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

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

In this post I will discuss Michael Porter’s 3 Generic Competitive Strategies. My goal in these posts is to provide concrete yet easy to use frameworks that founders of early stage startups can quickly learn and adapt as they work on moving their organizations through the discovery process that takes them from being a startup to becoming a company.¹

To ensure we are on the same page, and thinking about the issues from the same starting point . . . first, some definitions. You can skip past the definitions if you have already seen them in one of my previous posts.

Definition #1: What is a Startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model.² 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 Porter³

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

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

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

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

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

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

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

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

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

Examples:

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

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

The image below, showing the startups that have been built by unbundling CraigsList shows another risk of the cost leadership strategy; namely that someone else can compete with some aspect of another startup’s business model by pursuing differentiation or focus as a strategic choice.⁴

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

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

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

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

Examples: Apple.

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

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

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

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

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

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

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

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

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

Here’s Paul in his own words:

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

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

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

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

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

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

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

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

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

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

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

1. My target audience is made up of  first-time startup founders who do not have any background in business, finance, economics, or strategy. ?
2. I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports. ?
3. Keith H. Hammond, Michael Porter’s Big Ideas. Accessed on Jun 20, 2015 at http://www.fastcompany.com/42485/michael-porters-big-ideas ?
4. It is not clear to me if the unbundling of CraigsList arose from conscious choices made by others observing the markets it served, or if this is a phenomenon that has only become obvious after the fact. ?