Strangling innovation: Tesla versus “rent seekers”

This story originally appeared on Steve Blank’s blog and is reprinted with permission.

The greatest number of jobs is created when startups create a new market – one where the product or service never existed before or is radically more convenient. Yet this is where startups will run into anti-innovation opponents they may not expect. These opponents have their own name –  “rent seekers” – the landlords of the status quo.

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Smart startups prepare to face off against rent seekers and map out creative strategies for doing so. … First, however, they need to understand what a rent seeker is and how they operate. …

Recently, the New York and North Carolina legislatures considered a new law written by Auto Dealer lobbyists that would make it illegal for Tesla to sell cars directly to consumers. This got me thinking about the legal obstacles that face innovators with new business models.

Examples of startups challenging the status quo include: Lyft, Square, Uber, Airbnb,SpaceX, Zillow, Bitcoin, LegalZoom, food trucks, charter schools, and massively open online courses. Past examples of startups that succeeded in redefining current industries include Craigslist, Netflix, Amazon, Ebay and Paypal.

While Tesla, Lyft, Uber, Airbnb, et al are in very different industries, they have two things in common: 1) they’re disruptive business models creating new markets and upsetting the status quo and 2) the legal obstacles confronting them weren’t from direct competitors, but from groups commonly referred to as “rent seekers.”

Rent seekers
Rent seekers are individuals or organizations that have succeeded with existing business models and look to the government and regulators as their first line of defense against innovative competition. They use government regulation and lawsuits to keep out new entrants with more innovative business models. They use every argument from public safety to lack of quality or loss of jobs to lobby against the new entrants. Rent seekers spend money to increase their share of an existing market instead of creating new products or markets. The key idea is that rent seeking behavior creates nothing of value.

These barriers to new innovative entrants are called economic rent. Examples of economic rent include state automobile franchise laws, taxi medallion laws, limits on charter schools, auto, steel, or sugar tariffs, patent trolls, bribery of government officials, corruption and regulatory capture. They’re all part of the same pattern – they add no value to the economy and prevent innovation from reaching the consumer.

No regulation?
Not all government regulation is rent or rent seeking. Not all economic rents are bad. Patents for example, provide protection for a limited time only, to allow businesses to recoup R&D expenses as well as make a profit that would often not be possible if completely free competition were allowed immediately upon a product’s release. But patent trolls emerged as rent seekers by using patents as legalized extortion of companies.

How do rent seekers win?
Instead of offering better products or better service at lower prices, rent seekers hire lawyers and lobbyists to influence politicians and regulators to pass laws, write regulations, and collect taxes that block competition. The process of getting the government to give out these favors is rent-seeking.

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Rent-seeking lobbyists go directly to legislative bodies (Congress, State Legislatures, City Councils) to persuade government officials to enact laws and regulations in exchange for campaign contributions, appeasing influential voting blocks or future jobs in the regulated industry. They also use the courts to tie up and exhaust a startup’s limited financial resources.

Lobbyists also work through regulatory bodies like FCC, SEC, FTC, Public Utility, Taxi, or Insurance Commissions, School Boards, etc.  Although most regulatory bodies are initially set up to protect the public’s health and safety or to provide an equal playing field, over time the very people they’re supposed to regulate capture the regulatory agencies. Rent seekers take advantage of regulatory capture to protect their interests against the new innovators.

PayPal – dodging bullets
PayPal consistently walked a fine line with regulators. Early on the company shut down its commercial banking operation to avoid being labeled a commercial bank and burdened by banks’ federal regulations. PayPal worried that complying with state-by-state laws for money transmission would also be too burdensome for a startup, so it first tried to be classified as a chartered trust company to provide a benign regulatory cover, but failed. As the company grew larger, incumbent banks forced PayPal to register in each state. The banks lobbied regulators in Louisiana, New York, California, and Idaho, and soon they were issuing injunctions forcing PayPal to delay its IPO. Ironically, once PayPal complied with state regulations by registering as a “money transmitter” on a state-by-state basis, it created a barrier to entry for future new entrants.

U.S. auto makers – death by rent seeking
The U.S. auto industry is a textbook case of rent-seeking behavior. In 1981, unable to compete with the quality and price of Japanese cars, the domestic car companies convinced the U.S. government to restrict the import of  “foreign” cars. The result? Americans paid an extra $5 billion for cars. Japan overcame these barriers by using their import quotas to ship high-end, high-margin luxury cars, establishing manufacturing plants in the U.S. for high-volume lower cost cars and by continuing to innovate. In contrast, U.S. car manufacturers raised prices, pocketed the profits, bought off the unions with unsustainable contracts, ran inefficient factories, and stopped innovating. The bill came due two decades later as the American auto industry spiraled into bankruptcy and its market share plummeted from 75% in 1981 to 45% in 2012.

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Innovation in the auto industry
According to the Gallup Poll, American consumers view car salesman as dead last in honesty and ethics. Yet when Tesla provided consumers with a direct sales alternative, the rent seekers – the National Auto Dealers Association turned its lobbyists loose on State Legislatures, robbing consumers in North Carolina, New York, and Texas of choice in the marketplace.

In these states, it appears, innovation be damned if it gets in the way of a rent seeker with a good lobbyist.

Much like Paypal, it’s likely that after forcing Tesla to win these state-by-state battles, the auto dealers will find that they’ve dealt themselves the losing hand.

Rent seeking is bad for the economy
Rent seeking strangles innovation in its crib. When companies are protected from competition, they have little incentive to cut costs or to pay attention to changing customer needs. The resources invested in rent seeking are a form of economic waste and reduce the wealth of the overall economy.

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Schumpeter’s theory of creative destruction — that entry by entrepreneurs was the disruptive force that sustained economic growth even as it destroyed the value of established companies – didn’t take into account that countries with lots of rent-seeking activity (pick your favorite nation where bribes and corruption are the cost of doing business) or dominated by organized interest groups tend to be the economic losers. As rent-seeking becomes more attractive than innovation, the economy falls into decline.

Startups, investors, and the public have done a poor job of calling out the politicians and regulators who use the words “innovation means jobs” while supporting rent seekers.

What does this mean for startups?
In an existing market, it’s clear who your competitors are. You compete for customers on performance, ease of use, or price. However, for startups creating a new market – one where either the product or service never existed before or the new option is radically more convenient for customers — the idea that rent seekers even exist may come as a shock. “Why would anyone not want a better x, y or z?” The answer is that if your startup threatens their jobs or profits, it doesn’t matter how much better life will be for consumers, students, etc. Well organized incumbents will fight if they perceive a threat to the status quo.

As a result, disrupting the status quo in a regulated market can be costly. On the other hand, being a private and small startup means you have less to lose when you challenge the incumbents.

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If you’re a startup with a disruptive business model, here’s what you need to do:

Map the order of battle

• Laughing at the dinosaurs and saying, “They don’t get it” may put you out of business. Expect that existing organizations will defend their turf ferociously i.e. movie studios, telecom providers, teachers unions, etc.
• Understand who has political and regulator influence and where they operate
• Figure out an “under the radar” strategy that doesn’t attract incumbent lawsuits, regulations, or laws when you have limited resources to fight back

Pick early markets where the rent seekers are weakest and scale

• For example, pick target markets with no national or state lobbying influence. i.e. Craigslist versus newspapers, Netflix versus video rental chains, Amazon versus bookstores, etc.
• Go after rapid scale of passionate consumers who value the disruption i.e. Uber and Airbnb, Tesla
• Ally with some larger partners who see you as a way to break the incumbents’ lock on the market. i.e. Palantir and the intelligence agencies versus the Army and IBM’s i2, / Textron Systems’ Overwatch

AirBnb – Damn the torpedoes, full speed ahead
For example, Airbnb thrives even though almost all of its “hosts” are not paying local motel/hotel taxes or paying tax on their income, and many hosts are violating local zoning laws. Some investors and competitors may be concerned about regulatory risk and liability. Airbnb’s attitude seems to be “build the business until someone stops me, and change or comply with regulations later.”  This is the same approach that allowed Amazon to ignore local sales taxes for the last two decades.

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When you get customer scale and raise a large financing round, take the battle to the incumbents. Strategies at this stage include:

• Hire your own lobbyists
• Begin to build your own influence and political action groups
• Publicly shame the incumbents as rent seekers
• Use competition among governments to your advantage, eg, if  New York or North Carolina doesn’t want Tesla, put the store in New Jersey, across the river from Manhattan, increasing New Jersey’s tax revenue
• Cut deals with the rent seekers. i.e. revenue/profit sharing, two-tier hiring, etc.
• Buy them out i.e. guaranteed lifetime employment

Steve Blank is a retired serial entrepreneur and has been a founder or participant in eight Silicon Valley startups since 1978. After he retired, he wrote a book about building early stage companies: Four Steps to the Epiphany. He’s moved from being an entrepreneur to teaching entrepreneurship to both undergraduate and graduate students at U.C. Berkeley, Stanford University and the Columbia University/Berkeley Joint Executive MBA program.