In the venture-capital world, large companies acquiring small ones used to mean big returns and innovation within industries such as software development and computer chips. But since the rise of tech giants like Google, Facebook, and Apple, deals like these are creating kill zones, product spaces no investor will touch.
Chicago Booth’s Raghuram G. Rajan and Luigi Zingales, and Booth research professional Sai Krishna Kamepalli, analyzed what happened to nine apps that were bought out by Google or Facebook. They show that when each startup was bought, venture-capital investments in the same space dropped over 40 percent on average in the following three years. But when a company other than Google or Facebook made the acquisition, investments in the same space went on to grow by more than 40 percent over the next three years.
Why? The researchers created a model to explain what’s going on. They argue that early adopters with high switching costs—influencers or app writers—could drive this dynamic. These early adopters could latch onto platforms or apps they see as innovative and, in turn, drive other users there.
But there are costs involved. It takes time and effort to learn and test new apps, and to switch from one app to another. So when early adopters think an app is going to be acquired and fully integrated into an app they are already used to, they may not invest the time into learning these new products. And when that happens, early adopters won’t recommend these products to others. With few users, eventually these apps, or the startups behind them, end up selling to the incumbent for a fraction of their potential worth.
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