LinkedIn and my office wall both suggest that I possess an MBA. While I didn’t attend Harvard, one of the prestigious business schools like Booth, or Wharton – I did sit in my UT classroom and listen to academics instruct on business. I wasn’t as academically jaded as I am now, I had started my first “side hustle” business four years earlier and started my first “quit my job and bet the farm” business during my sophomore year.
This isn’t a post about business school, or my thoughts on majoring in entrepreneurship, but a reflection on one of the most important things I learned. In hindsight, I might have gotten an A in the course, but like most things, I didn’t learn it without a few bruises to my ego and damage to my net worth.
What is this coveted nugget of entrepreneurial gold? What did Michael Porter, an American academic known for his theories on economics and business strategy, chisel on top of Mount Cambridge for MBA students across the globe?
“Five Competitive Forces that Shape Strategy” a.k.a. Porter’s Five Forces.
Porter’s writings are known for addressing competition between players in mature industries, and how these forces impact the ability to earn a return on investment. In entrepreneur-land, it is quite a bit simpler- which of these competitive forces can immediately ruin your business? I can’t think of a successful business that didn’t face these same challenges when they were starting off. It’s not about creating a business that is “Porter Proof”, but rather being aware of what your businesses weaknesses are and planning ahead to mitigate them.
Google, Wikipedia, and the actual Harvard Business School article will do a better job describing the actual content than me, so I’d suggest starting there if you aren’t familiar. If you have a general grasp or like most entrepreneurs, figure you’ll be fine winging it, let me walk you through my personal issues against Porter’s relic.
- Power of Suppliers– What are your business inputs, and what is their ability to control pricing?
- If you are buying and selling a commodity, then your suppliers have very little pricing power as the definition of a commodity is an indistinguishable product purchased solely on price. If you are buying diamonds or iPhones, or bedazzling iPhones with diamonds to- you have extraordinarily little control over what De Beers or Apple set their pricing at. You can try your best to convince your fiancé that a piece of coal is pretty much a diamond; however, it’s not an easy sell or substitution. If you have software that runs on the backbone of a Microsoft product, and Microsoft decides it doesn’t want your software to have access anymore, you’re in an equally disagreeable position.
- I started and ran a construction materials distribution company for three years. We bought materials from a manufacturer and sold them to contractors who installed them on houses. Since we were a new company to the market, we were unable to sell any of the major product lines and were only allowed to sell a single product. Said another way, imagine you were opening a car dealership, but the only car you could sell is a Renault. It’s not ideal, but sure, Ford and Toyota must protect their existing dealers and they’d be ticked if they let some nobodies sell their cars and flood the market. Maybe after a few years, we’d be able to sell Chevy- but sure, we were just happy to sell Renault. So, as you can see, only selling a single product gives an enormous amount of power to the supplier. It’s hard to make rent and payroll when you as a lumber yard with no lumber, has only nails and a hammer.
- Where are your business inputs coming from? Are you buying raw materials? Are you integrating into another dominant software platform? Is it people?
- Power of Buyers– Who are your customers and how much power do they have over your pricing? If you have a company doing 1M a year in revenue- would you rather have 100,000 customers paying $10 or 10 customers paying $100,000?
- I can think of a few examples I have with companies I’ve started, but the example of this that speaks to me loudest is my time being an outside sales engineer. Sure, it was outside sales, but it was more of an account manager. There was a relatively fixed number of customers that bought our type of product, and only about a dozen big players. Thirty accounts comprised my client list, with only 4 or 5 “big” clients and with only one of these bought from me loyally. Said another way, of the 30 customers, only one made up about half of my quota. What kind of pricing power did that customer have over me? Tremendous. If that customer stops buying from me, I’m not meeting my quota. Customer wants a better price; customer gets a better price. This is an untenable position to be in long term. The sum of all fears occurred when the operations side of the company botched a major project for this customer. Having a few big customers is easy and gives one a false sense of security. Whether you have 100,000 customers or ten, people are fickle, shit happens, and your start-up is never too big to fail.
- Threat of New Entrants- How easy is it for others to enter your industry or space? Naturally, the easier it is to join, the worse it is for the industry. Let’s take two extremes- When’s the last time you saw someone pitching a nuclear power plant at a start-up competition? Kind of hard to get past that $6B seed round. On the other extreme, if you are an Herbalife “entrepreneur”, a successful day for you is adding more entrants. The more people that sign up under one’s Herbalife “triangle”, the more competitors/entrants will be competing for that same, next customer.
- I’ve started and ran two commercial contracting companies. Unlike other trades, roofing requires no licensing in Texas. So the door is wide open to anyone. Disgruntled sales man that couldn’t sell a job to sell his life, ends up calling your old customers and offering a lower price because he isn’t required to have insurance, or any overhead. What a world class winner! Even worse, if that salesman was actually selling and bringing in revenue to an existing roofing company, it doesn’t take too long for them to decide to start their own company. This happens regularly in construction companies and can also be seen in professional entities when someone really shines. Consider a law practice or consultant that brings in a ton of high dollar customers to his firm. How do they prevent them from opening their own shop? They make them a “partner” so that they are on the same team instead of starting up their own firm and keeping more of the profits at the expense of having to run the company. You think Justin Timberlake would still be cool carrying N*Sync on his back? Probably not.
- Threat of new entrants is especially difficult to stomp out in Technology. It’s very easy to copy software and functionality. It’s even harder when your company’s software is built on the back of Facebook, apple, amazon, google, or Microsoft. Not only are you dependent on these enormous companies to allow you to access their software and users- but they already employ the world’s best programmers who could recreate your software over a three-day weekend. Further, after said 3-day weekend, these companies already have billions of users. Now your entire company is just a routine product update that a lot of existing users will complain about.
- What does your start up do? When investors ask about IP- hopefully, it’s not just so they can feel smart using a term commonly heard on Shark Tank. They want intellectual property because it, at least in theory, prevents others from joining the space and competing. IP can come in a lot of ways, but having engaged, active users or a strong brand following can be just as, if not more effective than a patent.
- Threat of Substitute- What else can your customers use to scratch that itch besides your product? Circling back to the diamond ring example in power of suppliers- while you may be able to sweet talk your fiancé into a different piece of carbon, there aren’t very many substitutes to diamond coated drill bits. It’s either a diamond and it’s going to cut, or it’s not a diamond and it’s not going to cut. Economics has plenty of pages dedicated to substitutions in terms of goods and price elasticity. If Toyota’s next year of vehicles start costing more than their Honda counterparts, it wouldn’t be surprising that some Camry shoppers might find themselves behind the wheel of an Accord. It’s the same reason that most grocery store chains have their own brand of ketchup that is universally cheaper than the Heinz bottles on the same shelf. Cars and ketchup are examples of products that have readily available substitutes. Consumers may want the Heinz bottle, but they might not want it enough to pay twice as much.
Alternatively, do you ever wonder why big pharma and drug dealers do so well? If you have a life-threatening condition, you can’t grab a Hill-Country-Fair epi-pen from Wal-Mart. If you have an addiction to cocaine, you aren’t going to be able to settle for cup of coffee from Starbucks. These products have no substitutes and are either heavily regulated or illegal.
Regarding start-ups, threat of substitution can come in a lot of forms. Think about mom & pop stores that once sold cameras and film. Who would have thought that cellphones equipped with cameras would be the substitution that would be put these businesses under? If you still really want a camera- are you going to find a camera store, or jump on to amazon? Are you going to trust the guy at your local camera store, or the 4.1-star rating based on 2,372 verified customers? The harder it is to substitute your product or service, the stronger your company will be. Always remember- regardless of what problem your company solves better than anyone else, your customers or would be customers are doing just-fine without you. The strongest threat of substitution is the threat of never being adopted at all.
- Competitive Rivalry– How many, and how strong are the current competitors? By now, having reached number 5 of Porter’s five forces, it should be clear that these are all somewhat related. The better your company sits with regards to the four other forces will directly determine how competitive the industry is. In the realm of start-ups and entrepreneurship, this one is almost binary or pass/fail. If you wanted to start a door-dash, uber eats type of company 10 years ago, you could have had a leg up and might have made it work. If you are thinking of starting one in 2020, you might want to read this article again. As a start-up, your company should be in a niche rich market where you can hope to get traction and success before you have direct competitors. If your company is only slightly better than the existing alternative, it’s going to be harder to get customers, harder to raise money, and harder to recruit. The best start ups are the ones that do not really seem to be competing. Starting a business can be hard. Running and growing a business is even harder. The one thing you can control is your product/service/offering. Make the product so much better than the alternatives that it doesn’t seem like you are in a competitive market. Unlike the other four forces, the competitive rivalry isn’t something that you should be on the lookout for- either your product is good enough that customers will pay for it, or its not. If your start up is competing on price with other competitors from the start, then you might need to ask yourself if you really are solving a big enough problem, or if your solution is really a solution.
At Seed Round Capital, we’ve endured nearly every imaginable entrepreneurial challenge. As much as this article was tailored to fit Porter’s five forces, it’s easy to see how entrepreneurial experiences fit his framework. Ultimately- if you are starting a business, you need to be doing something better, faster, or cheaper than everyone else. Chances are- you didn’t dream of starting a company so that you could learn how to spend every waking hour chasing investors for money or spending time keeping those that do give you money updated with details about your progress every month. At Seed Round Capital we help you focus on what you do best, running and growing your business, while we help you identify, attract and manage investors.