Disruption’s Biggest Threat: Imitators
In Brief: Many disruptive companies fail to present a sustainable long-term profit formula due to competitors quickly copying the model. Disruptive companies quickly resort to being the cheapest provider, turning it into a battle of price. Without a sustainable “moat” such as an ecosystem of products that consumers prefer despite competition, disruptors are at risk of being copied and disrupted by other similar companies. This article explores how to identify which type of companies are at risk of turning into a commodity.
When was the last time you rode in an Uber with a driver who did not also have a Lyft sticker? When you ordered groceries for delivery, did you check to see which service was cheapest? Why do you choose an iPhone over a Samsung (or vice versa)? If you are an avid technology user, these questions all have very clear answers that go in different directions. The diametric responses boil down to one word: commoditization. For some services, you care about the brand or the company, while for others, you care simply about price. This article explores what separates the two and what a business owner or investor can do to protect themselves from becoming or investing in a commoditized company.
There are two flavors of commoditization worth exploring. Those are the “what” (a product or service itself turning into a commodity) and the “how” (the process of commoditization and how a company responds, such as how IBM responded to computers turning into a commodity over time). This article will focus on the “what” and the companies, who themselves, turn into commodities.
Merriam-Webster’s dictionary defines a commodity as: “a good or service whose wide availability typically leads to smaller profit margins and diminishes the importance of factors (such as brand name) other than price.”
In business lexicon, a commodity is simply a product or service where customers care more about price than other unique features. It requires no further explanation before you can ask yourself: do you care whether you ride in an Uber or a Lyft? This decision usually boils down to two major factors: which ridesharing service currently offers the shortest wait time and which one predicts the cheapest price? Hold it right there, you say: it is not only about price — the time of wait is a huge factor. Actually, at its core, the price determines the wait time, so it is all about price.
When you climb into an Uber or a Lyft, the drivers typically have window stickers for both services. The wait time for a car on either service is a function of how many drivers are in the area, which is a factor of which areas offer the most money at that time. Ask your driver how they chose which app to turn on — it usually involves an answer related to which is paying the most via rates or a bonus structure. To them, it is about the price which is why the system works so well. When your willingness to pay meets the driver’s willingness to accept, a market is created and the transaction occurs. Therefore, while you care about time and price, your wait time is the determined by the driver’s desire for a higher wage and vice versa. There is nothing profound about this realization, rather it is the first lesson of any basic economics course and should describe the conditions present in almost any business.
Where Uber and Lyft become so unique is that fact that both companies use the same contracted workers, allowing drivers to switch which company they’re working for every few minutes, or literally shop the market for riders on either app until they find a passenger for the right price. There is nothing stopping the drivers from doing this, or even using other additional ridesharing apps. The same is true for the passengers.
Uber could offer their drivers higher wages or provide customers with lower rates, but both of these cause the company or the drivers to operate below their average variable cost, which is unsustainable in the long run. In fact, a recent study found that Uber and Lyft drivers earn only $3.37 per hour after factoring in expenses. Therefore, the low prices that customers enjoy are built on cutting costs, not just below those sustainable by the companies (Uber has yet to show a profit), but also below the opportunity cost of drivers who could earn more money elsewhere. It is hard to believe that ridesharing prices could drop any lower than they are, making it a priority for ridesharing companies to find a sustainable advantage if they are to survive. The history of American business, especially the second industrial revolution (circa 1875), is littered with defunct companies who tried to win the market by producing cheaper than everyone else in an unsustainable manner. Eventually, a company must either achieve some sort of monopoly (or a flavor of monopolistic competition) or run out of money as investors realize there are other more immediately profitable opportunities elsewhere.
The problem with commoditization, such as the battle between Uber and Lyft, is that the features that made them “disruptive” are easily replicated by competitors. First, Ubers were so much more convenient than taxis, but it did not take long for taxis to also start using apps to call for on-demand rides. However, Uber was still cheaper, but then it became about price again, and all taxis had to do were lower their rates, which many did. But Uber still offered a better ride experience than a taxi. However, the ride experience was replicated by Lyft, who used the same exact drivers as Uber. So what is Uber’s competitive advantage beyond being able to offer better prices? Not even this, because Lyft can replicate the price structure. Uber knows this, hence it has been searching for driverless car technology and other potential sources of competitive advantage that would give the company an irrefutable advantage, even if temporary.
The problem of commoditization is not confined to ridesharing, rather it is pervasive among “disruptive companies” that are powered by a centralized app that relies on decentralized contracted workers. To maintain some kind of monopolistic power over a market, a new company must own some form of monopolistic power: a key resource, intellectual (or secret) property, or massive economies of scale. Many startup companies rely on being a first-mover as a key resource that will gain network effects where people will use their service because other people use the service (the reason you use Facebook instead of checking 30 other similar platforms daily). However, this only works if users have a reason to use only your platform. In many two-sided markets, such as ridesharing or grocery delivery, the first-mover is only good enough until a competitor enters the space, applying lessons learned from the first-mover’s launch, allowing the second-mover to offer the same service for cheaper because of fewer overhead and development costs. This phenomenon can be seen in the restaurant meal delivery service, where restaurants jump service-to-service depending on which one (grubhub, chownow, uber eats, etc) charges the smallest fee.
The tell-tale signs of commoditization risk
- A company relies on a network of providers who have no particular loyalty and are only on the network because the price is right.
- A competitor can use the same providers without assembling a new network by simply offering a better price.
- Distribution of a product or service is easy via the internet.
- There is only one product or service that the company provides where the customer is not “addicted” to a full ecosystem of products (such as Apple or Amazon)
- There is no ownership of intellectual property (not necessarily patents, which are easy to work around, but a legitimate IP advantage that other larger providers demand and would be willing to buy from the company).
- The main value proposition of the company is that its product is cheaper than existing alternatives. This stages the battle to be about price; someone will always end up being cheaper.
What is a disruptive startup company to do?
The classic preventative strategy to this problem is to create a “moat” or something insurmountable by competitors. This is ideal, but the disruptive world of Silicon Valley has proven this is an almost impossible task. How can one file a patent on the idea ridesharing? They can’t! The other option would be to operate in secrecy, but that does not lend itself well to growth in a two-sided market such as ridesharing where people need to know about the service. The third option would be to acknowledge the reality and capture as many profits as fast as possible from the onset, but this is not conducive to growth, which is why most startups place all of their earned revenue into growth opportunities. A final option would be to follow in the footsteps of Apple (easy to say, not easy to do, but it provides a strong example).
There is a reason people prefer one smartphone or another, whether it be Apple, Samsung, Motorola, etc. They all have mostly the same functions including calling, texting, web, apps, and music. However, unlike the Uber v. Lyft or grocery delivery service comparison, there are many people that genuinely prefer an iPhone over the rest of the competition to the point that they will only buy an iPhone. Price is not a key determining factor when these people buy their iPhones. Ironically, price becomes the main determinant for these same customers as they hail a ride via the Uber and Lyft apps outside the Apple Store. People pay for the iPhone because of a multitude of reasons but many of the primary determinants are not easy to replicate and form a moat. Some of the reasons include:
- A consistent level of quality and warranty in both hardware and software, which sounds easy to replicate, but in reality, is extremely hard to carry out across an entire product ecosystem. Many companies have failed because they cannot manage quality or service to Apple’s level.
- An ecosystem of products that fit seamlessly together such as phones, computers, music, apps, and watches. Competitors have replicated each of these, but so far, none have managed to offer a significant competitive challenge.
- Apple has realized that branding matters significantly to a consumer product. Thus their products are identified as a luxury for which the consumer is willing to pay a premium, both for measures of quality and for its universal recognition.
Apple’s overarching source of monopolistic strength is its ecosystem of products that are high-quality and easy to use. This trait is also seen in other companies such as Google and Amazon, who also create ecosystems. While individual components of the ecosystems are easy to replicate and compete against, the entire ecosystem is virtually insurmountable.
What is an investor to do?
An investor in startup companies can be in a difficult position when betting on a new disruptive company because his or her goals are not always aligned with the company. While both company and investor desire to gain maximum future profitability, in the absence of a moat, profits will be short-lived. Most companies know this and present grand strategies for future product development, but few acknowledge the reality that moats are much harder to find than a Powerpoint slideshow can demonstrate.
Many modern startups rely on network effects or a single piece of technology to create their moat. As competitors follow the revenues of the first-mover, they tap into the initiated network created by the first-mover, turning it into a battle for the lowest price, since each company is vying for and using the same network. Hence, grocery delivery, restaurant food delivery, ridesharing, and other general concierge services have turned into myriad competitors all vying for the same network of contracted workers. When user money is involved for sources of revenue, network effects are almost impossible; most dominant networks such as Facebook, Instagram, Reddit, etc are all free to the user.
Sustaining profits can only be found when a company can create some sort of monopolistic power that survives in spite of competition. An example is the iPhone, which has plenty of competitors, but enough consumers do not care because they demand the Apple ecosystem. The same is true of Amazon’s Alexa; there are many providers of similar devices, but Alexa offers integration with an ecosystem that others do not. Microsoft can be seen emphasizing the ecosystem as well, successfully pulling their Office products back into an ecosystem via Office365. Thus, the ecosystem creates a powerful and sustaining moat that thrives despite competition. This is in contrast to the many startup companies which offer a single product that customers are quickly willing to substitute when the price is right.
If investors want to invest in a company that sustains profitability until its initial public offering and then continuing beyond as a successful company, the investor must find companies that have the ability to put all initial profits into continued growth, while having enough ideas to create an ecosystem of products and services before they become commodities. This highlights the principle taught in most basic business classes: an entrepreneur needs more than one product idea to sustain the future company. Yet, many disruptive startups get infatuated with the first idea and imitators quickly follow before customers’ dependency on an ecosystem occurs.
Identifying startup companies with the potential for an ecosystem of products, investors and founders’ whose goals are aligned towards this end, and managers who have the capability to continue the ecosystem’s growth are the key factors in sustaining a disruptive company before other competitors respond through imitation.
Disclosures: The author holds stock in Apple, Google, and Microsoft. The author has no other financial relationships with the companies mentioned or their competitors.
