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Notes on Strategy; Where Does Disruption Come From?

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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

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.
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.
Clayton M. Christensen, The Innovator’s Dilemma. 2006 Collins Business Essentials Edition.
Brant Cooper and Patrick Vlaskovits, The Lean Entrepreneur. Wiley, 2013, pp. xx.
Clayton M. Christensen, The Innovator’s Dilemma. 2006 Collins Business Essentials Edition, pp. xviii.
Ibid.
Clayton M. Christensen, The Innovator’s Dilemma. 2006 Collins Business Essentials Edition, pp. 16.
Clayton M. Christensen and Michael E. Raynor, The Innovator’s Solution. 2003, Harvard Business School Publishing, pp. 45.
Clayton M. Christensen and Michael E. Raynor, The Innovator’s Solution. 2003, Harvard Business School Publishing, chapter 3.
Startups building products for the enterprise customer should be able to develop an analogous framework, assuming one does not already exist.
Marc Anrdeesen, Product/Market Fit, Jun 25, 2007. Accessed on Jul 18, 2015 at http://web.stanford.edu/class/ee204/ProductMarketFit.html
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.
This is a risk for early stage investors as well as startups.
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.
It is worth noting that Clayton Christensen’s analysis and research focuses on business-to-business markets.
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/
See statements like: “Move fast and break things.” or “Let chaos reign.”
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.
I have discussed economic moats here: Revisiting What I Know About Network Effects & Startups and here: Revisiting What I Know About Switching Costs & Startups
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/
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

Notes on Strategy; For Early Stage Technology Startups

by

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

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

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

The purpose of this blog post is to attempt to synthesize certain fundamental lessons on strategy that are relevant for anyone trying to build a business. 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. As part of the discussion, I will attempt to provide concrete yet easy to use frameworks that founders of early stage startups can use as they work on moving their organizations through the discovery process that takes them from being a startup to becoming a company. 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.

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.

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

Some additional observations about strategy;

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

Strategic Decision Making Tools for Early Stage Technology Startups

Porter’s 5 Forces: In a 5Michael E. Porter, The Five Competitive Forces That Shape Strategy. Accessed on Jun 21, 2015 at https://hbr.org/2008/01/the-five-competitive-forces-that-shape-strategy.">2008 update to his 1979 HBR Article: How Competitive Forces Shape Strategy, Michael E. Porter discusses the “5 Forces” that have a direct impact on strategy.

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

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

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

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

Threat of Substitutes: This has not happened recently, but it used to be that when I would ask a founder “Who is your competition?” the quick response would be “We do not have any competition!” I’d shake my head and think to myself, they must not understand the meaning of substitute. According to Michael Porter “A substitute performs the same or a similar function as an industry’s product by a different means.” For example, videoconferencing is a substitute for travel. The threat posed by substitutes can be camouflaged by the apparent difference between the way an early stage startup perceives its customer value proposition and the way its customers perceive that same value proposition in comparison to the substitute. One way to think of substitutes is to ask “How are customers fulfilling that need or solving that problem now?” Another way to think about substitutes is to ask the question “Where are customers spending less money because they have chosen to buy our product?” Industry profitability is constrained by a high threat of substitutes. Consider the threat posed to social-networking like Twitter and Facebook from the chat and messaging apps. Facebook has been more responsive to those threats, and has strengthened its strategic position through its acquisitions of Instagram, Oculus Rift and Whatsapp. The threat posed by substitutes is high if customers are indifferent to the price-performance trade-offs they have to make if they switch to the substitute. The threat is also high if switching costs to customers are minimal, or non-existent. To find examples of how the threat of substitutes functions, think of the threat that Facebook is posing to Google’s business model of selling ads tied to users’ search activity. Or the threat that the shift from desktop-centric to mobile-centric computing poses to all kinds of businesses that have been built from the desktop centric point of view. Or the current debates around the relationship between startups in the on-demand economy and their employees, and the implications for the startups that are currently on either either side of that debate. 6Annie Lowery, How One Woman Could Destroy Uber’s Business Model – and Take the Entire “on-Demand” Economy Down With It. Accessed on Jun 21, at http://nymag.com/daily/intelligencer/2015/04/meet-the-lawyer-fighting-ubers-business-model.html.

Rivalry Among Existing Competitors: Think Uber and Lyft, Microsoft’s Internet Explorer and Netscape Navigator, Apple iTunes and Spotify/Pandora etc, Apple’s iOS and Google’s Android, Apple’s iPhone and Samsung’s Galaxy, Apple’s Watch and the burgeoning number of wearables designed and produced by other competitors in that market. Evidence of intense rivalries among existing competitors is found in frequent price-cuts, ubiquitous sales and marketing campaigns, and relatively short product and service upgrade cycles. Combined with the threat of new entrants, rivalry among existing competitors leads to a land-grab by incumbents to access new markets where rivalry is less intense and potentially lock rivals in other markets out of the new markets. A land-grab could also be initiated in anticipation of intense rivalry developing in the future. The on-demand ride-sharing wars that are playing out around the world today provide a text-book example of this phenomenon. High rivalry among existing competitors constrains profitability along two dimensions; the intensity of the competition, as well as the basis on which that competition is taking place. Factors that contribute to a high intensity of rivalry are: Competitors roughly equal in size, slow growth, high exit barriers, high levels of commitment to the market and the industry, and poor signaling. One mistake rivals often make? They engage in mutually destructive price-cuts in succeeding rounds of attack and retaliation. Or, they might engage in other tactics that lead to an overall degradation of the customer experience or user experience for their mutual customers. Particularly destructive behavior is most liable to occur when the individual rivals’ products cannot be differentiated from one another by their target customers, the rivals are each faced with a cost structure characterized by high fixed costs and low marginal costs, it is difficult to make quick capacity adjustments in response to surges or declines in demand, and the product is perishable. 7Consider how the transient, perishable nature of “time” has influenced the behavior of ride-sharing rivals – a ride not delivered today can never be recouped. It is gone forever. Ideally, competition among rivals should aim to grow the profitability of the industry or market for all players within it, while raising barriers to entry.

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

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

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

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

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

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

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

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

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

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

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

In classical game theory, players move, bet, or strategize simultaneously. Both hidden information and chance elements are frequent features in this branch of game theory, which is also a branch of economics.” 8Game Theory. Accessed on Jun 21, 2015 at http://mathworld.wolfram.com/GameTheory.html

For a flavor of the wide application of game theory;

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

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

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

Following are some observations based on their paper:

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

The Goals Grid – A Tool for Clarifying Goals and Objectives: I discovered The Goals Grid in 2009 while working on two turnaround assignments, and feeling dissatisfied with the tools I had acquired in business school – it quickly became clear to me that those tools did not translate readily when I was in the trenches, working with people on the frontlines of fine-dining, and general aviation, who lacked the training in strategy and management that students in MBA programs in the United States receive. I needed something I could discuss with them, but that they could then implement without me. 9Fred Nickols updated it in 2010. Accessed on Jun 22, 2015 at http://www.nsac.org/Endowments/Docs/GoalsGrid.pdf

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

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

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

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

The analyses can be performed using the grid below.

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

Some observations about the goals grid;

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

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

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

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

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

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

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

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

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

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

Briefly: The DNFD Strategic Framework in Action

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

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

A strategic plan should cover:

  1. Product
    • What features of the startup’s product are critical for this stage of the startup’s life cycle?
      • For example, what features should the minimum viable product include? What should it exclude? Why? 11The minimum viable product is the least expensive product that allows the startup to test the most important hypothesis on which its business model depends.
    • How is the startup going to identify its customers? Why do those customers buy the product? Why do those potential who do not buy the product make that choice? What will cause them to change their mind?
    • What features does the product need to have if it is going to help the startup win its market?
    • What does the landscape of features look like for competitive or substitute products within the startup’s  market and Value Net, how should the product be positioned relative to that landscape? Why? What are the trade-offs resulting from those choices?
  2.  Finance
    • How will the startup increase revenues?
    • How will the startup reduce costs?
  3. Operations – see related discussion in: Why Tech Startups Can Gain Competitive Advantage from Operations
    • How will the startup get better at creating its products?
    • How will the startup get better at delivering its products to its customers?
    • How will the startup ensure that its operations infrastructure does not become obsolete?
    • How will the startup ensure that its operations become a source of sustainable competitive advantage and differentiate it from its competitors, while protecting and enhancing its current chosen position in its Value Net?
    • How will the startup ensure that its operations infrastructure do not lock it into a position that becomes competitively disadvantageous?
  4. Growth
    • How will the startup gain new customers?
    • How will the startup strengthen its bonds with its existing customers?
    • How will the startup win back customers it has lost?
    • How will the startup expand into new markets?
    • What adjacent markets should the startup consider entering? What risks will it face in doing so?
    • What new geographic markets should the startup consider entering? Why? Why no?
    • What does the startup need to do in terms of marketing, sales, advertising and public relations as those activities relate to the startup’s growth?
  5. People
    • What does the startup need to do in order to attract and retain the best people it can find to help it accomplish its stated goals and objectives?
    • How should the startup develop the people on its existing team?
    • How does the startup motivate its people, and empower them to accomplish things they previously did not know or believe they could accomplish?

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

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

Closing Notes

  1. This blog post has covered a lot of ground, not all of which is applicable to every startup at this moment. However, even a startup that is made up of two engineers developing the early versions of a software product needs to make choices regarding what they should build. That startup needs a strategy.
  2. Strategy should not become stagnant once it has been developed, it should evolve and adapt to the changing circumstances that a startup finds itself in.
  3. In thinking of a how startup develops a competitive advantage I am thinking of of how it combines the resources that it controls which help it search for a repeatable, scalable, and profitable business model. These resources might be tangible or intangible.
  4. A related issue is how the startup influences its external environment and the factors that influence competition such that those factors do not cause it harm.
  5. A startup has a competitive advantage when it is implementing a strategy and a business model that cannot simultaneously be implemented by its current or potential competitors. It has a sustainable competitive advantage when its strategy and business model cannot simultaneously be implemented by current or potential competitors, and when those competitors cannot duplicate the benefits of that strategy and business model. 12Jay Barney, Firm Resources and Sustained Competitive Advantage. 1991, Journal of Management, Vol. 17, No. 1. Accessed online on Jun 23, 2015 at http://www3.uma.pt/filipejmsousa/ge/Barney,%201991.pdf
  6. The startup’s culture is an important source of competitive advantage, and ought to work in concert with its strategy. For example, employees of Facebook should “Move fast, and break things.” within the tenets of its strategy. When Andy Grove “Let chaos reign.” at Intel he did so within the parameters of Intel’s strategy. 13See for example; Jay B. Barney, Organizational Culture: Can It Be a Source of Sustained Competitive Advantage? The Academy of Management Review, 07/1986

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

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

References

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.
My target audience is made up of  first-time startup founders who do not have any background in business, finance, economics, or strategy.
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.
Keith H. Hammond, Michael Porter’s Big Ideas. Accessed on Jun 20, 2015 at http://www.fastcompany.com/42485/michael-porters-big-ideas
Michael E. Porter, The Five Competitive Forces That Shape Strategy. Accessed on Jun 21, 2015 at https://hbr.org/2008/01/the-five-competitive-forces-that-shape-strategy.
Annie Lowery, How One Woman Could Destroy Uber’s Business Model – and Take the Entire “on-Demand” Economy Down With It. Accessed on Jun 21, at http://nymag.com/daily/intelligencer/2015/04/meet-the-lawyer-fighting-ubers-business-model.html.
Consider how the transient, perishable nature of “time” has influenced the behavior of ride-sharing rivals – a ride not delivered today can never be recouped. It is gone forever.
Game Theory. Accessed on Jun 21, 2015 at http://mathworld.wolfram.com/GameTheory.html
Fred Nickols updated it in 2010. Accessed on Jun 22, 2015 at http://www.nsac.org/Endowments/Docs/GoalsGrid.pdf
Obviously more rigorous analysis would have been performed at Apple, but one can see how it makes sense to study this course of action very closely.
The minimum viable product is the least expensive product that allows the startup to test the most important hypothesis on which its business model depends.
Jay Barney, Firm Resources and Sustained Competitive Advantage. 1991, Journal of Management, Vol. 17, No. 1. Accessed online on Jun 23, 2015 at http://www3.uma.pt/filipejmsousa/ge/Barney,%201991.pdf
See for example; Jay B. Barney, Organizational Culture: Can It Be a Source of Sustained Competitive Advantage? The Academy of Management Review, 07/1986

What Is Your Business Model?

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Invariably, when I am meeting the founder of a startup for the first time to discuss the possibility that KEC Ventures might invest in their startup I ask this question; “What is your business Model?” 1This post is an updated version of 4 separate posts authored by me, and first published at Tekedia between Sept. 18th, 2011 and Oct. 30th, 2011. Any similarities between this article and those posts is deliberate.

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

To ensure we are on the same page about what a startup is, I will begin with a definition; A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model. 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. As an investor, I hope that each early stage startup in which I have made an investment matures into a company.

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

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

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

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

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

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

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

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

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

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

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

Why?

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

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

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

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

I will end this discussion with some related observations;

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

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

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

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

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

References

This post is an updated version of 4 separate posts authored by me, and first published at Tekedia between Sept. 18th, 2011 and Oct. 30th, 2011. Any similarities between this article and those posts is deliberate.
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.

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

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.
You can find Alibaba’s SEC Form F-1 here. Accessed online; Sept. 12, 2014.
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.
Heather Brilliant, Elizabeth Collins, et al. Why Moats Matter: The Morningstar Approach to Stock Investing. Wiley. Hoboken, NJ. 2014; p. 1
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.
Network effect is often colloquially referred to as network externality. However, the two are not precisely the same.
Ibid; p. 27
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.
Ibid.
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.
This is based on the work of Prof. Arun Sundararajan. Accessed at http://oz.stern.nyu.edu/io/network.html on Sept. 12, 2014.
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
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.
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.
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

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.
Fred Nickols, Strategy: Definitions & Meanings, 5/24/2012. Accessed online on Aug. 10th, 2014
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.
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.
I am assuming here that initially the startup relies on outside service providers for technology that is not core to its business model.
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.
Jonathan Helliger; Building Efficient Data Centers with The Open Compute Project, Apr. 7th, 2011. Accessed online, Aug. 15th, 2014.
Jon Brodkin; Who Needs HP and Dell. Facebook Now Designs All Its Own Servers, Feb. 14, 2013. Accessed online, Aug. 16, 2014.
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.
Gary Rivlin; Wallflower at The Web Party, Oct. 15th, 2006. Accessed online, Aug. 16th, 2014.
Abel Avram; Debate: What’s The Reason for MySpace’s Decline?, Mar. 30, 2011. Accessed online, Aug. 16th, 2014.