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Industry Architecture and Entry of Entrepreneurial Startups:

The Case of the IT Sector

by

Jeffrey L. Funk

Associate Professor

National University of Singapore

7 Engineering Drive 1

Block E3A, 4th Floor

Singapore 129793

etmfjl@nus.edu.sg

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Industry Architecture and Entry of Entrepreneurial Startups:

The Case of the IT Sector

Abstract

This paper uses the literature on industry architecture to examine the tradeoffs involved

with the entry timing of vertically disintegrated entrepreneurial startups. While the

conventional wisdom on entry timing focuses on capabilities and dominant designs, the

literature on industry architecture focuses on capabilities and transaction costs. Falling

transaction costs, through for example the emergence of open standards, can reduce the cost

of entry for vertically disintegrated startups while economies of scale in capabilities can

increase the cost of entry over time. Focusing primarily on transaction costs, this papers

analysis shows that more entrepreneurial startups were founded (and thus entered) after a

relevant open interface standard had been released than were founded before the release.

These results suggest that large numbers of entrepreneurial opportunities still exist after open

interface standards are released, even when these open interface standards are defined as

dominant designs, and that the emergence of these open standards may be an open important

signal for entry by entrepreneurial startups.

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1. Introduction

Understanding where entrepreneurs should look for opportunities remains an important

issue for practitioners and academics. The popular press focuses on final products such as

MP3 players (e.g., i-pod), mobile phones (e., i-phone, Google phone), Internet search (e.g.,

Google), tablet computers (e.g., i-pad) and personal digital assistants. The literature on

entrepreneurship has found that entrepreneurs do better in software than hardware (Audretsch,

1991) or in industries with rapid growth, low capital intensity, small scale, and low

concentration (Bygrave and Zacharakis, 2003; Shane, 2004; Baron and Shane 2005). The

literature on technological management and innovation has found that technological

discontinuities, particularly those that destroy competencies, provide opportunities for new

entrants (Tushman and Anderson, 1986; Anderson and Tushman, 1990; Henderson and Clark,

1990; Christensen, 1997) particularly when firms enter before a dominant design emerges

and defines the necessary capabilities for firms (Utterback, 1994; Suarez and Utterback,

1995).

On the other hand, a growing body of research has concluded that the emergence of

vertical disintegration has challenged incumbents and thus this research implies that vertical

disintegration has led to opportunities for new entrants in a variety of industries (Langlois,

1992; 2003, 2007; Baldwin and Clark, 2000; Arora et al, 2001; Chesbrough, 2003).

Furthermore, these results have led to an increasing interest in so-called industry

architectures, which are an abstract description of the economic agents within an economic

system and represent the degree of vertical (dis)integration in an industry (Jacobides,

Knudsen and Augier, 2006). Changes in industry architecture can come from technological,

institutional, or social changes that impact on the way in which economic agents divide up

work. In particular, reductions in transaction cost can reduce both the costs of having work

done by multiple agents and the importance of integrative capabilities and thus facilitate the

emergence of vertical disintegration (Brusoni and Prencipe, 2001; Jacobides, 2005; Jacobides

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and Winter, 2005). These reductions in transaction costs can come from the emergence of

open standards, modular designs (Langlois, 2003, 2007), and other events such as

governments (or legal systems) requiring the un-bundling of products, restricting a firms

ownership/market share in a market, or approving open standards (Arora et al, 2001;

Kenney, 2003; Steinmueller, 2003) where these events can emerge in either a bottom-up or

top-down process (Jacobides, 2005; Jacobides and Winter, 2005).

In spite of this wide agreement that vertical disintegration is occurring and is somehow

related to entrepreneurial opportunities, however, empirical research has not addressed the

relationship between the emergence of vertical disintegration and entrepreneurial

opportunities nor has it challenged the conventional wisdom on dominant designs. More

specifically: 1) what are the mechanisms by which vertical disintegration emerges and creates

entrepreneurial opportunities; 2) what are the tradeoffs between early and late entry for

vertically disintegrated startups; and 3) under what conditions can firms enter after a

so-called dominant design emerges?

The information technology (IT) sector is an appropriate one to consider these issues.

Vertical disintegration has emerged in almost every type of computer system, open standards

have played a role in the emergence of this vertical disintegration (Langlois, 1992; Ceruzzi,

1998; Baldwin and Clark, 2000), there has been a decline in the number of firms (i.e.,

shakeout) in most of these vertically disintegrated layers (Flamm, 1988; Langlois, 1992;

Steffens, 1994; Hatfield et al, 1999; Campbell-Kelly, 2003), and the number of de novo

entrepreneurial startups has steadily grown.

2. Theoretical Discussion

The most widely used models of technological change in the management and economic

literature are the product life cycle (PLC) and cyclical model of technological change. Both

characterize the evolution of an industry in terms of technological discontinuities, dominant

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designs, and incremental change (Anderson and Tushman, 1990; Tushman and Rosenkopf,

1992). Technological discontinuities can replace existing products and technologies or they

can create entire new product categories (Tushman and Anderson, 1986; Utterback, 1994;

Christensen, 1997). For example, it is generally agreed by the management (Anderson and

Tushman, 1990; Langlois, 1992; Baldwin and Clark, 2001) and other literatures that

mainframe, mini, and personal computers, client server computing, and the Internet represent

technological discontinuities within the IT sector.

The emergence of such a discontinuity is generally defined as the beginning of a

products life cycle. Research on the product life cycle has found that there is typically a large

decline (i.e., a shakeout) in the total number of firms through mergers, acquisitions, and exits

where these shakeouts occur even when the total market for these products continues to grow

rapidly (Gort and Klepper, 1982; Klepper and Grady, 1990; Agarwal and Gort, 1996; Klepper,

1997; Klepper & Simons, 1997). For example, there were large shakeouts in the number of

automobile and television (Klepper and Simons, 1997) and personal computer (Hatfield,

1999) manufacturers in the 1910s, 1950s, and 1980s respectively even though the markets for

these products continued to grow long after the shakeouts had occurred. The conventional

wisdom in the technology management (Teece, 1986; Utterback, 1994; Suarez and Utterback,

1995) and entrepreneurship (Bygrave and Zacharakis, 2003; Shane, 2004; Baron and Shane,

2005) literatures is that the emergence of a dominant design has been a trigger for these

shakeouts because they define a set of necessary capabilities that firms must have in order to

effectively compete,

On the other hand, the literatures on modular design, interface standards, other research

on the product life cycle, and industry architecture imply that the emergence of dominant

designs may not lead to a shakeout in the number of firms and that certain kinds of open

dominant designs may lead to increases in the number of firms and thus the number of

entrepreneurial opportunities. Modular designs are those in which the interfaces that

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determine how the functional components or modules in a product or process design will

interact are specified to enable the substitution of component variations within the design.

Design rules (Baldwin and Clark, 2000) define the interaction between these modules (Ulrich,

1995; Sanchez and Mahoney, 1996; Brusoni and Prencipe, 2001). The term standard or

interface standard (Farrell and Saloner, 1985; Katz and Shapiro, 1985, 1994; Shapiro and

Varian, 1999) is often used to define the way in which these different modules interact when

products from different firms are compatible with the same interface design rules. The greater

the extent to which design rules or interface standards are open, the greater the extent to

which new entrants may challenge vertically integrated incumbents (Langlois, 1992; Langlois

and Robertson, 1992; Baldwin and Clark, 2000; Langlois, 2003, 2007).

Other research on the product life cycle also supports the notion that the emergence of

dominant designs may not lead to a shakeout in the number of firms. Klepper (1996, 1997)

explains a shakeout in the number of product manufacturers in terms of economies of scale in

R&D where R&D can be linked to capabilities and where economies of scale in these

capabilities cause small firms to be acquired or to exit the industry. He also concluded that

the emergence of independent equipment and process technology suppliers reduce the need

for scale in R&D by product manufacturers, creates entrepreneurial opportunities for these

product manufacturers, and thus prevents a shakeout in the number of them. Although his

analysis focused on final manufacturers, as do most analyses of the product life cycle, his

argument is consistent with the notion that vertical disintegration enables new firm entry, in

this case in the final product1.

The framework of industry architectures can probably better address these issues than the

product life cycle model can (Jacobides, Knudsen and Augier, 2006), particularly if some

1 Klepper (1997) also concluded that the existence of sub-markets prevents a shakeout in the number of these final manufacturers since

their existence reduces the advantages of scale in R&D. a more comprehensive analysis could address the number of sub-markets and their

impact on economies of scale in R&D.

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concepts from the product life cycle model (shakeouts and economies of scale in capabilities)

are imported into the framework of industry architectures. According to the literature on

industry architecture, falling transaction costs, through for example the emergence of open

standards, can reduce both the costs of having work done by multiple agents and the

importance of integrative capabilities and thus facilitate the emergence of vertical

disintegration (Brusoni and Prencipe, 2001; Jacobides, 2005; Jacobides and Winter, 2005).

Since previous research implies that incumbents have trouble adapting to these changes in

industry architecture (Storper and Christopherson, 1987; Langlois, 1992; Baldwin and Clark,

2000; Arora et al, 2001; Christensen et al, 2002; Chesbrough, 2003), it is expected that the

emergence of open standards will enable some de novo entrepreneurial startups to become

successful providers of these modules. Thus, de novo startups will be more successful in

providing modules that involve open standards than in providing modules that do not involve

open standards. This leads to Hypothesis 1:

Hypothesis 1: de novo entrepreneurial startups are more represented among suppliers of

modules that involve open interface standards than in those that do not,

But when should these firms enter a market (i.e., become suppliers of a specific module)

and what are the relative tradeoffs between entering early or late? Kleppers (1996, 1997)

theory of economies of scale in R&D for product and process capabilities recommends early

entry. Early entrants can begin doing R&D, selling products, and developing the relevant

capabilities. Later entrants will be at a disadvantage in terms of these economies of scale in

capabilities and thus may incur higher R&D costs as a percent of sales than do an earlier

entrant. On the other hand, the literature on industry architecture suggests that reductions in

transaction costs, through for example the emergence of open design rules and open standards,

can facilitate the entry of vertically disintegrated suppliers. Assuming these open standards do

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eventually emerge, early entrants may incur higher entry costs than do later entrants because

initially few system suppliers have set open design rules, because open standards have not yet

been defined for these design rules, and because when these open standards do emerge the

early entrants may not notice, they may be unable to adapt, or they may incur high costs in

their attempts to adapt to the open standards and the capabilities that are associated with them.

Furthermore, if these open standards are defined by designs that can be classified as dominant

designs, firm that enter after a dominant design emerges may incur lower entry costs than

firms that enter before a dominant design emerges.

Figure 1 summarizes these tradeoffs for a case when an open standard does eventually

emerge for a specific module. As systems providers set open design rules for interfaces and as

standards emerge for these design rules, the transaction costs associated with different firms

supplying different modules and thus the entry costs for a supplier of a specific module

declines. On the other hand, economies of scale for capabilities in a specific module increase

over time thus increasing the cost of entry over time. It should be noted that if open standards

are later replaced by closed ones, this may raise transaction costs and in combination with

economies of scale may raise the costs of new entry (which is not shown in Figure 1).

Assuming that economies of scale in R&D increases as characterized by Klepper (1996),

this paper focuses on the falling transaction costs from the emergence of open design rules

and interface standards and whether these falling transaction costs enable new firms to enter

even after an open standard is defined. In particular, since existing firms are often slow to

adapt to the emergence of open standards and to the changes in industry and inter-firm

architecture that are brought about by these open standards (Storper and Christopherson,

1987; Langlois, 1992; Baldwin and Clark, 2000; Arora et al, 2001; Christensen et al, 2002;

Chesbrough, 2003, the emergence of open standards may enable some de novo

entrepreneurial startups to enter (and perhaps be founded) and succeed even after an open

standard has emerged. This leads to the following hypothesis:

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Hypothesis 2: more de novo entrepreneurial startups are founded after open standards

emerge than before they emerge

3. Methodology

This paper uses the literature on the IT sector to define the technological discontinuities,

the modules for each discontinuity, the emergence of design rules, interface standards, and

other factors that impacted on falling transaction costs, the classification of the design rules

and standards as either open or closed, and the dates of release for open standards. The

relevant literature includes academic papers and books from the management, economic, and

historical fields, practitioner-oriented accounts, and encyclopedic histories. The emergence of

open standards for a specific interface refers to the year in which the open interface standard

is released (e.g., the release of the IBM PC in 1981). Although the emergence of an interface

standard typically follows the emergence of the discontinuity, in some cases the emergence of

standards may precede the emergence of the discontinuity (e.g., UNIX emerged before the

first workstation was introduced in 1980) particularly when the standards and vertical

disintegration emerged in a bottom-up process (Jacobides, 2005).

The sample of firms was taken from Datamation magazine and includes those that were

ranked at least once in the Datamation 50 or Datamation 100. Datamation magazine used

sales data from annual reports to annually (in a June issue) rank the top 50 IT firms in the

North American market in terms of IT revenues between 1975 and 1996, the top 100 IT firms

between 1979 to 1994, and for most years broke down each firms revenues into multiple IT

categories (e.g., mainframe versus mini-computers, peripherals and software) and

summarized the firms annual activities in a half page description. Focusing on the most

successful firms in an industry can be problematic due to so-called sampling on the

dependent variable. One reason why this is not a major problem with this papers database is

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that this database is large enough to represent the entire set of firms in the IT sector. Second,

the representativeness of this sample was checked by testing Hypothesis 2 for the most

successful firms in the IT sector; these are defined as those firms that were ranked by

Datamation in the top 25 IT firms at least twice. Third, the paper is testing whether a majority

of successful firms were founded after open standards emerged, and not whether firms should

enter after an open standard has emerged. This last point is addressed in the discussion

section.

This paper used the Datamations firm descriptions, breakdowns in firm revenues, and

other sources (see footnote #2) to classify each firm for each year in terms of one

technological discontinuity and its associated system (e.g., mainframe, mini-, and personal

computers and client-server systems) and one vertically disintegrated layer (e.g., computer

design, peripherals, software) within these technological discontinuities/systems. More than

80% of the de novo firms in the Datamation 100 were classified each year in the same layer

and system/discontinuity2. The same sources (in particular the Internet) were also used to

classify each firm as either de novo or de alio and to identify the firms founding date. This

paper focuses on de novo firms and their founding date because this data was easier to obtain

than was data on entry date into the relevant vertically disintegrated layers by de novo or de

alio firms. Since firms have to be founded before they can release products, this analysis will

underestimate the extent to which successful firms have entered a market after the emergence

of open interface standards.

Firms were classified as de novo firms if they were founded to enter the IT sector and as

de alio firms if they entered the IT sector from another sector. Partly to prevent double

2 For those few firms whose classifications did change at least once, short historical descriptions were constructed from the firm

descriptions in the Datamation magazines and other sources such as the Computer Industry Almanac (Juliussen et al, 1987), the Internet, and

historical accounts of software (Steinmueller, 1996; Campbell-Kelly, 2003), local area networks (von Burg, 2001), hard disks (Christensen,

1993), and printers (Dorfman, 1987) in order to more accurately classify them.

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counting within a specific vertically disintegrated layer, for the small number of mergers and

acquisitions (

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Table 2 also summarizes the relevant standards for these discontinuities and Figure 2

roughly summarizes the changes in vertical disintegration that were brought about by the

emergence of these standards. As discussed in the subsequent sub-sections, open standards

emerged for the interfaces between computers and peripherals, operating systems (OSs) and

application software, and computers and some services (e.g., remote services). Key events

related to the emergence of these open interface standards include the release of IBMs

System/360 in 1964, of 16-bit mini-computers in 1970, of TCP/IP (transmission control

protocol/ internet protocol) specifications for the Internet in the late 1970s, of the IBM PC in

1981, and of the Ethernet for local area networks (LAN) in the early 1980s, plus IBMs

announcement of software unbundling in 1969 and partial agreements on UNIX in the mid-

to late-1970s On the other hand, open standards did not emerge for the interfaces between the

OS (operating system) and CPU (central processing unit) for mainframe and mini computers

and only initially for personal computers (PCs). Furthermore, they did not emerge between

application software from different systems/discontinuities and instead experience in dealing

with these non-standard interfaces became a barrier to entry for new suppliers of system

integration services (discussed in more detail in sub-section 4.4).

Hypothesis 1 can be tested by looking at the ratio of de novo to total number of firms in

Table 3 or the total number of de novo firms in the vertically disintegrated layers. Comparing

the different software layers shown in Table 3, the proportion of de novo to total number of

firms is greater in those layers for which open standards did emerge than for layers for which

they did not emerge (systems integration in column labeled application software). Hypothesis

1 was tested using hypothesis testing for the difference between two binomial proportions

(Mitra, 1993, p. 119). The smaller proportion of de novo to total number of firms in systems

integration software (10 of 24) than in other software (35 of 39 is significant at the 0.001

level.

Furthermore, a lack of open standards for the interfaces between the OS and CPU for

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computers made it difficult for independent providers of OSs and CPUs, much less de novo

ones, to emerge. For OSs, only one firm (Microsoft) had any level of success before 2000.

For CPUs, although the Datamation rankings do not include semiconductor suppliers, the

literature on the computer industry primarily emphasizes one firm, Intel (Flamm, 1988,

Langlois, 1992; Ceruzzi, 1998). A much smaller number of de novo firms in these layers than

in the other layers shown in Table 3 provide further confirmation of Hypothesis 1.

Excluding those layers (i.e., systems integration) for which open standards did not emerge,

Table 4 shows the number of de novo firms that were ranked at least once in the Datamation

100 and that were founded before and after open standards emerged for specific vertically

disintegrated layers. Although a small number of firms are represented twice in Table 4

because a few of them are classified into different layers/discontinuities in different years, the

total number of firms shown in Table 4 (150) is less than the total number of firms in Table 1

(170) since firms classified as systems integrators or classified as other are eliminated from

Table 4.

Hypothesis 2 is addressed using Table 4. Sixty five percent (97 of 150) of the de novo

firms were founded after an open standard was released. Hypothesis 2 was first tested using

hypothesis testing for the difference between two binomial proportions (Mitra, 1993, p.

119). The larger proportion of de novo to total number of firms founded before (97 of 150)

than after (523 of 150) open standards emerged is significant at the 0.001 level. Furthermore,

a similar proportion (13 of 21) of the of the most successful firms (those spending more than

two years in the top 25 IT firms) were established after these open standards were released

(See Table 4). These results suggest that large numbers of entrepreneurial opportunities still

exist after open interface standards are released, even when these open interface standards are

defined as dominant designs, and that the emergence of these open standards may be an open

important signal for entry by entrepreneurial startups.

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4.1 Mainframe computers

Open standards emerged for some modules and their interfaces but not for others in

mainframe computers. The first key event was the release of IBMs System/360 in 1964. In

order to reduce the rising software costs of computers, IBM designed the System/360 to be a

modular system in which software and also peripherals (such as storage devices and printers)

could be mixed and matched with any computer in the family of System/360 computers

(Fisher et al, 1983; Flamm, 1988; Pugh, 1995; Ceruzzi, 1998). Although IBM did not intend

for its customers to purchase peripherals from other manufacturers, the release of the IBM

System/360 inadvertently made this possible as the design rules that defined the interface

between computers and peripherals became open to the public thus reducing the transaction

costs associated with other firms selling peripherals to users of IBMs System/360.

Furthermore, although other computer manufacturers had already opened their design

rules in order to facilitate their use of externally available peripherals, IBMs large share of

the mainframe computer market caused its design rules to become industry standards and the

IBM System/360 to become a so-called dominant design for mainframe computers (Fisher et

al, 1983; Dorfman, 1987; Flamm, 1988; Tushman and Rosenkopf, 1992; Baldwin and Clark,

2000). This increased the potential size of the market for independent suppliers of peripherals

and in combination with the falling transaction costs associated with the emergence of a

single standard facilitated the founding of many new firms (Fisher et al, 1983; Flamm, 1988;

Baldwin and Clark, 2000). As shown in Table 4, four of the 9 de novo mainframe peripheral

suppliers in the Datamation 100 were founded after the IBM System/360 was released.

As for application software, IBM opened the interface between its OS and application

software in 1969 under pressure from the U.S. government. Until then IBM made its large

library of application software available for free to all customers that leased IBMs

System/360 computers (Flamm, 1988; Baldwin and Clark, 2000). It was only after the U.S.

Justice Department started an anti-trust case against IBM that IBM un-bundled its hardware

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and application software in 1969 thus making IBMs interface between hardware and

software an open industry standard in 1969 (Steinmueller, 1996; Campbell-Kelly, 2003). As

with peripherals, this reduced the transaction costs associated with other firms selling

application software to users of IBMs System/360 and thus facilitated the founding of many

new firms (Campbell-Kelly, 2003). As shown in Table 4, seven of the twelve de novo

mainframe software firms in the Datamation 100 were founded after IBM announced the

unbundling of its software and hardware.

Open standards did not emerge for other modules and their interfaces in mainframe

computers. None of the mainframe computer manufacturers opened the design rules that

defined the interface between their CPUs and OSs and instead they designed their own CPUs

and OSs. A lack of open design rules, much less open interface standards, prevented

reductions in both the transaction costs associated with different firms designing these

modules and the importance of integrative capabilities from occurring. Mainframe computer

suppliers competed in these integrative capabilities and both IBMs high share and economies

of scale in capabilities (Fisher et al, 1983, Flamm, 1988; Ceruzzi, 1998; Klepper, 1997)

reduced the chances of entry by new computer manufacturers and caused IBM to have the

highest market value in the IT sector until the 1990s (Baldwin and Clark, 2000). Nevertheless,

1 of 2 de novo mainframe computer suppliers was founded after the release of IBMs

System/360.

From the standpoint of users, not all of them could afford mainframe computers. The

emergence of other open standards provided opportunities for firms to provide so-called

remote services to users that could not afford mainframe computers. Through the emergence

of open standards, users were able access these remote services on dumb terminals that were

attached to telephone lines through modems. The key event that enabled the emergence of

open standards for the interfaces modems and telephone lines was the DC Circuit Court of

Appeals decision for Hush-a-Phone in 1956 (Brock, 1981; Cortada, 2004). The Court ruled

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that third parties could attach devices to AT&Ts telephone system. As shown in Table 4, all

of the de novo firms involved with remote services were formed after the first standards for

connecting modems to telephone lines were first established in the late 1950s (Cortada,

2004).

4.2 Mini-computers

Open standards also emerged to some extent for mini-computers. A key event for

mini-computers was DECs release of a 16-bit mini-computer in 1970, which many observers

(Flamm, 1988; Rifkin and Harrar, 1988; Ceruzzi, 1998) including management scholars

(Anderson and Tushman, 1990) consider a dominant design for mini-computers. The success

of IBMs System/360 had defined word lengths with multiplies of 8-bits (now considered one

byte) as an industry standard. Although many suppliers of peripherals and application

software were already selling to users or manufacturers of mini-computers, the introduction

of 16-bit machines increased the compatibility between mini-computers and between them

and mainframe computers (Ceruzzi, 1998) and thus further reduced the transaction costs

associated with different firms providing mini-computers, peripherals, and applications

software, some in the form of so-called value-added resellers (VARs), which combined these

modules for specific industry applications (Rifkin and Harrar, 1988; Ceruzzi, 1998).

Furthermore, these reductions in transaction costs also reduced the importance of integrative

capabilities and enabled vertically disintegrated mini-computer suppliers to dominate the

market (Flamm, 1988; Rifkin and Harrar, 1988). As shown in Table 4, a little more than half

(19 of 36) of the de novo suppliers of mini-computer-related products were founded after

DECs 16-bit mini-computer emerged as a dominant design in 1970 and defined an open

standard between peripherals, computers, operating systems, and application software.

4.3 Personal Computers (PCs)

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Open standards also emerged to some extent in PCs. As documented in a great deal of

detail elsewhere, perhaps best by Langlois (1992), the design rules for the IBM PC became

the standards for these interfaces. IBM intentionally opened the design rules for the interface

between most of the key components such as the microprocessor, OS, application software,

and the so-called BIOS software, which was IBMs only proprietary part of the PC, in order

to attract outside suppliers. Unfortunately for IBM, other firms were able to re-engineer the

BIOS software and other interface design rules and offer so-called IBM compatible

computers that relied on many of the exact same components (e.g., microprocessor, OS, and

peripherals) that were used in the IBM PC. For example, Compaq, and Dell were founded

after the release of the IBM PC and used the externally available OSs, microprocessors,

peripherals, and application software to become successful suppliers of PCs. In other words,

the release of the IBM PC inadvertently reduced both the transaction costs associated with

different firms supplying different modules and the importance of capabilities in multiple

modules and of those associated with integrating them.

However, as shown in Table 4, a smaller proportion of de novo firms were founded after

the release of the IBM PC (14 of 33) than were founded before its release (19 of 33). One

reason for this smaller proportion than in the other discontinuities/systems is the increases

transaction costs that came from the closing of some interface standards. Although the

interface standards that define the interaction between the CPU, OS, and application software

were relatively open when IBM first released its PC in 1981 (and thus I define them as open

for the analysis done for Hypothesis 1 with the data in Table 3), most observers argue that

Microsoft gradually increased its control over these interface standards in the late 1980s and

early 1990s and this control increased the transaction costs associated with different firms

supplying the OS and application software and thus reduced the number of entrepreneurial

opportunities for application software providers (Ceruzzi, 1998; Campbell-Kelly, 2003). For

example, initially successful software from WordPerfect (word processing), Lotus

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(spreadsheet), and Borland (database) was largely replaced by software from Microsoft in the

1990s (Campbell-Kelly, 2003) and only two PC application software providers, Adobe and

Novell, remained in the top 50 software firms by 2002 (Cusumano, 2004).

4.4 Client-Server Computing

Unlike the other discontinuities, client-server systems did not emerge through a top-down

process in which a relatively complete computer system was introduced at a single point of

time. Instead it emerged through multiple bottom-up processes (Jacobides, 2005) that

involved the parallel introduction of open standards for workstations (UNIX), the Internet

(TCP/IP), and LANs (Ethernet) before Microsofts Windows 3.0 marked the official

beginning of client-server computing in the early 1990s (Ceruzzi, 1998; Moore, 1999; Brock,

2003; Campbell-Kelly, 2003). UNIX was gradually improved and revised following its

release by AT&T in 1970 where 1978 is defined as the emergence of the open standard for

UNIX because variations began to emerge after 1978. The TCP/IP standard for the Internet

was established in the late 1970s (Abbate, 1999) and the first version of the Ethernet standard

for LANs was released in 1980 (von Burg, 2001) where the emergence of these open

standards gradually reduced the transaction costs associated with different firms supplying

these modules.

As shown in Table 4, more de novo were founded after the release of these open standards

than were founded before their release (19 of 33). Seven of the ten LAN/router suppliers from

the Datamation 100 were founded after the LAN standard was released in 1980 and the

Internet standards were released in the late 1970s. For workstations, all 12 of these firms

eventually used UNIX or another externally available OS and also externally available

microprocessors in their workstations3 and 9 of 12 were founded after the version of UNIX

3 Although a standard also emerged for workstation microprocessors in the form of Suns SPARC (Scalable Processor Architecture), which

is a RISC-(Reduced Instruction Set Computing) based microprocessor (Garud and Kumaraswamy, 1993; Khazam and Mowery, 1998;

Sorensen, 2003), since the literature on the computer industry focuses more on UNIX than RISC or SPARC (Abbate, 1999; Ceruzzi, 1998;

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that is common to all subsequent versions was released in 1978.

For system software, all of the firms classified as suppliers of system software started as

suppliers of software for mainframe, mini-, and personal computers and merely upgraded

their software for client-server systems after Microsoft successfully introduced Windows 3.0

in the early 1990s. They were able to do this because the users of client-server systems

already used mainframe, mini-, and personal computers and thus demanded backward

compatibility with these computers as they upgraded their systems to client-server systems

(Flamm, 1988, Ceruzzi, 1998). Therefore, the relevant dates for when open standards

emerged for system software suppliers are when open standards were established for

mainframe, mini-, and personal computer software. Eight of the system software suppliers

were initially suppliers for mainframes including Oracle, SAS, and JD Edwards and all eight

of them were founded after IBM announced unbundling in 1969. SAP and System Software

Associates were initially suppliers for mini-computers and Sybase was initially a supplier for

PCs. Both SAP and System Software Associates were founded after the release of 16-bit

mini-computers and Sybase was founded three years after the release of the IBM PC.

An alternative way to analyze system software would be to consider the interface for which

the emergence of an open standard would have reduced the transaction costs associated with

new entrants providing system software. Since users demanded backward compatibility with

their existing systems, the relevant interface is between the software for previous (i.e.,

mainframe, mini-, and PC software) and client-server systems (i.e., system software).

However, open standards for these interfaces have never emerged (Besen and Farrell, 1994;

Shapiro and Varian, 1999; van Everdingen et al, 2000) partly since incumbent suppliers of

software did not want such an open standard to emerge and instead used control over their

Campbell-Kelly, 2003), this paper uses the release of the first version of UNIX as the date for the release of the open standard (i.e., dominant

design) for workstations.

20

proprietary design rules to upgrade customers from existing software (for mainframe, mini, or

personal computers) to the system software for client-server systems (Moore, 1999; Shapiro

and Varian, 1999).

The last vertically disintegrated layer to consider is system integration, for which open

standards have never emerged. Although this layer is included in this sub-section on

client-server systems, it is probably more accurate to include this layer as a separate

sub-section since it has existed since the early days of main- frame computers. Firms in this

layer initially provided contract software for sophisticated users such as the military and other

government agencies and this contract software gradually became more complex and

proprietary as the complexity of computer systems has increased. Now called systems

integrators, the early providers of these services successfully resisted the emergence of open

standards between different computer systems and between software for these different

computer systems (cited in the previous paragraphs) and have used their proprietary systems

to increase the switching costs for users (Shapiro and Varian, 1999; van Everdingen et al,

2000). These switching costs have increased the transactions costs associated with new

entrants providing systems integration services. The result is that de novo firms are

represented less among systems integrators than other providers of software (see earlier

discussion of Hypothesis 1) and none of the firms defined as a systems integrator in the

Datamation 100 (either de alio or de novo) were founded after 1982 and more than half of

these firms were founded before 1970. Many of the de alio system integrators in the

Datamation lists came from the accounting or general consulting industries. They used their

relationships with IT users in their accounting and general consulting work to build a large

installed base of customers for system integration services and create switching costs to

maintain this installed base.

5. Discussion

21

This paper uses the literature on industry architecture to challenge the conventional

wisdom on entry timing and re-examine the tradeoffs for vertically disintegrated

entrepreneurial startups. The conventional wisdom is that the emergence of a dominant

design defines a set of necessary capabilities that firms must have in order to effectively

compete, leads to the exit or acquisition of firms that are deficient in these capabilities, and

thus causes a decline, i.e., a shakeout, in the total number of firms, where these shakeouts

occur even when the size of the market continues to grow. This suggests that firms must enter

and be founded before a dominant design emerges.

The literature on industry architecture suggests there is a tradeoff between early entry to

develop capabilities and later entry to benefit from lower transaction costs. For each module

or so-called vertically disintegrated layer, early entrants can begin doing R&D and

developing capabilities. Later entrants will be at a disadvantage in terms of these economies

of scale in capabilities and thus may incur higher R&D costs as a percent of sales than do

earlier entrants. On the other hand, the emergence of open design rules and open standards

can reduce the transaction costs associated with different firms providing these different

modules. The emergence of these externally available modules also reduces the importance

of integrative capabilities and thus increases the advantages of vertically disintegrated firms

vis--vis vertically integrated firms. Furthermore, if the relevant open standards are defined

by designs that can be classified as dominant designs, the emergence of such a dominant

design would also reduce transaction costs and thus facilitate the entry of new firms.

Assuming that economies of scale in R&D increases in the same way for all modules as

characterized by Klepper (1996), this paper focuses on declining transaction costs from the

emergence of open design rules and interface standards and whether these declining

transaction costs enable new firms to enter. Hypothesis 1 addressed whether de novo

entrepreneurial startups are more represented among modules that involve open interface

standards than in those that do not. It was found that the proportion of de novo to total

22

number of firms, or the number of de novo firms was much larger for those vertically

disintegrated layers in which open standards emerged than for those layers in which they did

not. A lack of open standards for the interfaces between application software from different

systems/discontinuities and for the interfaces between a computers OS and CPU reduced the

number of opportunities for de novo startups in systems integration and in OSs, and CPUs

respectively. The former was tested by comparing the proportion of de novo to total number

of firms in systems integration software (10 of 24) than in other software (36 of 40); the

difference in these proportions is significant at the 0.001 level. The latter was tested by

comparing the small number of independent suppliers of OSs and CPUs with the much larger

numbers of firms in other layers.

After excluding those layers for which open standards did not emerge, the analysis

focused on founding date for new entrants. Since market entry must occur after a firm is

founded, a comparison of when firms were founded and when open standards emerged will

underestimate the extent to which the emergence of open standards reduces transaction costs

and facilitates market entry. This papers analysis found that more de novo firms were

founded after open standards were released (97 of 150) than before they were released (53 of

150) and this is significant at the 0.001 level. These results suggest that entrepreneurial

opportunities still exist after an open interface standard has been established and to some

extent the entrepreneurial opportunities are created by the emergence of the open interface

standards since their emergence reduces transaction and thus entry costs. Furthermore, since

these open standards are often defined by designs that are classified as dominant designs by

the literature on technology management, these results suggest that entrepreneurial

opportunities still exist after a dominant design containing open standards has been

established and to some extent the entrepreneurial opportunities are created by the release of

an open dominant design that reduces the transaction costs associated different firms

supplying different modules.

23

This papers analysis of multiple modules and interface standards also suggests that

reductions in transaction costs may lead to new firm entry in different ways for different

situations. For example, open standards are needed before some services can be

technologically provided and thus the emergence of open standards may dramatically (as

opposed to gradually) reduce the transaction costs associated with different firms providing

different modules in a very short time. This was probably the case with remote services that

could not be provided before an open interface between computers and telecommunication

systems was defined and a standard for this interface in the form of a modem was released.

Thus, all of the firms that are classified as providers of remote services in Table 4 were

founded after the initial standards for modems were established. More recent examples of

services that could not be provided before open standards were defined are (PC) Internet

content and applications (Abbate, 1999) and mobile Internet content and applications (Funk,

2007).

Second, the emergence of some open standards probably increased the size of the market

for many types of computer peripherals and software and reduced the number of interface

design rules that had to be addressed by suppliers of peripherals and software. For example,

although some firms supplied peripherals to computer manufacturers other than IBM before

the System/360 was released, the release of the System/360 opened up a large new market for

these peripherals and defined a single standard for the interface. To some extent similar things

occurred following IBMs decision to unbundle hardware and software in its mainframe

computer and the release of the 16-bit mini-computers and the IBM PC. Third, the emergence

of open standards makes it easier for firms to supply the final product, computers, using

externally available peripherals, application software, OSs, and CPUs. This was the case with

16-bit mini-computers, the IBM PC, and workstations in that the emergence of externally

available modules reduced the transaction costs associated with new entrants combining these

externally available modules into computers.

24

The case of Apples i-Phone will hopefully illustrate some of these issues and the problems

with the management literatures characterization of entrepreneurial opportunities and

dominant designs. The conventional wisdom about dominant designs would focus ones

attention on phones and the potential reduction in the number of opportunities for new phone

entrants that the i-Phone might bring. However, this papers analysis would focus ones

attention on how the greater use of open standards in the i-Phone than in other phones has

already enabled thousands of firms to enter the mobile phone industry and become providers

of application software. Furthermore, the emergence externally available modules that the

open standards is bringing might enable other firms to use these same modules to supply

mobile phones in much the same way that the release of the IBM PC inadvertently facilitated

the entry of personal computer manufacturers.

One thing that this paper is not arguing, however, is that firms should be founded after an

open standard has emerged. The real issue is not timing, it is how firms can recognize the

emergence of open design rules and open standards in for example the i-Phone. Economies of

scale in R&D and other functions means that early entry is better than late entry as long as

firms can adapt to changes in interface design rules and standards. However, the large

proportion of de novo firms that were founded after open standards were released suggests

that adapting to changes in design rules and standards is a very large challenge. Future

research should attempt to better understand how early entrants failed (and other firms

succeeded). Did they fail because they did not notice the changes in design rules or the

emergence of standards or because they were unable to adapt to their emergence and to the

new capabilities that were associated with the emergence of these standards?

Future research should also address several limitations in this study. First, a larger sample

of firms would provide a better test of the two hypotheses. Second, testing the hypothesis

with entry date rather than founding data could provide more detailed insights into the impact

of falling transaction costs on entry timing. Third, similar arguments could also be made for

25

better quantifying the degree of agreements on standards (e.g., there were more versions of

UNIX than in other standards). Fourth, data on economies of scale in for example, R&D

would enable one to further analyze the tradeoffs between economies of scale in R&D and

falling transaction costs. Fifth, data on economies of scale in R&D could be combined with

data on the total number of firms in each module to analyze the impact of economies of scale

in R&D on the total number of firms and thus the number of entrepreneurial opportunities in

each layer.

6. Conclusions

This paper re-characterizes the issue of entry timing using the literature on industry

architecture. Focusing on a specific module, early entrants can benefit from economies of

scale in capabilities while later entrants can benefit from the reductions in entry costs that

occur as open design rules and open standards emerge and that reduce the transaction costs

associated with different firms supplying different modules. Focusing on transaction costs,

this papers analysis found that a larger number of successful de novo firms were founded

after the release of open standards than were founded before their release. These results

suggest that the emergence of open standards can facilitate the entry of new firms and if the

relevant open standards are defined by designs that can be classified as dominant designs the

emergence of such a dominant design would also reduce transaction costs and thus facilitate

the entry of new firms.

26

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31

Table 1. Number of De Novo and De Alio Firms in the Datamation Rankings and the Number of New Firms Entering these Rankings (either top 50 or top 100) Each Year

All firms in top 50 All firms in 51-100 Firms New to List Year De Novo De Alio De Novo De Alio De Novo De Alio Total (1)

1975 22 28 NA NA 22 28 50 (2) 1976 21 29 NA NA 3 2 5 1977 22 27 NA NA 0 1 2 1978 21 28 NA NA 1 2 3 1979 19 30 30 19 30 20 51 (2) 1980 17 33 25 23 8 14 22 1981 19 31 26 22 3 4 8 1982 19 31 26 23 6 2 10 1983 20 30 24 24 3 6 10 1984 21 29 30 18 12 3 16 1985 21 29 33 16 9 3 12 1986 23 27 33 17 11 4 15 1987 23 27 36 14 9 4 13 1988 24 26 34 16 5 2 7 1989 25 25 38 12 10 1 11 1990 26 24 34 16 3 2 5 1991 29 21 34 16 11 3 14 1992 28 22 34 15 4 1 5 1993 29 21 37 12 6 0 6 1994 31 19 39 10 13 4 18 1995 31 18 NA NA 1 2 4 1996 31 19 NA NA 0 1 1 Total NA NA NA NA 170 109 288 Notes: (1) Some of the numbers for the de novo and de alio firms to not add up to 50 or to 100 because of a lack of information on some firms. Thus, the differences between the number 50 and the sums of columns 2 and 3 and the sums of columns 4 and 5 are the number of unknown/unclassifiable firms. The same reason accounts for the differences between the total number of new firms to the list in column 8 and the sum of columns 6 and 7. (2) The numbers 50 and 51 reflect the first year of the Datamation 50 and 100 lists respectively and thus there were by definition a large number of firms new to the list in those two years. NA: Not applicable

32

Table 2. Status of Standards for Discontinuities/Systems in the Information Technology Sector (1950 to 1995)

System Interface Between Name of Standard or Product Defining Standard

Year Established/Released

Open vs. Closed

Computer and Peripherals IBM System/360 1964 Open OS and Application S/W IBMs unbundling of

software and hardware 1969 Open

OS and CPU IBM System/360 1964 Closed

Mainframe Computer

Computer and Remote Services

Various enacted after Hush-a-Phone case

1956 Open

Computer and Peripherals Extensive product documentation by computer firms

1965 Open

OS and Application S/W Open Computer and Value-Added Reseller

16-bit word length (multiple of 8-bits)

1970 Open

Mini- Computer

OS and CPU None NA Closed Computer and Peripherals Open OS and Application S/W Initially

open

Personal Computer (PC)

OS and CPU

IBM PC (later called WINTEL standard)

1981

Closed Computers and Internet TCP/IP 1980 Open Computers and LAN Ethernet 1980 Open Computers and Users Windows 1990 Closed Application S/W from Different Systems/ Discontinuities

None NA Closed

Client- server system

Workstation OS UNIX 1978 Open

Abbreviations: CPU (central processing unit); OS (Operating System); LAN (Local Area Network); S/W (software); NA (Not applicable) Sources: (Rifkin and Harrar, 1983; Flamm, 1988; Langlois, 1992; Steffens, 1994; Pugh and Aspray, 1996; Ceruzzi, 1998; von Burg, 2001; Campbell-Kelly, 2003).

33

Table 3. Proportion of De Novo to Total Number of Firms

Computers Peripherals Application Software

Operating Systems

Discontinuity

Proportion

All Firms

Proportion

All Firms

Proportion

All Firms

Proportion

All Firms

Mainframe 0.29 7 0.60 15 0.80 15 0 0 Mini 0.67 21 0.50 10 0.83 6 0 0 Personal 0.50 16 0.57 30 1.00 7 1.00 1 Client-Server 1.00

(4) 12 (4) 0.67 (3) 15 (3) 1.00 (1)

0.42 (2) 11 (1) 24 (2)

0 0

Total 0.62 52 0.59 70 0.71 63 1.00 1 (1) system software (2) system integration services (3) LAN/Routers (4) Workstation-related products and services

34

Table 4. Number of De Novo Firms Founded before the Discontinuity, after the Discontinuity

but before an Open Standard is Released, and after the Open Standard is Released Number of Firms that were Founded System/

Discontinuity

Module/Vertically Disintegrated Layer

Number ofDe Novo Firms Before Standard is

Released After Standard is released

Computer 2 1 1Peripheral 9 5 4

Mainframe Computer

Software 12 5 7Time sharing 3 3Process services 12 12

Remote Services

Terminals 10 10Computer 14 8 6Peripherals 5 2 3Software 5 2 3

Mini- Computer

Value Added Reseller 12 5 7Computer 8 4 4Peripheral 17 11 6

Personal Computer

Software 8 4 4Workstation 12 3 9Local Area Network/Router 10 3

7Client Server Systems

System Software

11 11

Total Number of Firms 150 53 97

35

Table 5. The Most Successful De Novo Firms* for each Vertically Disintegrated Layer and their Date of Founding System/ Discontinuity

Module/ Vertically Disintegrated Layer

Firm Date of Founding

Years in the Top 25

Computer CDC Amdahl

1957 1970**

1975-1989 1977-81, 83-92

Peripheral

Storage Technology Memorex

1969** 1961

1979-84, 91-92 1975-1980

Software Computer Associates

1974** 1989-1996

Mainframe Computer

Terminals

Mohawk Data Sciences Datapoint

1964** 1969**

1975-1977 1980-1982

Mini- Computers

Computer DEC Data General Prime Tandem

1957 1969 1972** 1974**

1975-1996 1975-1991 1981, 85-86, 88-91 1986-94

Computer Apple Compaq Dell

1977 1982** 1984**

1981-1996 1987-1996 1992-1996

Peripheral Seagate Quantum Conner Peripherals

1978 1980 1986**

1987-1996 1992-1996 1990-1994

Personal Computer

Software Microsoft 1975 1990-1996 Workstaton Sun 1982** 1988-1996 LAN/Router Cisco 1984** 1993-1996

Client Server Systems System

Software Oracle 1977** 1994-1996

*defined as in the top 25 firms in the Datamation ranking for at least two years **established after the relevant standard had been released

36

Figure 1. Cost Tradeoffs for Timing of Entry/Establishment (1)

Time

Costs

Reductions intransaction costs

Minimum costs of entry/establishment

Increasedeconomies ofscale (includingR&D)

(1) Assumes the eventual emergence of open standards. The emergence of closed standards would increase transaction costs and this case is not shown here.

Figure 2. Evolution of Industry Architecture for IT Sector

1950 1960 1970 1980 1990

MainframeComputers

Mini-Computers

PersonalComputers

(PCs)

Computer Design

User (3)Customization

System360

Peripherals

IBMUnbundling

16-bitword

length

IBM PC

Windows, UNIX, TCP/IP,Ethernet,

S/W: software; App: application; OS: operating system; CPU: central processing unit; VAR: Value-added reseller. (1): Includes PCs and workstations. (2) Mainframe computers and workstations are also used as servers; (3) Includes contract S/W and services; 4) includesfacility management, computer leasing, and remote services such as processing or time-sharing.

User Customization (3)

VARsPeripherals

App S/WPeripherals

OSMicroprocessor

Peripherals Mic

ropr

oces

sor

Syst

ems

Softw

are

and

Syst

ems I

nteg

ratio

nA

pp/ S

/W

OS

Net

-w

orks

Mic

ropr

oces

sor

OS

App

S/W

Clie

nt (1

) Des

ign

Serv

er (2

) Des

ign

Contract S/W, Services (4)

Contract S/W, Services (4)

Peripherals

Computer Design

App S/W

Contract S/W, Services (4)

Application S/WPeripherals

Computer Design

ComputerDesign

Computer Design Computer Design

Computer Design

Client-ServerSystems