28 Mar Three steps to sustainable competitive advantage
Co-authored with Ryan Janssen – tech investor & entrepreneur.
Intro: What’s Your Entrepreneurial Story?
VC: “So tell us about your company. Why can you sell used bicycles better than eBay?”
CEO: “We have a better product. Just look at our sweet product demo!”
VC: “That is great. But eBay has 35,000 employees. Surely, some of them can make as good of a product?”
CEO: “But eBay isn’t focused on this! We are!”
VC: “True. But if you’re right and this is a billion-dollar opportunity, what stops eBay from choosing to focus on this once you’ve validated it?”
CEO: “Passion mumble mumble network effects.”
Moreso, VCs care about unfair advantages for reason – getting this right is the most important ingredient for hypergrowth. Peter Thiel feels this concept is so important he spent 3 chapters of his book on it. It’s a fast-moving, competitive marketplace out there, yet many businesses fail to plan for this in advance.
The key concept here is Sustainable Competitive Advantage (aka SCA). It’s underrated, misunderstood, and especially elusive – and having a true SCA is ultimately the factor which separates the megaexits from the acquihires.
There’s really three steps to building SCA into your business plan:
- Think long-term
- Find your unfair advantage
- Figure out how to get there
Let’s break down how to navigate each of these steps when planning and pitching your business.
Node 1: Think long-term
The first step is easy – start thinking about your marketplace not as a static entity, but instead reactive, adaptive, and dynamic.
The mistake entrepreneurs often make at this stage is not taking a long-term mindset. You’re current company isn’t important – what’s important is your company five years from now.
The first questions to ask yourself are:At what point does your user acquisition saturate and become more expensive? (hint: the answer is never “never”)
a. At what point does your user acquisition saturate and become more expensive? (hint: the answer is never “never”)
b. What happens to your unit economics as competitors enter the market and try to compete on price?
c. How hard or easy is it for a new startup to become your competitor? How hard for a big company?
This happens in the “real world” every day – quite often in the form of LTV and CAC drifting together like the image above. In particular, consumer businesses in 2017 are feeling the high cost of user acquisition – this is why IAC earns $3bn/year but squeezes out a -1.3% profit margin. If your startup built a business plan on $1 facebook clicks in 2011 and now they’re $15, you’re sunk.
Dynamic markets are also ever-present for B2B businesses as well. Customer attention saturates with every new entrant trying the same sales tactics. This is why Salesforce could scale its business by cold-calling in 2005, but as more companies tried that, it lost effectiveness and was quickly replace by inbound marketing.
In short, you need to continually run your business three years in advance. Paint a picture of what your market will look like in the future. Get very familiar with the law of decreasing marginal returns. And think in the context of how you can defend the business in the long term.
2) Find your unfair advantage
If you’re thinking critically enough to pass the first check, this one will also be easy – hopefully, you’ve planned and positioned your business with SCA in mind.
The trap most founders fall into here is overestimating how sustainable their competitive positioning is. Over half of the pitches VCs hear rely on an SCA that isn’t really defensible.
Some of the notable “unfair advantages” that aren’t really sustainable:
- Better product: Snapchat was a better product until Instagram Stories caused a 15-40% decline in snapchat story views – that decreasing line below shows how undefensible a better product is. Ditto Meerkat – the hottest startup of 2015 was cut short because Twitter’s Periscope made a nearly identical product.
Chart of Snapchat story engagement after Instagram Stories launch – source: Techcrunch
- Better team: Yes, your rockstar team is important. But there’s no shortage of rockstars at Google. And even if your team is better, someone else has more resources to lure them with – like how Uber hired away a healthy chunk of CMU’s data science team.
- IP: VCs hate pitches with a “patent protected” product. Defending patents is expensive and time consuming.
If anything it’s a structural advantage for the big incumbents. Google has spent $4m (and climbing) disputing IP with Oracle. Apple just demanded $6m in legal costs from Samsung for beating them in their IP case. Your patent is neat, but worthless without the resources to back it up.
- Better UX/UI: A more specific version of “Better product.” The perfect example here is the online music industry – Spotify, Pandora, iTunes, Google Music, Tidal, have now spent a decade stressing over their user experiences to no conclusion. This is really a lack of SCA – they’re all giving away the same music, and no one player has been able to achieve a decisive advantage.
Unfortunately, a lot of the really sustainable advantages are sustainable because they’re hard. Brand will take years of customer goodwill. Scale is exactly what you’re competing against as a start-up.
So where, then, can a start-up find an “achievable” competitive advantage?
- Platform independence: The best startups exploit the immovable structural limitations of the incumbents. Apple notes is a great product, but it sucks if you have one PC, android table, or whatever. Evernote can be more cross-platform than Apple Notes by its very nature.
- Network effects: The classic. A two-sided network, once established, is incredibly hard to disrupt. ai, for example, was able to speed to a large Series A because of it’s strong, self-reinforcing community of data scientists. Slack is a classic network of networks model with a correspondingly similar exponential growth curve.
There’s a trap here, though – don’t become too optimistic on the strength of your network. Consider Uber and Lyft – each thought they had a strong network lock-in until every driver started using 2 or 3 different apps. As a result, the entire industry is facing severe margin pressure and Uber still subsidizes a huge portion of every ride. The lesson for your business: if you’re going to bet the company on network effects, critically examine the possibility there may actually be no network.
- Data: Yes, you’ll never have as much data as Google. But the rise of reciprocal data applications (RDAs) will likely power the next stage of hyperscale startups. Having data is good, having a mechanism for developing more proprietary data is better – this is exactly why Waze was worth $1.1bn to Google.
3) Figure out how to get there
The good news in this competitive gauntlet: every impenetrable incumbent today had no defensible advantage earlier in its history.
This is where the rest of the kickass stuff about your business comes in – great team, good products, solid customer traction, etc. In fact, most businesses zoom right to this node without showing enough consideration to your future defensibility.
So the key here is context. Every one of these things should be viewed as a path to your SCA.
We just decided a great product isn’t sustainable – in the long run, Google can out-build you. But a great product, timed properly, can help a company reach another SCA. For example: before Instagram was an entrenched social network giant, it just one of the first apps to offer filters. People downloaded it because it took better photos, and that momentum led them a strong SCA.
In fact, almost every giant in tech today followed that same one-two punch:
Maybe your business is the first to develop AI for a certain trading algorithm that it will ultimately parlay it into a Markit-style data advantage. Or perhaps your new social network for families is so well-designed it will grow rapidly until the network effects start kicking in. The most effective VC pitches use this one-two framework to articulate how your startup will achieve and sustain market leadership.
SCA is the key to nailing an amazing VC pitch, and it’s good business. Hypergrowth is only possible with an amazing business model, and amazing business models need to have a strong defense. To that end, every startup needs to:
- think seriously about its advantages now,
- be brutally honest over whether those can be copied (ie, are they “unfair”), and
- plan how it can use what it has to get to that unfair advantage
Even more importantly – this is an ongoing concept that you should revisit often as you grow your business. Your product strategy, your go-to-market, your revenue model, your capital plan – these should all be framed by that all-important unfair advantage. The one that will let your business take off like a rocket ship rather than getting stuck in the competitive swamp of decreasing margins.
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