Regulatory scrutiny is good for the future of software

Now that digitization has become the norm, government regulation seems to be following close behind. While many lament government regulation as an infringement on innovation, I believe increased scrutiny is a net positive for the future of the software industry.

First, it’s important to recognize that increased regulation is a reflection and acknowledgment of the dramatic impact that software is having on economies and societies. As a result, programs running quietly in the background have now become the center of scrutiny and sometimes even controversy.

It might be hard to remember in this age when companies like Facebook are subject to increasing government investigation, but for decades the technology industry generally existed and thrived outside the public eye.

The biggest issues for regulators were related to what companies did with their market dominance (i.e., anti-competitive practices that stifled innovation, as was the case with AT&T, IBM, Microsoft and today’s tech titans) rather than how their software operated.

Products and apps are increasingly driven by artificial intelligence and machine learning, especially those in sensitive areas that impact people’s lives and well-being. We see it most clearly in the public debate over consumer technology companies, but now the examination is moving deeper into the software stack.

Questions are being asked by regulators and consumers alike. And these questions aren’t just centered on what R&D labs are doing with the mountain of data they collect (and get for free from consumers), but how exactly these AI/ML algorithms are learning every second of every day.

Indeed, according to a recent survey by the Pew Research Center, 56% of Americans now believe major technology companies should face more regulation. But despite the growing risk of regulation of the software industry, the capital markets continue to reward digital companies, including the larger companies that are under constant scrutiny regarding antitrust claims and consumer privacy.

To me, this optimistic outlook by the capital markets trending toward more regulation is in many ways a positive indication for the future growth and evolution of industry-specific (e.g., fintech) software solutions.

We at Cota Capital have a direct view inside the boardrooms across our portfolio companies, and we are seeing an uptick in concern about emerging technologies. But we believe this increased scrutiny is a strong and healthy indicator of their potential. While the concerns, of course, stem from the significant threats of deploying such innovations the wrong way, the potential of the technology to fundamentally change society for the better cannot be minimized.

I’d venture that companies that reach unicorn status fastest have a higher likelihood of getting regulated. If regulators are not interested in a particular technology or significant applications of that technology, I’d take a closer look at whether the company in question is operating in the right space and going in the right direction. If there are no concerns about a technology, then there may also not be a significant opportunity for that technology. In other words, show me a business that should not be regulated, and I will show you a dying business.

Therefore, the possibility of regulation itself creates significant opportunities for companies. To understand what I mean, let’s look at the global financial crisis of 2007-2008 and the ensuing regulation of the financial services industry.

As policymakers attempted to address that crisis, financial services institutions throughout the world were hit by a torrent of new and complex rules and regulations. Banks were forced to respond by making new and significant investments in risk and compliance management systems. This, in turn, led to even greater investments in data and AI as financial institutions sought to gain a clearer understanding of their consumers and the overall operations of their business.

Venture capitalists helped power this trend by enabling the creation of hundreds of unicorns and counting. In fact, the third quarter of 2021 alone saw the birth of 42 new fintech unicorns, according to CB Insights. Today, incumbent financial institutions, insurance carriers, and other industries that underwrite risk for a living now have to contend with these innovative new players and adapt to change if they want to survive.

This is further accelerated by the mainstream adoption of technologies like blockchain, DeFi, cryptocurrencies and NFTs. Without appropriate and measured regulatory oversight and professional management teams that can navigate these complex landscapes, there is a chance that these innovations may implode before reaching their full potential.

If regulation in the financial services industry is the model to be followed, we may be at an inflection point across the technology industry. Greater government oversight is a sign of the centrality of digital in our world and creates opportunities for sophisticated startups that can skillfully navigate a more regulated environment. In fact, startups that can anticipate and design changing regulatory requirements in their products and platforms will have the greatest potential to achieve hyper-growth.

When it comes to regulation, resistance will not only be futile — it may also be fatal to all stakeholders.