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May 2021

Every Early-Stage Startup Must Identify and Evaluate a Strategic Advantage

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Whether you’re building a company or you're thinking about investing in it, it’s important to understand your strategic advantage. In order to determine one, you should ask fundamental questions like: what’s the long-term, sustainable reason that the company will stay in business? 

The most important elements for founders to consider when figuring out their strategic advantage(s) include: one-sided or “direct” network effects (e.g. with social media sites like Facebook), marketplace network effects (e.g. with two-sided marketplaces like Uber), data moats, first mover, and switching costs. 

Let’s take a quick look at an example of one-sided network effects. At the very earliest stages of Facebook’s existence, it was just Mark Zuckerberg, a few friends, and their basic profiles. The nascent social media platform wasn’t useful beyond a few dorm rooms. They needed a strategic advantage or the company would not make it beyond the edge of campus. In fact, Facebook only truly became a useful platform—and accelerated as a business—when more users came into the fold as more types of email addresses were accepted. Add to that the introduction of an ad marketplace revenue model and you have a clear strategic advantage—based on one-sided network effects—that gave Facebook a strategic advantage over other early social media sites like MySpace. These one-sided network effects are distinguished from two-sided network effects.

Two-sided network effects are most common in marketplace business models. In a two-sided network, there is often supply and demand that is being matched, like Uber riders (demand) being matched with Uber drivers (supply). The Uber product is not necessarily more valuable just because more users (riders) join, the way Facebook is more valuable when more users join. In fact, when more users (riders) join the demand side of the Uber network, it might actually be worse for the user experience--it’s harder to find a driver, and wait times get longer. The demand side (riders) gets value from more supply (drivers) joining the platform and vice-versa. That’s why it’s called a two-sided network, or a marketplace. 

Regardless of industry, a successful startup without a strategic advantage is just a validated business model vulnerable to copycat companies looking for a market entry point. Copycats can range in size from startups with similar grit to large companies, like Facebook or Google, with limitless resources to drive competition into the market and potentially drive the startup with the original idea out of business. This vulnerability can prove fatal unless a startup’s founding team explores and embraces a strategic advantage or multiple. 

More specifically, startup founders need to uncover a strategic advantage that is 1) tied to their mission; 2) additive for the particular industry or use case; 3) informed by network effects or other sources of defensibility like switching costs or data moats; and 4) with an end-user experience that draws more users to the platform or offering that scales along with growing demand. For example, Uber became truly useful when UberX was introduced to enable regular folks to drive on the supply side and more riders to find a more affordable way from A to B on the demand side.

How to evaluate strategic advantage

Most investors will be skeptical of a startup’s long-term viability and investment quality unless they see a clear strategic advantage in an initial meeting. Many will walk away unless founders deliver a clear plan to realize the full extent of it in their pitch deck. Founders shouldn't materially alter their pitch to cater to investors. However, they should put in the time to examine their business for a strategic advantage and devise a way to measure success.

If you’re looking for a place to start evaluating your startup’s strategic advantage, consider the following questions:

What does liquidity look like?

For each strategic advantage, a startup should have a marquee metric associated that captures success within a broader industry context and makes sense for the company’s specific business model. In Uber’s case, the operative strategic advantage metric in the early days of app-based transportation was average wait time given the high user demand for convenient and affordable rides. According to an early head of growth at the company, every minute shaved from rider wait time generated a significant spike in user acquisition—a finding that still helps Uber retain a large share of the ridesharing market today.

What are the switching costs?

If your startup is in the consumer space, a marketplace, or operating within a customer-centric industry like interior design or real estate, it’s vital to measure switching costs. They can be large or miniscule, but there’s often more to the switching costs equation than just dollars and cents. Regardless of the industry and startup operating model, founders need to understand the full value of switching from using or selecting their platform, marketplace, or offering to a competitor’s version.

Ridesharing is a clear example where two companies, Uber and Lyft, hold the majority of market share with competitors in the far distance. In order to switch from Uber to Lyft, a customer needs to be logged into both apps with a credit card and/or bank account attached for payment. They also need to enter personal information, like their home and work addresses, in order to draw usefulness from the platform. This is where concern for privacy and security comes in to add to the cost of individual Lyft rides and UberEats orders. Many people have both Lyft and Uber active on their phones because the companies have earned consumer trust, brand recognition, and market share. However, a lot fewer have a third ridesharing app, like Via or Wingz, due to these additional factors.

Which side of the network values the other more?

This question is most applicable to startups with a marketplace business model. In the early days of Uber and Lyft, for instance, riders clearly valued the availability of drivers more because it was increasingly tough to hail a cab or find a public transit alternative—especially in big cities like New York. 

This dynamic changed as the ridesharing industry scaled and growth started to depend just as much on attracting drivers to the platform (with Uber and Lyft leading the way). But it was riders with the value majority on day one and early entrants Uber and Lyft knew their survival, then success defeating third party apps depended on finding them rides as quickly as possible.

The importance of doing homework

It’s a solid bet for startup founders that the potential investors and VCs they’re scheduled to pitch have dedicated a large portion of their careers, life, and education towards understanding both the business and academic side of industry. While I do not personally think an MBA is necessary to succeed in business as an operator or investor (disclaimer: I do have one), I think it’s vital for founders in pursuit of funding to do the homework. Look at the history of your chosen industry. Understand the market forces at play, who the category leaders are, where consumer demand gaps might allow for strategic advantage, and what lessons from other company successes and failures apply to your specific business model.

Whether or not you choose to dive into the academic side of business, I’d definitely familiarize yourself with Porter’s 5 Forces. Many VCs, in particular, will come into founder meetings with hard questions built around these very principles. Many will think founders have fully mapped the industry they’re in—whether it’s real estate, healthcare, transportation, finance, or something else—to make the roadmap toward achieving strategic advantage as granular as possible. If nothing else, founders should get comfortable with them in order to close the preparedness gap and meet investors on a more level playing field.

VCs may also enter the Zoom meeting or conference room thinking founders have come up with 100 ways to achieve strategic advantage. While you may not need 100, you should be able to tell investors why your vetted strategic advantage separates your company from the pack—and how it will be impacted by industry- or marketplace-specific network effects. For founders who commonly come across investor questions like, “What happens if Google decides to copy you?”: I recommend coming up with a valid model for how long it would take a big tech company like them to do just that. I’d also plan to dive into why your business model is tough to replicate over night. At the very least, investors will take you seriously and understand you came to secure funding for a sustainable business with long-term prospects and a solid plan for success.

Additionally, never underestimate the power of approaching a legacy market and competition landscape with fresh eyes. When you’re in the initial pitch meeting, make it a point to outline clear differences in business model, strategic advantage, and user or customer experience your startup provides. Convince investors (and your founding stakeholders) by leaning into why the company would succeed even if a Google or a Microsoft chooses to replicate the concept.

The best strategic advantage is having at least one

Startup leaders should be concerned if their company doesn’t currently have a strategic advantage. The reason: while business might be good now, it won’t be for long without one. There are simply too many opportunities for other companies to introduce a slightly more appealing alternative and/or for users to move on for a variety of reasons. As Harvard Business School Professor Tom Eisenmann points out, the odds are already stacked heavily against startups regardless of the strength of their operating models, product or service roadmaps, and value proposition. That’s why it’s crucial for founders to put in the effort to understand the value of strategic advantage, thoroughly evaluate market dynamics and network effects to unveil one or multiple, and do the homework necessary to crisply present why their company is sustainably different—and more resilient—than anything in existence.

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