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.
These effects are accentuated by something else. Unlike conventional businesses, two-sided platforms and related apps don’t charge money for their products. Instead, they collect data on users to sell to advertisers. But this means innovative app developers can’t compete by cutting prices or fees to consumers, and that removes a key element from competition.
If kill zones lead to less investment and innovation, government policies that block these types of mergers seem like an obvious response. However, the researchers note that if the government does respond this way, customers may not benefit from being part of larger networks. For example, Google or Facebook might not have the same usefulness they have now. Instead of blocking mergers, focusing on ways to lower switching costs for early adopters by perhaps mandating interoperability across platforms could foster more innovation and competition and fewer kill zones.