Contracting Efficiency and New Firm Survival in 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 of this model, ASPs experienced business failure and high rates of exit. Drawing on agency theory, we argue that the efficiency of contracting arrangements between ASPs and client organizations is an important determinant of ASP survival. We test this prediction using a unique data set combining multiple sources that allows us to track an ASP from the year of founding through the beginning of 2006. Contractual misalignment, or adopting contracts mismatched with the underlying agency costs, 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 potential 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 multiple theoretical domains.