Innovation Footprints

What if . . . ?

Strategy

Revisiting What I Know About Network Effects & Startups

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The recently announced IPO of Alibaba got me thinking last week about network effects 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. – what they are, how they develop and evolve, and how network effects can help or hurt a startup. 2You can find Alibaba’s SEC Form F-1 here. Accessed online; Sept. 12, 2014.

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

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

Definition #1: What is a startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model. 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.

Definition #2: What is an economic moat? An economic moat is a structural barrier that protects a company from competition. 4Heather Brilliant, Elizabeth Collins, et al. Why Moats Matter: The Morningstar Approach to Stock Investing. Wiley. Hoboken, NJ. 2014; p. 1 In my case, when I am studying a startup, I am interested in the economic moats that will enable the startup to mature into a great business, and hence a great company – one that can keep competition at bay while earning great returns for its investors. Morningstar identifies 5 moat sources; Intangibles, Cost Advantage, Switching Costs, Network Effect, and Efficient Scale.

Definition #3: What is a network? Any group or system of interconnected people or things. Think; my nuclear family is a network to which I belong. My extended family is a larger network which includes my nuclear family, as well as the nuclear families of each of my relatives. A small business exists in a network that is comprised of its customers, its suppliers, its competitors, its regulators, and so on and so forth. A large network might be formed by a collection of smaller networks. 5I know this seems obvious. However, I was having a discussion via email with Kate Bradley Chernis while writing this. She and her co-founders are building a product to empower SMB’s manage their marketing campaigns. When I told her the topic of this blog post she stated that she finds that many SMB owners have no understanding of the networks that they belong to, or how they can use their networks to enhance their business. I added this definition after that exchange.

Definition #4: What is a Network Effect? A network effect occurs when the value of a good or service increases for both new and existing users as more customers use that good or service. 6Network effect is often colloquially referred to as network externality. However, the two are not precisely the same. The network effect is a virtuous cycle that allows strong companies to become even stronger. 7Ibid; p. 27 Network effects are also known as direct-benefit effects. I think direct-benefit effects makes it easier to remember why network effects can be such a powerful economic moat.

How do network effects develop? Direct-benefit effects develop and become stronger in settings where some form of interaction, or compatibility with others is important. 8David Easley and Jon Kleinberg. Networks, Crowds, and Markets: Reasoning About a Highly Connected World. Cambridge University Press, June 10, 2010 draft version. P. 509. Accessed online on Sept. 12, 2014. In other words, the number of other people using the technology has a direct impact on how valuable that technology is to each individual user. Direct-benefit effects contribute to the strengthening of an economic moat only in so far as they directly contribute to increasing positive externalities for the members of the network. What is an externality? It is “any situation in which the welfare of an individual is affected by the actions of other individuals, without a mutually agreed-upon compensation.” 9Ibid. One can have positive or negative externalities. A positive externality occurs when individual and aggregate welfare increases with the addition of more users to the network. A negative externality occurs when welfare decreases with the addition of more users. 10As an example, think of a website or app that starts to crash and become inaccessible due to capacity constraints as the number of users increases dramatically. Network effects evolve positively for a startup if the members or users of the network derive both inherent value and network value from their use of the product. Inherent value is value that an individual user derives because of that individual user’s consumption of the product or service. For example, even if I were in a network compromising only me, I would derive inherent value from owning one copy of MS Office running on Windows because I could now more easily do word-processing using MS Word or analyze quantitative data using MS Excel. I derive network value from MS Office and Windows because if other people buy and use those products, it becomes easier for me to share my work with them and for them to share their work with me. I derive network value from being able to collaborate with every other person who also uses MS Office and Windows.

Types of Direct-benefit Effects: To fully parse through how a startup I am studying might build an economic moat based on network effects I need to be able to understand the subtle nuances that differentiate one type of network effect from another. 11This is based on the work of Prof. Arun Sundararajan. Accessed at http://oz.stern.nyu.edu/io/network.html on Sept. 12, 2014.

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

This diagram by Ray Stern conveys the power of positive network effects, and the corollary – negative network effects can help erode the competitive position an incumbent occupies. 12Eric Jorgenson, The Power of Network Effects: Why They Make Such Valuable Companies, and How To Harness Them. Accessed on Jun 27, 2015 at https://medium.com/evergreen-business-weekly/the-power-of-network-effects-why-they-make-such-valuable-companies-and-how-to-harness-them-5d3fbc3659f8

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

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

  1. Lock-in or switching costs occur when a member of one network cannot switch from that network to another without suffering substantial costs. The switching costs could be monetary and non-monetary. Often, the non-monetary switching costs far outweigh the monetary costs. Non-monetary costs might include the loss of massive amounts of information and data, business process disruptions, and so on and so forth. Antitrust regulators do not like to see situations in which such costs bar new competitors from entering a market and create a monopoly for an incumbent – IBM, Microsoft and Apple have all faced antitrust action. Switching costs can also exist in physical goods industries, for example razors and blades, and also printers and printer-cartridges. Switching costs are not an issue as long as users perceive that they derive more value from being within the network than the inconvenience they suffer as a result of lock-in or switching costs.
  2. Network congestion occurs when the experience of each member of the network deteriorates as the network’s membership grows. In other words the network becomes less efficient from the users’ perspective. As a result of this each member of the network derives decreasing inherent and network value from the network. Think; A website, web or mobile app that is consistently unavailable because too many people are trying to access it simultaneously.
  3. Conflicts of interest occur when a network operator behaves in ways that limit or restrict the ability of network members to freely form sub-networks. According to David Reed: 13David Reed. That Sneaky Exponential – Beyond Metcalfe’s Law to the Power of Community Building. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.

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

That observation might be used to explain the demise of Friendster and Myspace in the face of competition from Facebook. It has also been used to predict the success of Ebay during a time when Yahoo was the most dominant web-portal. 14David Reed. Weapon of Math Destruction: A Simple Formula Explains Why The Internet is Wreaking Havoc on Business Models. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.

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

What strategies should a startup that’s competing in a market in which network effects matter employ in order to win? There are a number of strategies that might be employed 15Based on Prof. John M. Gallaugher’s Understanding Network Effects. Accessed at http://www.gallaugher.com/Network%20Effects%20Chapter.pdf on Sept. 12, 2014. independently or in combination with one another by competitors seeking to compete effectively against a rival, or by market leaders seeking to maintain that position.

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

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

Further Reading

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

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. ↩ You can find Alibaba’s SEC Form F-1 here. Accessed online; Sept. 12, 2014.
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. ↩ Heather Brilliant, Elizabeth Collins, et al. Why Moats Matter: The Morningstar Approach to Stock Investing. Wiley. Hoboken, NJ. 2014; p. 1
5. ↩ I know this seems obvious. However, I was having a discussion via email with Kate Bradley Chernis while writing this. She and her co-founders are building a product to empower SMB’s manage their marketing campaigns. When I told her the topic of this blog post she stated that she finds that many SMB owners have no understanding of the networks that they belong to, or how they can use their networks to enhance their business. I added this definition after that exchange.
6. ↩ Network effect is often colloquially referred to as network externality. However, the two are not precisely the same.
7. ↩ Ibid; p. 27
8. ↩ David Easley and Jon Kleinberg. Networks, Crowds, and Markets: Reasoning About a Highly Connected World. Cambridge University Press, June 10, 2010 draft version. P. 509. Accessed online on Sept. 12, 2014.
9. ↩ Ibid.
10. ↩ As an example, think of a website or app that starts to crash and become inaccessible due to capacity constraints as the number of users increases dramatically.
11. ↩ This is based on the work of Prof. Arun Sundararajan. Accessed at http://oz.stern.nyu.edu/io/network.html on Sept. 12, 2014.
12. ↩ Eric Jorgenson, The Power of Network Effects: Why They Make Such Valuable Companies, and How To Harness Them. Accessed on Jun 27, 2015 at https://medium.com/evergreen-business-weekly/the-power-of-network-effects-why-they-make-such-valuable-companies-and-how-to-harness-them-5d3fbc3659f8
13. ↩ David Reed. That Sneaky Exponential – Beyond Metcalfe’s Law to the Power of Community Building. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.
14. ↩ David Reed. Weapon of Math Destruction: A Simple Formula Explains Why The Internet is Wreaking Havoc on Business Models. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.
15. ↩ Based on Prof. John M. Gallaugher’s Understanding Network Effects. Accessed at http://www.gallaugher.com/Network%20Effects%20Chapter.pdf on Sept. 12, 2014.

Why Tech Startups Can Gain Competitive Advantage from Operations

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Hunter Walk’s blog post serves as the inspiration for this one. He points out that operations is key for startups operating in the on-demand economy. I want to pick up where he left off, and attempt to connect the dots. This post will answer the question “Why is operations important for tech startups?”

All else equal, and I know that is rarely true, operations marks the difference between an unsustainable competitive advantage and a sustainable competitive advantage. 1Any errors in appropriately citing my sources is 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. In order to understand the role of operations in determining the success or failure of a startup we must start with some definitions.

Definition #1: What is a startup? When I think of a startup I prefer to paraphrase the definition provided by Steve Blank and Bob Dorf in their book The Startup Owner’s Manual; 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. The defining characteristic of a startup is that of experimentation – to have a chance at survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model.

Definition #2: What is a company? A company is what a startup becomes once its search for a repeatable, scalable and profitable business model is complete. The inflection point between startup and company is characterized by the creation of the kind of infrastructure that we typically associate with large companies. For example, it becomes essential to have an HR organization where one was previously unnecessary. It become necessary to have a marketing and sales organization where that would have been hard to justify during the startup phase. Finally, it might also become necessary to build a sophisticated finance and accounting organization where previously there was not much to monitor or report, and someone with an unsophisticated understanding of accounting was adequate for the startup’s requirements, or the role might have been filled by someone working on a part-time basis. Basically, a startup becomes a company when its continued existence depends nearly equally on having the right organizational structures in place to ensure that the business is well managed as it does on having the right product or service to sell.

Definition #3: What is strategy? According to Fred Nickols, strategy is the accumulation of perspectives, positions, plans, patterns, tactics, choices, policies, concrete actions, decisions, thoughts, ideas, insights, experiences, goals, memories, perceptions and expectations that enable a company bridge the gap between the factors of production that the company controls and the output that it wishes to create and deliver to its customers. 2Fred Nickols, Strategy: Definitions & Meanings, 5/24/2012. Accessed online on Aug. 10th, 2014 More succinctly, strategy is the qualitative essence of how a company does what it says it will do for its current and prospective customers. At a high level, strategy gives broad, abstract and general answers to the question; In what direction should we travel?

Definition#4: What is marketing? Marketing is the process by which the producer of a product or service creates demand for its output. It involves various modes of communication aimed at helping consumers interpret the value that the producer hopes to deliver to each consumer that buys the product or service. Marketing includes sales, advertising, public relations, and any other practice or activity whose ultimate goal is to build awareness in order to directly or indirectly facilitate sales. Marketing is what makes operations necessary. Without marketing, there would be no demand to satisfy.

Definition #5: What is operations? Operations is the set of activities in a startup or a company that takes inputs and turns them into the final product or service through which the value proposition is delivered to the market. Operations is focused on the process of transformation – transforming tangible and intangible inputs into something that the market is willing to pay for, at a cost level that enables the producer to earn a profit consistent with the accompanying strategy. Operations seeks to answer the question; How do we implement strategy?

In a fine dining restaurant operations is the process of transforming the knowledge and experience of every member of the restaurant’s staff into a consistently enjoyable and memorable dining experience. This process has to deliver results in tangible and intangible ways. Dishes have to be executed to a high degree of excellence, and the atmosphere, decor and service have to evoke emotions of pleasure, satisfaction and joy that meet or exceed diners’ expectations and cause them to dine at the restaurant as frequently as the restaurant’s operators wish. Each time a diner has a meal at the restaurant it must be memorable, in a good way.

In a general aviation company operations is the process that begins with finding out the traveler’s needs, matching those needs with a specific aircraft, and then safely transporting the traveler from the point of departure to the desired destination within a period of time acceptable to the traveler. Each time a traveler is transported from one place to another, that passenger must arrive safely. Also, the passenger should have enjoyed the trip enough to choose that charter company as frequently as its operators wish.

In a software startup operations is the process that begins with designing and creating the software, delivering it to users, and then ensuring that it is available whenever users or customers wish to use it. The experience of using the software has to be such that it is the first choice that users think of when they consider using software to facilitate that specific set of activities.

Once a strategic choice has been made, the process of transforming inputs into outputs is accomplished through capabilities within the organization. The diagram below shows the connection.

What is the connection between strategy, capabilities, and operations?
What is the connection between strategy, capabilities, and operations?

Strategy is concerned with answering the question; Where should we go? Operations is concerned with answering the question; How will we get there? The question around capabilities is; What do we have to be good at to get there? While all this is happening, processes that determine how a startup does its work are being developed. Processes matter because eventually a set of processes will lead to the development of a certain set of capabilities. As a result, it is essential to think about which capabilities are most critical to the startup’s survival before adopting one process over another. Eventually, as the startup matures it builds up a legacy of past choices that may limit or enhance the strategic options it can pursue in the future. Faced with a period of dramatic change in consumer or customer preferences, market structure, technological innovation, or regulations, flexibility is what separates winners from losers. The key attributes of a successful operations organization are:

    1. It must work hand in hand with strategy, marketing, finance, human resources, and every other area within the company.
    2. It must implement procedures and processes that lead to the right blend of capabilities within the company – for exploiting current opportunities, or resolving future threats.
    3. It must make infrastructure choices that protect the startup’s strategic flexibility to deal with current and unforeseen developments in the market.

Here are a few examples of how strategic and operational flexibility made the difference between startups that otherwise were neck-and-neck at some point in time – Friendster, Myspace, and Facebook.

What do you do when your users adopt your product for uses you did not intend or foresee? Facebook and Friendster were founded roughly around the same time. Friendster was founded in 2002, Facebook in 2004. Friendster reportedly grew to 3 million users within 3 months after it became generally available to the public in the United States. It soon became obvious that users were using Friendster for purposes its creators did not intend. For example they started creating various types of profile pages that were not tied to a real person – these became known as Fakesters. Friendster’s founders decided to prevent users from creating such profiles. Facebook experienced a similar behavior from its users. However, it took a different approach. It observed such behavior, learned from it and eventually enabled the behavior it observed. For example, users’ habit of creating profile pages for parties on college campuses eventually led to the development of the events feature on Facebook. In effect;

Facebook continuously watched how users used, and of course misused, their products by gathering usage data. These data guided their product development roadmap and helped ensure they were building features or making changes to their services that would encourage users to recommend the service to others (fan-out) and continue using it themselves (retention). 3Fisher, Michael; Abbott, Martin; Lyytinen, Kalle (2013-11-01). The Power of Customer Misbehavior: Drive Growth and Innovation by Learning from Your Customers (p. 103). Palgrave Macmillan. Kindle Edition.

While we can not say precisely what motivations drove the opposite reactions Friendster and Facebook had to observed user behavior, we can guess that a need for operational simplicity motivated Friendster’s response. Locking down and restricting the number of ways in which its users could engage with its product made operations easier to manage. On the other hand, Facebook’s approach seems to reflect a philosophy that is more outward looking and user-centric. In other words, operations would adapt to ensure that Facebook’s product evolved to reflect the desires and wants expressed by its users in their day to day interaction with the product. In the process, Facebook developed capabilities that strengthened its strategy and so on and so forth. 4Twitter and Zynga are two more examples of cases in which product features, and operations have been adapted and modified on the basis of observed user behavior. Pinterest just updated its web and mobile apps with a messaging feature. From the outside it appears this update is a response to the observed behavior of its users.

What do you do when your technology infrastructure appears to be unable to keep up with growth, and the accompanying demands? 5I am assuming here that initially the startup relies on outside service providers for technology that is not core to its business model. Sometimes things change in a really big way as a startup makes the transition from searching for a business model to scaling. Maybe its marketing and its product are so successful that existing infrastructure proves to be inadequate to meet the demands that the startup’s customers and users place on it. The startups that thrive and go on to become transformative companies adapt operations to deal with this reality. To do so they call on new capabilities that they have developed over the course of time. Google 6Jeff Dean(2008 Google I/O Session Videos and Slides); Underneath The Covers at Google: Current Systems and Future Directions. Accessed online, Aug. 15th 2014. and Facebook 7Jonathan Helliger; Building Efficient Data Centers with The Open Compute Project, Apr. 7th, 2011. Accessed online, Aug. 15th, 2014. provide examples. They both realized that the off-the-shelf server hardware that they were relying on to run their operations were not necessarily designed to handle the massive amounts of data that their unique business models require them to each deliver to their users and customers daily. As a result they have modified their operations so that they now develop, design and build their own server infrastructure. 8Jon Brodkin; Who Needs HP and Dell. Facebook Now Designs All Its Own Servers, Feb. 14, 2013. Accessed online, Aug. 16, 2014. There are many benefits to be derived from this. For example; First, this practice saves them money by optimizing energy usage. Second, it ensures that their business runs smoothly and efficiently so that users and customers have an experience that is commensurate with the value propositions that Facebook and Google have made and the experience users and customers have come to expect. Third, this makes it more difficult for new competitors to compete directly with Facebook or Google in the core areas of their business. As a testament to the soundness of this approach, many other companies that rely on technology as a cornerstone of their business operations are moving towards the practice of building their own custom server and networking hardware and software. 9Netflix, Amazon and RackSpace are each reported to have adapted their operations to rely on custom designed server hardware. I assume there are others we do not yet know about. At one point SingTel, the huge Asian telecommunications company was thinking of building its own CDN instead of relying on providers like Akamai.

Contrast the fate of Facebook with that of Myspace and Friendster. Remember that Friendster, Myspace and Facebook were founded in 2002, 2003, and 2004 respectively. At one point Myspace was the most visited social networking site in the world. It briefly overtook Google as the most visited website in the world. So What happened to Friendster and Myspace? I am certain there is more than one reason for their failure. However, reports in the press suggest that their inability to adapt the technology that was core to running their business played an important role in their loss of market leadership to Facebook, and their subsequent failure – they continued to rely on server hardware and software from original equipment manufacturers who build off-the shelf servers. Friendster reportedly slowed down as traffic to its website grew. 10Gary Rivlin; Wallflower at The Web Party, Oct. 15th, 2006. Accessed online, Aug. 16th, 2014. Similar observations are made about Myspace. 11Abel Avram; Debate: What’s The Reason for MySpace’s Decline?, Mar. 30, 2011. Accessed online, Aug. 16th, 2014. While we do not know the full details, we can deduce that operations at Friendster and Myspace did not mature to the the same extent that operations at Facebook had matured.

As these examples suggest, operations is critical to the survival of any entity that intends to grow to any substantial size by satisfying demand from a large number of customers or users. To succeed technology startups cannot make the mistake of treating operations like an unwanted orphan stepchild. Rather, operations must have a seat at the table, and it must participate in a healthy exchange of ideas, information and opinions with strategy, marketing, finance and accounting, and HR about how each of those functions can work, individually and in concert, to accomplish the goal that the startup wishes to set for itself. Tech startups can ill afford to have operations start from the bottom.

 

 

References   [ + ]

1. ↩ Any errors in appropriately citing my sources is 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. ↩ Fred Nickols, Strategy: Definitions & Meanings, 5/24/2012. Accessed online on Aug. 10th, 2014
3. ↩ Fisher, Michael; Abbott, Martin; Lyytinen, Kalle (2013-11-01). The Power of Customer Misbehavior: Drive Growth and Innovation by Learning from Your Customers (p. 103). Palgrave Macmillan. Kindle Edition.
4. ↩ Twitter and Zynga are two more examples of cases in which product features, and operations have been adapted and modified on the basis of observed user behavior. Pinterest just updated its web and mobile apps with a messaging feature. From the outside it appears this update is a response to the observed behavior of its users.
5. ↩ I am assuming here that initially the startup relies on outside service providers for technology that is not core to its business model.
6. ↩ Jeff Dean(2008 Google I/O Session Videos and Slides); Underneath The Covers at Google: Current Systems and Future Directions. Accessed online, Aug. 15th 2014.
7. ↩ Jonathan Helliger; Building Efficient Data Centers with The Open Compute Project, Apr. 7th, 2011. Accessed online, Aug. 15th, 2014.
8. ↩ Jon Brodkin; Who Needs HP and Dell. Facebook Now Designs All Its Own Servers, Feb. 14, 2013. Accessed online, Aug. 16, 2014.
9. ↩ Netflix, Amazon and RackSpace are each reported to have adapted their operations to rely on custom designed server hardware. I assume there are others we do not yet know about. At one point SingTel, the huge Asian telecommunications company was thinking of building its own CDN instead of relying on providers like Akamai.
10. ↩ Gary Rivlin; Wallflower at The Web Party, Oct. 15th, 2006. Accessed online, Aug. 16th, 2014.
11. ↩ Abel Avram; Debate: What’s The Reason for MySpace’s Decline?, Mar. 30, 2011. Accessed online, Aug. 16th, 2014.