Contracting and Firm Survival in Nascent Markets Enabled by Information Technology

Application service providers (ASP), who host and maintain Information Technology (IT) applications across the Internet, emerged as an innovation in the way IT services are delivered to client firms. In spite of many potential benefits to user firms, ASPs experienced business failure and high rates of exit. Drawing upon agency theory, we argue that the failure rates of ASPs can be explained by the efficiency in contracting arrangements between ASPs and client organizations. To test these predictions, we construct a unique dataset combining multiple sources that allows us to track each ASP from the year of founding through the beginning of 2006. We show that contractual misalignment, or adopting inefficient contracts, significantly lowers the probability of survival of service providers in the ASP marketplace. The impact of misalignment is particularly severe when coupled with adjustment costs that impede the transition to aligned contracts. To account for the heterogeneity in ASPs' knowledge of contracting, we test for endogenous self-selection of ASPs in the relationship between contractual misalignment and survival. Our results are robust to a variety of model specifications as well as alternate explanations of survival from industrial organization, organizational ecology and the resource-based view of the firm