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Business Model Canvas

“Liking” Facebook’s Business Model – The #EconomicMoats Remix

March 10, 2016 by Brian Laung Aoaeh

Facebook Employee Sign Hack: Pride 2015 (Image Credit: Facebook)
Facebook Employee Sign Hack: Pride 2015 (Image Credit: Facebook)

Note: I published “Liking” Facebook’s Business Model on December 26, 20011 at Tekedia. This article updates that discussion by incorporating developments since then. It also folds in discussion of the economic moats that Facebook has developed around its business. Large segments of this article are exactly identical to the post that was published by Tekedia in 2011.

Introduction

The primary purpose of this post was to demonstrate how one might apply the Business Model Canvas in trying to understand Facebook’s business model. Assuming we understand the business model, I then apply the Economic Moats framework to thinking about Facebook.

It is a fair critique to accuse me of playing “Monday-Morning Quarterback” since it is easy to pick on an extreme success like Facebook and use it as an example. However, from my perspective as an early stage venture capitalist who is basically teaching himself the trade that critique ignores at least one benefit of this kind of case study – mainly that it is useful for trying to recreate the path I might have followed in thinking about Facebook had I been introduced to Mark Zuckerberg in 2004 when he was raising his first outside capital from investors. Think of this as the self-taught early stage venture capitalists’ version of working in a science laboratory, trying to recreate the experiments and reproduce the results that have brought us the advances of the past. Such work is what lays the groundwork for original scientific discoveries in the future.

Also, I should point out that I do not have direct access to inside-information about Facebook’s early days. This case is constructed on the basis of information, reports, and data that are in the public domain.

Okay, with those disclaimers out of the way . . . On with our case study.

According to Michael Rappa; “In the most basic sense, a business model is the method of doing business by which a company can sustain itself – that is, generate revenue. The business model spells-out how a company makes money by specifying where it is positioned in the value chain.” Alex Osterwalder and Yves Pigneur say that; “A business model describes the rationale of how an organization creates, delivers and captures value.”

What problem does Facebook solve?

My son’s paternal grandparents live in Nigeria, as does his uncle – my younger brother. His aunt – my younger sister lives in Ghana. His grandfather has never met him, nor have his uncle and aunt. His grandmother paid him a visit for three months soon after he was born. He was only two months old when she visited.

I had been asking myself the question; “How can I ensure that his grandparents, his uncle, his aunt and other members of his extended family do not miss out on his childhood entirely?” My desire to answer that question in a comprehensive way helped me to overcome my objections to Facebook. I joined Facebook in November 2009.

Facebook enables its users to connect with one another through the company’s social networking online portal. Users connect socially with their “friends” in a “social-network” to share status updates, articles, videos, music, photographs and other content through Facebook.

Facebook’s users can interact with one another in a number of different ways:

  • Users can connect directly as “friends” – this allows the highest degree and freedom of interaction subject to privacy controls that each user can put in place to govern their activity on Facebook.
  • Users can connect to one another as subscribers/followers – this is a one-way connection. Subscribers will see and can comment on the public posts by the person to whom they have subscribed. This feature was a recent addition when I wrote the original post in 2011.
  • Users can interact with one another through Facebook Messenger, an instant messaging app that has evolved since the function was first introduced to Facebook’s users in 2008. 
  • Facebook acquired Instagram in 2012 Instagram built a social network for sharing photos.
  • Facebook acquired WhatsApp in 2014. WhatsApp is a mobile instant messaging app that is popular in developing markets.
  • Facebook acquired Oculus VR in 2014. Oculus VR is  a virtual reality technology startup. 

Founded in 2004, Facebook’s mission is to give people the power to share and make the world more open and connected. People use Facebook to stay connected with friends and family, to discover what’s going on in the world, and to share and express what matters to them.

– Source: Facebook, as of March 2016

The following list highlights some of Facebook’s features:

  • User profiles and homepages – users post status updates on their homepage or wall.
  • Messages, Chat and Social Hangouts (video chat).
  • Photos + Videos – users can tag one another in photos and videos.
  • Games + Apps – people can play games with one another, or share other information through specialized apps.
  • Groups and Pages – people can form a group or create a page for sharing information around an issue of interest.
  • Events – people can use Facebook to plan events and invite others to participate.
  • Credits – this is the virtual currency for transactions on Facebook.

Reports in the press suggest that Facebook has about 800 million active users around the world. An active user is a user who has returned to Facebook’s website within 30 days.

ComScore reports that 82% of the world’s 1.2 billion online population participates in some form of social networking. Social networking eats up 20% of the time people spend online. Facebook’s users account for 75 percent of the time spent on social networking websites. Facebook’s users also account for more than 14 percent of the time people spend online around the world.

December 2015 Update: 

Monthly Active Users: 1.59 billion monthly active users as of December 31, 2015

Daily Active Users: 1.04 billion daily active users on average for December 2015

Mobile Monthly Active Users: 1.44 billion mobile monthly active users as of December 31, 2015

Mobile Daily Active Users: 934 million mobile daily active users on average for December 2015

How Does Facebook Make Money?

Facebook does not charge its users a sign-up or monthly fee. So, how does Facebook make money if users like me get to use it for free? There are three sources of revenue for Facebook;

  • Advertising – Facebook can deliver targeted ads to its users based on information that they provide during sign-up or as they interact with their friends.
  • Games + Apps – Facebook is paid a 30 percent fee by companies that develop games and applications for its user base. This fee is applied to in-game or in-app sales.
  • Virtual Goods – Facebook earns a slice of revenue from the sale of virtual goods to its users.

Reports in the press speculated that Facebook’s 2011 revenue would be in the neighborhood of $4.5 Billion. Advertising should account for the majority of that amount, followed by revenue from games and apps. Virtual goods account for only a small portion of Facebook’s revenues.

March 2016 Update: Revenue for the full year 2015 was $17.93 billion, representing an increase of 44% over revenue for the full year 2014.

The Business Model Canvas – The Building Blocks of Facebook’s Business Model

Note: Business Model Generation was not published till July 2010, nearly 6 years after thefacebook.com launched. Still, using the business model canvas to analyze Facebook’s business Model is instructive.

Customer Segments

  • Mass market – any one that uses the internet and wants to connect and socialize with family, friends and other people that are online.
  • Advertisers – big, medium and small companies that wish to advertise to the hundreds of millions of people that spend time on social network websites. Reports estimate that people spend about 3 to 4 times as much time on Facebook as they spend on Google.
  • Developers – apps, social games, and virtual goods.

Value Proposition(s)

  • Enable users to connect and share with family, friends and other people with whom they share a common interest.

Channels

  • Website
  • Mobile App

Customer Relationships

  • Network effects – users will gravitate to the social network where most of their friends are already users.
  • Relatively high switching costs – users are less likely switch to a competitor after sharing a lot of content on Facebook.

Revenue Streams

  • Advertising – fees generated from online display banner ads delivered to users through Facebook.com. There are probably two or three different categories of advertising.
    • Not entirely clear if this will work, but the team has been pitching this to advertisers since it was two months old. Might need to verify this assumption with someone in the advertising industry.
  • Facebook Credits – 30 percent share of in-app and in-game transactions.
  • Virtual goods – straight virtual goods sales not connected to use of an app or a game by the user.

Key Resources

  • People – employees, and Facebook’s more than 800 million active users.
  • Technology – software, servers and other cloud-based services that Facebook must purchase from other companies to support its operations.
  • Brand – people have to trust in what Facebook represents.

Key Activities

  • Developing and improving the Facebook platform – both the frontend user experience and backend data processing capacity. The company was reported to have started working on proprietary server designs to support its operations – reports suggested the company might be worried about the speed at which conventional server designs allow it to serve content to its millions of daily users.

Key Partners

  • Third party developers – apps, games and other features to enable people connect and share with one another using Facebook’s platform.

Cost Structure

  • Employees – Facebook reportedly has between two and three thousand employees spread across offices in 15 countries. The company seems to be preparing for a burst of growth in the size of its workforce.
  • Technology – server maintenance, software latency and optimization issues; this will continue to be a concern as people generate and share more and more content using smartphones.

The company says that more than 50% of its more than 800 million active users log onto Facebook on any given day. Nielsen estimated in a report on social media that American internet users collectively spent more than 53 billion minutes on Facebook in May 2011. The average user has 130 Facebook friends. The company also says people interact with more than 900 million objects on the website and that the average user is connected to 80 community pages, groups and events. On the average day Facebook’s users upload 250 million photos. Facebook is available in 70 languages, and 300,000 users helped to translate the site by using Facebook’s translations app. On the average day, Facebook’s users install apps 20 million times. During the average month, half a billion people use an app on Facebook or experience the Facebook platform on other websites (e.g. to share this story from Tekedia with your friends on Facebook). In all more than 7 million apps and websites are integrated with the Facebook platform. There are 475 mobile operators globally working to promote and deploy Facebook’s mobile products through their mobile networks and on their mobile devices (for example Facebook’s Android, iOS and Blackberry apps). More than 350 million active users currently access Facebook through a mobile device.

Facebook was launched in February 2004. As the preceding paragraph clearly demonstrates, the over-arching elements of Facebook’s business model that we have discussed have led it to unbelievable success. This success has occurred in spite of the fact that Facebook was not the very first social networking company. MySpace launched in August 2003, and before that Friendster was founded in 2002. Classmates.com, SixDegrees.com and Makeoutclub.com preceded Friendster. One may argue that Facebook benefited from technological advancements that its predecessors could not exploit. One may also argue that Facebook launched at a time when millions of people had become accustomed to the concept of social networking. I suspect there’s a lot of truth in both of those arguments. However, I would also argue that Facebook did a better job of understanding the intricacies of its business model better than its predecessors, and then executing that business model more effectively than any of its predecessors. Put those three arguments together and one can see that Facebook’s phenomenal growth is not completely outside the realm of possibility.

Facebook Menlo Park HQ (Image Credit: Facebook)
Facebook Menlo Park HQ (Image Credit: Facebook)

Economic Moats Analysis

I am now going to pretend that I have travelled back in time, to September 2004. As fortune would have it I am a reasonably well-liked early stage VC who invests in startups raising their very first round of capital from institutional investors. Someone I know has introduced me to the founder of The Facebook; and describes it as “a web directory that the college-kids are going crazy about.” I agree to meet in two weeks, when some time opens up on my schedule. In the meantime I start doing some cursory reading about this “thing.”

The issues I am most concerned about are, in order of priority;

First, how do I know that thefacebook.com has proven that its value proposition will hold? Around that time reports in the press highlighted how addictive thefacebook.com had become to its users. Here are some examples:

  • According to this article in the Harvard Crimson, 650 students had signed up for thefacebook.com within 5 days of the site’s launch on February 4, 2004.
  • An article in the Duke Chronicle in April 2004 described how popular the social network had become with students at Duke University.

Even those who don’t know why they love Thefacebook can’t stay away.

“It’s a stupid, stupid website, but I am completely addicted,” freshman Emily Bruckner said. “I just go around and look at all of my friends and see who they’re friends with. It’s like a contest to see who has the most friends.”

Source: Thefacebook.com Opens to Duke Students, Duke Chronicle; April 14, 2004.

Value Proposition – The bottomline: Users love thefacebook.com, and there is plenty room for growth. The are millions of college students around the world that thefacebook could target as users.

Second, do I have a sense of how the team intends to grow the business? Will the team’s ideas about growth work? Based on reports in the press, it appears thefacebook is growing rapidly, and so I have to assume the team has figured what it will take to grow within the market on which it has chosen to focus initially. There may yet be some work to do here, but so far so good. Each user is encouraged to invite some friends upon first signing up for thefacebook, and the website also suggests people that new users might know who are already on the site. Friendster is doing well within the general population, so there’s one example of how thefaceboook too might grow beyond college-campuses . . . when that makes sense.

Growth – The bottomline: The team seems to have figured out a method to accelerate growth on college campuses. That’s a good sign. There may be a few outstanding questions, but this is probably a good point at which to consider making a investment if growth can continue to accelerate.

Third, and finally . . . How does the team believe thefacebook.com will make money? This is a critical question since it speaks to thefacebook.com’s future prospects for becoming a self-sustaining entity. The team has been pitching itself as an online marketing service to advertisers . . . It will be interesting to see how advertisers react to this.

Revenue – The bottomline: Murky. Not clear if this will work. But Google is having success selling ads online through its Content Targeting Advertising. So not out of the realm of possibility. But no definitive answers at hand.

Economic moats help early stage technology startups preserve and enhance the advantages they enjoy over their competitors as time goes on their business model matures. There are five ways in which a startup can build an economic moat; Network Effects, Switching Costs, Efficient Scale or Cost Advantages, Intangibles, and Brand. Note, that I discuss “brand” under the heading of “Intangibles” but it stands alone as one of the 5 sources of an economic moat.

  • Brand: High. Becoming known as the platform for college students for intra- and inter- college social networking. Highly sought after by students at colleges where it is yet to launch a community.
  • Network Effects: High. Platform gets more useful for users as more of their friends sign-on to become users.
  • Efficient Scale or Cost Advantages: High. Users invite friends. Word-of-mouth seems to be spreading and helping keep costs of acquiring new users relatively low.
  • Switching Costs or Buyer Lock-in: Undetermined. Need more data. But should increase as people interact more and more on thefacebook.com. Described as addictive. Wonder how long that addictive quality will last. Need to get better understanding of user-perception of value.
  • Intangibles:
    • Intellectual Property: None necessary right now, but might be needed in the future to solve technical problems caused by growth. TBD.
    • Research and Development: Need to figure out revenue model. Also, what problems has Friendster run into that might be relevant for thefacebook.com? How is the team thinking about this?
    • Culture and Management: TBD. Young team, college students. Mark has prior experience building social-networking applications.

Conclusion: So, would I have invested? I do not know. There is more that goes into a decision like that one than the preceding analysis. However, at first blush there are no “smoking-gun” reasons not to take a closer look. To avoid saying no at this stage it would help to keep the following lessons in mind – they are adapted from Andrew Chen’s discussion about his decision to pass on making an early stage investment in Facebook when he had the opportunity to do so after he convinced himself that “Facebook would never be a billion dollar company.” Note: I wrote about this in April 2012 in a post that was published at Tekedia. The following discussion is adapted from that post.

  • Lack of experience and lack of knowledge are two distinctly different things. Do not confuse them with one another. Pass on making an investment because of a lack of knowledge, do not pass only because of a lack of experience.
  • Do not take solace in data and statistics without first verifying that such analyses are relevant within the given context. Data and statistics often inspire unjustified confidence, but calculations are useless if what you are calculating is wrong, irrelevant or simply inapplicable to the startup’s situation and future markets.
  • Do your own homework. Treat data and statistics from others with extreme skepticism. At the very least, try to interpret third party data based on your own analyses.
  • By definition, your past experience might be useless in understanding the most promising startups that you will encounter. Start from first-principles. Understand the fundamentals of what the startup is trying to do before you leap to conclusions grounded in your past experience. Don’t let your professional history and learned logic become a hindrance.
  • Business models matter, but execution matters more than the relative attractiveness or unattractiveness of the business model that exists at the time you encounter and early stage startup.
  • Heuristics are useful, but only up to a point. See the point on “past experience” above.
  • Keep an open mind, peel away the layers . . . Lack of conformity with the stereotypes you have become familiar with is an insufficient reason for passing on a startup.
  • Lastly, set all the analyses aside and spend some time thinking about what would happen if the team succeeds in accomplishing what it is setting out to do. If that happened, is that a story you’d want to be part of?

 

 

Filed Under: Business Models, Case Studies, Entrepreneurship, Innovation, Intellectual Explorations, Startups, Strategy, Technology, Venture Capital Tagged With: Business Model Canvas, Business Models, Competitive Strategy, Early Stage Startups, Economic Moat, Investment Analysis, Long Read, Network Effect, Switching Costs, Venture Capital, Viral Growth, Viral Marketing

Revisiting What I Know About Intangibles & Startups

October 26, 2015 by Brian Laung Aoaeh

IMG_1050
My notebook and pencil. a book I was reading, and my headphones.

 

This is the third post in my series of blog posts on economic moats. I have already written about Network Effects and Switching Costs. The remaining three sources of an economic moat are Cost Advantages, Efficient Scale, and Intangibles. ((Any errors in appropriately citing my sources are entirely mine. Let me know what you object to, and how I might fix the problem. Any data in this post is only as reliable as the sources from which I obtained it.))

In writing this post I am trying to consolidate what I have learned about intangibles & startups for myself.

I also hope that it is useful for first-time seed-stage technology startup founders who are trying to build a product, achieve product-market fit, and raise financing from venture capitalists. Often such founders are trying to accomplish all that while they also try to learn strategy, management and other subjects they perhaps had not been exposed to before they decided to build a startup. My goal in that sense is to provide one example of how an early stage venture capitalist might be thinking about these issues while assessing startups for a potential investment.

To ensure we are on the same page, I’ll start with some definitions. In the rest of this discussion I am primarily focused on early stage technology startups. If you by-chance have read the preceding posts in this series, you would have seen some of these definitions already.

Definition #1: What is a startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model. ((I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports.))

A company is what a startup becomes once it has successfully navigated the discovery phase of its lifecycle. As an early stage investor one of my responsibilities is to assist the startups in which I am an investor to successfully make the journey from being a startup to becoming a company.

Definition #2: What is an economic moat? An economic moat is a structural barrier that protects a company from competition. 

That definition of a moat is the one provided by Heather Brilliant, Elizabeth Collins, and their co-authors in Why Moats Matter: The Morningstar Approach To Stock Investing.

I take things a step further in thinking about startups and companies with business models that rely on technology and innovation. I think of a good moat as performing at least two functions; first, it provides a structural barrier that protects a company from competition. Second, it is an inbuilt feature of a company’s business model that enhances and strengthens its competitive position over time.

As a result I have arrived at the following definition of an economic moat pertaining specifically to early stage technology startups;

An economic moat is a structural feature of a startup’s business model that protects it from competition in the present but enhances its competitive position in the future.

Definition #3: What are Intangible Assets? An asset is a resource that is owned by a startup with the expectation that it will provide an economic benefit to the startup in the future. Intangible Assets are assets that are not physical in nature; intellectual property, brands, skill in research and development, regulatory environment, culture and management.

Baruch Lev explains why intangibles matter:

Intangible assets—a skilled workforce, patents and know-how, software, strong customer relationships, brands, unique organizational designs and processes, and the like—generate most of corporate growth and shareholder value. They account for well over half the market capitalization of public companies. They absorb a trillion dollars of corporate investment funds every year. In fact, these “soft” assets are what give today’s companies their hard competitive edge.

– Baruch Lev, Sharpening The Intangibles Edge, Harvard Business Review June 2004 Issue ((Baruch Lev taught me accounting while I was an MBA student at NYU Stern, his constant emphasis on intangibles increased my interest in getting better at assessing the connection between intangibles and competitive advantage from an investment analyst’s perspective.))

In the remainder of this post I will discuss each broad category of intangibles from the perspective of an early stage startup and the issues such a startup’s founders ought to be aware of.

Intellectual Property

Bottom line: All things equal, a startup with a sophisticated understanding of the role that IP plays in creating value for customers and shareholders will be more attractive to shareholders than its peers.

According to the World Intellectual Property Organization: “Intellectual property (IP) refers to creations of the mind, such as inventions; literary and artistic works; designs; and symbols, names and images used in commerce.” As far as early stage technology startups are concerned I am mostly interested in copyrights, trademarks, patents, and trade secrets.

I am not an IP attorney, so please consult an IP attorney if you read this and have specific questions about how to protect your startups IP. The goal of this discussion is not to examine the intricate legal details and nuances of IP law, but rather to offer a broad view of the IP landscape with pointers about some of the issues to which first-time founders should pay attention.

Copyrights: This is a form of protection that is granted to the original author of any piece of work that can be stored in some form of fixed media. A copyright protects the original author’s work from indiscriminate copying by other people. Among other things, copyrights protect computer software, computer programs, blog posts, advertisements, marketing materials, videos, pictures etc etc. Merely creating the work in a form of fixed media establishes the copyright. In other words, an algorithm that exists in my mind is not protected by a copyright, but my copyright comes into existence the moment I commit it to software or document it some other tangible way – for example, in a notebook.  While it is not necessary to register the copyright in order for the right to exist, there is a benefit to copyright registration with the appropriate legal jurisdiction. In the United States, a copyright holder can not file a lawsuit for infringement if the copyright is not registered with the United States Copyright Office.

It is important for early stage startup founders who rely on outside vendors and other contractors to understand the “work for hire doctrine” and its implications on copyright ownership. According to the United States Copyright Office: “If a work is made for hire, an employer is considered the author even if an employee actually created the work. The employer can be a firm, an organization, or an individual” The parameters for determining who is an employee is not very straightforward in an environment within which the early stage startup; exerts little or no control over the how the work is done, exerts little or no control over the employee’s work schedule over the duration of the contract, or does not provide the employee with benefits or withhold income taxes from the employee’s pay. Due to these ambiguities, I think that early stage startup founders should make it a practice to protect some of the work done by contractors and vendors with work for hire agreements. A good work for hire agreement will state unambiguously that the work product covered by the agreement between the startup and the contractor is a work for hire to the benefit of the startup.

For  an individual, copyrights extend for the life of the original author and for an additional 70 years beyond the author’s death. For a startup, the copyright extends for 120 years from the date of creation or 95 years from the date of publication.

Trademarks: According to the US Patent and Trademark Office “A trademark is a brand name. A trademark or service mark includes any word, name, symbol, device, or any combination, used or intended to be used to identify and distinguish the goods/services of one seller or provider from those of others, and to indicate the source of the goods/services.”

Establishing a trademark is an important part of how an early stage startup begins to communicate its brand with its customers or users. Trademarks can take different forms, for example a distinctive sound can be used as a trademark.

Similar to copyright protection, merely using the mark in the course of doing business establishes the trademark right for the startup that owns the mark.

According to the International Trademark Association trademarks are:

  1. Fanciful Marks – coined (made-up) words that have no relation to the goods being described (e.g., EXXON for petroleum products).
  2. Arbitrary Marks – existing words that contribute no meaning to the goods being described (e.g., APPLE for computers).
  3. Suggestive Marks – words that suggest meaning or relation but that do not describe the goods themselves (e.g., COPPERTONE for suntan lotion).
  4. Descriptive Marks – marks that describe either the goods or a characteristic of the goods. Often it is very difficult to enforce trademark rights in a descriptive mark unless the mark has acquired a secondary meaning (e.g., SHOELAND for a shoe store).
  5. Generic Terms – words that are the accepted and recognized description of a class of goods or services (e.g., computer software, facial tissue).

A fanciful mark has the strongest trademark protection. A generic mark has the weakest protection. Over time, the protection afforded a fanciful mark can wane if that term becomes a generic term that is used to describe a category.

A startup founder seeking trademark protection should seek the advice of an IP attorney since this is a more complicated topic than copyright protection.

Patents: According to the World Intellectual Property Organization “A patent is an exclusive right granted for an invention. In other words, a patent is an exclusive right to a product or a process that generally provides a new way of doing something, or offers a new technical solution to a problem. To get a patent, technical information about the invention must be disclosed to the public in a patent application. The patent owner may give permission to, or license, other parties to use the invention on mutually agreed terms. The owner may also sell the right to the invention to someone else, who will then become the new owner of the patent. Once a patent expires, the protection ends, and an invention enters the public domain; that is, anyone can commercially exploit the invention without infringing the patent. A patent owner has the right to decide who may – or may not – use the patented invention for the period in which the invention is protected. In other words, patent protection means that the invention cannot be commercially made, used, distributed, imported, or sold by others without the patent owner’s consent.”

A utility patent is used to protect the functional features of an invention. Most of the patent applications made to the US Patent and Trademark Office are for utility patents. A design patent is used to protect the appearance of an invention. Utility patents generally provide broader protection than design patents, also it is easier to avoid infringing on a design patent. Utility patents are more expensive to obtain and take longer to obtain.

To receive patent protection an invention must be:

  1. Patentable,
  2. New, or novel,
  3. Useful,
  4. Non-obvious, and
  5. Adequately described.

Additionally, software and business process patent applications will likely be subjected to a “machine or transformation test.” The machine test means that software or business processes can not be patented unless they are combined with a machine of some sort – a computer. The transformation test means that software or business processes cannot be patented unless they transform one thing into another, different thing, or into a different state.

An invention is “adequately described” in a patent application if “someone of ordinary skill in the arts” can replicate the invention using nothing but prior background in that technical field along with the inventor’s description in the patent application.

An invention is non-obvious if someone of ordinary skill in the arts would not necessarily have reached the deductions made by the inventor on the basis of prior art in that technical field.

A theory will not receive patent protection, in and of itself it is not useful in a practical application.

There are two main patent award systems; first to invent, or first to file. In first to invent jurisdictions, the first person or group of people to conceive of an invention will be awarded patent protection if they go through the application process successfully and can demonstrate that they indeed conceived of the invention first. In a first to file jurisdiction the first person or group of people to file an application for patent protection will be awarded the patent irrespective of when they conceived of the invention relative to other inventors pursuing the same invention. The United States is a first to invent jurisdiction.

In the US, the clock starts ticking when an inventor first discloses the invention to the public – such disclosure could happen during a presentation to investors, a sales pitch to potential customers, or a presentation at an industry conference. Once public disclosure of the invention has occurred, the inventor has one year within which to file a patent application. If a year elapses without the inventor filing for patent application, that inventor then forfeits patent protection for that embodiment of the invention.

To avoid this, a provisional patent application can be filed with the USPTO to preserve a filing date. A final, or utility application has to be filed within 12 months of the provisional application. The utility application is what the USPTO examines in order to determine the merit of the inventors appeal for patent protection.

Outside the United States, inventors do not have the benefit of a grace period. As a result any international patent applications must be made as soon as possible, in order to preclude public disclosure by the inventor.

Public disclosure causes the invention to become part of the “prior art” in the field of the invention.

In 2009 I worked on an intellectual property audit with the management team at David Burke Group, that process culminated in the issuance of a patent, US 20100310736 A1 which describes a process for aging meat. The dry-aged steaks served at DBG restaurants are prepared using this process. That was my first experience securing intellectual property rights on behalf of a company.

In 2011 our team at KEC Holdings ((KEC Holdings is the parent company of KEC Ventures.)) invented a family of financial derivatives. I assumed responsibility for (1) ensuring that our valuation methodology was justifiable on the basis of widely accepted financial and economic principles, and (2) working with an IP attorney to attempt to obtain patent protection for the idea. Our electronic documentation of the idea came to 50+ pages of background, mathematical derivations and proofs, problems and worked solutions to demonstrate how the invention might be used in practice, valuation tables etc etc.

In 2012, I worked with a team of founders in Ghana who wanted to seek a patent for their idea. I was a volunteer mentor/advisor to the team. They worked with a patent agent in India. The working relationship was ineffective for reasons that were entirely preventable if the team had embraced some simple suggestions about how to work with a patent agent/attorney working on their behalf.

What have I learned about how to work with a patent attorney or patent agent?

Generally, a patent attorney or patent agent is unlikely to be an expert in the technical field of an invention even if they specialize in the legalities of obtaining a patent in that field; a software patent attorney is unlikely to understand the nuances of a software product as well as a software engineer. For that reason, it is the inventor’s responsibility to transfer as much background knowledge as possible about the technical field of the invention and specific nuances of the invention itself to the patent agent/attorney. First, this will help the attorney perform a more complete and comprehensive patentability search. Second. it will ensure that the patent application is drafted correctly from the outset. That has the benefit of minimizing rework. Third, it will also help the attorney answer questions and respond to objections during the period when the patent is being examined by patent examiners.

Here are some additional suggestions:

  1. Maintain “excruciatingly detailed” notes about the invention. You should describe the invention such that someone of considerably less expertise than you can understand the description. Also, keep pictures, drawings, figures, and any data that you create as you go through the invention process. It is a good idea to maintain a “lab-book” with numbered pages, dates, and handwritten notes about how you have tested your invention using theory, as well as the steps you have taken to test the output of what you have created. These can be supplemented by electronic notes created with MS Word, and also saved as PDF files as well as spreadsheets you have developed to test the idea further.
  2. Describe of prior attempts to do what your invention does, and keep notes about why those prior attempts did not work.
  3. Keep notes about the alternatives to your invention, and descriptions about how your invention is unique. You should describe the advantages of your invention over the prior art and alternative approaches.
  4. Keep records about any discussions you have had about the invention with people outside of the immediate team working on your startup’s product.

Assuming it makes sense, you should discuss the possibility of obtaining international patent protection with your IP attorney. In certain instances it is possible to speed up a patent application in the founders’ home jurisdiction by first obtaining a patent abroad using the Patent Cooperation Treaty (PCT) between different jurisdictions. You should ask your attorney about this, and come up with a strategy that works given your specific circumstances.

Here’s one illustrative example:

A startup founder in the United States must decide how to protect her idea with a patent. If she files in the US it will likely take 5 years or more before the patent is granted. If she files in the UK the wait is much shorter, 2 years or less before she may expect to be granted the UK patent. What should she do? She would like to obtain patent protection in the US and the UK since she believes these are her startup’s two most important markets. She should ask her patent attorney about using the PCT and Fast Track Examination under the Patent Prosecution Highway (PPH) to speed up the process.

What is the PPH? According to the USPTO: “The Patent Prosecution Highway (PPH) speeds up the examination process for corresponding applications filed in participating intellectual property offices. Under PPH, participating patent offices have agreed that when an applicant receives a final ruling from a first patent office that at least one claim is allowed, the applicant may request fast track examination of corresponding claim(s) in a corresponding patent application that is pending in a second patent office. PPH leverages fast-track examination procedures already in place among participating patent offices to allow applicants to reach final disposition of a patent application more quickly and efficiently than standard examination processing.”

In the scenario I painted above, our founder should apply for the UK patent and then use that as the basis for requesting fast track examination of her US patent application at the appropriate time. In which case she might obtain her UK patent as well as her US patent within 24 months of filing her patent application in the UK; 18 months to get her patent granted in the UK and 6 months under PPH to get her patent granted in the US. Remember, I am not a patent attorney. Discuss this with you lawyer.

Trade Secrets: A trade secret is any confidential and non-public information that confers a competitive advantage on the owner of that information because of it is not known to the public, and especially because it is not known to competitors in that market. The owner of the information must make demonstrable effort to keep the information secret.

Trade secrecy can be lost by legitimate means, such as reverse-engineering by a competitor. Also, trade secret protection lasts for as long as the information remains confidential and undisclosed to the public. Any kind of information can be designated as a trade secret by its owner.

The key to maintaining trade secrecy is the creation of internal practices and procedures that are designed to protect the information designated as “trade secrets” from being divulged to the public.

The mystique behind the formula for Coca Cola is one famous example of a trade secret.

Trade secrets have the following advantages, among others:

  1. It is cheaper to obtain IP protection through trade secrecy than by going through the process of obtaining a patent.
  2. A trade secret can cover subject matter that would not qualify for patent protection, for example; mathematical formulae, algorithms etc.
  3. Protection of IP through trade secrecy comes into effect almost instantaneously, and that protection can last indefinitely if appropriate processes, procedures and practices are put in place.

Trade secrets have the following disadvantages, among others:

  1. As previously stated, trade secrets can be reverse engineered by others.
  2. Information protected by one party (A) could legitimately be “independently invented” by another party (B) which then proceeds to seek and obtain patent protection for the invention. In that case A would be in violation of B’s rights as the patent holder. I do not understand how this works in “first-to-invent” jurisdictions, so it is worth speaking with an attorney if a choice has to be made between trade secrecy and patent protection.
  3. Once trade secrecy is lost, it is lost forever.
  4. Trade secrecy provides a significantly lower degree of protection than protection obtained from holding a patent.

https://www.youtube.com/watch?t=216&v=AQpaKJjEQR8

Brand

Bottom line: To build a strong brand early stage startup founders must start by building a product that wins wide and sustained adoption by the market because the startup has intimate knowledge of its customers/users.

A startup’s brand develops primarily as its users and customers build an accumulation of experiences with its product or service over time. Ideally, these accumulated experiences should lead to customers and users having a positive affinity towards the product or service. The positive feelings that users or customers feel towards the startup and its product should be amplified through public relations, media and press commentary about the startup, community outreach, marketing, and advertising. Trademarks, copyrights, design, and iconography should all reinforce the positive emotions that the startup is accumulating within its users/customers towards itself. Lastly, knowledge that a startup has developed “trade secrets” which contribute to the pleasant experiences customers/users have each time they use the product/service can serve as a powerful source of implicit brand affinity and loyalty.

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Austin McGhie puts things succinctly in his book Brand is A Four Letter Word when he defines a brand as:

  1. “A brand is emotional shorthand for a wealth of accumulated or assumed information.” or
  2. “A brand is present when the value of what a product, service, or personality means to its audience is greater than the value of what it does for that audience.”

According to Heather Brilliant, Elizabeth Collins, and their co-authors in Why Moats Matter: “A brand creates an economic moat around a company’s profits if it increases the customer’s willingness to pay or increases customer captivity. A moatworthy brand manifests itself as pricing power or repeat business that translates into sustainable economic profits.”

Austin McGhie emphasizes throughout his book that a company’s brand embodies the market’s response to:

  1. The company’s product,
  2. The customer/user’s experience when they use the product, and
  3. The company’s marketing strategy, which should lead to a differentiated and valuable positioning of the company and its products relative to its competitors.

Early stage technology startup founders commonly treat marketing as an afterthought. That is a mistake. The excuse I have encountered when we discuss this topic is that there is insufficient capital for the startup to devote to marketing. The problem with that line of thinking is that it exposes a lack of imagination; marketing is not a one-size-fits-all proposition, nor does it always have to be expensive in order to be effective. Moreover, a startup’s founders are its most effective marketers in the very early days of its existence.

What should marketing look like during those early days when capital is scarce and the startup appears to lurch from one near-death experience to another? It should be a simple, uncomplicated strategy to:

Communicate to customers;

  1. What – What problem does the startup’s product solve for them?
  2. How – How is this better than the current alternative?
  3. Why – Why should they accept the risk that comes with trying a product from an early-stage startup? Why will they gain more than they stand to lose?

One complexity that early stage technology startup founders must contend with is that marketing in technology is multifaceted in the sense that there are numerous constituencies engaging with the startup’s marketing at any given time. Prospective customers want to know if they should switch to the new product/service. Investors want to know if they should make an investment. Potential distribution partners want to determine if there is a benefit for them in forming a partnership. Employees want to get a sense of how much job-security they can expect. Technology press and bloggers want to be first to scoop the next big thing. Regulators want to make sure that consumers are protected. Oh, and don’t forget competitors too. They’ll be paying rapt attention.

Research and Development

Bottom line: Research and development should purposely seek to strengthen the startup’s ability to win and retain customers, and increase profitability.

To understand why an early stage startup founder’s attitude towards research and development (R&D) matters, we first need to understand what it is.

Paraphrasing Investopedia, R&D is:

The set of systematic, investigative, and exploratory activities that a business chooses to conduct with the intention of making a discovery that can either lead to the development of new products or procedures, or that can lead to an improvement of existing products or procedures, and in the process create better ways of solving customers’ problems, creating new profit opportunities for the business.

Notice the key elements of R&D:

  1. It is systematic, investigative, and exploratory – it seeks to expand the boundaries of organizational knowhow and organizational capacity.
  2. It seeks to solve customers’ problems in a better way than the status quo.
  3. It seeks to create new opportunities for the startup to make profits.

For those reasons, R&D is one important means by which any organization that operates in a competitive market can create an enduring competitive advantage for itself.

There is only one valid definition of business purpose: to create a customer.

– Peter Drucker

If you agree with that definition, then it follows that activities that make a startup more likely to create and hold onto new customers must be pursued. Those activities are what we call R&D.

Research demonstrates the important role that R&D can play in investment returns:

In this paper, we examined the future excess returns of R&D intensive firms. Firms with R&D intensity measure greater than (lesser than or equal to) that of the industry are classified as Leaders (Followers). We show that Leaders have sustained future profitability. However, the future risk-adjusted excess returns are higher for Leaders than Followers, suggesting that the stock price does not incorporate the R&D relevant information in a timely fashion. We then directly examine the difference across Leaders and Followers of two risk measures: stock return volatility and future earnings variability. We find that Leaders have lower stock return volatility and earnings variability, ceteris paribus. We then examine whether the financial analysts’ help mitigate the apparent lack of information with respect to R&D, and find that even though the longterm earnings growth estimates for Leaders is high, they revise these estimates downwards perhaps as a reaction to short-term earnings. Overall, it appears that the stock market does not incorporate the Leaders’ potential for sustained future profits as argued in the strategy and economics literatures.

– Baruch Lev, Suresh Radhakrishnan, and Mustafa Ciftci. The Stock Market Valuation of R&D Leaders ((Lev, Baruch and Radhakrishnan , Suresh and Ciftci, Mustafa, The Stock Market Valuation of R&D Leaders (March 2006). NYU Working Paper No. BARUCH LEV-15. Available at SSRN:http://ssrn.com/abstract=1280696))

So what does this mean for early stage investors? All else equal, invest in startup founders who show indications of being capable of building organizations that will become R&D leaders in the markets in which they have to compete.

How might one go about assessing this? How often in the past have the founders’ started with the same information as everyone one else, but examined it in a way that led to unexpected results that proved to be correct and so enabled them to exploit an opportunity others ignored or did not know existed?

Culture and Management

Bottom line: The early stage startup founders who excite me the most have convinced me that they know how to build an organization that will become exceedingly more valuable than the sum of its parts. They must inspire excellence from their co-founders, from other early team members they recruit to join the startup, and they must inspire devotion from their early customers.

Does the startup’s culture, and the assumptions that its founders make about the core assets it should acquire and how it should be structured as an organization lead to an overwhelmingly positive reaction from the market and from its customers?

One aspect of seed stage investing that I feel is not sufficiently discussed explicitly is how much of a bet seed-stage investors are taking on the founders’ decision-making skill as managers of entrepreneurial risk, and the assumptions that drive those decisions.

What are the kinds of decisions seed-stage investors are betting founders will make, and make correctly on a consistent enough basis to yield a return on the investors’ capital?

Below, I paraphrase some definitions of an entrepreneur to help highlight this idea.

Jean-Baptiste Say: An entrepreneur shifts resources out of an area of lower productivity and into another area of higher productivity and return. (1800)

Frank H. Knight: An entrepreneur is someone who confronts a business challenge and is confident enough to risk financial loss in order to overcome that challenge. (1921)

Joseph Schumpeter: An entrepreneur is someone who exploits market opportunities through technical and organizational innovation. (1965)

Peter Drucker: An entrepreneur is someone who always searches for change, responds to it and exploits it as a business opportunity. (1970)

Robert Hisrich: An entrepreneur is someone who takes the initiative to organize social and economic factors of production in order to create something unique that is of value to society, and accepts financial and social risk in the process. (1990)

In some cases, including the entrepreneurial context, uncertainty includes not only uncertainty about others’ actions, but also uncertainty regarding the courage and willingness of others to act.

– Ross B. Emmet, Frank H. Knight on the “Entrepreneur Function” in Modern Enterprise (PDF)

What are some of the decision-making pitfalls that can cause the failure of an otherwise promising seed-stage startup? I’ll list some examples I have encountered since 2010.

  1. Insufficient focus on the customer, too much focus on the technological innovation.
  2. Sub-par outcomes regarding recruiting great people, and empowering them to bring the founders’ vision into reality.
  3. Inability to think creatively about new organizational designs and structures that will yield better insights about shifts in the expectations of existing customers, the potential pockets of potential new customers, and opportunities that might be going unrecognized by competitors.
  4. Incongruities between what the startup needs to accomplish in order to satisfy its customers and achieve product-market fit, and the choices that the founders make. For example, relocating the startup and its team to a geographic region that makes it difficult to reach its most promising potential early customers and makes it difficult to recruit the people it needs.

There are many others.

One problem seed-stage investors face in trying to sort founders who go on to build successful companies from founders who fail to get past the startup phase is that it is very hard to differentiate between skill and luck at that stage because the financial ratios and metrics that one could use to make that determination do not yet exist. Managerial decision making skill only reveals itself over time.

So what is a seed-stage investor to do? Study the founders’ past accomplishments and try to determine which aspects of that track record result from decision-making skill. Isolate them from the other aspects of the founders’ past accomplishments that could be attributed to luck. Weigh those two things during the assessment of what that means for the startup. I try to provide sufficient time to observe founders’ decision-making skills and abilities before I have to make a final decision – individual skill matters just as much as collective skill. As a result I am interested in the role that each co-founder plays in the final outcome. For example, did the CTO fail to prevent the team from making an incorrect choice of the technology on which to build the product? If so, does the CTO take personal responsibility for that failing, or does the CTO attempt to pass blame and make excuses?

Culture is the way in which a group of people solves problems.

– Geert Hofstede

It is also important to remember that the culture of a startup is determined predominantly by the attitude, behavior, and personality of the founders. In trying to understand the kind of culture that will develop as an early stage startup evolves I am interested in trying to understand if the following things are true.

  1. The founders are self-aware, and understand how their behavior affects the startup through the response it elicits from members of their team, from their early customers/users, and from their early investors. Example: They hire strong performers who have complementary skills, and they empower those people to excel.
  2. The way the founders talk about themselves and the organization they are building is distinctive, it illuminates the founders’ beliefs about the world, and about the reality they will create as a result of those beliefs. Example: No one could confuse this startup with another startup because the distinction between the two is unambiguous.
  3. The founders understand what they need to do to build a winning team. They also know why they need to do those things if they want their team to succeed. Example: They communicate clearly. They hold themselves accountable. They are adept at reducing harmful internal conflict. They promote and moderate the types of internal debate and disagreements that will help their team make better decisions. They motivate people to work hard, and in exchange offer fair reward and recognition for the hard work it takes to build the startup. They encourage experimentation, and learning from failure. They are great teachers, and great students. They bring out the best in others by inspiring great performance.
  4. The founders understand that culture is not something they can ignore until things are falling apart, rather it has to be tended continually. Culture matters just as much as engineering, sales, and other organizational functions that are much easier to measure and manage. Example: They understand that an organization with a strong culture is easier to manage, and often will have a longer period of sustained excellence than an organization with a weak culture.

Culture is the collective programming of the mind which distinguishes the members of one group from another.

– Geert Hofstede

Regulatory Environment

Bottom line: If it is appropriate I want to see some evidence that founders have an understanding of the role that regulations might play; will they be a catalyst or an impediment? What can the startup do to make regulations work in favor of the business model that the startup has set out to create?

I have to admit that this is the most difficult intangible for me to discuss for a number of reasons. First, I have relatively less experience on this subject than on the preceding ones. Second, it is such a specialized subject that it is most likely a function that will largely be outsourced to a lobbyist, at least in the United States. Last, this is unlikely to be something a startup needs to worry about until it has grown considerably, which is likely to happen well beyond the seed stage.

The regulatory environment is the framework of rules, laws, and regulations that the startup and its competitors have to adhere as they go about their operations.

Startup founders who can play a role in shaping the regulatory environment that is developed to govern their activities have a better chance of influencing events in their favor than founders who demonstrate an inability to influence legislation.

In the United States there are many examples of regulators requesting comment from participants in an industry during the period when rules, laws, regulations are being crafted to govern the activities of organizations within a given market.

It’s worth observing that the benefits of this asset accrue to every entity that decides to enter that market after rules have been established by regulatory bodies. As a result, first-movers who bear the cost of creating a favorable regulatory environment might be at a relative disadvantage to other organizations that decide to enter the market after a regulatory framework has been established since the first-mover would have borne all the social, political, and financial risks of putting the regulatory environment in place. In comparison to the first-mover, fast-followers get a free-ride.

Concluding Thoughts

Assessing intangibles and their potential impact on the future of an early stage startup is hard work that can seem to rely on information that is even more qualitative and less data driven than other aspects of early-stage startup analysis. Nonetheless, it is important to think through the issues carefully since that work can lead to important conclusions that highlight potential risks, point to future areas of opportunity, and yield better decisions about when and where the investor should deploy scarce capital.

Collectively, intangibles are important because once a startup establishes them as an asset, it is impossible for that asset to be replicated in exactly the same way by a competitor.

Additional Reading

Blog Posts & Articles

  1. Most Company Culture Posts Are Fluffy Bullshit – Here’s What You Actually Need To Know
  2. 80% of Your Culture Is Your Founder
  3. The Ultimate Guide To a Startup Company Culture
  4. Netflix: Reference Guide on Our Freedom & Responsibility Culture (PDF)
  5. A Summary of Peter Drucker’s Innovation and Entrepreneurship
  6. Peter Drucker’s Life and Legacy – A Drucker Sampler

Books

  1. Reinventing Organizations
  2. Delivering Happiness
  3. Work Rules
  4. Setting The Table
  5. Small Giants
  6. Good To Great and Built to Last (See also: Was “Built To Last” Built to Last?)
  7. Innovation and Entrepreneurship

Filed Under: Business Models, Entrepreneurship, Funding, Innovation, Management, Strategy, Technology, Venture Capital Tagged With: Brand, Business Model Canvas, Business Models, Due Diligence, Early Stage Startups, Economic Moat, Innovation, Intangibles, Intellectual Property, Investment Analysis, Margin of Safety, Persuasion, Strategy, Venture Capital

Notes on Strategy; For Early Stage Technology Startups

June 23, 2015 by Brian Laung Aoaeh

Alternate Title: What Can 24’s Jack Bauer Teach a Tech Startup Founder About Strategy? 

Google Search for "What is Strategy"
Google Search for “What is Strategy”

Running a business without a strategy is like breathing air without oxygen.

The purpose of this blog post is to attempt to synthesize certain fundamental lessons on strategy that are relevant for anyone trying to build a business. ((Let me know if you feel I have failed to attribute something appropriately. Tell me how to fix the error, and I will do so. I regret any mistakes in quoting from my sources.)) As part of the discussion, I will attempt to provide concrete yet easy to use frameworks that founders of early stage startups can use as they work on moving their organizations through the discovery process that takes them from being a startup to becoming a company. ((My target audience is made up of  first-time startup founders who do not have any background in business, finance, economics, or strategy.))

To ensure we are on the same page, and thinking about the issues from the same starting point . . . first, some definitions.

Definition #1: What is a Startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model. ((I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports.)) As an investor, I hope that each early stage startup in which I have made an investment matures into a company.

Strategy is about making choices, trade-offs; it’s about deliberately choosing to be different.

– Michael Porter ((Keith H. Hammond, Michael Porter’s Big Ideas. Accessed on Jun 20, 2015 at http://www.fastcompany.com/42485/michael-porters-big-ideas))

Definition #2: What is Strategy? An early stage startup’s strategy is that deliberate set of integrated choices it makes in order to create a sustainable competitive advantage within its market relative to rival startups and market incumbents. It is the means by which a startup combines all the elements within its environment to create and deliver value for its customers, while simultaneously capturing some of that value for itself and its investors. Strategy answers questions about what the startup should do and what it should not do in order to find a repeatable, scalable and profitable business model.

Strategy as an Integrated Cascade of Choices: From Playing to Win, by A.G. Lafley and Robert L. Martin. HBR Press (2013)
Strategy as an Integrated Cascade of Choices: From Playing to Win, by A.G. Lafley and Robert L. Martin. HBR Press (2013)

Some additional observations about strategy;

  1. Strategy can be granular and tangible or broad and intangible. It is granular and tangible as one goes further down the organizational hierarchy. It is broad and intangible as one approaches the top of an organization.
  2. Strategy helps a startup decide how to utilise its internal and external resources and capabilities towards reaching its ultimate goals and objectives.
  3. In a growth stage startup or mature company, effective strategy makes choices and trade-offs in the following areas;
    • Supply chain
    • Manufacturing, product development
    • Distribution channels
    • Human resources
    • Finance
    • Research and development
    • Operations
  4. For an early stage startup strategy involves choices and trade-offs in the following areas;
    • Value propositions
    • Customers – segments, relationships
    • Key activities
    • Key resources
    • Key partners
    • Cost structure
    • Revenue streams
Alex Osterwalder's Business Model Canvas, from the book Business Model Generation
Alex Osterwalder’s Business Model Canvas, from the book Business Model Generation

Strategic Decision Making Tools for Early Stage Technology Startups

Porter’s 5 Forces: In a 2008 update to his 1979 HBR Article: How Competitive Forces Shape Strategy, Michael E. Porter discusses the “5 Forces” that have a direct impact on strategy.

Michael E. Porter – The Five Forces That Shape Industry Competition Image Credit: Harvard Business Review (2008)

Threat of New Entrants: This is the degree to which a startup can expect to face intense competition because the number of direct rivals it faces keeps increasing. Direct rivals are other startups that enter the market with a value proposition that is nearly identical to that which a given an incumbent startup is offering its customers. High threat of new entrants imposes a ceiling on profitability, limits how much value an incumbent startup can capture for itself, and imposes high costs on the existing competitors within the industry or market. As a result, it is important for startup founders to think about how they might construct an economic moat around their business. Michael Porter discusses seven major sources of barriers to entry; supply-side economies of scale, demand-side benefits of scale, customer switching costs, capital requirements, incumbency advantages independent of size, unequal access to distribution channels, and restrictive government policy.

Bargaining Power of Suppliers: Suppliers become powerful when they form a more concentrated group than the startups that they sell to and do not rely on startups for the significant proportion of their revenues. Additional factors leading to supplier power include; the suppliers offer products that are differentiated and unique, startups face high switching costs in moving from that supplier group to an alternative product, a lack of satisfactory alternatives to the product or service provided by the supplier group. These factors combine to put the suppliers in an enormously strong negotiating position, and enables them to maintain high prices and pass nearly all cost increases on to their startup customers.

Bargaining Power of Buyers: This is the opposite of supplier power. Powerful buyers can have a debilitating impact on the profitability of a group of startups that supply them with goods or services. The factors that contribute to powerful buyers are; a small number of buyers with each purchasing in large volumes relative to the size of each incumbent startup, buyers perceive and experience no switching costs if they switch from one startup’s products to products supplied by one of its competitors, the quality and reliability or lack thereof of products or services provided by suppliers does not affect the buyers’ ability to maintain or improve the quality of their goods or services.

Threat of Substitutes: This has not happened recently, but it used to be that when I would ask a founder “Who is your competition?” the quick response would be “We do not have any competition!” I’d shake my head and think to myself, they must not understand the meaning of substitute. According to Michael Porter “A substitute performs the same or a similar function as an industry’s product by a different means.” For example, videoconferencing is a substitute for travel. The threat posed by substitutes can be camouflaged by the apparent difference between the way an early stage startup perceives its customer value proposition and the way its customers perceive that same value proposition in comparison to the substitute. One way to think of substitutes is to ask “How are customers fulfilling that need or solving that problem now?” Another way to think about substitutes is to ask the question “Where are customers spending less money because they have chosen to buy our product?” Industry profitability is constrained by a high threat of substitutes. Consider the threat posed to social-networking like Twitter and Facebook from the chat and messaging apps. Facebook has been more responsive to those threats, and has strengthened its strategic position through its acquisitions of Instagram, Oculus Rift and Whatsapp. The threat posed by substitutes is high if customers are indifferent to the price-performance trade-offs they have to make if they switch to the substitute. The threat is also high if switching costs to customers are minimal, or non-existent. To find examples of how the threat of substitutes functions, think of the threat that Facebook is posing to Google’s business model of selling ads tied to users’ search activity. Or the threat that the shift from desktop-centric to mobile-centric computing poses to all kinds of businesses that have been built from the desktop centric point of view. Or the current debates around the relationship between startups in the on-demand economy and their employees, and the implications for the startups that are currently on either either side of that debate. ((Annie Lowery, How One Woman Could Destroy Uber’s Business Model – and Take the Entire “on-Demand” Economy Down With It. Accessed on Jun 21, at http://nymag.com/daily/intelligencer/2015/04/meet-the-lawyer-fighting-ubers-business-model.html.))

Rivalry Among Existing Competitors: Think Uber and Lyft, Microsoft’s Internet Explorer and Netscape Navigator, Apple iTunes and Spotify/Pandora etc, Apple’s iOS and Google’s Android, Apple’s iPhone and Samsung’s Galaxy, Apple’s Watch and the burgeoning number of wearables designed and produced by other competitors in that market. Evidence of intense rivalries among existing competitors is found in frequent price-cuts, ubiquitous sales and marketing campaigns, and relatively short product and service upgrade cycles. Combined with the threat of new entrants, rivalry among existing competitors leads to a land-grab by incumbents to access new markets where rivalry is less intense and potentially lock rivals in other markets out of the new markets. A land-grab could also be initiated in anticipation of intense rivalry developing in the future. The on-demand ride-sharing wars that are playing out around the world today provide a text-book example of this phenomenon. High rivalry among existing competitors constrains profitability along two dimensions; the intensity of the competition, as well as the basis on which that competition is taking place. Factors that contribute to a high intensity of rivalry are: Competitors roughly equal in size, slow growth, high exit barriers, high levels of commitment to the market and the industry, and poor signaling. One mistake rivals often make? They engage in mutually destructive price-cuts in succeeding rounds of attack and retaliation. Or, they might engage in other tactics that lead to an overall degradation of the customer experience or user experience for their mutual customers. Particularly destructive behavior is most liable to occur when the individual rivals’ products cannot be differentiated from one another by their target customers, the rivals are each faced with a cost structure characterized by high fixed costs and low marginal costs, it is difficult to make quick capacity adjustments in response to surges or declines in demand, and the product is perishable. ((Consider how the transient, perishable nature of “time” has influenced the behavior of ride-sharing rivals – a ride not delivered today can never be recouped. It is gone forever.)) Ideally, competition among rivals should aim to grow the profitability of the industry or market for all players within it, while raising barriers to entry.

Factors that influence strategy: In debates about strategy with other management theorists, academics and practitioners, Michael Porter has stated;

It is especially important to avoid the common pitfall of mistaking certain visible attributes of an industry for its underlying structure.

He describes the following factors that influence strategy and competition within an industry;

  1. Industry growth rate
  2. Technology and innovation
  3. Government
  4. Complementary products and services

The key is for startup founders and their investors to analyze each of the five forces that shape competitive strategy within the context of each of these factors. The factors are not inherently good or bad, but must be assessed in the context of the the five forces and the impact they have on developments within the industry.

Jack Bauer, the star character in 24 always seems to be thinking several steps ahead of everyone else surrounding him. Image Credit: Wikimedia

You probably think I’m at a disadvantage; I promise you I am not.

– Jack Bauer (24: Live Another Day); speaking to a group of armed men suspected of planning to carry out a terrorist attack on London. He appears ambushed, trapped, outnumbered and outgunned by them.

Definition #3: What is Game Theory? According to Wolfram Mathworld; “Game theory is a branch of mathematics that deals with the analysis of games (i.e., situations involving parties with conflicting interests). In addition to the mathematical elegance and complete “solution” which is possible for simple games, the principles of game theory also find applications to complicated games such as cards, checkers, and chess, as well as real-world problems as diverse as economics, property division, politics, and warfare.

Game theory has two distinct branches: combinatorial game theory and classical game theory.

Combinatorial game theory covers two-player games of perfect knowledge such as go, chess, or checkers. Notably, combinatorial games have no chance element, and players take turns.

In classical game theory, players move, bet, or strategize simultaneously. Both hidden information and chance elements are frequent features in this branch of game theory, which is also a branch of economics.” ((Game Theory. Accessed on Jun 21, 2015 at http://mathworld.wolfram.com/GameTheory.html))

For a flavor of the wide application of game theory;

  1. Malcolm Gladwell attempted to apply it to analysis of athletic prowess in this May 2006 article in The new Yorker.
  2. Michael A. Lewis, then a professor at the Silberman School of Social Work at Hunter College in NYC applied probability and game theory to an analysis of The Hunger Games in this April 2012 article in Wired.
  3. Clive Thompson writes about a claim by Bruce Bueno de Mesquita, a professor at my alma mater New York University and “one of the world’s most prominent applied game theorists” that he could predict when Iran will get the nuclear bomb in this August 2009 article in the New York Times Magazine article.

Playing The Right Game – Using Game Theory To Shape Strategy: In their 1995 Harvard Business Review article – The Right Game: Use Game Theory to Shape Strategy Adam M. Brandenburger and Barry Nalebuff offer advice that startup founders can use to guide the choices they make as they navigate the terrain that lies between their startup’s emergence as an embryonic organization and its hopeful maturity into a company.

Unlike war and sports, business is not about winning and losing. Nor is it about how well you play the game. Companies can succeed spectacularly without requiring others to fail. And they can fail miserably no matter how well they play if they make the mistake of playing the wrong game. The essence of business success lies in making sure you’re playing the right game.

Following are some observations based on their paper:

  1. There are two basic types of games; rule-based games and freewheeling games. Business is a complex mix of both.
  2. To aid them formulate their startup’s strategy, the startup’s founders and investors must think far out into the future to make postulations about how the game might unfold by analyzing how all the players in the game will react to moves by another player in the game. This involves reasoning forward and then reasoning backwards to the present in order to determine what actions taken today will lead to the outcome that the startup wishes to bring into existence in the future. They state: “For rule-based games, game theory offers the principle, To every action, there is a reaction. But, unlike Newton’s third law of motion, the reaction is not programmed to be equal and opposite.”
  3. The startup’s founders must eschew egocentrism and instead embrace allocentrism, i.e. they must focus less on their startup’s actions but rather must focus on the actions, desires, expectations, ambitions, goals, objectives etc. etc. of their rivals. They state: “To look forward and reason backward, you have to put yourself in the shoes—even in the heads—of other players. To assess your added value, you have to ask not what other players can bring to you but what you can bring to other players.”
  4. Startup founders should seek and create opportunities for “Coopetition” – “It means looking for win-win as well as win-lose opportunities. Keeping both possibilities in mind is important because win-lose strategies often backfire.” They cite the example of a price war as a move that ultimately leaves all the players in a game worse off because it reestablishes the status quo, but at a lower price. Starting a price war is a lose-lose move.
  5. It is important to think of the players within a startup’s Value Net; an environment created by the startup’s customers and suppliers – arranged vertically in the Value Net framework, and its substitutors and complementors – arranged horizontally in the Value Net. The startup itself is positioned where the Value Net axes intersect. The startup transacts with its counterparties positioned along the vertical axis – resources and money flow between the startup and its customers and suppliers. The startup does not transact directly with its substitutors or complementors, but it interacts with them nonetheless. Often, strategists do not pay sufficient attention to how a startup’s interactions with its substitutors and complementors can be modified in order to create win-win outcomes for the players in the startup’s Value Net. They recommend drawing the Value Net, and monitoring changes that occur to the elements of the game using that map.
  6. The elements of a game are; The Players – customers, suppliers, substitutors, complementors and, of course, the startup itself. The Added Values – this is what each player brings to the game, and the key task here is to consider means by which the startup might make itself a more valuable player. The Rules – in business these are fluid and likely not transparent, although this is not always so, also the players in the game might agree to change them. Tactics – these are short term moves the startup makes in order to shape how it is perceived by other players in the game, or to maintain uncertainty within the game for its benefit. The scope – these are the boundaries of the game. Founders might consider expanding or shrinking the boundaries of the game in keeping with what they believe works best for the ultimate outcomes that the startups wishes to realize.
  7. The authors discuss “The Traps of Strategy” – briefly outlined;
    • The startup does not have to accept the game that it finds itself in.
    • The startup does not have to change the game at the expense of other players within its Value Net.
    • The startup does not have to be unique to succeed. On its own, uniqueness is an insufficient dimension along which to pursue success.
    • Founders’ failure to study and see the whole game can prove expensive and fatal because any moves towards one group of players in the game has counterpart move with the other players along that axis. Draw the Value Net.
    • Founders’ failure to think methodically about changing the game can prove expensive, focusing inwardly on the startup instead of outwardly on the other players within the Value Net limits the strategic options available. Use PARTS.

The Goals Grid – A Tool for Clarifying Goals and Objectives: I discovered The Goals Grid in 2009 while working on two turnaround assignments, and feeling dissatisfied with the tools I had acquired in business school – it quickly became clear to me that those tools did not translate readily when I was in the trenches, working with people on the frontlines of fine-dining, and general aviation, who lacked the training in strategy and management that students in MBA programs in the United States receive. I needed something I could discuss with them, but that they could then implement without me. ((Fred Nickols updated it in 2010. Accessed on Jun 22, 2015 at http://www.nsac.org/Endowments/Docs/GoalsGrid.pdf))

The Goals Grid focuses startup founders’ attention by asking 4 questions;

  1. What are you trying to achieve?
  2. What are you trying to preserve?
  3. What are you trying to avoid?
  4. What are you trying to eliminate?

It then connects these questions to the problems the startup’s founders seek to solve by rephrasing those questions;

  1. What do you want that you don’t have? You should be trying to achieve this.
  2. What do you already have that you already have? You should preserve this.
  3. What do you lack that you don’t want? Avoid this.
  4. What do you have now that you do not want? Eliminate this as quickly as possible.

The analyses can be performed using the grid below.

The Goals Grid by Fred Nickols. Image Credit: http://www.advocus.co.uk

Some observations about the goals grid;

  1. It is super flexible, and can be used at multiple levels in an organization. It can be used for corporate-wide strategic planning activities as well as team or individual-contributor level tactical planning.
  2. The ease with which this analyses can be performed make it possible to unshackle the goals grid from our general notions of strategic planning cycles. There is nothing to prevent individuals or small teams within a startup from creating whatever cycle they need to create in order to use the goals grid to accomplish objectives, keep one another accountable. For example in certain circumstances it might make sense to have a monthly goals grid planning and update cycle. In another context perhaps quarterly cycles make more sense. Yet still, in some other context, perhaps weekly goals grid planning cycles make sense.
  3. While they do not explicitly mention using the goals grid at Pandora, this case study published in the First Round Review shows how powerful a system analogous to this can become – The Product Prioritization System That Nabbed Pandora 70 Million Monthly Users with Just 40 Engineers.
  4. If it is used, the goals grid should be applied to each component of a startup’s business model while it is in the search and discovery phase of its existence.

The “Do Not Fucking Do” Framework aka Asset/Customer Reuse Matrix:

Discussing Strategy at KEC Ventures with the founders and management of one of our startups in 2014.
Discussing Strategy at KEC Ventures with the founders and management of one of our startups in 2014.

Sometimes people who are unaccustomed to thinking about strategy can become paralysed by the volumes of information they have to consider during the process of developing a strategy for an organization; a startup, a company, a corporation, or a division of a corporation. Any kind of organization can use a form of this framework to narrow down its choices.

The vertical axis represents assets or ” degree of asset reusability” while the vertical axis represents customers or “degree of customer reusability”. In the  diagram below I have used assets and customers respectively. One difference is that if I had labeled the axes “degree of asset reusability” and “degree of customer reusability” respectively then I would have also had to label them so that they go from “High” near the origin to “Low” as one moved farther from the origin along each axis.

Generally, activities in Quadrant 1 rely on assets that the startup already owns to create new products that the founders believe will be readily accepted and adopted by the startup’s customers. Activities in this quadrant are comparatively “easy” for the startup to execute. Activities in Quadrant 2 and Quadrant 4 are “easy” along only one axis of the decision matrix, they are “hard” or difficult along the other. In Quadrant 2 the startup has to find new customers, which is harder than selling to existing customers. However, it is relying on assets that it already owns, or can very easily obtain. In Quadrant 4 the startup is selling to its existing customers but it is using assets that it does not own, and cannot easily obtain.

Quadrant 3 is the “Do Not Fucking” do that shit region; in this region the startup is developing a product using assets that it does not own, nor can easily obtain, to sell to customers that it does not already have, nor can easily obtain. In this region the startup’s activities are hard along both dimensions of the decision matrix.

As the diagram illustrates the activities labelled A, B, C, and D should relatively easily be migrated from their respective originating quadrants once they are sufficiently mature. In the case of A & B, the new customers stick around long enough for the startup to develop a close and relatively durable bond with them.  We can go through a similar thought process for C & D. The key is for startup founders to figure out how to quickly move A, B, C and D into Quadrant 1 as quickly as possible.

The activities labelled E pose a tougher challenge. Generally it is best to avoid them at all cost. Pursuing those activities places the startup at risk of material and substantial loss. Any decision to pursue them requires careful analysis of what it will take to conduct the R&D required to develop the product, as well as estimates of the costs that have to be incurred in order to create demand and win new customers for that product and for the startup. Sometimes its just a matter of timing, but at other times the issues at play are more complex, creating an opaque environment that makes it difficult to make such assessments, and often making it difficult to move those activities into one of the other three available quadrants. DNFD does not mean “don’t do that under any circumstance” but rather “you better have a really good reason for doing that” and so there are situations under which careful strategic analysis leads to one conclusion and one conclusion only . . . You better fucking do that or you’ll get killed. We’ll look at an example below.

The DNFD Strategy Framework - It is easiest to use existing assets to sell to existing customers.
The DNFD Strategy Framework – It is easiest to use existing assets to sell to existing customers.

Briefly: The DNFD Strategic Framework in Action

  1. Should Apple produce a tablet? Assume you were assessing Apple’s strategic options soon after it became clear that the iPod/iPhone and iTunes/App Store were going to be wildly successful. How would you decide if it made sense to do more work determining if Apple should develop and market the iPad? Very quickly; first, people who buy iPods or iPhones are likely to want a tablet like the iPad for those activities they no longer enjoy engaging in on their laptop or desktop computers, and for which the customer experience on the iPod or the iPhone is unsatisfactory at best. Moreover, the organizational capabilities that Apple has acquired over the course of time as it has developed the iPod and iTunes, and then the iPhone and the App Store and brought those products to market are easily transferable to developing, producing, and marketing the iPad. ((Obviously more rigorous analysis would have been performed at Apple, but one can see how it makes sense to study this course of action very closely.))
  2. Should Facebook create its own games? When Zynga announced that it was going to develop its own platform so that it did not depend solely on Facebook as a distribution channel for its games, some people might have immediately assumed that Facebook would rapidly start developing its own games to compete with its one-time partner turned rival, Zynga. The DNFD Framework would suggest that this is not so obvious, from the perspective of an outsider trying to assess the situation. However, one might have asked the following questions; Can Facebook easily reuse its accumulated organizational capabilities to publish games that go on to become immensely popular amongst Facebook’s users? If  yes, would these games have a high degree of acceptance and adoption by Facebook’s users? Next, what trade-offs would Facebook have to make in order to start developing its own games? As you can see, these questions are not so straightforward? For example, even though Zynga’s games became immensely popular, one would have to ask how much, on average, of all user activity in a given year on Facebook was devoted by its users to Zynga’s games? Was it significant, noteworthy, or miniscule? As of this writing Facebook has not made any moves to become a publisher of games like Zynga. However, it bought Oculus Rift, a virtual reality device company – it is not yet clear what that means for the prospects of Facebook/Oculus entering the game publishing business. I would not hold my breath if I were you.
  3. Should Facebook build its own data centers? It is late 2008 and youhave been asked to conduct an analysis on the subject: Facebook should build its own data centers; Yes or No? Your analysis will form the basis of the direction Facebook takes on this issue. What would your conclusion be?
    • What is Facebook?
    • What is Facebook’s business?
    • Why should Facebook be concerned about building its own data centers? Think 5, 10, 15 years out.
    • Who is the customer? What are the assets? Will the customer readily and willingly adopt the product?
    • Can Facebook afford to fund the R&D and other costs associated with building its own data centers?
    • What are the opportunity costs that Facebook will confront if it does this?
    • What advantages will Facebook gain? What disadvantages will it face? Does one outweigh the other?

In What Format Should A Strategic Plan Be Maintained? The goal of strategic planning is to create a map that guides the actions of the people in an organization. Good strategy is inextricably linked to execution, and operations. It is management’s responsibility to ensure that strategy is understood to sufficient depth and detail, by everyone in an organization, within the context of the different roles and responsibilities that different people bear and fulfill.

A strategic plan should cover:

  1. Product
    • What features of the startup’s product are critical for this stage of the startup’s life cycle?
      • For example, what features should the minimum viable product include? What should it exclude? Why? ((The minimum viable product is the least expensive product that allows the startup to test the most important hypothesis on which its business model depends.))
    • How is the startup going to identify its customers? Why do those customers buy the product? Why do those potential who do not buy the product make that choice? What will cause them to change their mind?
    • What features does the product need to have if it is going to help the startup win its market?
    • What does the landscape of features look like for competitive or substitute products within the startup’s  market and Value Net, how should the product be positioned relative to that landscape? Why? What are the trade-offs resulting from those choices?
  2.  Finance
    • How will the startup increase revenues?
    • How will the startup reduce costs?
  3. Operations – see related discussion in: Why Tech Startups Can Gain Competitive Advantage from Operations
    • How will the startup get better at creating its products?
    • How will the startup get better at delivering its products to its customers?
    • How will the startup ensure that its operations infrastructure does not become obsolete?
    • How will the startup ensure that its operations become a source of sustainable competitive advantage and differentiate it from its competitors, while protecting and enhancing its current chosen position in its Value Net?
    • How will the startup ensure that its operations infrastructure do not lock it into a position that becomes competitively disadvantageous?
  4. Growth
    • How will the startup gain new customers?
    • How will the startup strengthen its bonds with its existing customers?
    • How will the startup win back customers it has lost?
    • How will the startup expand into new markets?
    • What adjacent markets should the startup consider entering? What risks will it face in doing so?
    • What new geographic markets should the startup consider entering? Why? Why no?
    • What does the startup need to do in terms of marketing, sales, advertising and public relations as those activities relate to the startup’s growth?
  5. People
    • What does the startup need to do in order to attract and retain the best people it can find to help it accomplish its stated goals and objectives?
    • How should the startup develop the people on its existing team?
    • How does the startup motivate its people, and empower them to accomplish things they previously did not know or believe they could accomplish?

When I have collaborated with others in creating strategic plans in the past those plans started out as notes in my notebook. Then they migrated to notes in a word processor, and finally to a presentation deck that management could use to guide organization-wide conversation about overall strategy, as well as brief summaries, explanations, examples and ideas to help managers communicate the message down the organization. However, the most important work started at the front-lines; studying customers, talking to be people directly doing the work that leads to the creation, delivery and fulfillment of the organization’s value proposition to its customers. That is where the real work of creating strategy occurs.

A strategic plan should be readily and easily accessible to everyone in the organization, and should be updated as frequently as is necessary to suit the startup’s goals and objectives.

Closing Notes

  1. This blog post has covered a lot of ground, not all of which is applicable to every startup at this moment. However, even a startup that is made up of two engineers developing the early versions of a software product needs to make choices regarding what they should build. That startup needs a strategy.
  2. Strategy should not become stagnant once it has been developed, it should evolve and adapt to the changing circumstances that a startup finds itself in.
  3. In thinking of a how startup develops a competitive advantage I am thinking of of how it combines the resources that it controls which help it search for a repeatable, scalable, and profitable business model. These resources might be tangible or intangible.
  4. A related issue is how the startup influences its external environment and the factors that influence competition such that those factors do not cause it harm.
  5. A startup has a competitive advantage when it is implementing a strategy and a business model that cannot simultaneously be implemented by its current or potential competitors. It has a sustainable competitive advantage when its strategy and business model cannot simultaneously be implemented by current or potential competitors, and when those competitors cannot duplicate the benefits of that strategy and business model. ((Jay Barney, Firm Resources and Sustained Competitive Advantage. 1991, Journal of Management, Vol. 17, No. 1. Accessed online on Jun 23, 2015 at http://www3.uma.pt/filipejmsousa/ge/Barney,%201991.pdf))
  6. The startup’s culture is an important source of competitive advantage, and ought to work in concert with its strategy. For example, employees of Facebook should “Move fast, and break things.” within the tenets of its strategy. When Andy Grove “Let chaos reign.” at Intel he did so within the parameters of Intel’s strategy. ((See for example; Jay B. Barney, Organizational Culture: Can It Be a Source of Sustained Competitive Advantage? The Academy of Management Review, 07/1986))

Further Reading: These notes are intended only as a starting point. Below some books that you should consider reading.

    1. The Management Myth: Debunking Modern Business Philosophy – Argues, not unreasonably, that there’s no evidence that competitive advantage can be created in advance, and takes issue with Michael Porter’s ideas about competitive advantage. Personally, I am less interested in arguments between academics, and more interested in understanding how people who need to run a business can get better at day-to-day, and long-term execution. The key is to get better at making sensible trade-offs in the present, in order to increase the odds of success in the future. No one can predict the future. Anyone who makes such a claim is a liar.
    2. The End of Competitive Advantage: How to Keep Your Strategy Moving as Fast as Your Business – Argues that Porter’s ideas lead to a dangerous complacency; eventually creating the inertia that ensures that entrenched incumbents get displaced by nimble upstarts. In other words competitive advantage is transient, not permanent.
    3. Playing to Win: How Strategy Really Works – Practical examples of how to make strategic choices for people managing any kind of organization. Arms readers with a definition of strategy, the Strategy Choice Cascade, and the Strategic Structuring process.
    4. Good Strategy Bad Strategy: The Difference and Why It Matters – Departs from other books on strategy by focusing on a range of fundamental issues that have received little attention. It deals more with the day to day issues strategists must confront, and less with the conceptual arguments about competitive advantage. I wish it existed in 2008/2009 when I needed to translate what I had been taught in business school with real-world scenarios with which I had to contend. Hindsight analysis is easy, developing a forward-looking strategic plan that will work is more difficult. This book focusses on helping illuminate how you can get better at the latter.
    5. Good to Great: Why Some Companies Make the Leap…And Others Don’t & Built to Last: Successful Habits of Visionary Companies (Harper Business Essentials)
    6. Small Giants: Companies That Choose to Be Great Instead of Big

Filed Under: Uncategorized Tagged With: Business Model Canvas, Business Models, Business Strategy, Competitive Strategy, DNFD Strategy Framework, Early Stage Startups, Economic Moat, Game Theory, Goals Grid, Innovation, Investment Analysis, Long Read, Network Effect, Operations, Porter's 5 Forces, Switching Costs, Technology, Value Creation, Venture Capital

A Note on Developing and Testing Hypotheses

June 10, 2015 by Brian Laung Aoaeh

Working on Problem Sets
Working on Problem Sets

This post is a continuation of the discussion I started in A Note On Startup Business Model Hypotheses. In this post I will describe how one might go about developing and testing a hypothesis about any aspect of a startup’s  business model. ((Let me know if you feel I have failed to attribute something appropriately. Tell me how to fix the error, and I will do so. I regret any mistakes in quoting from my sources.))

I will use a fine-dining restaurant as a motivating example.

To ensure we are on the same page, first some definitions.

Definition #1: What is a startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model. ((I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports.))

Definition #2: What is a business model? A business model is the description of how a startup will create, deliver and capture value. Alex Osterwalder’s Business Model Canvas is one framework for describing and documenting the elements of a startup’s business model.

Alex Osterwalder's Business Model Canvas, from the book Business Model Generation
Alex Osterwalder’s Business Model Canvas, from the book Business Model Generation

Definition #3 What is a hypothesis? A hypothesis is a statement, or a group of statements, that proposes an answer to a question, or a solution to a problem, in a manner that is testable through experimentation. The goal of experimentation and testing is to determine if the hypothesis is correct, and to inform the subsequent actions that the startup should take on the basis of that evidence.

A hypothesis is;

  1. A guess about the process underlying a set of observations that have been made by the founder.
  2. A testable guess, in the sense that it attempts to establish and predict the basic relationship between two or more variables that interact with one another to lead to the observed phenomena. This allows the researcher to test what happens when one of those variables is allowed to change, while others are held constant.
  3. Not the same as a research question; in the sense that a research question is broad while a hypothesis is more narrow in scope.

Motivating example; A fine-dining restaurant is experiencing an ongoing slump in revenues. The restaurateur wishes to test a number of possible approaches to reversing that trend. From prior experience they believe that the following factors each has a positive impact on overall sales at the restaurant;

  1. Wine Sales
  2. Liquor Sales
  3. Appetizers
  4. Seasonal Menu Changes
  5. Table Turns
  6. PR, Advertising and Marketing

How should management determine where to make an adjustment in order to improve overall sales without incurring a large capital outlay?

Discussion

Let us assume that Sales can be modeled by the following relationship. ((I am in no way suggesting this is the appropriate model for this problem. I am using this only for the purpose of this discussion. Assume the restaurateur has developed this model after years of experience in the industry, and based on trial and error. This model is supported by the last 5 years of sales data.))

Restaurant Sales as A Function of Various Factors
Restaurant Sales as A Function of Various Factors

Remember that the goal is to try to figure out a course of action without spending too much by way of capital until the restaurateur is fairly certain that any capital deployed to this end will yield a disproportionately positive result.

To keep the discussion brief, let’s focus on two of the factors that management believes play an important role in driving revenues from the preceding list. Let’s focus on Wine Sales and PR, Advertising, and Sales.

Assume the restaurant is laid out such that the front-of-the-house is organized as two nearly identical dining rooms, they are separated by an ornate vestibule. During the experiment one dining room is operated status quo, while the other is operated as part of the experiment. Management feels this makes sense because guests are typically evenly split between the two dining rooms. Let’s call them Dining Room #1 – the control dining room, and Dining Room #2 – the dining room in which the experimental change is implemented.

Possible Hypotheses for Wine Sales Program – Experiment #1

  1. General Hypothesis: Implementing a wine-program will have an effect on sales.
  2. Directional Hypothesis: Implementing a wine-program will have a positive effect on sales.
  3. Testable Hypothesis: If we implement a wine-program we will increase revenue significantly because average check size increases substantially when wine sales increase.

Experiment #1: Management might hold all the factors constant, but implement an in-house training program to get wait-staff more comfortable speaking to guests of the restaurant about it’s current small collection of wine. Waiters in Dining Room # 2 are coached to discuss wines before guests order their meal, and afterwards when a guest might be considering a dessert. Let’s assume this program lasts a month. At the end of the month, management compares data from Dining Room #1 with data from Dining Room #2.

Possible Hypotheses for Inside-Sales Program – Experiment #2

  1. General Hypothesis: Implementing an inside-sales program will have an effect on sales.
  2. Directional Hypothesis: Implementing an inside-sales program will have a positive effect on sales.
  3. Testable Hypothesis: If we implement an inside-sales program we will increase revenue significantly because average check size increases substantially when wait-staff are encouraged to engage with guests.

Experiment #2: In this experiment, which also lasts a month, management trains wait-staff in Dining Room #2 to engage guests in casual conversation and to speak more enthusiastically and informatively about each day’s specials. Wait-staff are trained to highlight upcoming events at the restaurant that regular guests might find interesting enough to return for – a special prixe-fixe Wine Dinner the following week, for example. On occasion, every 90 minutes or so, the restaurant’s chef de cuisine spends about 10 minutes walking through Dining Room #2 and socializes with guests. The restaurateur wishes to determine if making things like this a more consistent part of how the restaurant operates makes sense from the perspective of increasing revenue.

During each experiment management collects the following data for each day, each week, and also for the month:

  1. Total Revenue
  2. Average Check Size – Revenue per Table
  3. Average Wine Sales – Wine Sales per Table
  4. Positive Social Media Mentions
  5. Negative Social Media Mentions
  6. In-restaurant Reservations – future reservations made while the guest is at dinner as a result of learning about an upcoming special event. This only applies to Experiment #2.

 

9-inch tall stack of paper - 6 months worth of studying
9-inch tall stack of paper – 6 months worth of studying

Now that the restaurant has collected some data it is time to test the data to see what conclusions the restaurateur might be able to reach based on each of the experiments.

Stating Null and Alternative Hypotheses

To test the hypotheses our restaurateur must make two different statements that will form the basis of a test; The Null Hypothesis states that the effect our restaurateur thinks exist does not in fact exist. The Alternative Hypothesis makes a statement opposite to that made in the null hypothesis, and typically is the statement we want to prove.

Experiment #1: Null and Alternative Hypothesis

  1. Null Hypothesis: Implementing a wine sales program has no effect on revenue.
  2. Alternative Hypothesis: Implementing a wine sales program has a positive effect on revenue.

Experiment #2: Null and Alternative Hypothesis

  1. Null Hypothesis: Implementing an inside-sales program has no effect on revenue.
  2. Alternative Hypothesis: Implementing an inside-sales program has a positive effect on revenue.

Note that the null and alternative hypotheses stated above are merely examples. The restaurateur could formulate each of those statements in more general terms, or with more specificity than I have done. To some extent that choice depends on the granularity of the data that was collected from the experiments.

At this point our restaurateur can perform a test of statistical inference to reach a conclusion – the outcome would be a “rejection” or “a failure to reject” the null hypothesis. A rejection of the null hypothesis leads us to accept the alternative hypothesis. A failure to reject the null hypothesis leads us to fail to accept the alternative hypothesis.

Assuming that the restaurateur rejects the null hypothesis in both instances, then it makes sense to spend some capital trying to build out a more robust version of each of the experiments we described, with the intention of operationalizing what was done during the experiment and making those practices a permanent part of how the restaurant is managed and run on an ongoing basis.

Closing comments:

  1. I have glossed over a significant amount of detail. That was deliberate. The goal of this post is not to discuss statistical theory, but to think about how statistical thinking can help startup founders who need to make important choices about how to utilize scarce resources. More detail can be found in any good introductory level business statistics text book.
  2. While going through this process our restaurateur needs to ask more questions than I did in this post. For example, what does “significant” mean? Is a 5% increase in revenue significant? Why? Is a 20% increase in revenue significant? Why? Or, why not? Are the costs associated with implementing the changes necessary to make what was done during the two experiments a permanent operating practice of the restaurant justified by the restaurateur’s forecasts of the long term benefit of doing so? Why, or why not?
  3. It is always important to think about sources of error whenever one is conducting an experiment that is supposed to yield data that decisions like the one I described in this post will be based upon. In this instance, one concern might be that the restaurateur is not collecting the appropriate data on which this decision should be based. Or, for example, that a single month is not a wide enough window of time to determine if the effect observed during this period of the experiment persists during the remaining 11 months of the year.

Notwithstanding those concerns, I believe that when it is possible, this kind of analysis should always complement management’s intuition.

Filed Under: Business Models, Customer Development, Entrepreneurship, How and Why, How To, Innovation, Investing, Lean Startup, Startups, Venture Capital Tagged With: Business Model Canvas, Business Models, Early Stage Startups, Hypothesis Testing, Long Read, Probability, Statistics, Strategy, Venture Capital

A Note on Startup Business Model Hypotheses

March 29, 2015 by Brian Laung Aoaeh

Light bulbs on Staircase

One of the observations I have arrived at over the course of meeting founders of early stage startups is that often it is not clear during our conversations if they have spent time examining the hypotheses that underlie the business model for the startup they are building.

This post ((Any mistakes in quoting from my sources are entirely mine. This post is an updated and adapted version of my posts The Startup Customer Development Model and Customer Discovery Phase I: State Your Business Model Hypotheses? which were published at Tekedia.com on September 3rd, 2012 and January 21, 2013 respectively. Large portions of this update are identical to the originals.)) is my attempt to outline some of the areas that I consider as I try to understand an early stage startup’s business model and the hypotheses that are the foundation on which its success must rest. ((I have adapted portions of: Chapter 2 and Chapter 4 of The Startup Owner’s Manual Vol. 1: The Step –by-step Guide for Building a Great Company, Steve Blank and Bob Dorf, Pub. March 2012 by K and S Ranch Publishing Division.))

To ensure we are on the same page, first some definitions;

Definition #1: What is a startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model. ((I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports.))

Definition #2: What is a business model? A business model is the description of how a startup will create, deliver and capture value. Alex Osterwalder’s Business Model Canvas is one framework for describing and documenting the elements of a startup’s business model.

Definition #3: What is Customer Development? Customer Development is a 4-step process by which a startup answers the questions it needs to answer in order to find a business model that is repeatable, scalable, and profitable. Step 1 and step 2 of Customer Development cover the “search” phase of a startup’s life-cycle. Step 1 is Customer Discovery. Step 2 is Customer Validation. More on those a little later.

Definition #4 What is a hypothesis? A hypothesis is a statement, or a group of statements, that proposes an answer to a question, or a solution to a problem, in a manner that is testable through experimentation. The goal of experimentation and testing is to determine if the hypothesis is correct, and to inform the subsequent actions that the startup should take on the basis of that evidence.

Step 1 in the Customer Development Process: Customer Discovery – this involves translating the initial vision behind the startup into a set of hypotheses about each component of the business model. This allows experiments to be performed that either validate or invalidate each proposed hypothesis. In my experience the exercise of testing hypotheses about the business model with prospective customers accomplishes at least two things. First the startup entrepreneur gets to hear directly from customers about the elements of the business model’s value proposition that are most critical from the point of view of the startup’s customers or partners. Second it jump-starts the sales process even before the startup has invested much time or money into building a product. The founders of a hardware startup discussed their idea for an innovative new product with a potential partner. The partner’s input proved crucial in determining the direction they followed with regard to product design – it evolved from a product with one offering to one with three distinct but complementary offerings.

The revenue model also changed based on those discussions. Even better, the partner agreed to work with this startup to bring the product to market when it is ready. Obviously, there’s still a lot to be done – product design, product development and manufacturing for example. Yet those initial discussions have been critical in conferring the kind of credibility that has made it possible for the startup to seek an audience with other potential partners. Customer discovery for this startup also involved market research to determine the priority of features from the perspective of individual end-use customers – the men and women who might actually decide to purchase the startup’s offering once it becomes available to consumers.

Step 2 in the Customer Development Process: Customer Validation – this step proves that the work done in step 1 is easily repeatable, scalable, and capable of delivering the customer volume required to build a profitable company. The startup I described above is now building prototypes based on all the information it gathered during the Customer Discovery process. Eventually we will test our ability to deploy the product in the field – a few hundred first, then a few thousand, and barring any major setbacks, tens-of-thousands, then hundreds of thousands.

During that process we will test how well the back-end software works with the hardware that we have designed and manufactured once people are actually using the device. At each step I expect we will go back to the drawing board on several aspects of the product and the business model. For example, our pricing model may not reflect reality since our market research confirmed the hypothesis that our potential customers have never encountered a device like the one we are developing. We may discover that customers will gladly pay more for the value proposition we offer than we currently plan to charge. It is important to note that we have gone through a number of product pivots during Customer Discovery. For one, we made an incorrect hypothesis about the amount of space our partners would be willing to devote to this new device, never mind all the assurances they gave us during early conversations.

We also made a number of pivots in terms of the user experience and the interface through which users will interact with the device because we realized that a number of hypotheses we had made about certain design, engineering, and manufacturing issues related to the product were just flat out wrong. The product we will soon show to our partners satisfies the desires individual end-use customers told us they seek in a product like ours ((Market research involved nothing more than a description of the device. In other words, we relied on potential customers’ ability to imagine a future in which they could use the device we were setting out to develop.)), in a manner that accounts for the constraints our partners expressed they would eventually have to contend with in deploying the devices when they come to market. Moreover, this exchange of information led us to develop a product with performance characteristics far superior to what we would have achieved within the parameters of our previous vision. We expect to make a few more pivots before all is said and done.

Developing Hypotheses During Customer Discovery

The first step in customer discovery is developing a rough estimate of market size and sketching an initial business model for your startup using the business model canvas, which I have discussed in some detail in What is Your Business Model? Using the business model as a guide, develop a hypothesis brief for each component of the business model canvas. A hypothesis brief should contain a succinct statement of the hypothesis itself as well as a sufficiently detailed but brief outline of the information that makes the hypothesis a reasonable and valid one for that business model component.

The market size hypothesis is probably the most critical, even though it does not correspond directly to any of the business model canvas components. Investors like to back companies that target potentially large markets. At the same time, be careful to differentiate the total addressable market opportunity, the serviced addressable market, and your target market. Needless to say, your initial target market will be the smallest of these three. In most cases a bottom-up estimate is better than a top-down estimate because it is relatively easy for an investor who wishes to do so to replicate a bottom-up estimate. Whereas, a top-down estimate could be viewed as “hand-waving” with no basis in reality.

The value proposition hypothesis should discuss the problem your startup solves for its customers. A segment of this brief should capture product features, and a minimum set of initial product features that early customers would be willing to pay for. This is the minimum viable product, a bare-bones version of your product that solves the “core” problem your customers face. Put another way, your minimum viable product is the least developed product that you can create in order to validate your most important hypotheses about the problem you are solving and what your customers or users will accept.

The customer segments hypothesis forces you to answer the questions “Who are my customers?” and “What problems do my customers face?” The hypothesis brief should discuss customer problems, types, and archetypes respectively. Understanding “a day in the life” of your typical customer is a powerful way to understand your startup’s customers. Finally, Steve and Bob suggest you develop a customer influence map. There is an important aspect finding customers that can be overlooked. What is the smallest group of customers that is experiencing the pain or problem you are solving most acutely? Perhaps they do not have enough money to be attractive to incumbents. Or, perhaps they are a niche that is considered weird and unprofitable by your competitors. Start your experiments there. Why? If your product indeed solves their problem, they will adopt it quickly. On the basis of broad adoption within that niche, you can plot a path to other communities of customers who are facing the same problem. In other words, find the groups of people who will be your “Innovators” and “Early Adopters” and focus your early efforts on those groups.

The channels hypothesis should differentiate between physical, web, and mobile channels. An important consideration during the development of this brief is whether your product fits the channel. At this stage it is important to pick the channel with the most potential and to focus on gaining customers and cultivating sales through that channel to the near exclusion of every other alternative. With very few exceptions, since you are still testing your hypotheses, developing your business model, and determining what product is best positioned to solve your customers problems avoid the temptation to launch via multiple channels.

I was having lunch with the founder of an early-stage startup on Thursday, last week. She was giving me an update – the struggle to raise seed capital from investors, what she’s learning about building a team, and so on. We got to talking about how she would distribute her startup’s MVP. Her initial plan would have cost her a lot of money – capital she can’t afford to spend and a significant portion of the round she’s trying to raise, because she was thinking about traditional channels – the most obvious route to the customers she thinks she needs to get to. I pointed out that without further testing, she was taking a very risky gamble whose most likely outcomes do not favor her startup. Instead I suggested she spend the least amount of money she can to test non-traditional channels, and maximize the yield from those avenues before she does anything big and splashy through traditional channels. In this example, her hypothesis was poorly formed because it failed to take her startup’s capital constraints into full consideration.

The market-type and competitive hypothesis discusses the nature of the market into which your startup is entering and tries to anticipate the competitive landscape of the market that you will be attacking. You might consider it the second half of the value proposition hypothesis – your product solves a product for a group of customers, or a market. In broad terms a market already exists, or your startup is creating a completely new market where none existed previously. Your market entry strategy will depend on the market type you identify, as will your cost of entry into that market. In an existing market, your startup will have to position itself against the competition in a manner that ensures it can win given the basis upon which you have chosen to compete.

The customer relationships hypothesis describes how you get, keep and grow your customers. It is similar to the LBGUPS model, which I discussed in What Is Your Business Model? There’s no need to emphasize that this is an important hypothesis brief – without customers or users your startup will die a not premature death. How you get, grow and keep customers is very channel dependent. Your analysis should take that into account, and should also factor in related costs.

The key resources hypothesis discusses how you’ll obtain resources that are critical to your startup’s operations but that you do not have within the startup. These resources might be physical resources, financial capital, human capital, or intellectual property. In each case it is important to list the resource and an outline of how it will be secured to enable the startup run its operations. For example, servers can be rented in the cloud at a cost that is lower than managing your own server. Another example, a first-time founder who does not yet have a technical co-founder might partner with an outsourced software development shop to build and MVP with which to run some experiments. Often the devshop will remain as a service provider till the startup becomes self-sufficient enough to bring that work in-house. I have a bias for startups that control their intellectual property.

The key-partners hypothesis describes the partners that are essential to enabling your startup to succeed. It also describes the value-exchange that keeps the partnership alive. For example, a startup might have all its development and design work done by a software engineering consulting firm established for that specific purpose. In this case the startup pays the software engineer money in exchange for software engineering related to its product. Key-partner relationships might take the form of a strategic alliance, a joint new business development effort, a key supplier relationship, or co-opetition. Certain of these are more common early in the startup lifecycle, and others are more common late in the startup lifecycle. It is important to realize that a partner should not have control over anything that is critical to your startup’s ability to exist and do business.

The key activities hypothesis summarizes your startup team’s understanding and assumptions about where its energies should be most focused in order to create the most value for its customers. These are those activities that you feel cannot be left to one of your startup’s key partners. For example, a hardware startup might view design as a key activity, while assembly is left to a manufacturing partner in a low-cost manufacturing jurisdiction.

The revenue and pricing hypothesis brief is important because it ensures that the startup can extract value for itself and its investors. It asks a number of simple questions all related to revenue. The nature of the specific questions asked depends on the channel, but the essence of those questions remains the same. Together they should enable you determine if there’s a business worth pursuing along the path you have chosen for your startup.

The cost structure hypothesis brief forms the second half of the value extraction hypotheses – the first being the revenue and pricing hypothesis. Your startup’s cost structure must ensure that it can effectively deliver on the value proposition it has promised customers, and keep a portion of the revenues that the startup cultivates in the form of profits. Here too the questions asked will be relatively simple, and will reflect the channel and the market type. For example, a startup whose only channel is the web will have a lower cost structure than one with a physical channel.

Once your hypothesis briefs are complete, your entire startup team should discuss the output. Seek contradictions, conflicts and inconsistencies. The most important reason for developing these hypotheses is to ensure that the actions that your startup is taking have the highest probability of yielding success that is possible.

During my conversations with founders I listen carefully to determine if the startup has thought about these issues, or is thinking about them – it depends on the stage. I become concerned when I get the sense that important questions have been left unasked and unanswered.

Filed Under: Business Models, Customer Development, Entrepreneurship, Funding, How and Why, Innovation, Lean Startup, Long Read, Startups, Venture Capital Tagged With: Business Model Canvas, Business Models, Due Diligence, Early Stage Startups, Persuasion, Pitching, Venture Capital

What Is Your Business Model?

February 1, 2015 by Brian Laung Aoaeh

“It is a B2B2C business model.” is generally not what I am hoping to hear when I ask “What is your business model?” #BusinessModelGeneration

— Brian Laung Aoaeh (@brianlaungaoaeh) February 2, 2015

Invariably, when I am meeting the founder of a startup for the first time to discuss the possibility that KEC Ventures might invest in their startup I ask this question; “What is your business Model?” ((This post is an updated version of 4 separate posts authored by me, and first published at Tekedia between Sept. 18th, 2011 and Oct. 30th, 2011. Any similarities between this article and those posts is deliberate.))

Typically, the response I get is unsatisfactory. In this post I will discuss what I expect startup founders to include in their answer.

To ensure we are on the same page about what a startup is, I will begin with a definition; A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model. ((I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports.)) As an investor, I hope that each early stage startup in which I have made an investment matures into a company.

That leads to another question; What is a business model According to Michael Rappa; “In the most basic sense, a business model is the method of doing business by which a company can sustain itself – that is, generate revenue. The business model spells-out how a company makes money by specifying where it is positioned in the value chain.” Alex Osterwalder and Yves Pigneur say that; “A business model describes the rationale of how an organization creates, delivers and captures value.”

Other definitions exist, but taken together, these two statements provide us with enough basis for understanding what we should expect to learn from an adequately developed business model.

The business model should tell us how the entrepreneur expects to create value. To do this, the entrepreneur must decide what activities are core to the business the entrepreneur wishes to start. The question of how the entrepreneur creates value is also important because the answer to that question will often contribute to an understanding of the customer base that the business can expect to rely on.  This might seem trivial at its face. It is not. Understanding the customer base for which the business expects to create value is central to many other decisions that the business will have to make as it matures and approaches the launch of its product or service on the market.

Our definition of a business model raises a second question; how does the startup deliver value? I expect the startup founders I meet with to have started thinking about the process by which the value that the startup creates will be delivered to its target customers.

Given a reasonably well defined customer value proposition, our entrepreneur must now decide how that value is going to “be put in the hands” of the people that will become customers of the startup. The process of delivering the product or service that the entrepreneur has developed involves several distinct phases; Learn, Buy, Get, Use, Pay and Support. Employees of AT&T are believed to have developed the acronym LBGUPS (pronounced ELBEEGUPS) as a means of remembering the phases of this process as it relates to AT&T’s products. It is most effective to think of LBGUPS as a continuous, circular, and repetitive process.

  • Learn – when new customers first become aware of the product or service and acquire information and knowledge about how they may benefit from its use. Typically the startup accomplishes this through some sort of marketing, sales and public relations activity.
  • Buy – when customers decide to make a purchase after having learned about the new offering and communicate the desire to act on their decision to someone in a position to initiate the next phase of the process.
  • Get – when customers actually take delivery of the new product. This might happen in a physical or virtual store. It might involve shipping the product to the customer. If the customer is buying a service then this typically happens in person, or the service could be delivered remotely.
  • Use – when customers actually use or consume the product, or benefit from the service.
  • Pay – when customers pay for the product. This might happen simultaneously with buy. Sometimes there’s a time-lag between buy and pay – for example, in a fine dining restaurant a guest dines before before paying for the meal.
  • Support – when customers are provided with additional information that is aimed at resolving any problems they may have encountered during any of the preceding phases. Support should serve as an opportunity to encourage customers to remain, or to come back the next time they need to purchase a similar product or service. This is the role of technical support, customer service and customer relations. Done well, support should lead right back to learn.
How will your startup deliver value?
How will your startup deliver value?

Every startup must ask, and find answers to a number of questions while going through the process of delivering value to customers. What is the most effective channel for marketing, advertising, public relations, and sales? Where should we place our product or service in order to enable evaluation by potential customers as they make the buy decision? How do we put the product or service in a customer’s hands once that customer has made a purchase? What do we need to do to ensure that the customer uses our product after they have bought it and we have delivered it? How do we ensure that our customers are paying us, in full and on time? What is the mechanism by which we get paid by our customers? What problems might our customers encounter, and how should we help them resolve those problems in order to ensure that they come back to learn more about our other offerings and buy more from us in the future?

Often, each question that the startup seeks to answer will give rise to other questions that must be answered as well. This process requires trade-offs. It might be too costly to attempt to exploit every possible marketing channel and so the entrepreneur must choose only a few out of many. An over elaborate support structure might prove too expensive to maintain over the long term. Also, that might create bad-habits that the startup’s revenue structure has not been designed to carry without tipping the company into a position where it is experiencing difficulties, this touches on the issue of pricing.

Next, let’s examine the third question that our definition of a business model raises; How does the business capture value? A startup founder should be able to describe how the startup will create value, deliver that value to its customers and in-turn capture some value for itself and its investors.

Michael Rappa’s statement about business models emphasizes the importance of revenue streams. Revenues comprise the cash that a startup’s customers exchange for the product or service that the startup provides. In the process of this exchange, a transfer of ownership or usage rights takes place – in an outright sale, the customer assumes ownership. In a lease, licensing or rental agreement ownership remains with the seller, but the buyer is granted usage rights for a contractually agreed period. Revenue streams can be one-off or recurring.

I have no argument against the suggestion that startups should focus keenly on developing and growing revenue streams. However, my experience has taught me that startups must focus equal attention on profit, and on the related issue of costs.

Why?

In order to reach self-sustaining growth, a maturing start-up must quickly put itself in a position to invest in areas that are critical to its ability to create and deliver value to its customers – it has to invest in those assets that make its revenue streams possible. Costs represent the price the company pays to obtain the resources it must bring together in order to create and deliver value to its customers. A business earns a profit when its total revenues exceed its total costs. A successful business model should lead to an outcome in which customers perceive the entrepreneur as adding value. They demonstrate this by paying more for the product than it cost the entrepreneur to produce it – leading to a profit for the entrepreneur.

Earning a profit makes it possible for the startup to invest in the assets that are most critical to its ability to create and deliver value. Controlling and managing costs effectively while growing revenues will ensure that the startup maximizes its profit.

How will your startup capture value? You should be able to describe how your startup will grow revenues, manage costs, invest for growth, and maximize profits. This is not a static process. It should be dynamic and ongoing. Your startup will not be operating in a stagnant market. Therefore, your product and pricing strategies will need to adapt from time to time in response to competition as well as other market forces.

Also, depending on the stage at which KEC Ventures is considering an investment, it might not yet be clear which revenue model will work best for the startup. A seed stage startup might not yet have settled on a revenue model. A startup to which we are speaking about a series A financing should have some well formulated ideas about its revenue model, and in fact should be running some experiments to validate its hypotheses. An existing startup in our portfolio in which we are contemplating making a follow-on series B investment should most certainly have settled on a revenue model, and be in the process of scaling the business model in a repeatable, and profitable way.

I will end this discussion with some related observations;

First; It is often tempting to assume that one startup can simply copy or imitate the business model of one of its competitors. That may work in the short-term. In my opinion that is not an approach that confers a lasting competitive edge, certainly not in fledgling markets and industries, and often not in mature industries either. An important aspect of business model development is the deliberate and conscious selection among a number of alternative choices regarding product design, customer development, revenue models and cost structure; the wholesale copying of a business model simply because it has worked for another startup suggests the entrepreneur has abdicated responsibility for understanding the dynamics at play in each of those critical areas. That is a recipe for a failed startup adventure in which I am not eager participate.

While I oppose the wholesale copying of a business model that someone else has developed, I am a strong proponent of learning from the experience of other startups – the successes and the failures. There is real value in knowing what has ensured that some startups thrive. There is even more value in knowing what has proved fatal to others.

Second; It might take several attempts before a startup discovers the business model that works best – reflecting an industry in its earliest stage of development. Even then, the business model must evolve with the passage of time. Technology changes. Labor markets shift. National economies expand and contract. Opportunities not present in the past will present themselves in the future. Competitive threats that did not exist at the time the startup was formed appear as soon as other individuals notice a new chance to earn economic profits. Regulations emerge as a result of changes in political mood. A business model that does not adapt and evolve reflects a startup founder who does not grasp the nature, extent and complexity of the numerous challenges that lie ahead. Such founders, and the startups they are building, are bound to fail.

Third; The business model is not the business plan. Your business plan should certainly discuss your business model, yet the two are distinct and different. The business model is a framework within which the startup’s activities occur. The business plan is a document whose main purpose is to serve as a record of the startup’s goals, the reasons why those goals make sense and can be achieved, the manner in which the goals will be accomplished and the timeline within which the startup expects to implement its plan – presumably the plan is to become profitable as soon as possible within the tenets of the business model.

I am a fan of The Business Model Canvas. In fact, I use it each time I sit down to study a startup in which I believe KEC Ventures should invest. Using it ensures that I understand the business model, that I understand the risks that might lie ahead, and that I am comfortable that the startup indeed has found an opportunity to create, deliver, and capture value.

Filed Under: Business Models, Entrepreneurship, How and Why, Innovation, Long Read, Pitching, Uncategorized, Venture Capital Tagged With: Business Model Canvas, Business Models, Due Diligence, Early Stage Startups, Investor meeting, Long Read, Pitching, Value Creation, Venture Capital

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