Regulatory hacks

A common way to think of business regulations is by analogy to sports: the rules are specified up front, and the players follow the rules. But real regulations don’t work that way. Regulations follow business as much as business follows regulations.

Sometimes the businesses that change regulations are startups. Startups don’t have the resources to change regulations through lobbying. Instead, they need to start with regulatory hacks: “back door” experiments that demonstrate the benefits of their ideas. With luck, regulators are forced to follow.

Nextel was one of the all-time great regulatory hacks. In the late 80s and early 90s, the FCC’s rules banned more than two cellular operators per city. As Nextel’s cofounder said, “the FCC thought a wireless duopoly was the perfect market structure”. Nextel (called Fleet Call at the time) circumvented these rules by acquiring local (e.g. taxi, pizza truck) dispatch radio companies, which they then connected to create a nationwide (non-dispatch) cell phone service.

Predictably, the cellular incumbents tried to regulate Nextel out of existence. From a 1991 New York Times article:

In a move that could threaten cellular telephone companies, the Federal Communications Commission may decide on Wednesday to grant a small radio company’s request to provide a new form of mobile telephone service in six major cities, including New York. If the request is approved, the action could inject new competition into the industry. At the moment, Federal rules permit only two cellular systems to operate in any city. But the new proposal could open up a regulatory back door, allowing companies that provide private radio service for taxi fleets and delivery services to offer mobile telephone services to individuals…. The proposal has alarmed the industry, which has heatedly opposed it and enlisted support in Congress late last year to delay the F.C.C.’s decision.

The incumbents argued that Nextel’s service would interfere with public safety frequencies and therefore endanger the public. They also argued that Nextel’s service would be too expensive:

Some analysts contend that the radio handsets for Fleet Call and its imitators will be more expensive than cellular units. The technical features of cellular equipment are now standardized nationwide, making it possible to bring down costs through higher selling volumes. Specialized mobile services are currently different in each city.

And their call quality would be inferior:

Some analysts contend that Fleet Call’s local service is likely to be inferior as well. “It is highly unlikely to be as good as cellular service,” said Denise Jevne, telecommunications analyst with T. Rowe Price Associates in Baltimore.

The FCC eventually decided not to block Nextel. Nextel grew to become a top five US cellular operators before it was acquired by Sprint in 2004 for $35B. Their service turned out to be cost-competitive, high quality, and safe. The only thing endangered were the incumbents’ profits.

What Nextel faced in 1991 is very similar to what many startups face today. Uber is being threatened by the taxi industry, Aereo by the TV broadcasting industry, and Airbnb by the hotel industry. Some industries, like finance, are so heavily regulated that almost any new idea runs into regulatory objections.

Of course regulations that truly protect the public interest are necessary. But many regulations are created by incumbents to protect their market position. To try new things, entrepreneurs need to find a back door. And when they succeed, it will all look obvious in retrospect. Today’s regulatory hack is tomorrow’s mainstream industry.

 

Incumbents

Almost every startup has big companies (“incumbents”) that are at some point potential acquirers or competitors.  For internet startups that primarily means Google and Microsoft, and to a far lesser extent Yahoo and AOL.  (And likely more and more Apple, Facebook and even Twitter?).

The first thing to try to figure out is whether what you are building will eventually be on the incumbent’s product roadmap. The best way to do predict this is to figure out whether what you are doing is strategic for the company. (I try to outline what I think is strategic for Google here). Note that asking people who work at the incumbents isn’t very useful – even they don’t know what will be important to them in, say, two years.

If what you are doing is strategic for the incumbents, be prepared for them to enter the market at some point. This could be good for you if you build a great product, recruit a great team, and are happy with a “product sale” or “trade sale” – usually sub $50M. If you are going for this size outcome, you should plan your financing strategy appropriately. Trade sales are generally great for bootstrapped or seed-funded companies but bad if you have raised lots of VC money.

If your product is strategic for the incumbent and you’re shooting for a bigger outcome, you probably need to either 1) be far enough ahead of the curve that by the time the big guys get there you’re already entrenched, or 2) be doing something the big guys aren’t good at. Google has been good at a surprising number of things. One important area they haven’t been good at (yet) is software with a social component (Google Video vs YouTube, Orkut vs Facebook, Knol vs Wikipedia, etc).

The final question to ask is whether your product is disruptive or sustaining (in the Christensen sense).  If it’s disruptive, you most likely will go unnoticed by the incumbents for a long time (because it will look like a toy to them). If the your technology is sustaining and you get noticed early you probably want to try to sell (and if you can’t, pivot). My last company, SiteAdvisor, was very much a sustaining technology, and the big guys literally told us if we didn’t sell they’d build it. In that case, the gig is up and you gotta sell.