Startup Product Development and Financing Decisions against a Market Incumbent

Abstract

Problem defi nition: Startups are emerging in many industries, and many startups have to compete with an existing fi rm in the market. The most critical decisions for a startup include what product should be developed and how to nance the company. Academic/practical relevance: Although they are interrelated decisions, the joint product development (in terms of product design and pricing) and fi nancing (in terms of internal or external financing) decisions of a startup, especially in the presence of a market incumbent, have not been studied in the prior literature. Methodology: We study the problem using a stylized model under the framework of vertical product differentiation where consumers differ in their willingness-to-pay for quality and market uncertainty exists for the startup product. Results: We fi nd that it is optimal for a startup to pursue pure internal financing, even if external financing is available, when the startup product's market uncertainty is either very small or very large. Otherwise, the startup benefi ts from a combination of internal self- financing and external debt financing, and the optimal debt leverage first increases then decreases with the market uncertainty. We characterize conditions for when the startup should launch a high-end or low-end product relative to the incumbent's. Surprisingly, having fewer (resp., more) financial resources|when external financing is inaccessible (resp., accessible) to the startup|does not always lead to a poorer (resp., better) product offering from the startup. Managerial implications: Our work provides guidance for how a startup should make joint product development and financing decisions in the presence of a market incumbent and shows the impact of the startup's accessibility to external financing on the firms and the consumers.