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Investment Analysis

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.

FullSizeRender

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

Notes On Early Stage Technology Investing; Art, Science, or Both?

June 18, 2015 by Brian Laung Aoaeh

Conducting market research is an important part of the investment decision making process.
Conducting market research is an important part of the investment decision making process.

Often when I have asked other people this question I get a response that leaves me feeling dissatisfied. It seems most investors are compelled to take one side over the other, and, at least as far as the admittedly small sample  of investors I have asked this question are concerned, insufficient thought is given to the notion that perhaps early stage investing has elements that make it like art in some respects but like science in others.

I am writing these notes on early stage technology investing in order to clarify my own thinking on the subject. ((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.)) Ideally, once I am done I should have a clearer understanding of how my process for arriving at “yes” or “no” decisions should work, in what context certain steps can be truncated or even eliminated altogether, and the risks I am exposing our fund’s limited partners and myself to by the choices I make during the period over which I study and analyse an early stage startup that is an investment prospect.

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.

Definition #2: What is art? 

The expression or application of human creative skill and imagination, typically in a visual form such as painting or sculpture, producing works to be appreciated primarily for their beauty or emotional power. ((http://www.oxforddictionaries.com/us/definition/american_english/art, acessed Jun 18th, 2015.))

In an article published in 2010, Marilina Maraviglia says:

This question pops up often, and with many answers. Many argue that art cannot be defined. We could go about this in several ways. Art is often considered the process or product of deliberately arranging elements in a way that appeals to the senses or emotions. It encompasses a diverse range of human activities, creations and ways of expression, including music, literature, film, sculpture and paintings. The meaning of art is explored in a branch of philosophy known as aesthetics. At least, that’s what Wikipedia claims.

Art is generally understood as any activity or product done by people with a communicative or aesthetic purpose – something that expresses an idea, an emotion or, more generally, a world view.

It is a component of culture, reflecting economic and social substrates in its design. It transmits ideas and values inherent in every culture across space and time. Its role changes through time, acquiring more of an aesthetic component here and a socio-educational function there. ((Marilina Maraviglia, What Do We Really Mean By Art? Accessed on Jun 18th, 2015 at http://www.smashingmagazine.com/2010/07/23/what-do-we-really-mean-by-art/))

Lastly, according to Tolstoy:

To evoke in oneself a feeling one has once experienced, and having evoked it in oneself, then, by means of movements, lines, colors, sounds, or forms expressed in words, so to transmit that feeling that others may experience the same feeling — this is the activity of art.

Art is a human activity consisting in this, that one man consciously, by means of certain external signs, hands on to others feelings he has lived through, and that other people are infected by these feelings and also experience them. ((Leo Tolstoy, Art and Sincereity. Accessed on Jun 18th, 2015 at http://denisdutton.com/tolstoy.htm))

I will attempt to extract a few key characteristics that I think qualify something as art on the basis of the preceding quotations. ((Adapted from: What is art? An Essay on 21st Century Art, Sylvia Hartmann. Accessed on Jun 18th at http://silviahartmann.com/art.php))

First, art is initially conceived or imagined entirely in the artist’s mind.

Second, the artist uses an artistic medium to transform what has been an intangible object in the artist’s mind into something tangible that other people can experience.

Third, art evokes a response from the people who experience it.

Finally, art is transformative in nature. Once experienced, art changes how we see and experience the world.

Definition #2: What is science? Conventional, and commonly held notions about what constitutes science often mistake and confuse the “pedagogy of science” with the “practice of science” . . . What does that mean precisely?

When we learn science we do so in a very formulaic manner. This makes sense, the first step in becoming a scientist is learning a sufficient amount of the body of knowledge that man has accumulated over time thanks to the work done by generations of scientists. The same is true for mathematics. That makes sense . . . Structure and process are important if the typical student of science is to make steady progress through the accumulated body of knowledge, until that student has built enough mastery of the subject to begin making new contributions to the knowledge we keep accumulating about the world. Out of necessity, the process of learning science adheres to the “scientific method” . . . It is linear, and simple, and provides structure for how one goes about mastering the accumulated knowledge of science. Generally, the process of teaching and learning science leaves little room for creativity. This leads many to develop and embrace the notion that the practice of science is an endeavor devoid of creativity. The way science is taught and learned also leads to the misconception that science is uniformly precise at every stage, and that it leads to conclusive answers to the questions that scientists investigate.

However, how one learns science is not the same as how one practices science. The following images attempt to illustrate that point.

Real Process of Science (1 of 3) . Image Credit: University of California Museum of Paleontology's Understanding Science
Real Process of Science (1 of 3). Image Credit: University of California Museum of Paleontology’s Understanding Science
Real Process of Science (2 of 3). Image Credit: University of California Museum of Paleontology's Understanding Science
Real Process of Science (2 of 3). Image Credit: University of California Museum of Paleontology’s Understanding Science
Real Process of Science (3 of 3). Image Credit: University of California Museum of Paleontology's Understanding Science
Real Process of Science (3 of 3). Image Credit: University of California Museum of Paleontology’s Understanding Science

In real-life, scientists:

  1. Create knowledge using an iterative process in which new advancements are built on prior work, in relatively small, incremental steps. The process starts with ideas, beliefs, or guesses . . . conceived entirely in the scientist’s mind. Old knowledge is revised, and modified based on new discoveries made possible by advancements in technology.
  2. Conduct research for which there’s no pre-determined outcome. For example, the evidence obtained from observation and experimentation might contradict the researcher’s best before-the-fact guesses and assumptions as well as established and accepted theory.
  3. Always begin with an idea that can be tested through observation, experimentation, measurement, and analysis. Observation, experimentation, measurement, and analysis – together, these constitute the scientist’s medium.
  4. Conduct experiments to test the ideas that they seek to investigate. The process of conducting experiments is the method by which they collect the necessary evidence that leads them to ultimately accept or reject the idea under investigation. To succeed at this they must be willing to reject conventional-wisdom, and scrutinize closely-held and cherished beliefs based on the evidence and observations of the experiments they perform.
  5. Typically work in collaboration with other scientists, or scientists-in-training. For example, as an undergraduate mathematics and physics double major at Connecticut College, I spent three years assisting Prof. Arlan W. Mantz with research on the temperature dependence of molecular absorption line widths and shapes using tunable semiconductor diode lasers. The nature of scientific collaboration can be direct or indirect.
  6. Often say that ” . . . further research needs to be conducted on this topic . . . ” This refrain seems to be a common feature of presentations in which scientists present their work. Yet, if one understands science as the pursuit of a deeper, nuanced, and increasingly sophisticated understanding of the laws that govern the natural world . . . That makes complete sense. Scientific research is ongoing in its search for better answers to questions that non-scientists might consider closed-to-debate.
  7. Transform our understanding of the laws of nature, and in so doing change the relationship that we each have with the world around us.

I can’t find a substantive difference between what we stereotypically call “art” and that which we stereotypically call “science” . . . Can you?

Does science evoke a response from the people who experience it? Each time I use one of the many objects that has become part of modern life, I am filled with awe at what scientists have accomplished. I will grant that there is one difference between “art” and “science”; namely it is that art is related to notions of aesthetic beauty. Yet, one could argue that there is aesthetic beauty in science as well.

Consider the equation:

Mass-Energy Equivalence
Mass-Energy Equivalence

Let’s set dogma aside, for a moment; Can one argue objectively that this equation is not an aesthetically pleasing way to express the relationship that exists between the energy and the mass of an object?

What are the implications for me as an early stage investor, if “art” and “the practice of science” are more alike than they are different?

Here is a scientist’s code of conduct according to the University of California Museum of Paleontology: ((“Participants in science behave scientifically.” Understanding Science. University of California Museum of Paleontology. Accessed on Jun 18th, 2015 at http://undsci.berkeley.edu/article/0_0_0/whatisscience_09))

  1. Pay attention to what other people have already done. Scientific knowledge is built cumulatively. If you want to discover exciting new things, you need to know what people have already discovered before you. This means that scientists study their fields extensively to understand the current state of knowledge.
  2. Expose your ideas to testing. Strive to describe and perform the tests that might suggest you are wrong and/or allow others to do so. This may seem like shooting yourself in the foot but is critical to the progress of science. Science aims to accurately understand the world, and if ideas are protected from testing, it’s impossible to figure out if they are accurate or inaccurate!
  3. Assimilate the evidence. Evidence is the ultimate arbiter of scientific ideas. Scientists are not free to ignore evidence. When faced with evidence contradicting his or her idea, a scientist may suspend judgment on that idea pending more tests, may revise or reject the idea, or may consider alternate ways to explain the evidence, but ultimately, scientific ideas are sustained by evidence and cannot be propped up if the evidence tears them down.
  4. Openly communicate ideas and tests to others. Communication is important for many reasons. If a scientist keeps knowledge to her- or himself, others cannot build upon those ideas, double-check the work, or devise new ways to test the ideas.
  5. Play fair: Act with scientific integrity. Hiding evidence, selectively reporting evidence, and faking data directly thwart science’s main goal — to construct accurate knowledge about the natural world. Hence, maintaining high standards of honesty, integrity, and objectivity is critical to science.
Image Credit: Tasha S. K. Aoaeh
Image Credit: Tasha S. K. Aoaeh

What are the risks I take if I cling to the notion that early stage investing is “all art” and “no science”? For one, I will not subject my own assumptions, hunches, guesses, biases, ideas, visions, opinions to the level of scrutiny to which they should be subjected. Worse yet, I might fail to subject other people’s ideas and assumptions to sufficient scrutiny and testing. Instead; I might rely on decision-making heuristics like “pattern-matching” and I might engage in “groupthink” or succumb to social-proof bias . . . I might fail to maintain a mind that is sufficiently open and flexible to recognise an early stage startup founder poised to transform the world because that founder does not fit my idea of what such a founder “looks like” . . . I might pass on a great startup investment for reasons that are completely irrelevant simply because I have failed to develop my own thinking and ideas about its prospects . . . I might fail to unlock promising new markets before the greatest returns have already been harvested by other early stage investors because I lacked enough curiosity and discipline to ask nuanced questions and challenge myself to acquire new knowledge and insights from other sources and other people – possibly people outside circles within which I am most comfortable . . . I might spend my career in early stage technology investing in a self-imposed exile to the land of piddling mediocrity.

Leonard Mlodinow on human thought and the evolution of science – podcast by Guardian ScienceWeekly #np#SoundCloudhttps://t.co/KjJRVOH8wO

— Brian Laung Aoaeh (@brianlaungaoaeh) June 19, 2015

I find none of those possible outcomes palatable; early stage investing is both an art and a science. The best early stage venture capitalists behave in keeping with that belief. It is their trade secret.

Science is Uncertain - Freeman Dyson
Science is Uncertain – Freeman Dyson

Further Reading

  1. The Pleasure (and Necessity) of Finding Things Out

Filed Under: Business Models, Innovation, Investing, Lab Notes, Lean Startup, Science, Strategy, Technology, Venture Capital Tagged With: #InvestmentPhilosophy, #WorldView, Business Models, Early Stage Startups, Innovation, Investment Analysis, Long Read, Strategy, Technology, Venture Capital

Revisiting What I Know About Network Effects & Startups

September 12, 2014 by Brian Laung Aoaeh

 

‘One IPO that is probably worth the hype.’ – Chris Beauchamp on the #  with @kerushton in the Telegraph. http://t.co/l8FqFRYwzJ

— IG (@IGcom) September 1, 2014

 

The recently announced IPO of Alibaba got me thinking last week about network effects ((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 them.)) – what they are, how they develop and evolve, and how network effects can help or hurt a startup. ((You can find Alibaba’s SEC Form F-1 here. Accessed online; Sept. 12, 2014.))

That is something I think about a lot, practically every day. In other words each time I am sitting across from a founder listening to that founders’ explanation of a startup’s market, the problem it is solving, and its business model, I am also thinking about the economic moats it might build around itself in order to sustainably fend off competition. One way it might do that is through network effects.

To ensure we are on the same page, let’s start with some definitions. In the rest of this discussion I am primarily focused on early stage technology startups.

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.

Definition #2: What is an economic moat? An economic moat is a structural barrier that protects a company from competition. ((Heather Brilliant, Elizabeth Collins, et al. Why Moats Matter: The Morningstar Approach to Stock Investing. Wiley. Hoboken, NJ. 2014; p. 1)) In my case, when I am studying a startup, I am interested in the economic moats that will enable the startup to mature into a great business, and hence a great company – one that can keep competition at bay while earning great returns for its investors. Morningstar identifies 5 moat sources; Intangibles, Cost Advantage, Switching Costs, Network Effect, and Efficient Scale.

Definition #3: What is a network? Any group or system of interconnected people or things. Think; my nuclear family is a network to which I belong. My extended family is a larger network which includes my nuclear family, as well as the nuclear families of each of my relatives. A small business exists in a network that is comprised of its customers, its suppliers, its competitors, its regulators, and so on and so forth. A large network might be formed by a collection of smaller networks. ((I know this seems obvious. However, I was having a discussion via email with Kate Bradley Chernis while writing this. She and her co-founders are building a product to empower SMB’s manage their marketing campaigns. When I told her the topic of this blog post she stated that she finds that many SMB owners have no understanding of the networks that they belong to, or how they can use their networks to enhance their business. I added this definition after that exchange.))

Definition #4: What is a Network Effect? A network effect occurs when the value of a good or service increases for both new and existing users as more customers use that good or service. ((Network effect is often colloquially referred to as network externality. However, the two are not precisely the same.)) The network effect is a virtuous cycle that allows strong companies to become even stronger. ((Ibid; p. 27)) Network effects are also known as direct-benefit effects. I think direct-benefit effects makes it easier to remember why network effects can be such a powerful economic moat.

How do network effects develop? Direct-benefit effects develop and become stronger in settings where some form of interaction, or compatibility with others is important. ((David Easley and Jon Kleinberg. Networks, Crowds, and Markets: Reasoning About a Highly Connected World. Cambridge University Press, June 10, 2010 draft version. P. 509. Accessed online on Sept. 12, 2014.)) In other words, the number of other people using the technology has a direct impact on how valuable that technology is to each individual user. Direct-benefit effects contribute to the strengthening of an economic moat only in so far as they directly contribute to increasing positive externalities for the members of the network. What is an externality? It is “any situation in which the welfare of an individual is affected by the actions of other individuals, without a mutually agreed-upon compensation.” ((Ibid.)) One can have positive or negative externalities. A positive externality occurs when individual and aggregate welfare increases with the addition of more users to the network. A negative externality occurs when welfare decreases with the addition of more users. ((As an example, think of a website or app that starts to crash and become inaccessible due to capacity constraints as the number of users increases dramatically.)) Network effects evolve positively for a startup if the members or users of the network derive both inherent value and network value from their use of the product. Inherent value is value that an individual user derives because of that individual user’s consumption of the product or service. For example, even if I were in a network compromising only me, I would derive inherent value from owning one copy of MS Office running on Windows because I could now more easily do word-processing using MS Word or analyze quantitative data using MS Excel. I derive network value from MS Office and Windows because if other people buy and use those products, it becomes easier for me to share my work with them and for them to share their work with me. I derive network value from being able to collaborate with every other person who also uses MS Office and Windows.

Types of Direct-benefit Effects: To fully parse through how a startup I am studying might build an economic moat based on network effects I need to be able to understand the subtle nuances that differentiate one type of network effect from another. ((This is based on the work of Prof. Arun Sundararajan. Accessed at http://oz.stern.nyu.edu/io/network.html on Sept. 12, 2014.))

  1. Direct network effects or one-sided network effects occur when increased usage leads explicitly to increased welfare for the members of the network. Think fax machines, telephones, messaging apps.
  2. Indirect network effects occur when the proliferation of network members leads to the proliferation of complementary goods and services such that the welfare of the network’s members increases significantly. Think iOS, Android, smartphones and apps.
  3.  Two-sided network effects are distinct from indirect network effects. A two sided network effect occurs when an increase in usage of the product by one group of network members increases the welfare of a separate and distinct group of other members of the same network. Think marketplaces, platforms that combine hardware and software, and software pairings in which there’s a reader and writer.
  4. Local network effects occur when an individual network member’s welfare increases not because of an increase in the overall network user base, but as a result of growth in the users within a  localized subset of the network’s membership. Think; as a user of Whatsapp, my welfare increases when more people in my cellphone’s contact list join the Whatsapp network. So, while I think it’s great that Whatsapp has 500 Million users, my welfare has no positive correlation to the size of  Whatsapp’s network. However, it does have a positive correlation with how many of my friends, family, colleagues, social and professional acquaintances become members of the Whatsapp network.

This diagram by Ray Stern conveys the power of positive network effects, and the corollary – negative network effects can help erode the competitive position an incumbent occupies. ((Eric Jorgenson, The Power of Network Effects: Why They Make Such Valuable Companies, and How To Harness Them. Accessed on Jun 27, 2015 at https://medium.com/evergreen-business-weekly/the-power-of-network-effects-why-they-make-such-valuable-companies-and-how-to-harness-them-5d3fbc3659f8))

The Power of Network Effects (Image Credit: Ray Stern, former CMO of Intuit)
The Power of Network Effects (Image Credit: Ray Stern, former CMO of Intuit)

How might a startup start to experience negative network effects? One of the most exciting things about the Internet is that it has lowered the barriers to competitors entering a space in which they perceive an opportunity to earn economic profits. That is great if I invest in a startup that is earning such profits, but not so great if events unfold such that other startups can launch a credible attack in order to win business away from the startup in which I am an investor.

  1. Lock-in or switching costs occur when a member of one network cannot switch from that network to another without suffering substantial costs. The switching costs could be monetary and non-monetary. Often, the non-monetary switching costs far outweigh the monetary costs. Non-monetary costs might include the loss of massive amounts of information and data, business process disruptions, and so on and so forth. Antitrust regulators do not like to see situations in which such costs bar new competitors from entering a market and create a monopoly for an incumbent – IBM, Microsoft and Apple have all faced antitrust action. Switching costs can also exist in physical goods industries, for example razors and blades, and also printers and printer-cartridges. Switching costs are not an issue as long as users perceive that they derive more value from being within the network than the inconvenience they suffer as a result of lock-in or switching costs.
  2. Network congestion occurs when the experience of each member of the network deteriorates as the network’s membership grows. In other words the network becomes less efficient from the users’ perspective. As a result of this each member of the network derives decreasing inherent and network value from the network. Think; A website, web or mobile app that is consistently unavailable because too many people are trying to access it simultaneously.
  3. Conflicts of interest occur when a network operator behaves in ways that limit or restrict the ability of network members to freely form sub-networks. According to David Reed: ((David Reed. That Sneaky Exponential – Beyond Metcalfe’s Law to the Power of Community Building. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.))

But many kinds of value are created within networks. While many kinds of value grow proportionally to network size and some grow proportionally to the square of network size, I’ve discovered that some network structures create total value that can scale even faster than that. Networks that support the construction of communicating groups create value that scales exponentially with network size, i.e. much more rapidly than Metcalfe’s square law. I will call such networks Group-Forming Networks, or GFNs.

That observation might be used to explain the demise of Friendster and Myspace in the face of competition from Facebook. It has also been used to predict the success of Ebay during a time when Yahoo was the most dominant web-portal. ((David Reed. Weapon of Math Destruction: A Simple Formula Explains Why The Internet is Wreaking Havoc on Business Models. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.))

What exactly do I mean by conflicts of interest? I love to buy books from Amazon. To save money, I prefer to buy used books if that is at all possible. Amazon has allowed independent merchants to market their goods in its marketplace. many of these merchants sell used books at substantial discounts to the price of a new book offered by Amazon. Let us assume that each time I wanted to make a purchase Amazon compelled me to purchase its own offering of that item, or pay a penalty if I insisted on making the purchase from one of its independent sellers. What effect do you think that might have on my behavior? What effect might that have on the behavior of the independent sellers? What if an Amazon competitor did not impose that penalty? How might that shift the competitive landscape? That is a relatively simple example. It should illustrate the point. When the operator of a network platform starts to compete with its platform partners it is engaging in behavior that will lead to the destruction of the network.

What strategies should a startup that’s competing in a market in which network effects matter employ in order to win? There are a number of strategies that might be employed ((Based on Prof. John M. Gallaugher’s Understanding Network Effects. Accessed at http://www.gallaugher.com/Network%20Effects%20Chapter.pdf on Sept. 12, 2014.)) independently or in combination with one another by competitors seeking to compete effectively against a rival, or by market leaders seeking to maintain that position.

  1. First mover adoption matters – a lead of a few months can be the difference between winning the market and losing it.
  2. It can pay to subsidize adoption – in order to seed the network it might be worth it to subsidize adoption by providing an in-network benefit of some sort. Dropbox offers free storage to new users, and members who help it acquire new users also get rewarded with free extra storage. However, it is important to strike a balance between subsidizing adoption and maintaining a tight control on costs. Ideally, the marginal cost of subsidizing adoption should be far far less than the marginal benefit of acquiring a new network member.
  3. Viral marketing matters – the success of mobile and web products that benefit from network effects can be greatly enhanced by encouraging viral promotion through social networks like Facebook, Twitter, Pinterest, Instagram, Snapchat, etc etc.
  4. Redefine the market – this has the benefit of bringing in more users who might previously have been inaccessible. It also makes it possible to develop a product or service that envelopes several distinct markets into one. Think; smart phones becoming capable of performing the functions of a media player, a camera, an email editor, an internet browser, a gaming device, a phone, a medical diagnostic tool, a fitness tracker, a notebook, an alarm clock, a GPS navigation system etc. etc.
  5. Form alliances and partnerships – when competing with a powerful incumbent this might make it easier to gain a toehold from which the competitor can then launch an entry into the market. Think; Google’s Android strategy at a time when it appeared Apple’s iOS was an unstoppable force in the smartphone market.
  6. Leverage distribution channels – to pry an opening into a market think of non-obvious ways by which a distribution channel might be created. A popular approach is to bundle a new product with an existing product from the same provider.
  7. Seed the market – one way to do this is to subsidize adoption by making room in the budget for a financial outlay specifically geared towards acquiring new users. For example, a messaging app might pay people in a foreign country to download the app and start using it in hopes that enough of them fall in love with the app and tell their friends about it. Another strategy related to this is to give away product to one group of network participants.
  8. Encourage the development of complementary goods – this is now a widely used strategy through the publication of SDKs and APIs to encourage the development of complementary products and services.
  9. Leverage backward compatibility – to do the opposite would be foolish since that would mean that at the beginning of each upgrade cycle the incumbent has no advantage over a new entrant competitor.
  10. Build-in compatibility with the market leader – this changes users’ options from one in which they have an “either-or” decision to make to one in which they have an “and” decision to make. Who does not like “and”? Every new entrant rival should consider this. For example new social networks ought to build seamless integration with Twitter, Facebook and other leading social networks into the product from the very outset.
  11. Close-off access to new entrants and existing rivals and innovate constantly – this makes it nearly impossible for rivals to steal away business from the incumbent leader in the market.
  12. Pre-announcements – from a large, well known, and well liked producer of a product or service can have the effect of slowing down the adoption of a rival’s competing offering. Some people might want to wait till they can compare the options more directly against one another. Think; when one of Apple’s competitors quickly schedules its product announcement to precede a major product announcement by Apple, but only after after Apple announces an event at which it will discuss a new line of products. The extreme case is when a rival rushes to announce and release its product prior to Apple’s product release date once Apple makes an announcement. 

Understanding networks effects and how they unfold for an early stage startup is critical. Markets in which such effects are present are often characterised by fierce competition and a bandwagon effect tends to take hold thanks to positive-feedback loops. Also, the nature of these markets is that a winner can emerge in remarkably short order and that winner typically garners a commanding market share lead over its competitors. Furthermore, once a winner has been established it is extremely difficult for competitors to win users away from it.

Further Reading

  1. Platform Power – A free book by Sangeet Choudary,  available for download at Platform Thinking Lab’s website.
  2. The Power of Network Effects: Why They Make Such Valuable Companies, and How To Harness Them – blog post by Eric Jorgenson
  3. Exponential Organizations: Why new organizations are ten times better, faster, and cheaper than yours (and what to do about it) – by Salim Ismail, Michael S. malone, and Yuri van Geest

Filed Under: Business Models, Case Studies, Entrepreneurship, How and Why, Innovation, Investment Analysis, Long Read, Technology, Valuation, Value Investing Tagged With: Direct-benefit Effects, Early Stage Startups, Economic Moat, Investment Analysis, Network Effect, Strategy, Value Creation, Venture Capital

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