Weekly Briefing Note for Founders

16th February 2023

This week on the startup to scaleup journey:
  • The secret to building competitive advantage
  • What are corporate investors really looking for?
  • The Innovator's Dilemma

The secret to building competitive advantage

Virtually every company is built on some kind of advantage. An entrepreneur uncovers an inefficiency in the market and then exploits it. Differentiation is initially built around a USP. But lasting companies do not rely on USPs alone. They rely on 'moats' - structural advantages that make it difficult for other companies to come in and repeat that same original discovery. This creates long term defensibility and strong returns. Warren Buffett helped popularise the concept, saying a company’s moat (or lack thereof) means everything when deciding to invest in it: “The key… is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” Interestingly, the moats of today mirror many of the foundational 'corporate' moats from the past, such as size and scale. But while the likes of Amazon and Google harness similar advantages as older generation businesses like General Electric and IBM, they have achieved it in a totally different way, right from the startup phase.

In the latest CB Insights report: "29 Business Moats That Helped Shape The World's Most Massive Companies", we find many powerful examples of long-term defensibility. These fit into one of 4 categories: Cost, Cultural, Resource, and Network Effects. Cost advantages are traditionally associated with economies of scale, but switching costs and sunk costs are also critical when trying to unseat products that have become deeply embedded in the customer's solution. A cultural moat is usually associated with intangible factors like brand and tradition, where customers are buying on factors other than price. Resource can be a key factor even for startups, especially in DeepTech hardware. Companies can leverage their pioneering internal expertise, patents, and/or legal protections to forge ahead unhindered, at least for a period of time. A product has a network effect when its value to its users increases in proportion to its use and the number of users using it. This is why investors seem to love network effects businesses above all others, due to this self-perpetuating growth flywheel.

NfX is a US Seed VC that for years has led industry thinking on the power of network effects. General Partner, James Currier, says that whilst he accepts that value creation mostly accrues in the out-years when usage, revenue, and growth compound, it's the decisions that founders make at the very outset that determine this. "In order to capture all of the compounding value in your business, you need to start at the beginning to position for long-term durability."  Currier sees durability as the confluence of multiple moats that, perhaps unsurprisingly, closely mirror the CB Insights research. NfX even has a Durability Formula: Durability = Network Effects + Economies of Scale + Brand + Embedding + IP. This isn’t a mathematical formula but rather a mental model for making sure founders address these five core forces as early as possible. He observes that startups that win big spend more time at the beginning, earlier than you might think, on creating products and business mechanisms that follow these five durability factors and thus drive increasing returns at scale. "As their companies get bigger, they get increasingly hard to overtake, and thus their value explodes."

What are corporate investors really looking for?

New research from McKinsey reveals that more than three-quarters of the Fortune 100 companies are now active in the venture capital (VC) space. Half have a VC arm (CVC) set up as a subsidiary. As a result, large companies are now involved in about a third of all venture deals. But founders have discovered that navigating this type of relationship is very different from mainstream VC. Success is not a given. Startups that understand the true motivations of corporates drive significantly better outcomes than those who see them as just another source of capital. Equally, corporates must align their thinking with startups to ensure their own ROI. Analysis of data from more than 2,000 companies showed that not all CVCs are equal: only 14 percent of corporates that invest in young companies have adopted the practices necessary to sustainably generate value from such relationships. Success is so elusive that a quarter of those that invested in 2015 were gone from the venture scene just three years later. McKinsey also found that more than 70 percent of CVC activity is sporadic or opportunistic, an approach that correlates with poor ROI. 

But, when done well, CVC investments can produce elevated outcomes for both parties. Top-tier corporate innovators - which tend to be twice as active as their industry peers - have been able to capture 2-3x the economic profit from these deals as their industry competitors. But the big motivation is the potential for long-term strategic benefits: 75% are motivated by the desire to gain market insights and cutting-edge ideas, 55% by access to new products, 45% by the opportunity to build important capabilities and participate in a broader ecosystem, and 25% by the chance to secure strategic options. As for start-ups, finding potential new clients was mentioned by almost all respondents as a key draw of CVC, with 40% also seeking access to distribution channels and 25% looking for help with branding. Those that manage to strike successful partnerships enjoy significant benefits. Startups that receive CVC investment within their first three financing rounds have a higher chance - between 21% and 64% - of making a successful exit than those relying solely on traditional VC. What’s more, the earlier in their development they receive that corporate support, the higher their chances of going public or securing a merger or buyout.

Seeking vision alignment at the outset is critical as both parties will naturally be driven by very different goals in their respective businesses. Startups want to grow as fast as possible and are ready to adjust their strategies quickly, often pivoting as they learn more about the product-market fit. They see corporates as channels to customers, but they want to protect their technology or other competitive advantages. Corporates, on the other hand, seek access to new solutions but want to be able to steer the strategic direction of their investments, prevent cannibalisation of legacy businesses (often a very misguided endeavour), and preserve their reputation with customers. With an aligned strategy and a shared roadmap for execution and scale, a joint definition of success can be developed. Key to this is the ability of the corporation to enthusiastically embrace the power of 'disruption', which often does not align with corporate culture. The alternative, one CVC executive noted, is to “be disrupted by someone else.”

The Innovator's Dilemma

A critical success factor in any CVC programme is the ability of the corporation to enthusiastically embrace the power of 'disruption'. This is the essence of what distinguishes startups from established companies. Understanding the significance of this mindset difference and what perpetuates it, is vital to the long-term viability of almost any startup/corporate collaboration. For founders seeking deeper understanding, there is no better place to start than the classic text on innovation: Clayton Christensen's  The Innovator's Dilemma. Christensen famously coined the word 'disruption' to distinguish between two types of technologies: Sustaining Technologies: These focus on growing existing technologies by enhancing their performance, mostly through extended functionality or increased capacity, and Disrupting Technologies: These change the landscape of an entire industry, or spark a new one altogether, because they solve a problem in an entirely new way or for an entirely new group of people. Established businesses and market leaders shine when it comes to the first kind. They have built up enormous efficiencies and vast amounts of resources, which make it easy to provide incremental progress at scale. But these same incumbents often struggle with the latter kind - they lack imagination, freedom to operate and swiftness in execution.

The reason startups have a chance to overtake industry titans when it comes to disruption is that it often starts in emerging markets. Christensen observed that when the resources, processes and values of a company don’t match the target market, even the best management won’t help. Market champions are loaded with resources, but have very hardened processes and a fixed set of values, which rarely match the new target market of a disruptive innovation. Emerging markets are not attractive for established firms because they do not provide significant short-term gains: First, disruptive products are often simpler and cheaper; they generally promise lower margins, not greater profits. Second, disruptive technologies typically are first commercialised in small, nascent markets. And third, leading firms’ most profitable customers generally don’t want, and indeed initially can’t use, products based on disruptive technologies. By and large, a disruptive technology is initially embraced by the least profitable customers in a market. "Hence, most companies with a practiced discipline of listening to their best customers and identifying new products that promise greater profitability and growth are rarely able to build a case for investing in disruptive technologies until it is too late.”

Christensen concluded that the way market leaders should solve the 'innovator’s dilemma' is through equipping independent subsidiaries with what they need. In words that will resonate with founders, he said that these unique firms shouldn't be pressured into being right the first time. "Careful planning, followed by aggressive execution, is the right formula for success in sustaining technology. But in disruptive situations, action must be taken before careful plans are made. Because much less can be known about what markets need or how large they can become, plans must serve a very different purpose: They must be plans for learning rather than plans for implementation."  We can see how the best CVC programmes have truly exploited Christensen's insights. Instead of the 'independent subsidiary', it is the startup (via the CVC) that becomes the vehicle for experimentation and learning. Startups have the imagination, the freedom to operate and swiftness in execution that corporates struggle to emulate. Above all, they provide the early warning system for future market disruption that will deliver an ROI way in excess of any financial return.

Happy reading!

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