Financing Digital Product Companies

Financing Digital Product Companies

Richard B. Carter (Iowa State University, USA) and Frederick H. Dark (Iowa State University, USA)
DOI: 10.4018/978-1-61692-877-3.ch005
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Faced with the prospect of positive and negative network externalities and the all-or-nothing phenomenon, digital product (DP) firms must choose the timing of their capital acquisitions carefully. Moreover, with typically high fixed-to-variable cost ratios, the risk to recovering the initial investment is critical. In this chapter the authors discuss various forms of financing for the DP firm, both short-term and long-term, with these issues in mind. But our primary focus is the initial public offering of equity (IPO) and particularly its timing. Through empirical analysis and case studies we show that if DP firms issue too early in their life cycle they may receive a price for their shares that is not commensurate with long-term prospects. However, issuing too late may mean that they either cannot sell shares or are unable to recover their initial investment.
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What was not understood well in the 1980s and early 1990s when the growth in DP firms escalated was that these firms, and their products that are in a digital format, are unique in comparison to traditional product firms. One of these unique characteristics is the importance of network externalities where a software development firm would have an advantage if there was product compatibility across many potential users. While network externalities can be a feature of traditional firms (e.g., railroads and trucking), it appears to be more important for DP firms. For example, externalities can decrease survivability for pioneers but increase survivability for technologically intense products and larger firms, and those with an installed base of customers (Srinivasan, Lilien, & Rangaswamy, 2004).

A potential consequence of markets with network externalities is an expression of the winner-take-all phenomenon (Yamamoto et al., 2002). For various reasons only a limited number of firms provide the product that becomes the dominant design while the others are left to whither. Microsoft Windows, for example, became the consumer favorite for operating systems and graphical user interfaces while others, like Linux, have not. And once one product leads its competitors its success accelerates as new users are more compelled to choose it because of its greater perceived utility. Though a number of firms may enter the market, only a limited number will succeed - relegating losers to technology lockout (Schilling, 1998). Schilling (2002) shows that in such markets failure to invest in learning, or poor market entry timing, can be detrimental. “Firms now (post-Internet) have to compete not only within, but also across differentiated channels, with some of the firms competing in multiple channels and transferring competition across them (Viswanathan, 2005).” As research shows, with differences in cost structures and/or externalities, the probability of success or failure can hang on the vagaries of consumers (Srinivasan, Lilien & Rangaswamy, 2004).

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