think Tech venture capital firms are not on the right track with airbnb -- especially giving it a higher market value than major hotel chains.

    When it was small airbnb could operate below the radar, now that it is big and very visible it will have a much more challenging time.

    So far, airbnb horror stories have been about property damage and eviction, but eventually their will be a fire, bodily inquiry, or death. Then airbnb will have a true horror story that will damage is reputation, acceptance and valuation.

    Also airbnb really has two lines of business, "private room" listings which is the innovative part and "entire place listings" which really are just traditional vacation rentals. According to this logic, HomeAway (which promotes tradition vacation rentals) should also have a soaring valuation.