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#NotesOnStrategy: Tips For Early Stage Startup Founders on How To Build A Culture of Accountability

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Getting from Point A to Point Z: How?
Getting from Point A to Point Z: How?

CULTURE EATS STRATEGY FOR BREAKFAST, OPERATIONAL EXCELLENCE FOR LUNCH, AND EVERYTHING ELSE FOR DINNER.

– Bill Aulet

During one of our weekly Monday morning team meetings we were talking about one of the startups in our portfolio . . . Things are going well; the product is pretty good and improving, sales are increasing, revenue is growing etc. It’s preparing to raise a big round within a few months.

There’s one problem . . . Accountability. Things are not happening when they should, people are not doing what they are supposed to be doing. It’s not yet fatal, but . . . A culture of accountability does not exist.

What should they do? The founder/CEO is proposing an approach to solving that problem that I believe is indirect and ineffective. I do not think it will work, and worse I think it will confuse his team and cause resentment and stress the team unnecessarily.

After the meeting, I posted a status update on Facebook asking my friends who are early stage startup founders if they have any nagging questions they’d like me to research and tackle in a blog post . . . A couple brought up team-building, accountability, and culture. One said:

I think organizational building/management/structure, HR, and team building get very short shrift in the startup dialogue, which is a shame. I understand why in the short run, but in the long run I suspect the costs can be high.

– Tayo Akinyemi

I had inadvertently found the topic for my next blog post.

I have some experience with situations in which accountability is a problem . . . Dating back to my days as a student at Connecticut College when I ran two businesses on campus to earn pocket money – one was a newspaper delivery business, the other was a deejay business; I respectively had to hold my best friend and my partner accountable, leading to me firing them for failing to keep up their end of our bargain; and again between 2008 and 2012 when I devoted substantial portions of my time to turning around two companies – in that case I did not have the authority to fire anyone, but I had the authority to hold people accountable and I played an important role in setting and getting buy-in for expectations, and then determining who should be held accountable meeting those expectations we had agreed on. I also had to help the senior leadership of the two companies learn how to build a culture of accountability. In addition I helped my mom and my dad run a number of small business while I was growing up, and since 1986 have discussed management and leadership issues my mom is grappling with as she has grown Summit School from 3 kids in our garage to several hundred pupils in Kano, Nigeria. Holding people accountable is hard, but necessary for organizations that want to grow and accomplish important things.

In this post I will first delve into a general discussion about management and leadership, then I will end with tips on how startup founders might foster accountability.

The intended audience for this article is early stage technology startup founders who have no training or prior experience in management or leadership, but who nonetheless need to come to grips with the basics in order to run their startups effectively. Consider this a launchpad from which one might do further reading and independent study.

If you have not already read my posts on team building you can get caught up on high-performing teams first here and then here, what religion teaches us about culture, and how management skill can enable startups to build an impregnable economic moat.

Fundamental Ideas About Leading and Managing Teams of People

One way to distinguish between leadership and management is to remember that; in the grand scheme of things leadership affects issues that are of strategic, relatively long-term importance to a startup, while management by comparison focuses on issues of tactical, and relatively short-term importance.

Things get confusing in startups because founders, who are really defacto leaders also have to fulfill responsibilities as managers till such a point that the organizational structure has evolved and the distinction is clear.

But what does this mean? Concretely? It means that a manager typically will be responsible for implementing a strategy and vision developed by the leader. Leaders focus primarily on creating a vision, developing a strategy to actualize the vision, and nurturing culture. Managers draw up detailed plans, discuss the plans with the leaders to get buy-in and approval, then they execute and implement those plans with the help of people on the teams that they manage.

Every leader is also a manager, but not every manager is a leader.

What is leadership? The definition of leadership that I find most compelling and applicable to early stage technology startups is based on this quote from John Quincy Adams:

If your actions inspire others to dream more, learn more, do more and become more, you are a leader.

To be a little more specific Kevin Kruse and Dr. Travis Bradberry define leadership as ” . . .  a process of social influence which maximizes the efforts of others toward the achievement of a greater good.”[3. What Makes A Leader? by Dr. Travis Bradberry on LinkedIn. Accessed on Jul 2, 2016.]

In order to become an effective leader one must understand the difference between a leadership model, a leadership philosophy, and a leadership style.

A leadership model is a practical framework that helps a startup founder develop into a competent and effective leader. A leadership model answers the “What?” question.

A leadership philosophy is a values-centric framework about how a startup founder should behave, and the sources from which the founder can derive power as a leader. A leadership philosophy answers the “Why?” question.

Lastly, a leadership style focuses on the reality of how a startup founder fulfills the responsibilities of a leader. A leadership style answers the “How?” question. This is an important issue, because effective leadership rests on authenticity . . . Obvious incongruence between a budding leader’s personality and choice of leadership style is one of the quickest paths to catastrophe.

In the context of an early stage startup, the leader’s tactical goals center on leading the team from one milestone to another. The leaders strategic goals center on guiding the startup through discovery, and ultimately to helping the team navigate its way to becoming a company.[4. 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. A company is what a startup becomes after it completes discovery.]

What is management? According to Mary Parker Follet; “Management is the art of getting things done through people.” Similarly, Harold Koontz says “Management is the art of getting things done through and with people in formally organized groups.” Lastly, Henri Fayol says “To manage is to forecast and to plan, to organize, to command, to coordinate and to control.”

Management is an ongoing process of producing results against pre-existing budgets, forecasts, targets, tactical and strategic initiatives through teams of people, and measuring performance with an eye towards continuous improvement.

I think it is worth reiterating that the function of leadership and management do not always have to be embodied in the same individual, though in the context of an early stage startup it is almost inevitable the the founders function as both leaders and managers.

The Psychological Contract, Theory X, Theory Y and Theory Z – Cliff Notes Version

The psychological contract is a set of tangible and intangible expectations, beliefs, feelings, and emotions that govern the relationship between an individual and that individual’s employer, manager, and leader. The most important aspects of the psychological contract are based on mutual trust and respect.

I like the Iceberg Model approach to thinking about psychological contracts because it depicts quite clearly my belief that the most salient aspects of effective leadership and management are intangible and hidden from view.[5. A diagram of the Psychological Contracts Iceberg Model is available here: http://www.businessballs.com/freepdfmaterials/psychological-contracts-iceberg-diagram.pdf]

I believe that there’s no repairing the relationship between a team member and that individual’s manager or leader if one party believes that the psychological contract has been violated.

Theory X is a management worldview that can be described as militaristic, or command-control-and-punish. Theory X managers subscribe to the belief that people hate work and cannot be relied upon to work responsibly towards meeting tactical goals. As such they need to be motivated through the threat of imminent punishment.

Theory Y is a management worldview that is the opposite of Theory X. Employees can be relied upon to apply self-direction, creativity, and a take-the-initiative attitude to solving problems faced by organizations and teams. There is no need for threats of punishment.

Theory X and Theory Y arise from Douglas McGregor’s work, and were popularised in his book The Human Side of Enterprise.

Theory Z arises from the work of William Ouchi, and combines MacGregor’s Theory Y with Japanese management concepts. It places an enormous amount of trust in the individual. It assumes and expects that individuals will demonstrate  commitment and loyalty to the team and the organization. Ouchi explained Theory Z in the book Theory Z: How American Management Can Meet The Japanese Challenge.

Source Unknown
Source Unknown

On Accountability

In Four Tips for Building Accountability, Rosabeth Moss Kanter says;

The tools of accountability — data, details, metrics, measurement, analyses, charts, tests, assessments, performance evaluations — are neutral. What matters is their interpretation, the manner of their use, and the culture that surrounds them. In declining organizations, use of these tools signals that people are watched too closely, not trusted, about to be punished. In successful organizations, they are vital tools that high achievers use to understand and improve performance regularly and rapidly.

Based on my experience, and Prof. Kanter’s article, here are a few tips for startup founders who are grappling with this issue for the first time.

Ask questions, ask more questions, and then ask even more questions. What seems blindingly obvious to the manager or the leader may not be so obvious to the individual team member responsible for executing the assignment and delivering results. The key to asking questions is to ask lots of them both before work begins, as well as while the work is in process, and after the project has either failed or succeeded. Before work starts leaders and managers need to be certain that their audience has internalized the message that the leader or manager wanted to convey. This ensures that there’s complete alignment of the leaders understanding of the “Why, What, When, Who, and How” they have tried to communicate and that this is understood by the team, as well as by individuals within the team.

Praise publicly, chastise and reprimand in private. While it is important to get work done in the near term. It is also crucial to build individual team members’ self-sufficiency and effectiveness over the medium- and long-run. It is very hard to do this if people feel humiliated in the presence of their peers, especially since the person experiencing the humiliation will often have a strong belief that they are being treated unjustly and unfairly. Note that this belief often bears no relation to “the facts” as the manager or leader might interpret them. For accountability to work people have to feel safe discussing difficult issues, and collaborating with one another to tackle and resolve issues that may feel difficult to discuss. However, if the focus is on learning how to become more successful as a team and as individuals on the team respectively, things become a lot easier. As Prof. Kanter says “The goal is to solve problems, not to hurl accusations or tear people down.”

No pencil, no pad? Poor performance is guaranteed. Take copious notes. In my experience things on the accountability train start falling apart when there’s a high degree of ambiguity. There’s an inexplicable tendency to assume “everyone knows what I mean” or “they will understand what I expect” without clear, direct, and succinct communication from the leader/manager, or worse “they will see that those doing the right thing are progressing and so they too will start doing the right thing.”

Leaders and managers who adopt that approach are failing the most basic and fundamental test of their ability to lead or manage a team. In my opinion it is a sign that they do not want to feel the responsibility of setting clear expectations and dealing with what that process entails. Perhaps they think of themselves as “friends” with the members of the team.

Be that as it may, the founder/leader/manager must communicate expectations, break big goals down into more specific and unambiguous tasks, and provide guidance about expected deadlines and desired results. Shying away from doing this is a red-flag. Inevitably, there will be problems down the line.

Taking notes is one way to ensure that nothing is miscommunicated, or that something that was communicated is not overlooked or even forgotten. I believe leaders and managers should take and share notes about their thinking related to the team’s work. I believe team members should take notes too . . . As time progresses, comparing notes, filling in gaps and making corrections is one way to avoid miscommunication and misunderstandings . . . An important step in the journey towards a culture of accountability.[6. I will not judge you if you use a pen instead, but I prefer pencils, mechanical pencils.]

Landmarks in A Culture of Accountability: Excruciating Clarity[7. Based on The Right Way To Hold People Accountable, Peter Bregman, Jan 11 2016. Accessed at Harvard Business Review on Jul 2 2016.]

In order to foster accountability the leader/manager must be clear, and must obtain confirmation that the audience “gets it.” The five necessary ingredients for building a culture of accountability are;

  • Clarity of expectations – does the team understand what the desired outcome should be?
  • Clarity of capabilities – does the team have the resources to meet the expectations it has created for itself?
  • Clarity of measurement – does the team understand how its performance will be judged?
  • Clarity of feedback – does the team understand that lines of communication should remain open in both directions in order to avoid surprises at the eleventh hour? Does the leader/manager understand that it is necessary to check in periodically and often about progress towards the goal?
  • Clarity of consequences – does the leader/manager have clarity around what must happen if the preceding 4 conditions have been met and yet the outcomes fall short of the expectations that the team has set for itself? The crux here is that the leader/manager has to be honest and sufficiently self-critical in order to ensure accountability traps do not keep arising “out of nowhere” . . . Under the worst circumstances some individuals have to be let go, but that is life.

Conclusion

Navigating the treacherous waters between launching a startup and becoming a company is hard work. That work is made exponentially more challenging by failures in leadership and management. It does not have to be that way. To make it easier it helps to build a culture of accountability.

Further Reading

Revisiting What I Know About Efficient Scale, Cost Advantages, & Early Stage Technology Startups

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This is the fourth post in my series of blog posts on economic moats. I have already written about Network Effects, Switching Costs, and Intangibles. In this post I will discuss how Cost Advantages and Efficient Scale might develop as an early stage startup travels through the discovery phase of its life-cycle. 1Any 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.

My goal for writing this post is to provide one example of how I might think about this topic when I am studying an early stage startup that is raising a round of financing from institutional venture capitalists.

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. 2I 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 is a cost advantage? According to the authors of Why Moats Matter, a cost advantage arises when a company can sustainably lower its costs of doing business relative to its competitors. Such a reduction in costs can be due to process advantages, superior location, economies of scale, or access to a unique asset. In other words;

A cost advantage is a structural feature of a startup’s business model that enables it to maintain sustainably lower overall costs of doing business than its competitors while earning equal or higher margins over time.

Definition #4: What is efficient scale? According to the authors of Why Moats Matter, “efficient scale describes a dynamic in which a market of limited size is effectively served by one company or a small handful of companies. The incumbents generate economic profits, but a potential competitor is discouraged from entering because doing so would cause returns in the market to fall well below the cost of capital.” In other words, from my perspective as an early stage investor;

A startup can scale efficiently if doing so does not drive its customer or user acquisition costs to unsustainable levels over time, and if the startup’s decision to enter that market does not drive returns in the market to levels that are below the cost of capital for incumbent companies in that market over the short term.

Sources of Cost Advantage

For early stage technology startups, these are the most important sources from which a cost advantage may be derived. 3I do not include Materials and Supplies under this discussion because I do not think that is a sustainable source of cost advantage for an early stage technology startup.

People & Culture: This cost advantage arises when a startup develops a unique organizational culture, management processes, and organizational structures that enable and empower members of the team to consistently generate results for the startup’s business that are significantly better than the results of its direct competitors and that beat the adjusted-performance of more well-established incumbents in that market. This source of cost advantage is intimately connected to the intangibles of Management and Culture, and Research and Development.

Systems & Processes: This cost advantage arises when a startup develops unique organizational processes that enable it to consistently generate comparatively superior results. The key categories of such systems and processes are Marketing and Sales Processes, Operational Processes, Distribution Processes, and Support Processes.

Marketing and Sales Processes focus on the activities that the startup takes in order to create demand for its product or service, and subsequently to satisfy that demand by delivering the product to its users or customers.

Operational Processes focus on the activities in a startup that take inputs and turn them into the final product or service through which the startup’s value proposition is delivered to the market. These are the processes that enable the startup to turn tangible and intangible inputs and turn them into something the market is willing to pay for. I have previously discussed this in: Why Tech Startups Can Gain Competitive Advantage from Operations.

Distribution Processes focus on the channels through which the startup’s product or service will be delivered to its users or customers. A key consideration that has to be made here is the choice between direct distribution and indirect distribution channels, and how the startup’s choice in this respect will affect its ability to maintain an overall cost advantage over its competitors.

Support processes focus on all the activities that make everything else that the startup does possible; for example HR and Talent Management, and Financial Planning and Analysis fall under this category.

This source of cost advantage is intimately tied to People & Culture, since the two combine to create an environment in which unique tangible and intangible assets are developed consistently over time such that the startup’s competitive advantage over its peers increases, and evidence that this is happening is seen in the startup’s historical key performance indicators.

Facilities: This cost advantage is derived from the physical infrastructure that a startup needs in order to operate. For early stage tech startup the hard decisions related to this source of cost advantage begin to be necessary when the startup has scaled to a point at which off-the-shelf hardware products are no longer good enough for what the startup seeks to accomplish. This is often the point at startups must consider the advantages or disadvantages they may derive from building custom hardware instead of relying on what’s available from outside vendors or partners. It can also be tied to a geographic location which gives the startup unfair access to an input that is critical for what it does.

Capital: This cost advantage is determined by the startup management team’s ability to allocate capital in such a way that the startup successfully navigates the path it must travel between being a startup and becoming a company. Cost advantages due to capital are determined by external sources of capital – potential outside investors and sources of trade credit, and internal sources of capital – existing capital raised from investors, financial management of money the startup expects from its users or customers and money it owes to the vendors and business partners with whom it has a working relationship.

Key Considerations for Efficient Scale

Here I am assuming that the investor has determined that the startup’s customer or user acquisitions costs will most likely decline over time, or in the worst case scenario they will stay relatively flat.

How I think about efficient scale for an early stage startup is closely linked to the concept of product-market fit. An early stage startup is approaching the product-market fit milestone when demand for its product at a price that is profitable for the startup’s business model, begins to outstrip the demand that could have been explained by its marketing, sales, advertising, and PR efforts.

When I am chatting with startup founders and I am trying to explain this concept I use the analogy of a cyclist on a steep hill to represent the founder’s startup. It’s probably a poor analogy, but I think it gets the point across in a way that is easy for them to internalize.

Before Product-Market Fit (BPMF) everything takes a lot of effort. Every sale is tough, everything that can go wrong will go wrong, and most of the sales deals will fall apart for reasons that are hard to explain. The cyclist is pedaling very hard to get uphill, and even maintaining balance on the bike is quite a challenge. Every breath brings with it the possibility that the cyclist could fall off the bike. With luck, the cyclist makes it to the top of the hill. Then, there is that moment when the cyclist senses that it is possible to keep going without as much exertion as it required to get to the top of the hill. Now the downhill journey begins. Gravity kicks in. The bike is gaining momentum even as the cyclist is frantically trying not to careen off the path. The cyclist’s exertions are now focused on skillfully applying the brakes at sharp turns and corners on the way downhill, and speeding up when then the path is straight and clear of obstacles. If this is a race and there are other cyclists ahead, then our cyclist must also focus on overtaking then one after another, and must also avoid getting caught in crashes caused by other cyclists in the race. After Product-Market Fit (APMF) demand for the startup’s product threatens to outstrip the startup’s ability to meet that demand. This is when a startup must scale, and scale fast and efficiently. There are two reasons to scale at this point. The first and most important reason is that there is demand for the startup’s product and the startup should meet the demand from its users or customers. The second reason is that APMF is also the point at which copy-cat competition starts to materialize from new entrants, and possibly from incumbents too.

Efficient scale means different things at different points in the startup’s lifecycle: The way a team of 2 co-founders scales the startup’s business is much different than the way that same startup will scale its business when the team has grown to 20 people. In other words the way to pursue scale BPMF differs markedly from the way to pursue scale APMF.

Premature scaling seems great initially, until it leads to startup failure and death: The Startup Genome Report Extra on Premature Scaling reports that startups that scale prematurely tend to start scaling earlier than startups that do not scale prematurely, they often also raise 3x as much capital and have valuations 2x as high as startups that do not scale prematurely. This trend continues till they fail. Also, 74% of startups scale prematurely. I will not go into the details of that report in this post, because I covered that in Notes on Strategy; Where Does Disruption Come From?

The cadence of hiring is important: BPMF hiring should be slow, deliberate and methodical since it is not yet clear what new team members will be working on and if what they will be working on is relevant for the startup’s overall success and longevity. APMF the challenge is to hire the right people for the startup as quickly as is necessary to keep up with demand, and cope with competition. For this reason building sound and cost-advantageous systems & processes, and modifying them as the startup grows is important. Startups that scale prematurely, and then fail tend to hire more people sooner in their lifecycle than startups that do not scale prematurely.

Technology-enabled scaling wins: Whether a startup focused on consumers or enterprises, it is important for the founders to think about ways in which technology can be used to enable and support the scaling process. This should go beyond the obvious area of gaining new users or customers. Rather, as the startup scales thought should be given to how it ensures that:

  • Teams do not become too large to get critical work done quickly, and that they have the tools to promote communication and collaboration once the startups physical layout is taken into account.
  • Customer or user acquisition is not slowed unnecessarily by a failure to account for what customers are willing to do in order to get the product.
  • Sales and revenue generation is not hobbled by a failure to use tools that will make salespeople as effective as they can be, given other existing constraints.
  • Operations can seamlessly transition from one order of magnitude of scale to another without a deterioration in customer or user satisfaction.

Culture makes a difference: All things being equal, startups with a strong culture will scale more successfully than startups that do not. Why? Culture ensures that as the startup grows by hiring new people, the entire organization continues to solve the problem the startup set out to solve in a consistent manner.

Eventually, most founders must also become managers and coaches: It gets to a point where the founders job evolves into one of mainly facilitating and enabling the work of other people, setting strategy, nurturing a vision, and managing a team of executives. This is how founders gain managerial leverage. Not every founder is cut out for this. Some want to remain as close to building the product as possible because that is where their passion and drive comes from. I prefer founders who are self-aware enough to know if they want to remain close to building the product, or if they want to make the transition from building things to managing people, and setting strategy. Usually, this is not an issue at the Seed or Series A stage, where I am most involved. Still, I like to get a sense of what might happen. I’d rather not invest if this could become an intractable problem before the startup has reached escape velocity.

This wraps up my main posts about economic moats.

As a sector, technology is notorious for being one in which economic moats are hard to maintain. However, every tech startup that was able to build a wide moat around its business earned fantastical returns for its earliest investors. Many have also had a lasting impact on how people live life, and how the businesses that use their products get work done. You would recognize so-called “wide-moat” or “narrow-moat” tech companies if I mentioned names. You might also recognize the “no-moat” tech startups that initially seemed destined for great heights, but then were dragged back down to earth by a combination of market forces.

In either case, I will be thinking about economic moats almost daily.

Further Reading

  1. Scaling Up Excellence
  2. Traction: Get A Grip on Your Business
  3. Scaling Up: How A Few Companies Make It . . . and Why The Rest Don’t

References   [ + ]

1. ↩ 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.
2. ↩ 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.
3. ↩ I do not include Materials and Supplies under this discussion because I do not think that is a sustainable source of cost advantage for an early stage technology startup.

Revisiting What I Know About Intangibles & Startups

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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. 1Any 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. 2I 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 3Baruch 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 4KEC 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.

Brand

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

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

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

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

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

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

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

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

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

Communicate to customers;

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

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

Research and Development

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

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

Paraphrasing Investopedia, R&D is:

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

Notice the key elements of R&D:

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

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

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

– Peter Drucker

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

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

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

– Baruch Lev, Suresh Radhakrishnan, and Mustafa Ciftci. The Stock Market Valuation of R&D Leaders 5Lev, 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

References   [ + ]

1. ↩ 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.
2. ↩ 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.
3. ↩ 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.
4. ↩ KEC Holdings is the parent company of KEC Ventures.
5. ↩ 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

Notes on Strategy; Michael Porter’s Generic Competitive Strategies for Early Stage Tech Startups

by

Vasco da Gama Bridge - Lisbon, Portugal. Image Credit: Tasha S. K. Aoaeh (2010)
Vasco da Gama Bridge – Lisbon, Portugal. Image Credit: Tasha S. K. Aoaeh (2010)

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

My post Notes on Strategy; For Early Stage Technology Startups led to follow up questions from a handful of readers who asked for additional posts with more explanations and examples. 1Let 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.

In this post I will discuss Michael Porter’s 3 Generic Competitive Strategies. My goal in these posts is to provide concrete yet easy to use frameworks that founders of early stage startups can quickly learn and adapt as they work on moving their organizations through the discovery process that takes them from being a startup to becoming a company. 2My 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. You can skip past the definitions if you have already seen them in one of my previous posts.

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. 3I 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 4Keith 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.

In Competitive Strategy, Michael Porter describes The 5 Competitive Forces That Shape Strategy. Later on in the book he discusses 3 Generic Strategies that a business can apply in order to maintain its position relative to its competitors, and also to cope with the 5 forces affecting competition.

Before delving into the details of the generic strategies, one observation; Often, discussions about strategy get stuck in dogma – is it about creating a competitive position that a startup can defend, or is it about gaining market share? I do not think strategy can be an either/or proposition in that sense. It must be both. Good strategy protects a startup’s current market position, while attempting to reshape the competitive landscape such that it tilts overwhelmingly to that startup’s advantage.

Also, by definition a startup is still searching for a strategy . . . so many of the examples I will use are of companies, not startups. However, the idea is that this helps a founder go through the search and discovery phase of building a startup with these frameworks in mind.

The following generic strategies help a startup create a defensible position in its market, but they should also be thought of as a means for launching offensive moves to gain market share as market conditions evolve.

Overall Cost Leadership: A startup that has decided to pursue this strategy has chosen to maintain the lowest cost structure amongst its rivals.  One could think of “broad-based” cost leadership as a choice to become the cost leader amongst all a startup’s rivals in a given market. Alternatively, “narrow-based” cost leadership is a choice to become the cost leader among a select few rivals within the market.

A startup might choose a cost leadership strategy in order to cope with the threats posed by powerful buyers who can push prices down, but no further down than the cost leader in that market can bear. Also, cost leadership provides wiggle room for dealing with the threats posed by powerful suppliers who can increase the costs of inputs that the startup needs in order to develop its own products. Becoming the cost leader in a given market lowers the threat posed by new entrants to the market under the established rules of competition because the decision to enter the market under those conditions would be difficult to execute at a cost that is acceptable.

Startups exploring cost leadership as a strategy should consider making large upfront capital expenditure investments with an eye towards achieving economies of scale within a relatively short window of time. As they gain market share and scale, startups pursuing a cost leadership strategy will need to continue making relatively large CapEx investments that are aimed at keeping their overall costs low.

Additionally, cost leadership entails paying more attention to continuous process innovation, higher than normal labor-monitoring practices and pay-structures that might be described by outside observers as “below market”, and intense scrutiny of and discipline towards keeping overhead costs within a narrow band relative to revenues.

Examples:

  1. Walmart
  2. Toyota
  3. Amazon
  4. CraigsList

Risks: For technology startups as cost leadership strategy can be risky because of the pace of technological change and innovation. The pace of change requires ongoing CapEx investments in process improvements at a cadence that is higher than the alternative. As an example, think of all the different reports about the investments Amazon is making in trying to figure out how to get goods from its warehouses and shipping centres to its customers. Furthermore, blind focus on cost leadership can make startups inattentive to shifts in customer preferences that make cost leadership a losing strategy as time progresses. Lastly, cost leadership creates a competitive landscape in which there’s a constant race to the bottom and brand loyalty plays no significant role. Products and services become a commodity.

The image below, showing the startups that have been built by unbundling CraigsList shows another risk of the cost leadership strategy; namely that someone else can compete with some aspect of another startup’s business model by pursuing differentiation or focus as a strategic choice. 5It is not clear to me if the unbundling of CraigsList arose from conscious choices made by others observing the markets it served, or if this is a phenomenon that has only become obvious after the fact.

Unbundling CraigsList

Differentiation: A startup that has decided to pursue differentiation as the basis for its broad strategy has chosen to try to develop something that will be perceived as being unique, novel and difficult to copy within its market. The key to success pursuing this strategy is that differentiation must make the startup’s product more valuable to the customers who pay for the startup’s product. Successful differentiation involves a combination of some or all of technological innovation, branding, product features, and design.

A startup might choose a differentiation strategy because it helps insulate it against competition. When implemented successfully, differentiation creates a barrier to entry that is very hard for new entrants to overcome. Successful execution of a differentiation strategy has a strong positive correlation with brand value, leading to customers of the startups products becoming less sensitive to price since by definition a highly differentiated product has no close substitutes.

The cumulative effects over time of a successful differentiation strategy become apparent in a number of ways. The threat posed by buyers reduces over time since they do not have a very good alternative to the differentiated product. Pursuing a differentiation strategy often means that the startup can maintain and enjoy profit margins that are considerably higher than average for that market. Consequently, startups that pursue a differentiation strategy maintain room for maneuvers that would have been unavailable had they pursued a cost leadership strategy instead.

The organizational traits that make pursuing a differentiation strategy possible are; strong marketing and brand-building skills, continuous product innovation, relatively large R&D expense, and an organizational culture that emphasizes customer support.

Examples: Apple.

Risks: The primary risk of differentiation as a strategy is the risk of ceding market share in the terms most people customarily think about it to a competitor pursuing a cost leadership strategy. Perceived differentiation can erode with time as competitors imitate product features and certain innovations are adopted as industry standards. Also, customers might become more sensitive to price and start making trade-offs that put the startup pursuing a differentiation strategy at a disadvantage.

Focus: Most early stage startups should start life pursuing a focused or niche strategy. A startup pursuing this strategy makes a deliberate choice to pin-point its resources on a narrow customer group, a particular product segment, or a limited geographic market. Focusing its effort on that particular target customer, product, or geographic market enables the startup to become very good at serving that niche especially well while gleaning the lessons it needs to learn in order to avoid more costly mistakes if it later on decides to pursue market-wide cost leadership or differentiation. In other words, focus as a strategy for an early stage startup entails pursuing either cost leadership or differentiation in a very narrow market segment in order to create and defend its initial beachhead. Only once that is secured does the startup seek to expand its reach.

Examples: Every early stage technology startup that grows successfully after the search for a repeatable, scalable, profitable business model is complete.

Advantages: I got stuck at this point in the post, unclear how to tackle the rest of it. Fortunately, 5 or so meetings I have had over the past two days with NYC-based startup founders at different stages of progress through the search process helped to point me in the right direction. Each of them is struggling with this fundamental question:

What I am building is so attractive to so many potential customers in so many different industries and markets. What should I do? I do not want to say no to any potential customers.

I get it. I understand the dilemma. Capital is scarce, your burn won’t go away if you wish to keep working on your startup. All these potential customers come along with promises of potential revenues to ease the stress posed by your lack of capital . . . The temptation to “take as much revenue as you can get, from whomever is offering it” is nearly impossible to resist. I get it. I would have the same struggle too if I were in your shoes.

Yet, we have to pause and think about this for a few minutes lest we do something rash.

Paul Graham is often quoted as having said that early stage startups should “do things that do not scale.” I could not agree with him more, in fact there are times when more mature companies could use a modified version of that advice.

What is often not well understood by some investors, and many founders  . . . especially first time founders is why that advice is so important.

Here’s Paul in his own words:

Almost all startups are fragile initially. And that’s one of the biggest things inexperienced founders and investors (and reporters and know-it-alls on forums) get wrong about them. They unconsciously judge larval startups by the standards of established ones. They’re like someone looking at a newborn baby and concluding “there’s no way this tiny creature could ever accomplish anything.”

That initial fragility is why focus is the only strategy that any early stage technology startup ought to pursue. Focus allows the founders and the startup to do a few things in those early days;

  1. Find, recruit, and gain an intimate understanding of the customers whose pain is most acute and for whom your solution is a highest priority item,
  2. Satisfy the needs expressed by these early users, and build product features and a user/customer experience that delights them beyond their wildest expectations,
  3. Use the lessons that you learn during this process of slow growth to figure out how to build the processes and procedures you will need to scale the excellence that should mark your execution at that scale to excellence as your startup exits the search and discovery phase, and lastly
  4. To do all this without stressing the organization to the point of failure.

If you have not done so yet, you should read Paul’s post. He delves into the subject in a way only he can.

Imagine of a team of 3 co-founders with 2 contract developers helping build a product, it could be an enterprise or consumer product . . . and let’s assume they raised $750K in outside capital. Now think of the stress that team would be taking upon itself if it were to try to serve 10 different enterprise customers in 8 different industries. Consider all the ways each of these industries might differ in terms of the business protocols that the startup would have to become subject to, now also consider the ways in which each of the 10 customers might differ from the others. With only a few exceptions, it would make more sense to win 10 customers in 1 or 2 industries . . . Gain experience, gather momentum in those markets, grow the team in step with the growth of the startup’s customer-base and revenues . . . . and only when business development in those initial markets has reached a tipping point, then the startup can begin exploring customer acquisition in other markets. An analogous thought process works for startups building apps for consumers, and reaches a similar conclusion.

Think of it as building a solid foundation before attempting to complete the structure which will rest on the foundation. What ever the size of the structure, it will not last if the foundation that is meant to hold it up is weak.

Most research about why early startups fails lists the top two reasons as some combination of “produced something for which there was no market” and “run out of cash” . . . The research is often not granular enough to enable us to say definitely what exact reason led to those conclusions, but . . . A failure by an early stage startup’s founders to adopt focus as the launch strategy makes those two outcomes inevitable. Why?

First, lack of focus means the startup spreads itself too thin and fails to find and devote its attention and resources to those customers or users with the highest propensity to use, and then pay for the product.

Second, a lack of focus can be exorbitantly expensive if the startup is selling a product that is far from fully-baked to multiple industries. Several rounds of customizations for a small number of customers in a given market without a sales process to increase the revenues from that market quickly results in expenses that can quickly get out of control. It is not difficult to think of how this plays out for startups building apps for consumers.

Closing Thoughts: Every early stage technology startup should start out pursuing a focus as its generic strategy. The time to make a choice between cost leadership and differentiation is once product-market fit has been established, which is the point at which the startups begins to transition from searching for a repeatable, scalable, and profitable business model to building out the organizational structures of a company. Also;

  1. The highly fluid and dynamic nature of the markets in which technology startups operate requires founders to be willing to experiment with combinations of the generic strategies once product-market fit has been established. They crucial requirement is to execute any such hybrid of the generic strategies in a way that strengthens the startups competitive position rather than weakening it.
  2. Strategy is not a “set it and forget it” proposition . . . One of the functions of a good board of directors is a semi-annual review of the startup’s strategy to determine if there’s reason to consider making an adjustment. I do not mean to suggest that the strategy should change every six months, but the board should examine the environment every six months or so in order to ensure that maintaining the current course is the right strategic choice.

 

References   [ + ]

1. ↩ 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.
2. ↩ My target audience is made up of  first-time startup founders who do not have any background in business, finance, economics, or strategy.
3. ↩ 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.
4. ↩ Keith H. Hammond, Michael Porter’s Big Ideas. Accessed on Jun 20, 2015 at http://www.fastcompany.com/42485/michael-porters-big-ideas
5. ↩ It is not clear to me if the unbundling of CraigsList arose from conscious choices made by others observing the markets it served, or if this is a phenomenon that has only become obvious after the fact.

How Studying Bankruptcy And Working On Two Turnaround Assignments Prepared Me To Become An Early Stage Venture Capitalist

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The Chinese Character for Crisis; Danger + Opportunity (From The Ten Strategies For Leading At The Edge)
The Chinese Character for Crisis; Danger + Opportunity (From The Ten Strategies For Leading At The Edge)

 

When I started business school at NYU Stern in the fall of 2005 my plan centered on taking every class in Bankruptcy & Reorganization, and Distressed Investing that I could. I took 3 elective classes in that area; Bankruptcy & Reorganization with Prof. Ed Altman, Case Studies in Bankruptcy & Reorganization with Prof. Max Holmes, and Investment Strategies: Distressed Investing with Prof. Allan Brown.

By my logic, if I learned how to assess and invest in dying companies, and then nurse them back to health, analysing, valuing and investing in healthy companies would seem easy by comparison. I was so sure of this that I also tried to turn my Equity Valuation elective into a pseudo Bankruptcy & Reorganization course too, by opting to value a bankrupt company for my final group-project. I do not recommend trying that.

I was still in business school when the economy began to falter. I moved from UBS to Lehman Brothers in late March 2007. A few days later New Century Financial Corp. filed for Bankruptcy. I was let go from Lehman Brothers a year later, on March 12, 2008. Bear Stearns collapsed and was acquired by JP Morgan Chase on March 16, 2008. I graduated from Stern in May, 2008. On September 7, 2008 Fannie Mae and Freddie Mac were taken over by the federal government. Lehman Brothers collapsed on September 15, 2008. On September 16, 2008 the Fed bailed out AIG.

The rest of 2008 was a bloodbath.

It was in that environment that I joined KEC Holdings, KEC Ventures parent company, in December 2008. I was employee #2. I had been hired into a new role that had not existed before at the company. My responsibilities encompassed any direct and indirect investments the company had made, or might make in the future.

Most notably, the company had already made 2 private equity investments; one in a private jet charter company and another in a fine-dining restaurant group – they were struggling to stay afloat given the economic environment. My first order of duty was to “make sure they don’t die” and “help them come out of this mess stronger than they were going into it.” There would be no financial engineering gimmickry. No tried and true business school textbook “indiscriminate” cost-cutting shortcuts. I had to roll up my sleeves and work with each company as intimately as necessary to achieve the objectives.

This post is about how we navigated that period. It is also about what that period between December 2008 and August 2013 has taught me about the challenges startups face, and my role as a venture capitalist.

Every day is a journey, and the journey itself is home. - Matsuo Basho
Every day is a journey, and the journey itself is home.
– Matsuo Basho

Further Background

Both companies were generating top-line revenues in the range of $20,000,000 – $30,000,000 per year. Both had fallen short of budgetary expectations in 2008, but the aviation company had a more prolonged string of losses than the fine-dining restaurant, partly because the restaurant was a more recent investment at that point. I functioned as an “external management consultant”; I was not a full-time employee of either company, but I worked with employees across the hierarchy of both companies. The restaurant company employed between 400 and 500 people while the aviation company had between 30 and 40 employees after several previous rounds of downsizing.

Both companies had watched as some of their competitors ran into strong headwinds, and subsequently shut down operations because the economic environment was so bleak.

Lesson #1: Understand The Business

Once a company is in financial distress investors have to decide if it is worth saving, and they also have to answer the accompanying question; can it be saved given current known constraints? The only way to do this is to develop a deep understanding of the business, and the context within which it is operating.

Between 2008 and 2012, confidence in the economy was very low. People simply were not splurging on expensive meals or luxury jets. An economist would say that private jet charter and fine-dining both have a high elasticity of demand.

I had no prior experience working at, let alone helping to run a restaurant or a private jet charter company. So I decided to spend the first six months in learning mode. I studied everything I could about both markets while I helped the executives and managers at both companies deal with day-to-day nuts-and-bolts issues.

This was important if I was going to build personal credibility, and if I wanted to win buy-in for my ideas from the executives and managers later on. I had to be able to influence them into doing things they probably did not believe in at the outset, and I had to do this with little real influence.

How this applies to early-stage startups: Today, I look for founders who embrace their expertise, and demonstrate a knowledge of their business that surpasses mine. However, the founder also has to demonstrate an ability to assist me learn enough about their industry to make a decision, and act as a useful sounding board for decisions that have to be made in the future.

Lesson #2: Understand The People

During those six months, I also tried to understand the protagonists in each situation. I relied on a technique I had learned in my Literature in English classes during secondary school in Ghana; character analyses.

A character analyses involves performing an in-depth study of the key characters in a drama, and trying to figure out each character’s story; What motivates that person? Why is that person who they are? What is the person afraid of? What drives that person? How does that person communicate? How does that person respond to pressure and stress. What does that person gain the most satisfaction from? What’s the state of that person’s family life? How does that person perceive me? How do I perceive that person? Does that person buy into the need for a turnaround? Is that person willing to commit to the turnaround? What biases does the person exhibit that I can identify? How does that affect things?

I had to be honest, and to contend with the pleasant and the unpleasant, especially around the perceptions other people had of me at the outset.

I took copious notes, and added to them until I felt I had a decent understanding of each of the people with decision-making authority that I would be dealing with most often; executives, managers, and front-line employees.

Perhaps an important, but often overlooked insight is that an investor should strive to understand the people within the context of the business. For example, is this person a leader or a manager? The distinction matters because it can spell the difference between beating about the bush with no results to show, or getting to the heart of the matter and fixing the problems that need to be solved at a tactical and granular level. Fred Wilson writes about this problem in: Leaders and Executives.

How this applies to early-stage startups: We make seed stage and series A investments. That early in a startup’s life, the people make all the difference. The market is important, so is the product. However, at this stage the future is still so nebulous and difficult to envision that the team that has decided to embark on that journey matters more than anything else. So, I have learned to focus on questions like; How did this team come together? Do the founders take responsibility for outcomes, or do they have a habit of passing blame? Do they have the intestinal fortitude to withstand the difficulties they are bound to face as individuals, and as a team on this difficult path they have chosen or will they wilt under pressure? What evidence do I have to support my answer to this question. What is their approach to learning, as individuals and as a team? Have they faced crises together? How did they fare when the going got tough? I will not ask most of these questions directly, but I will be processing every interaction, every bit of information I get, to determine answers to questions along this line of reasoning.

Lesson #3: Create A Sense of Urgency, But Provide Hope

Unlike a startup, a company in financial distress already has a product that it has sold successfully in the past, it also has a sense of who its customers are and where to find them. It is easy for the people within the company to succumb to status quo bias. This is identifiable by statements such as;

  1. “Everything will be fine, we just need to close this one sale.”
  2. “I feel confident it will happen, we have this sale in the bag.”
  3. “They are not our competitor, they do not do what we do!”

In the face of incontrovertible evidence that “they are up shit’s creek without a paddle” people will still choose to do what feels comfortable.

It was my responsibility to shake them out of that rut. As John P. Kotter says in Leading Change: Why Transformation Efforts Fail; 75% or more of a company’s management has to buy into the need for change, otherwise the chance that the change effort will fail is unacceptably high.

How did I do this? In both cases I did not shy away from asking questions that I expected to generate conflict. Indeed, on several occasions I had to have unpleasant and difficult conversations with the top managers and executives in both companies. I did this even if it appeared that I was “meddling” in areas where I had no business poking around. Of course, the idea that there was a part of either company’s operations that I “had no business” exploring was a fallacy only someone keen on maintaining the status quo would believe.

The message, delivered by the investors and the board, and reiterated by me during my frequent field trips, was simple; “The status quo is unacceptable, and failure for lack of effort is out of the question.” We had one chance to get it right, and we had to make the most of that chance even if it meant discomfort some of the time. We could get there with or without conflict. It was entirely up to us to make that choice.

How this applies to early-stage startups: The time for the whole team to start thinking about the Series A Round of Financing is the night before the Seed Round closes. Some one on the team should always be thinking about what it will take to raise the next round.

The time to start thinking about revenues is yesterday, even if you do not implement those plans immediately. Always have a plan. Always test your plan.

Lesson #4: Investors Have Ideas, But Management Runs The Business

Investors will always have ideas about how a business should be run. Sometimes investors know more about a certain topic than management. It is okay for investors to make suggestions, and to offer ideas to management. However, responsibility for choosing which ideas to accept and which to reject has to rest on the shoulders of management, and management has to accept accountability for the outcomes.

There are a number of ways this aspect of the relationship between investors and management might unfold;

  1. Investors can dictate to management what investors think management should do, or
  2. Investors can teach management how and why things should be done a certain way.

I chose the latter. That approach takes more time, but it is also more likely to lead to permanent change in behavior than the former. Also, once the lessons had taken root that approach allowed me to gradually pull back my involvement without jeopardizing the progress that management was making in improving results. It is an approach that builds self-sufficiency.

As part of the process, we cultivated the practice of communicating:

  1. Why a certain goal or strategic initiative was important for the company’s near term goals and long term vision.
  2. What had to get done in order for that goal or strategic initiative to be successfully executed.
  3. Who specifically was primarily responsible for seeing that it got done, and which executive they could go to as often as necessary in order to navigate what ever obstacles they might encounter.
  4. How it would get done, not in excruciating detail, but in broad terms. For example; Which teams needed to collaborate with one another in order to make it happen?
  5. When the team expected to be able to report back periodically on their progress, and importantly, when the project needed to be complete.

To do this successfully, I had to focus on asking questions and encouraging deeper levels of inquiry than was the custom beforehand. Asking probing questions helped us cut out the “bullshit” of conventional wisdom that is seductively easy to accept.

Each time I heard; “You do not understand, that is not how it is done in our industry.” I would ask; “Why?” That would lead to an examination of the assumptions behind the choices that had been made in the past. Often there was no good reason to refuse to try something different even if it seemed out of step with accepted industry convention.

How this applies to early-stage startups: I am looking for founders at the seed or series A stage whose judgement I can trust enough to feel they do not need me to opine on every decision they ever have to make. That does not mean I am passive. It means I need to trust their decision-making skill and maturity enough to feel confident they will consistently make the right choices for all the startup’s constituents without the need to run everything by investors.

From the investors’ perspective, a policy of “show, don’t tell” goes a long way. To paraphrase the oft quoted saying; “Give a founder a fish and . . . . ” If I feel there’s something a founder ought to learn, I’d rather provide a guide to enable that founder learn the applicable frameworks and how to apply them in day-to-day decision-making situations.

Lesson #5: Create Internal Value By Increasing Organizational Capacity

The way we defined it; Organizational capacity is the harnessing of a company’s human, physical and material, financial, informational, and intellectual property resources in order to enable the company to continually perform above expectations and strengthen its competitive position.

In difficult times especially, it is important that companies do not lose sight of the need to continue to find ways to increase organizational capacity.

One way we did this, in both cases, was to shift both companies off MS Exchange Server and onto Google Docs for Work. This was not easy because of cultural attachments to MS Exchange and fear of having to learn something new. Both companies made the shift, eventually. The immediate benefit they experienced was a dramatic reduction in the costs they incurred for IT assistance. A more important, though less tangible benefit was that both businesses could then afford to give every full-time employee a corporate email address and access to a corporate intranet portal. The benefits were enormous; easier collaboration, easier information transfer and sharing,  and increased security of corporate information and trade secrets. Quicker turnaround on tactical decisions because people could now communicate by chat.

Given the improvements in tools for collaboration, we encouraged the formation of cross-disciplinary teams to tackle some of the problems that each company was dealing with. This allowed people from one area of each business to interact more closely with their colleagues from another area of the business. They developed a better understanding of one another, and of the challenges and constraints that they each faced in trying to execute their day-to-day responsibilities. In turn this fostered a more collaborative relationship across the entire organization. It also enhanced the learning environment for all employees.

How this applies to early-stage startups: It does not take a lot by way of resources to create an environment that is rich in opportunities for cross-functional collaboration and learning. This comes in handy during due diligence because every member of the team will be able to speak knowledgeably about the startup’s immediate and long term plans.

Lesson #6: Direction Must Be Set From The Top, But Engagement Must Begin at The Bottom

We started working on trying to develop a strategic plan for both companies in summer 2009. Before this time, neither company had previously had a coherent strategy.

In consultation with the executives in each company, the board of directors set out the broad areas that the strategic plans ought to cover; Finance, Operations, People, Demand Creation, and Expansion.

Once those had been agreed on, it was my job to meet with front-line employees as well as managers in the field in order to obtain data and insight about how the strategic plan would have to be set up in order to function effectively for them given what each company was trying to accomplish.

That sounds easy. It is not. It took multiple meetings, of several hours each. The restaurant had multiple locations in NYC, one location in NJ and another in CT. I did not visit the location in Chicago, the CFO held discussions with them during his quarterly visits. I had to sift through everything I heard during those meetings, and I had to extract broad themes. Then I had to reconcile that with the strategic framework established by the board. Finally, I had to interpret that information from the perspective of the competitive landscape for each of the two companies. Finally, I had to synthesize it all into digestible chunks for the board, the executives, the managers and rank-and-file employees.

The goal of spending so much time on having these meetings with people across all ranks in each company was to ensure that once the strategy was developed and implemented, there would be complete alignment behind the vision embodied in the strategy, and just as important that every employee would be engaged in and committed to executing the tactical initiatives required to make the strategy succeed.

How this applies to early-stage startups: The founder creates the vision that investors and the startup’s team buys into. The team executes to turn that vision into a living, breathing, growing reality. Investors hopefully act as a positive catalyst to help the process unfold more quickly.

Lesson #7: Do Not Ignore The Soft Issues, Emphasize Both Hard and Soft Issues Simultaneously

My experience might as well be called The Tale of Two Turnarounds. In one company leadership admitted things were awful. They also admitted that they could use whatever help I could offer. They readily admitted their limitations as a team. We had many instances of conflict, but starting from a position of optimism and a willingness to try, the process moved along slowly, but steadily. We created a survey that we administered twice a year to get a sense of how employees were feeling, data that might not be captured in the key performance metrics we monitored weekly, monthly, quarterly, and annually.

We launched the strategic plan in January 2010 after 9 months of work specifically focused on that task. A year later the company made its first ever payments from a new profit-sharing plan that we had created as part of the new strategy. The payments were not huge, but they were evidence that the team’s hard work was paying off. It also created a feedback loop about how actions by employees affect the bottom-line performance of the company.

In the other company the founder, who was also the ceo, was grumpy and relatively uncooperative with investors. To cut a long story short, we launched the strategic plan in April 2010, after about 9 months of work specifically focused on that assignment. Within 6 months 75% of the managers with whom we had worked to develop and launch the strategic plan had left the company or had been fired. It was a classic case in which we would take two steps forward only to take four steps backward.

Morale dipped ever lower. The founders incessant talk about “a vision” and “a mission” became the butt of jokes among rank-and-file employees. It became clear that employees were becoming disillusioned with what the company stood for. While the company fared better than it would have if there had been no attempt at executing a turnaround and developing a strategy, it continued to perform well below its potential.

At a board meeting one day, the founder/ceo went into a vituperous rant about all the areas where the company was falling short. This was in early to mid 2012. I had to burst out in laughter. He might as well have been reciting problems whose solution formed the core of the strategic plan we created in 2010. Implementing that plan would have started the process of solving those problems he was so exercised about that day. We had lost two years for no good reason.

No amount of emphasis on key performance metrics made a difference. Without the founder’s full embrace of the strategic plan, nothing else mattered. I should point out that he had been intimately involved in crafting the strategic plan. This was not a plan that was forced down on him “from on high.” It became clear how badly things had deteriorated when a long time employee quit, this individual was the only employee at the company who had been there as long as the founder.

How this applies to early-stage startups: I am of a firm belief that the team is really important at the seed and series A stage, or at least until uncertainty around product market fit has been largely eliminated. So, I need to develop a sense that a founder is someone I can work with over the long haul . . . Actually, the kind of founder I am happy backing has to be someone I could envision myself working for if circumstances were different. Age, race, gender, religion . . . That is all irrelevant. Early in my process for assessing a startup I focus almost entirely on soft issues.

In one example, I sensed something amiss about the body language between 2 Spanish co-founders pitching a startup to my partner and I in 2013. I decided to tune out what they were saying in order to better observe their body language. There was something about their body language towards one another that did not align with what they wanted us to believe, in my opinion. We passed on their seed round, and decided to watch them till we could get more data about the relationship between the co-founders. That was nearly 3 years ago. I have heard no reports to suggest we made an error in that case.

Let chaos reign, then reign in chaos.

– Andy Grove, Only The Paranoid Survive

Lesson #8: Be Prepared For Chaos; Harness, Focus And Direct It, Empower People

Once employees understood the strategic plan as well as the tactical initiatives that accompanied it, they began developing ideas related to the various functional areas in each company and making suggestions to managers and excutives.

At first this was overwhelming . . . Managers had to do their own work, manage the work of the groups of people that they managed, and now . . . . They also had all these ideas being thrown at them from “left, right, and center.” The initial knee-jerk reaction was to try to “make it stop.”

That would have been a mistake. Among the deluge of ideas were some real gems.

For example, a maintenance department team member at the aviation company noticed that the company could cut down on its electricity usage by changing all the bulbs in its main hangar . . . No one had thought about that over the years, but our discussion about the strategic initiative around improving the product while reducing costs prompted him to take another look at the company’s hangars in search of opportunities to reduce operating costs. Thanks to improvements in technology over the years this was now a measure that could be implemented relatively easily.

In another instance, the team at our restaurant in CT had observed that on certain days of the week large groups of Chinese tourists visited the casino resort in which they are located. They had been thinking of a way to capture some of that business, but had assumed the corporate office would object to the menu changes they thought they had to make in order to execute that plan. As part of our implementation of the strategic initiative around increasing revenues, I suggested they conduct an experiment, analyze the outcome, and then seek assistance from the corporate office if the results looked promising. They did that, and saw a jump in revenues on two days of the week when business would otherwise have been slow. The corporate office gave its blessing, and assisted in making that practice more entrenched by using corporate resources to give it the polish required for company-supported initiatives.

How this applies to early-stage startups: A startup stops being a startup once its search for a repeatable, scalable, and profitable business model is complete. While that search is in process it is important that every member of the team feels empowered to contribute to the discovery of that business model. It can’t be the job of only some members of the team, it has to be part of everyone’s job. The faster a startup gets through the discovery process the better.

Lesson #9: The Turnaround Should Be Its Own Reward; Incentives Should Reinforce Change Not Drive It

It was nice to be able to make payments from the profit-sharing plan that we instituted. The payments were relatively small, yet they were tangible evidence to the employees, managers, and executives that they were collectively well equipped to make it through the ongoing turbulence and correct the mistakes of the past.

The sense of accomplishment employees felt translated into a number of things, among them;

  1. Newfound and increasing pride in being associated with a company that was succeeding where many of its rivals had failed.
  2. High levels of morale and optimism about the future of the company, and their place at the company. Less stress about employment security.
  3. A greater willingness to take the initiative in situations where the possibility of generating business for the company exists.

Basically, every employee was empowered to function as a salesperson on the company’s behalf. We arranged training sessions to equip every employee with the vocabulary they needed to understand in order to do that effectively. We also developed simple tools that they could use. They did not replace the company’s professional salespeople . . . They became an auxiliary sales force.

How this applies to early-stage startups: As startups grow, founders and early team members need to get better at the art and science of “managerial leverage” . . . What is managerial leverage? It is the process by which a manager creates output that far supersedes that manager’s input by using all the resources at the manager’s disposal to influence the work that is done by the group of people whose on-the-job effectiveness and work-output is affected by interactions with the manager.

What is a manager’s output? According to Andy Grove, co-founder and former CEO of Intel “The output of a manager is a result achieved by a group either under his supervision or under his influence.” Great managers create positive output that far exceeds expectations. Below average managers create output that fails to meet expectations given superior resources. Average managers? The team’s output would not be any different if the manager were absent.

The art of managerial leverage is in determining; how to apportion time, where to pay more attention, where to pay less attention, who to pay more attention to, who to pay less attention . . . . etc etc. The science of managerial leverage is in determining; what to measure, when to measure it, how often to monitor what is being measured, where bottlenecks are most likely to occur and why, and how to eliminate them . . . . etc etc.

Managerial leverage drives output. Output drives results. Results are measured and reflected in the KPI’s that founders and investors measure. Getting that order right is critical to a startup’s success.

Lesson #10: Learn To Listen, And Communicate Effectively

It is amazing how many problems can be solved relatively quickly if people would communicate more effectively internally and externally. Communication involves two actions; first listening actively in order to understand what is driving the actions of other people. Second, responding to what other people have said in a way that gets to the root cause of the problem being discussed.

During one of my field visits, I spent 8 hours on my first day listening to the executives talk about all the problems they each perceived, and how they felt the issues ought to be tackled. I spent that day with the CEO/President, the CFO, the Head of HR, and the Head of Sales. I encouraged open disagreement and debate.

On my second day I spent about the same amount of time speaking with the middle managers; again we discussed the problems they each perceived, and how they each felt the issues ought to be tackled.

On the third day I brought both groups together, and moderated an all day discussion about the problems the company was facing. Once again, I encouraged open disagreement and debate. Also, I put the inter-personal issues and conflicts that I had uncovered on the table. Things often got heated. It was my job to function as a pressure-release valve during those episodes. It was not pretty.

For example, I explained to the entire group how the CFO who was disliked by a large number of people within the company had made payroll on too many occasions by dipping into his personal 401(K) savings for example. The irony, the folks who disliked him routinely failed to provide the finance team with the data they needed in order to collect on accounts receivable from the company’s customers.

The outcome of this exercise was that;

  1. Everyone felt they had been given a chance to speak and be heard by the rest of the leadership team, and
  2. We discussed expectations in a fair amount of detail, enough so that more work could be done laying them out in adequate specificity rather than vaguely wondering what people could expect from one another, and finally
  3. Created an environment in which each member of the leadership team contributed in creating a communication framework against which they agreed to be held accountable

Our goals for the communication framework were that;

  1. Every employee should know what is expected of them, as individual team members,
  2. Every employee should know what to expect from every other member of the team,
  3. Employees should know what to expect from executives and managers, and lastly
  4. Accountability should be about improving team and company performance, not punishing individuals.

As Rosabeth Moss Kanter says in Four Tips for Building Accountability; “The tools of accountability — data, details, metrics, measurement, analyses, charts, tests, assessments, performance evaluations — are neutral. What matters is their interpretation, the manner of their use, and the culture that surrounds them. In declining organizations, use of these tools signals that people are watched too closely, not trusted, about to be punished. In successful organizations, they are vital tools that high achievers use to understand and improve performance regularly and rapidly.”

How this applies to early-stage startups: Startups typically have to move quickly, especially if they have taken in capital from institutional venture capitalists. A culture of blame, lack of cohesive teamwork, and a lack of organization-wide accountability is an insidious tumor that will eventually lead to failure. The founders who are most successful in the long run are those who do not shift responsibility when things are difficult, but instead serve as a model that other team members can emulate.

Closing Thoughts

Executing a turnaround and getting a startup through the phase of discovering a business model are really just two sides of the same coin. That experience has led me to the belief that it is when things seem bleak that great early stage investors prove their worth.

Further Reading

Blog Posts, Articles, & White Papers

  1. The Psychology of Change Management
  2. Motivating People: Getting Beyond Money
  3. The Irrational Side of Change Management
  4. The CEO’s Role in Leading Transformation
  5. The Role of Networks in Organizational Change
  6. All I Ever Needed To Know About Change Management I Learned at Engineering School
  7. Changing an Organization’s Culture, Without Resistance or Blame

Books

  1. High Output Management
  2. Only The Paranoid Survive
  3. How Did That Happen?
  4. HBR’s 10 Must Reads on Change Management
  5. HBR on Turnarounds

Notes on Strategy; Where Does Disruption Come From?

by

Introduction

You can imagine my surprise when I was browsing my Twitter feed one night last month and came across one of Marc Andreessen’s tweetstorms. This time he was tweeting about Clayton Christensen’s Theory of Disruptive Innovation.

Coincidentally, I have been thinking about writing a blog post on the subject since the Fall of 2014 – after a string of successive meetings with startup founders in which it became starkly clear to me that they were using the term “disruption” without actually understanding what it meant, or perhaps I should say, they used the term in a context that differs markedly from my understanding of what it means.

The purpose of this blog post is to; 1Any 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.

  1. Synthesize my understanding of Disruptive Innovation as popularized by Clayton Christensen’s work,
  2. To examine instances in which that process has unfolded in various industries,
  3. To develop a framework by which I can analyze a startup founders’ claims about “being disruptive” during my conversations with them, and
  4. Examine extensions of, and arguments against, Clayton Christensen’s work on Disruptive Innovation

I am thinking of this from the perspective of an early stage Seed and Series A investor in technology startups, not from the perspective of a management consultant advising market incumbents about how to avoid or prevent competition.

To insure that we are on the same page; first some definitions.

Definition #1: What is a startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model. 2I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator, discusses the startups that Y Combinator supports.

Definition #2: What is Sustaining Innovation? A “sustaining innovation” is an innovation that leads to product improvements without fundamentally changing the nature or underlying structure of the market to which it applies; it enables the same set of market competitors to serve the same customer base. 3Clayton M. Christensen, The Innovator’s Dilemma. 2006 Collins Business Essentials Edition.

In other words; a sustaining innovation solves a problem that is well understood within an existing market. The innovation improves performance, lowers costs and leads to incremental product improvements. The customers are easily identified, and market reaction to the innovation is predictable. Lastly, traditional business methods known within that market are sufficient to bring the innovation to market. 4Brant Cooper and Patrick Vlaskovits, The Lean Entrepreneur. Wiley, 2013, pp. xx.

Additionally;

  1. A sustaining innovation is evolutionary if it leads to product improvements that are gradual in nature, progressing along what might be described as a gradual step function.
  2. A sustaining innovation is revolutionary, discontinuous, or radical when it leads to product improvements that are dramatic and unexpected in nature, but that nonetheless leaves the market structure largely intact – even if there is a rearrangement of counterparties within the existing competitive hierarchy.
  3. Even the most dramatic and difficult sustaining innovations rarely lead to the failure of leading incumbents within a market. 5Clayton M. Christensen, The Innovator’s Dilemma. 2006 Collins Business Essentials Edition, pp. xviii.

Definition #3: What is Disruptive Innovation? A “disruptive innovation” is one that starts out being worse in product performance in comparison to the alternative, in the immediate term. However, as time progresses the disruptive innovation leads to a significant and fundamental shift in market structure – new entrant competitors serve an entirely changed customer base. 6Ibid.

In other words; a disruptive innovation solves a problem that is not well understood by the market, thus creating a “new market” for the new entrant. The innovation is dramatic and game-changing in ways that initially elude the mainstream customers as well as market incumbents serving those customers. The customer is often difficult to identify at the outset, and market reaction toward the innovation is unpredictable – from the perspective of the mainstream. Traditional methods and business models that have served the market can not support the innovation. 7Brant Cooper and Patrick Vlaskovits, The Lean Entrepreneur. Wiley, 2013, pp. xx.

Additionally;

  1. A disruptive innovation introduces a different and “comparatively inferior” value proposition than the value proposition the existing market is accustomed to; as such
  2. Disruptive innovations start out being attractive only to a relatively “fringe” and “new” but altogether “unprofitable” customer base with products that are;
  3. “Cheaper, simpler, smaller, and more convenient” for the customers that find them most attractive at the outset, and
  4. These products perform so “poorly” that mainstream customers in that market will not use them, and incumbent players are happy to keep “their best, and most profitable customers” while ceding “their worst, and unprofitable customers” to the startup bringing the disruptive innovation to market, but
  5. Eventually the disruptive innovation leads to market shifts which cause leading incumbents to fail as the new entrants supplant them.
Image Credit: Vadim Sherbakov
Image Credit: Vadim Sherbakov

Understanding What is Happening When a Market Undergoes Disruption

So what exactly is going on when a market experiences disruption? Contrary to what the term “disruptive innovation” suggests . . . the process is not sudden.

As Clayton Christensen states; Disruptive innovations are generally straightforward technologically. They consist of off-the-shelf components combined in a product architecture that is far simpler than existing alternatives or substitutes in a way that does not meet the needs of the core customers in an established market. They will often be derided and dismissed by incumbents as “inferior” because they offer benefits prized by an emerging class of customers in an emerging, but as yet unnoticed market. The disruptive innovation starts out being unimportant to the mainstream customer and so it is unimportant to the mainstream incumbent. 8Clayton M. Christensen, The Innovator’s Dilemma. 2006 Collins Business Essentials Edition, pp. 16.

Mainstream customers and mainstream investors hold mainstream incumbents captive – with demands for sustaining innovations, and demands for meeting or beating financial performance metrics like internal rate of return, net present value, return on equity, return on invested capital, gross margins, net margins etc. Faced with the choice between pursuing an unprofitable emerging class of customers or doubling down in the competition for the most profitable mainstream customers in that market, management teams running mainstream incumbents do the rational thing; they double down in heated competition for profitable customers.

The disruptive innovation improves so rapidly, that it soon starts to meet the needs of segments of the mainstream customer base. As the cycle continues, it reaches a stage where the incumbents find themselves squeezed into a tiny corner of the market, driven out of it altogether, or dead.

This process describes a “low-end disruption.”

Disruptive innovation might take another form; in a “new market disruption” the startup initially sets its sights on customer segments that are not being served by mainstream incumbents within a given market. A new market disruption starts by competing “outside” of an existing market; in new use-cases, or by bringing in customers who previously did not consume because of they lacked the know-how or financial resources needed to use the incumbent product. The new market is “small and ill-defined” . . . However, as the new entrant grows and improves its product, customers begin to abandon the incumbent in favor of the disruptive innovation. Usually, the incumbent cannot compete with the new entrant because the new-market disruption is accompanied by a structurally distinct business model which makes it feasible for the new entrant but infeasible for the incumbent, for example a cost structure that is so thin that it could not support the incumbent’s fixed costs. 9Clayton M. Christensen and Michael E. Raynor, The Innovator’s Solution. 2003, Harvard Business School Publishing, pp. 45.

What Is The Innovator’s Solution; For Early Stage Startups and Early Stage Venture Capitalists?

Of the many dimensions of business building, the challenge of creating products that large numbers of customers will buy at profitable prices screams out for accurately predictive theory.

– Clayton M. Christensen and Michael E. Raynor, The Innovator’s Solution

First: Understand Why Customers Buy What causes customers to buy a product? A startup wishing to disrupt an established market needs to be able to answer this question in a way that existing incumbents have not. The “Jobs-To-Be-Done” (JTBD) framework enables a startup to develop its product at the “circumstance” in which its customers find themselves at the time they need its product, and not directly at the circumstances. As Christensen and Raynor put it: “The critical unit of analysis is the circumstance and not the customer.”

The basic idea behind the jobs-to-be-done framework is that customers “hire” a product when they need to get a specific “job” done. The entrepreneur who understands what job the startup’s product is being hired to do can also develop an understanding of the other jobs that might be related and ancillary to the primary job. The regularity and frequency with which customers need to get that job done plays a role in product development; what features should be prioritized? Which features should be de-prioritized even though they at first seemed important? How should the product’s value proposition be communicated? What other features should be built so that customers need not combine several different products in order to complete the job, or if they do how does the startup capture those markets too?  10Clayton M. Christensen and Michael E. Raynor, The Innovator’s Solution. 2003, Harvard Business School Publishing, chapter 3.

In my opinion startups stand an even better chance of success if they can combine the JTBD framework with an understanding what broad needs their product satisfies for their customers using the parameters laid out by Maslow’s Hierarchy of Needs. This matters especially in the determination of how a startup should communicate the product’s value proposition to its target customer base. An incongruence between the startups marketing message and the customers’ psychological notions about the product will lead to missed opportunities for the startup. It might also lead a startup to chase after the wrong customer base at the outset. 11Startups building products for the enterprise customer should be able to develop an analogous framework, assuming one does not already exist.

When new ventures are expected to generate profit relatively quickly, management is forced to test as quickly as possible the assumption that customers will be happy to pay a profitable price for the product.

– Clayton M. Christensen and Michael E. Raynor, The Innovator’s Solution

Second: Be Patient For Growth But Impatient For Profits The investors and founders of a startup that claims to be disrupting a market must quickly test if the market dynamics the startup must confront are such that it can earn a profit given its business model. This is important because it indicates that for those startups that answer those questions positively, it is possible for them to pursue growth in a way that is healthy and sustainable irrespective of the magnitude of the growth.

The Startup Genome Report reached conclusions that support this notion. In an extra to the 2011 version of that report they study the effect of premature scaling on the longevity of startups. They found that 70% of the 3200+ high-growth technology startups scaled prematurely along some business model dimension.

Before delving deeper into the findings from the Startup Genome Report, we should understand “Product-Market Fit“. An early stage startup is approaching the product-market fit milestone when demand for its product at a price that is profitable for the startup’s business model, begins to outstrip the demand that could have been explained by its marketing, sales, advertising, and PR efforts.

Product/market fit means being in a good market with a product that can satisfy that market.

You can always feel when product/market fit isn’t happening.The customers aren’t quite getting value out of the product, word of mouth isn’t spreading, usage isn’t growing that fast, press reviews are kind of “blah”, the sales cycle takes too long, and lots of deals never close.

And you can always feel product/market fit when it’s happening. The customers are buying the product just as fast as you can make it — or usage is growing just as fast as you can add more servers. Money from customers is piling up in your company checking account. You’re hiring sales and customer support staff as fast as you can. Reporters are calling because they’ve heard about your hot new thing and they want to talk to you about it. You start getting entrepreneur of the year awards from Harvard Business School. Investment bankers are staking out your house. You could eat free for a year at Buck’s.

– Marc Andreesen 12Marc Anrdeesen, Product/Market Fit, Jun 25, 2007. Accessed on Jul 18, 2015 at http://web.stanford.edu/class/ee204/ProductMarketFit.html

In other words, the product-market fit milestone is that milestone at which we start to realize that the startup has an opportunity to grow in sustainable and profitable way. As organic demand for the product starts to overwhelm the startup – i.e. as the market starts to pull the product out of the startup, that is the point at which it makes sense for investors to become impatient for growth. Before Product-Market Fit (BPMF) a startup must “push” its product onto the market – customers and revenue grow in direct, linear proportion to sales and marketing expense. After Product-Market Fit (APMF) the market “pulls” the product out of the startup – customers and revenue grow positively, disproportionately, and exponentially out of proportion to any sales and marketing expense incurred by the startup. Investors and startup founders should become impatient for growth when the startup is in the APMF phase of its life-cycle. This approach should hopefully avoid situations like: Case Study: Fab – How Did That Happen?

According to Startup Genome Report Extra on Premature Scaling:

Note: They use the term “inconsistent startups” to describe startups that scale prematurely and “consistent startups” to describe startups that scale successfully.

  1. 74% of startups scale prematurely.
  2. Startups that scale appropriately grow about 20x faster than startups that do not.
  3. Inconsistent startups that raise funding from investors tend to be valued 2x as much as consistent startups and raise about 3x as much capital prior to failing.
  4. Inconsistent startups have teams that are 3x the size of the teams at consistent startups at the same stage.
  5. However, once they get to the scaling stage, consistent startups have teams that are 1.38x the size teams at inconsistent startups.
  6. Consistent startups take 1.76x as much time to reach the scale-stage team size than their inconsistent peers.
  7. Inconsistent startups are 2.3x more likely to spend more than one standard deviation more than the average cost to acquire a customer than their consistent peers.
  8. Inconsistent startups write 3.4x more lines of code and 2.25x more lines of code in the discovery and efficiency stages of their life-cycle. Discovery and efficiency are the first and third stages of the startup lifecycle, as described in the report. 13In their report they describe the stages of a startup’s life-cycle as Discovery, Validation, Efficiency, Scale, Sustenance, and Conversation. The report covers the first four.
  9. A majority of inconsistent startups are more likely to be efficiently executing irrelevant things at the Discovery, Validation, and Efficiency stages of their life cycle, while a majority of consistent startups seek product-market fit during those stages.
  10. The following attributes have no correlation to the likelihood that a startup will be inconsistent or consistent: market size, product release cycles, educational attainment, gender, age, length of time over which co-founders have known one another, location, tools used to track KPIs etc.

What are some of the mistakes that inconsistent startups make as they travel from launch to dysfunctional scaling to failure? The Startup Genome Report provides some examples:

Customer

  1. Spend too much on customer acquisition BPMF and before discovering a profitable, repeatable and scalable business model, and
  2. Attempt to ameliorate that problem with marketing, press, and public appearances.

Product

  1. Build a “perfect product” before knowing enough about the “Problem-Solution Fit”, and
  2. Investing into scaling the product BPMF, and
  3. Focusing on advanced product features which are later proven to be unimportant to customers.

Team

  1. Growing the team too fast,
  2. Hiring specialists and managers too early and not having enough people who can or will actually do the work that needs to get done, and
  3. Having too much hierarchy too early.

Finance

  1. Raising too little money at the outset,
  2. Raising too much money. 14This is a risk for early stage investors as well as startups.

Business Model

  1. Not spending enough time developing the business model, and only realizing after the fact that revenues will never support the startup’s cost structure.
  2. Focussing too much on maximizing profit too early in the startup’s life-cycle,
  3. Executing without observing and analysing the input from customers and the market, and
  4. Failing to pivot appropriately in the face of changing market conditions that are relevant to the startups based on its discovery-focused experiments.

The 4 Stages Of Disruption

In his article, Four Stages of Disruption, Steven Sinofsky describes the process of disruption using an analogy to the well known and well understood rubric for understanding the experience of someone experiencing significant loss.

The 4 stages of disruption are:

  1. Disruption: A new product appears on the market but is seen to be inferior to the existing mainstream alternative.
  2. Evolution: The new product undergoes rapid sustaining innovations.
  3. Convergence: The new product is now seen as a plausible replacement for the incumbent mainstream product because it has undergone enough sustaining innovations to make it comparable to the incumbent.
  4. Reimagination: During this stage there is a complete re-examination of the assumptions on which the market operates and new products are brought to market.

Sinofsky describes them as a process, as shown in the following diagram:

The 4 Stages of Disruption (Credit: Steven Sinofsky)
The 4 Stages of Disruption – Process (Credit: Adapted from Steven Sinofsky)

 

I think the framework is better understood as a cycle; because every incumbent must face a new entrant or new entrants seeking to disrupt the market and eventually every successful new entrant that disrupts a market itself becomes an incumbent facing disruption by a successive hoard of disruptive new entrants. The cycle is ongoing and continuous, and is driven by more than simple advances in technology. Human behavior plays a central role in shaping the cycle that creates room for disruption to occur because our tastes change over time, and as time progresses we begin to value things that we did not value in the past, and it is that insight into the confluence between technology and human behavior that enables certain entrepreneurs to build startups that become industry disruptors.

 

4 Stages of Disruption - Cycle
The 4 Stages of Disruption – Cycle (Credit: Adapted from Steven Sinofsky)

 

How Did That Happen? – Disruption in Action; Industries

Digital Cameras vs. Film Photography: Digital cameras threatened to disrupt film photography, but they mainly represented a sustaining innovation – largely improving on existing form factors already in use in that market and fulfilling the needs of people one would consider casual or professional photographers. It was not until digital camera technology was integrated into smart-phones that the photography market started to experience disruption. They appealed to anyone who had the desire to take a picture, photographer or not, it did  not matter. As Craig Mod argues in his 2013 New Yorker article Goodbye, Cameras: “In the same way that the transition from film to digital is now taken for granted, the shift from cameras to networked devices with lenses should be obvious.” Standalone cameras are simply no longer good enough because: “They no longer capture the whole picture.” Kodak’s demise follows the classic format of every great incumbent that has fallen into obscurity in the face of an onslaught from new entrants. Kodak was itself a disruptor at one point – taking photography out of the sole preserve of professionals and putting it in the hands of every casual photographer seeking to preserve memorable moments. In his 2012 Wall Street Journal article, Kamal Munir outlines the rise and fall of Kodak in The Demise of Kodak: Five Reasons. It is important to note that Kodak developed technology for a digital camera in 1975, yet it failed to understand why customers bought its products and so failed to shift its business model as aggressively as it could have to avoid the fate that began staring it it in the face in 1975, nearly 4 decades before it filed for bankruptcy. 15Theodore Levitt’s seminal HBR article “Marketing Myopia” first introduced this concept in 1960. You should read the original article as well as this update from 2004.

Mobile Phones vs. Fixed Line Telephones: One sign that mobile and broadband telephony is disrupting fixed line telephony is the European Commission’s 2014 decision to stop regulating fixed line telephony. The situation for fixed line telephony is no different with telephone companies announcing that they are abandoning their landline telephone infrastructure in favor of mobile and broadband phone service. Their reaction is being driven by consumer’s willingness to rid themselves of landlines in favor of cellphones for individual personal use and/or VOIP-enabled phones at home. Liquid Crystals were first discovered by the Austrian physicist Friedrich Reinitzer in 1888. Nearly 7 decades later, engineers and scientists at RCA were conducting research that led them to file the first LCD patent on November 9, 1962. The USPTO granted them the patent on May 30, 1967. However, RCA did not move aggressively enough to make the LCD technology that had been developed by its employees the center of its business model.

Liquid Crystal Displays vs. Cathode Ray Tubes: The emergence of LCD technology marked the beginning of the end for CRT technology in the TV market. The technology that led to the development of LCD televisions originated in 1888, when an Austrian Physicist, Friedrich Reinitzer discovered the strange behavior of cholesteryl-benzoate. Nearly 4 decades later, scientists and engineers working at RCA filed a patent application based on LCD technology on Nov 9, 1962. It was granted on May 30, 1967. Predictably, RCA did not do much with its head-start in the development of LCD technology, instead it gave up its advantage to Japanese, Korean, and Taiwanese upstarts.

 

Statistic: Global market share held by LCD TV manufacturers from 2008 to 2014 | Statista
Find more statistics at Statista

 

How Did That Happen? – Disruption in Action; Companies/Products

Google – Launching Sustaining and Disruptive Innovations:

 

While Google’s innovation in search are impressive, and helped it win that market at the expense of other search engines, it gained near absolute dominance in that market by developing a sustaining innovation in the form of its PageRank Algorithm, which is described in the paper by Sergey Brin and Lawrence Page: The Anatomy Of A Large Hypertextual Web Search Engine.
Statistic: Worldwide market share of leading search engines from January 2010 to April 2015 | Statista
Find more statistics at Statista

 

Rather, the industry that has been disrupted by Google is the online advertising market. Describing this in his article “What Disrupt Really Means” Andy Rachleff writes: “It was AdWords, its advertising service. In contrast with Yahoo, which required advertisers to spend at least $5,000 to create a compelling banner ad and $10,000 for a minimum ad purchase, Google offered a self-service ad product for as little as $1. The initial AdWords customers were startups that couldn’t afford to advertise on Yahoo. A five-word text ad offered inferior fidelity compared with a display ad, but Google enabled a whole new audience to advertise online. A classic new-market disruption. Most have forgotten that Google added significant capability to its advertising service over time and then used its much-lower-cost business model (enabled by self-service) to pursue classic Internet advertisers. Thus it evolved into a low-end disruption.”     Statistic: Net digital ad revenues of Google as percentage of total digital advertising revenues worldwide from 2012 to 2014 | Statista Find more statistics at Statista   Salesforce – Launching New Market and Low-End Disruptions: When Salesforce launched in 1999 it did so as a software-as-a-service (SaaS) platform that enabled companies that needed sales management software but could not afford the cost of annual multimilion dollar licenses for the mainstream products of the day. It’s initial product was lacking in features, and unreliable for the mainstream customers of the incumbent players in the CRM software market at that time. It built its business on non-consumption. As time progressed and its product matured in terms of reliability and features, Salesforce caused a low-end disruption as customers adopted its product while abandoning the more expensive CRM products sold by CRM market incumbents like Siebel Systems, Amdocs, E.piphany, PeopleSoft, and SAP.     Statistic: Market share of vendors customer relationship management software worldwide from 2012 to 2014 | Statista Find more statistics at Statista   Apple: Has Apple launched any disruptive innovations? Not if you asked Clayton Christensen in 2006 or again in 2007, or even in 2012. Yet I suspect that Nokia and Research in Motion feel differently about that question. The chart below is instructive.     IDC: Smartphone Vendor Market Share 2015, 2014, 2013, and 2012 Chart   Apple’s products have not been disruptive in the way that one might think of disruption if one adheres strictly to the line of analysis followed by Clayton Christensen and his collaborators. Perhaps one can argue that the iPod, the iPhone, and the iPad, each taken individually represents a sustaining innovation in the personal music player, the mobile phone, and the personal computer markets respectively. However, when one combines each of those products with the other elements in Apple’s product lineup there’s no denying that Apple has been disruptive to more than one industry. The “iPod + iTunes” has reshaped how people consume music, and has upended the music industry. The iPhone has led to a rethinking of what people expect from a mobile phone, and “iPod + iTunes + iPhone + AppStore” is responsible for the demise of Nokia and Research in Motion’s Blackberry as it has redefined how people consume media of all types. The “iPad + AppStore” combination is redefining how people consume media of all types, and redefining the relationship people have with their personal and laptop computers. Apple demonstrates the power of technology + design + branding + marketing as a powerful force in the process of disrupting established industries in consumer markets. 16It is worth noting that Clayton Christensen’s analysis and research focuses on business-to-business markets.     Statistic: 4G mobile device shipments worldwide from 2009 to 2020 (in 1,000 units) | Statista Find more statistics at Statista   Infographic: Has the PC Industry Bottomed Out? | Statista You will find more statistics at Statista   Netflix: At the outset Netflix seemed like a joke to executives at Blockbuster which dominated the US market for home-movie and video-game rental services, reaching its peak with 60,000 employees and 9,000 physical stores in 2004 after its launch on october 19, 1985. Netflix was founded in 1997 and started out as a flat-rate DVD-by-mail service in the United States using the United States Postal Service as its distribution channel. Presumably, the idea for Netflix was born after Reed Hastings, one of its co-founders was hit with a $40 late-fee after returning a DVD to Blockbuster well after its due date.  

Netflix DVD Mailer (Image Credit: Netflix)
Netflix DVD Mailer (Image Credit: Netflix)
Automated Netflix Mailer Stuffer (Image Credit: Netflix)
Automated Netflix Mailer Stuffer (Image Credit: Netflix)
Order Processing & Shipping Center (Image Credit: Netflix)
Order Processing & Shipping Center (Image Credit: Netflix)
Order Processing & Shipping Center: Sleeve Labels (Image Credit: Netflix)
Order Processing & Shipping Center: Sleeve Labels (Image Credit: Netflix)

  As you might imagine, executives at Blockbuster did not see the threat posed by Netflix and passed on 3 opportunities to buy Netflix for $50 Million. They failed to understand that people would rather not pay exorbitant late fees and that people valued the convenience of dropping the DVD from Netflix in the mail more than they enjoyed driving to Blockbuster’s physical retail stores. In other words; Netflix fulfilled the JTBD of “entertain me at home with something better than my options on TV” more conveniently than Blockbuster. The challenge that netflix must now face is how that original JTBD that it was hired to do by consumers is changing given the proliferation of mobile devices and the shift in consumer preferences away from physical media towards streaming media.      Infographic: Netflix' Successful Transition | Statista You will find more statistics at Statista

 

 But management and vision are two separate things. We had the option to buy Netflix for $50 million and we didn’t do it. They were losing money. They came around a few times.  – Former High-ranking Blockbuster Executive 17Marc Graser, Epic Fail: How Blockbuster Could Have Owned Netflix. Nov 12, 2013, accessed on Jul 18, 2015 at http://variety.com/2013/biz/news/epic-fail-how-blockbuster-could-have-owned-netflix-1200823443/

 

 

To anyone that ever rented a movie from BLOCKBUSTER, thank you for your patronage & allowing us to help you make it a BLOCKBUSTER night. — Blockbuster (@blockbuster) November 10, 2013

Blockbuster filed for bankruptcy in 2013. Today Netflix is streamed online through many internet-enabled smart tvs, streaming media players, game consoles, set-top boxes, blu-ray players, smartphones and tablets, as well as personal and laptop computers.

What Common Traits Do the Startup Founders Who Lead Disruptive Startups Share?

Disruptive innovation is built on much more than technology innovation. The startups that go on to disrupt markets combine innovation in technology with innovative approaches to market segmentation, product positioning, marketing strategy, business model innovation, business strategy, corporate strategy, customer psychology, and organizational design and culture.

As an investor in early stage technology startups that are still in the searching for and trying to validate a repeatable, profitable, and scalable business model it is critical that I become good at recognizing startup founders who can successfully see disruption through to a profitable harvest for the founders, and the LPs to whom I am responsible.

According to The Innovator’s DNA, startup founders capable of leading disruptive new market entrants display the following traits:

  1. Association: They make connections between seemingly disparate areas of knowledge, leading them to novel conclusions that elude other people.
  2. Questioning: They exhibit a passion for questioning the status quo.
  3. Observing: They learn by watching the world around them more closely than their peers and competitors.
  4. Networking: They have a social network that is wide and diverse, which enables them to test their own ideas as well as seek ideas from people who may see the world from a  distinctly different point of view.
  5. Experimenting: They continuously test their assumptions and hypotheses by unceasingly exploring the world intellectually and experientially.

These skills are echoed in The Creator’s Code, which describes extraordinary entrepreneurs as people who:

  1. Find The Gap: by staying alert enough to spot opportunities that elude other people by transplanting ideas across divides, merging disparate concepts, or designing new ways forward.
  2.  Drive For Daylight: by staying focused on the future, and making choices today on the basis of where they see the market going instead of where the market has been.
  3. Fly The OODA Loop: by continuously and rapidly updating their assumptions and hypotheses through the Observe, Orient, Decide, and Act framework. Fast cycle iteration helps them gain an edge over their competition, and catchup with the mainstream market incumbents. 18See statements like: “Move fast and break things.” or “Let chaos reign.”
  4. Fail Wisely: by preferring a series of small failures over a few catastrophic setbacks by placing small bets to test new ideas in order to gain further insight before they place big bets. By doing this they create organizations that learn how to turn failure into success and develop an inbuilt structural resilience.
  5. Network Minds: by harvesting the knowledge and brainpower from cognitively and experientially diverse individuals they develop unique approaches to solving multifaceted problems, problems whose solution might elude competitors.
  6. Gift Small Goods: by behaving generously towards others they strengthen relationships and build goodwill towards themselves and the organizations that they lead.

In The Questions Every Entrepreneur Must Answer, Amar Bhidé outlines a number of questions the feels every entrepreneur must answer in order to determine fit of the entrepreneur to the startup venture and of the startup venture to its context. 19Amar Bhidé,The Questions Every Entrepreneur Must Answer. From The Entrepreneurial Venture, readings selected by William A. Sahlman et al. 2nd edition, pp. 65 – 79. The questions are as follows;

  1. Where does the entrepreneur want to go?
    1. What kind of enterprise does the entrepreneur need to build in order to get there?
    2. What risks and sacrifices does such an enterprise demand?
    3. Can the entrepreneur accept those risks and sacrifices?
  2. How will the entrepreneur and the startup get there?
    1. Is there a strategy that can get the startup there?
    2. Can that strategy generate sufficient profits and growth within a time-frame that make sense for the entrepreneur and for the startup’s investors?
    3. Is the strategy, and the startup’s business model defensible and sustainable? 20I have discussed economic moats here: Revisiting What I Know About Network Effects & Startups and here: Revisiting What I Know About Switching Costs & Startups
    4. Are the goals for growth too conservative, or too aggressive?
  3. Can the founder or co-founders do it?
    1. Do they have the right resources and relationships?
    2. How strong is the relationship between the co-founders with one another, how strong is the organization’s team cohesion?
    3. Can the founder play her role?

The Role of Experts in Predicting The Success or Failure of Disruptive Innovations

Early stage investors often rely on the advice of subject matter experts as part of the due diligence process. Experts are great for determining if the technical innovation works as the founders say it does, however where investors can go wildly wrong is when they rely on subject matter experts for investment recommendations for disruptive innovations.

It should be obvious by now that most experts are poorly placed to offer advice that will be seen as correct when examined in hindsight if they are faced with a disruptive innovation.

The Only things we really hate are unfamiliar things.

– Samuel Butler, Life and Habit

The difficulty subject matter experts face in predicting how markets will evolve is captured in The Lexicon of Musical Invective, where the author captures the vituperous reactions of music critics to works that are now widely considered as masterpieces in the pantheon of Western music history. Why did these experts fail? They did not allow for the possibility that the future might differ from the present in which they were performing their analysis, nor did they allow for the possibility that people’s tastes in music would evolve away from what they had grown accustomed.

Experts experience too much cognitive dissonance when they have to make an investment recommendation regarding a disruptive innovation; what does it mean for their personal career security, what does that mean for the skills that they have worked so hard and so long to accumulate, what does that mean for their employer’s business?

Moreover, the fact that an individual is an expert in the technology behind the disruptive innovation does not mean that the same individual is an expert in all the other disciplines that are required to turn the technological innovation into a disruptive innovation.

Here are a few examples of instances in which experts got things horribly wrong: 21Adapted from Top 10 Bad Tech Predictions, by Gordon Globe. Nov 4, 2012, accessed on Jul 19, 2015 at http://www.digitaltrends.com/features/top-10-bad-tech-predictions/5/

  1. In 1977 Ken Olson said: “There is no reason anyone would want a computer in their home.” He was an engineer by training, and president, chairman and founder of Digital Equipment Corporation. Microsoft and Apple were startups.
  2. In 1956 Herbert Simon said: “Machines will be capable, within twenty years, of doing any work a man can do.” He made this statement after attending an AI conference at Dartmouth.
  3. In 1946 Darryl Zanuck said: “Television won’t be able to hold on to any market it captures after the first six months. People will soon get tired of staring at a plywood box every night.” He was a Hollywood magnate.
  4. In 1995 Robert Metcalfe said: “I predict the Internet will soon go spectacularly supernova and in 1996 catastrophically collapse.” He co-invented Ethernet technology and co-founded 3Com in 1979 with 3 other people. 3Com develops computer network products.
  5. In 1995 Clifford Stoll said: “The truth is no online database will replace your daily newspaper, no CD-ROM can take the place of a competent teacher and no computer network will change the way government works.” He was an astronomer, a hacker, and author, and a computer geek.
  6. In 2007 Steve Balmer said: “There’s no chance that the iPhone is going to get any significant market share.” He was the CEO of Microsoft. 22Mark Spoonauer, 10 Worst Tech Predictions of All Time. Aug 7, 2013. Accessed online on Jul 19, 2015 at http://blog.laptopmag.com/10-worst-tech-predictions-of-all-time

Criticisms of Clayton Christensen’s Theory of Disruptive Innovation

  1. In her 2014 New Yorker article; The Disruption Machine: What The Gospel of Innovation Get’s Wrong,JillLepore argues that:
    1. The theory is based on handpicked case studies, and it is not clear that these case studies are provide a sound basis upon which to build a theory.
    2. What Christensen describes as “disruption” can often be more accurately described as “bad management”
    3. The theory of disruption is built on retrospective analysis, it is unclear how useful it is in predicting how events will unfold.
  2. In his 2013 blog post: What Clayton Christensen Got Wrong, Ben Thompson examined the theory of disruption in the context of Apple’s introduction of the iPod, and later the iPhone. He argues that:
    1. The theory works well when we consider new market disruptions, but fails when we consider low-end disruptions, in consumer markets.
    2. The theory fails because consumers do not behave rationally.
    3. The theory fails to account for product attributes that cannot be documented but which consumers prize highly, all thing being equal.
    4. Vertical integration is a competitive advantage in consumer markets, because it allows vertically integrated producers to exert control over product attributes that customers value, but which would be near-impossible to control using a modular production framework.

Closing Thoughts

  1. The ideas on which “disruptive innovation” is built are not inviolable and permanent laws of nature. Early stage investors and startup founders should subject them to testing on a frequent basis. Disruption works in different ways in consumer markets than it does in enterprise, or business to business markets.
  2. Startup founders and their investors should combine Clayton Christensen’s ideas with those of Michael Porter in order to build a more complete strategic plan that can stand the vicissitudes of competition from the startup’s peers and the reaction from mainstream market incumbents.
  3. Good strategy is not a substitute for good management. Good strategy does not make good management obsolete.
  4. Building a better mousetrap is not necessarily the path to disruptive innovation and winning the market in which a startup is a new entrant.
  5. Low end disruptions almost always begin with a product that is significantly inferior in comparison to the product embraced by the mainstream market. Low end disruptions also have to be simpler, cheaper or more convenient than the mainstream product.
  6. New market disruptions do not necessarily have to be less expensive than the comparable product that is embraced by the mainstream market.
  7. Disruptive innovation entails much more than technological disruption. Incumbents can compete with technological disruption, and they always win in those scenarios. To succeed, startups seeking to disrupt a market must design business models that support their effort to bring their technological innovation to market and make it impossible for the mainstream market incumbents to respond in a manner that causes the startup to fail prematurely.
  8. The kernel of disruptive innovation is an insight that the mainstream market has ignored.
  9. Beware of investment advice from subject matter experts as it pertains to potentially disruptive startups. Test your biases against what can be proved by the market niche that the startup is first going to enter.

Further Reading

Blog Posts & Articles

  1. What “Disrupt” Really Means – Andy Rachleff
  2. The Four Stages of Disruption – Steven Sinofsky
  3. Marketing Myopia – Theodore Levitt, original 1960 HBR article
  4. Marketing Myopia – Theodore Levitt, 2004 HBR update
  5. How Disruption Happens – Greg Satell
  6. Good Disruption / Bad Disruption – Greg Satell
  7. Did RCA Have To Be Sold? – L.J. Davis
  8. What Clayton Christensen Got Wrong – Ben Thompson
  9. Clayton Christensen Becomes His Own Devil’s Advocate – Jean-Louis Gassée
  10. The Disruption Machine: What The Gospel of Innovation Gets Wrong – Jill Lepore
  11. Disruptive Business Strategy: What is Steve Jobs Really Up To? – Paul Paetz
  12. Clayton Christensen Responds to New Yorker Takedown of “Disruptive Innovation” – Drake Bennet
  13. How Useful Is The Theory of Disruptive Innovation? – Andrew A. King and Baljir Baatartogtokh, MIT Sloan Management Review Fall 2015 Issue
  14. What Is Disruptive Innovation? – Clayton Christensen et al, HBR December 2015 Issue
  15. Patterns of Disruption: Anticipating Disruptive Strategies of Market Entrants – John Hagel et al

White Papers

  1. Time To Market Cap Report
  2. Startup Genome Report Extra on Premature Scaling [PDF]
  3. Netflix: Disrupting Blockbuster [PDF]

Books

  1. The Innovator’s Dilemma
  2. The Innovator’s Solution
  3. The Innovator’s DNA
  4. Seeing What’s Next
  5. The Lean Entrepreneur
  6. What Customers Want
  7. The Creators Code
  8. The Entrepreneurial Venture
  9. Disruption By Design

References   [ + ]

1. ↩ 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.
2. ↩ 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.
3. ↩ Clayton M. Christensen, The Innovator’s Dilemma. 2006 Collins Business Essentials Edition.
4, 7. ↩ Brant Cooper and Patrick Vlaskovits, The Lean Entrepreneur. Wiley, 2013, pp. xx.
5. ↩ Clayton M. Christensen, The Innovator’s Dilemma. 2006 Collins Business Essentials Edition, pp. xviii.
6. ↩ Ibid.
8. ↩ Clayton M. Christensen, The Innovator’s Dilemma. 2006 Collins Business Essentials Edition, pp. 16.
9. ↩ Clayton M. Christensen and Michael E. Raynor, The Innovator’s Solution. 2003, Harvard Business School Publishing, pp. 45.
10. ↩ Clayton M. Christensen and Michael E. Raynor, The Innovator’s Solution. 2003, Harvard Business School Publishing, chapter 3.
11. ↩ Startups building products for the enterprise customer should be able to develop an analogous framework, assuming one does not already exist.
12. ↩ Marc Anrdeesen, Product/Market Fit, Jun 25, 2007. Accessed on Jul 18, 2015 at http://web.stanford.edu/class/ee204/ProductMarketFit.html
13. ↩ In their report they describe the stages of a startup’s life-cycle as Discovery, Validation, Efficiency, Scale, Sustenance, and Conversation. The report covers the first four.
14. ↩ This is a risk for early stage investors as well as startups.
15. ↩ Theodore Levitt’s seminal HBR article “Marketing Myopia” first introduced this concept in 1960. You should read the original article as well as this update from 2004.
16. ↩ It is worth noting that Clayton Christensen’s analysis and research focuses on business-to-business markets.
17. ↩ Marc Graser, Epic Fail: How Blockbuster Could Have Owned Netflix. Nov 12, 2013, accessed on Jul 18, 2015 at http://variety.com/2013/biz/news/epic-fail-how-blockbuster-could-have-owned-netflix-1200823443/
18. ↩ See statements like: “Move fast and break things.” or “Let chaos reign.”
19. ↩ Amar Bhidé,The Questions Every Entrepreneur Must Answer. From The Entrepreneurial Venture, readings selected by William A. Sahlman et al. 2nd edition, pp. 65 – 79.
20. ↩ I have discussed economic moats here: Revisiting What I Know About Network Effects & Startups and here: Revisiting What I Know About Switching Costs & Startups
21. ↩ Adapted from Top 10 Bad Tech Predictions, by Gordon Globe. Nov 4, 2012, accessed on Jul 19, 2015 at http://www.digitaltrends.com/features/top-10-bad-tech-predictions/5/
22. ↩ Mark Spoonauer, 10 Worst Tech Predictions of All Time. Aug 7, 2013. Accessed online on Jul 19, 2015 at http://blog.laptopmag.com/10-worst-tech-predictions-of-all-time