Strategy Essay #1: The two paths of a venture - Product Market Fit and Power
Around twice a month, I’ll be publishing shorter-form pieces on Strategy I have personally used for my own journey that I can churn out in a single-sitting that are critical for operators and investors alike to think through – designed for more entrepreneurial crowds in the venture ecosystem. I define Strategy as the “the study of the fundamental determinants of potential business value, and the path to sustaining that value.”
Though Strategy is often seen as erudite and overly intellectual (“startups are all about execution”), being able to think through the lens of Strategy is a skill-set important to every entrepreneur: to discuss nuanced pathways with investors and leaders, as an amplifier of mission for employees, and to develop deep clarity on what it takes to build a sustained business. Startup life is deeply challenging, emotional, and fast-paced – and it’s important to not be caught off-guard for situations that may arise or to be ill-prepared to tackle the future phases of the business. This is where Strategy comes in.
Now, most entrepreneurs are familiar with the term “product-market-fit” (or PMF). Absolutely, being able to nail PMF itself is essential for the business to even exist. We won’t touch upon how to get to PMF too much here as there are already many resources existing, but notice that the term product-market fit itself is focused on the value that is created when a product and a market connect (often due to innovations in technology, significant changes in consumer and/or institutional behavior, regulatory openings). Not business, but product.
As most who have done M&A or valuation work know – the bulk of business value comes in the out years. You won’t yield much from a few good years of positive market share, which then tapers off or disappears altogether. As Hamilton Helmer states in his books Seven Powers: “If a company were growing at 10% per year, the next three years would account for only about 15% of its eventual value.”
Thus, as important as PMF is, it is insufficient to build a business from. In fact, first-movers that find product-market fit are oftentimes attacked by players, often more capitalized, in the market who now have an opening and proof-points to move in to attack (e.g. Board approves of a budget to move into a particular market as they see an entrant succeeding). This is particularly accentuated in regions like Indonesia, where pure technology businesses are rarer and thus patents are less of a viable option to explore as protection.
Therefore, while finding PMF is an important first-leg of a business to undergo, a business must be prepared from day one to the second-leg of business value creation: what Hamilton Helmer coins as the “path to Power”. Power is defined as the set of conditions creating the potential for persistent differential returns. The key here is that persistent differential returns requires a business to sustain its market value over time: even in the face of competitors and changing market conditions. Power needs to elicit both an important Benefits for those who wield it, and additionally also Barriers for competitors to take away share.
Many startups that do not think through the Power framework end up ill-prepared when competitors come in and challenge their position. Imagine being in the midst of the chaos that is entrepreneurial life and having to struggle through finding a path to Power. One can be more calm if the paths to Power have been considered, and one’s business has a pathway to claim this Power. I’ll go as far as to say that if one does not have this path to Power thought through, you shouldn’t even raise your first fundraising round.
Now, how does one build Power? According to Hamilton Helmer, there are Seven Powers that exist. Many top companies have built Power in at least one, and many times more. If a business does not have at least one of these, they are doomed to eventually fail. The Seven Powers are as follows:
1. Network effects: One can develop Power in this if the value that users experience out of using the product increase proportionally to the number of users in the network. There could be multiple such networks that exist concurrently in the system (that each stack differential value to each other. For instance, LinkedIn is an example of a business that benefits from two-sided network effects. The more people there are in the ecosystem, the more headhunters will pay for value and therefore the more people will value LinkedIn as a platform to find jobs. Visa and Mastercard are examples of a five-sided network effects business (hence why they are so difficult to displace), where the network consists of the merchant, the issuing bank, the acquiring bank, the acquirer processor, the cardholder, and the issuing bank. The Benefit of the power of network effects is that they are able to charge higher prices due to the increased value that they bring, and the Barrier is that new entrants are prohibited from entering as gaining share would be uneconomical similar to Scale Economies. Businesses with this Power tend to be winner-take-all.
2. Counter-positioning: One can develop Power in this if in incumbents are disincentivized from entering into a similar business as it would cannibalize their existing business. This is also where existing inertia and agency issues come in as executives in large, incumbent businesses are not normally incentivized by long-term business results (e.g. if their existing business would hurt as a result of entering a new market, their Board and shareholders would penalize them – even if they do it for the right reasons). A great example of this is Vanguard, which entered into the market with a hands-off, passively managed ETF product. This was against the norm of actively managed funds like Fidelity that charged high margins for wealth management. In order for Fidelity to enter this space, they would have to give up their high margin product to pursue the lower-margin passive management product. From a logical and incentive-based perspective, this probably did not make sense for them to pursue.
3. Switching costs: One can develop Power in this, if switching from the product itself exacts meaningful consequences for the user. This enacts a Barrier for those entering into the space, as they would have to either create much higher value, or charge much lower prices just as an entry-point into the market itself. An example of this is hotel points or airline miles. To break through to existing customers from other players – a few airlines, if given proof, actually give those from other airlines who have accumulated points the same points on their system. Obviously this can get expensive (but maybe worth it). Technology-based switching costs are also very powerful, as engineering effort is very expensive. That’s why players like SAP or API-based providers (like those doing KYC) focus a lot of effort on business development. Once you crack the sales cycle, it’s very unlikely for players to switch out from you unless you really disappoint them – even if they threaten you. The more high-touch this is, and the more touch-points of trust involved (mostly for B2B businesses) the higher the switching cost.
4. Cornered resource: One can develop Power in this if there is something unique the business owns that no one else has a right to (unless transferred or bought). This cornered resource can be a person (through rare, and most people should not have an ego enough to think that they are the cornered resource), a right to a resource (e.g. raw materials), or patents. Many Indonesian conglomerates today have cornered resources in terms of material supply. For entrepreneurs starting out in Indonesia, this is most likely a cornered resource in technology. Engineering talent is still scarce here, so if one can crack in a meaningfully differentiated and extremely difficult technology product with a large market – the path to Power is quite clear.
5. Scale economies: One can develop Power in this if the unit costs of running the business significantly decrease as volume increase. The Benefit of the power of scale economies are reduced costs, and the Barrier is that competitors are impeded from share gain as their economics will be stripped away if they were to even try to “attack” (the economics would not make sense for them, for example, if they were to do price cuts as the one with Power can always cut them right back into oblivion). An example of scale economies is Amazon, as their distribution network allows them the benefit of an optimized supply chain hence allowing them to charge lower prices. Scale also enables one to negotiate better with suppliers.
6. Branding: One can develop Power in branding as an outcome of continued and differentiated customer love over time. It’s harder than one would think to build Branding Power, as it oftentimes does not just involve a product but even a personality to come into tie things together. One should not assume that one will have Branding Power, but it’s an important one to aspire to build up to. Luxury brands like Tiffany’s or LVMH are great examples of this – where they can charge multiples higher than competitors due to their perceived value. This is especially useful for products where customers do not want to risk uncertainty (e.g. luxury gifts like watches, diamonds, handbags, cars).
7: Process power: One can develop Power in process over a long-term of sustained culture. It’s nearly impossible to replicate Process Power even if an incumbent were to observe and understand from theory all parts that make another’s work. Businesses with this Power (Toyota, Danaher) oftentimes get there through long-term periods of bottoms-up experimentation, iteration, and rigor. As most people who run organizations know, managing people to drive processes is not easy. And to gain process power takes significant effort over a long period of time to even be able to imitate.
For entrepreneurs, the path to Power oftentimes rests upon building a foundation within the first four (network effects, counter-positioning, switching costs, cornered resource). The latter three (scale economies, branding, and process power) require time. It’s impossible for example to even anticipate when Branding Power will come into the picture as it is all about differential and consistent perceptions over a long period of time.
It is critical to evaluate one’s business across these seven dimensions, and plot the path to Power in them. To reiterate: product-market fit is NOT enough. It is important, but a business cannot exist without establishing Power. For further exposure to this in practice, I highly recommend people to listen to podcasts by Acquired (available on Spotify and Apple), where they do long-form historical and at-state analysis of some of the strongest, most enduring businesses in the world: Visa, CostCo, Nvidia, Pinduoduo, LVMH, and many others – and plot their “Power” out at the end of every episode. If you’re building a business, and are looking for help to do a Power analysis and brainstorm – feel free to reach out to me on LinkedIn at https://www.linkedin.com/in/nathangunawan/.