The Four-Way Fit framework places unique importance on the third domain: Model. To build an iconic enterprise, it’s not enough to achieve a value breakthrough. You must also discover a business model breakthrough, one that enables you to profitably scale while keeping cash flows manageable and building sustainable competitive advantage.
The Model domain is made up of five subdomains:
- Pricing claims
- Unit economics claims
- Customer acquisition method claims
- Cash flow claims
- Competitive moat claims
These five subdomains interact with each other in important ways. Pricing shapes unit economics. Unit economics shape your customer acquisition method. Pricing and unit economics also impact cash flows. All of these impact your sources of competitive advantage — your competitive moat. As you create claims within these five subdomains, you will need to account for these interrelationships.
There is a lot to cover here, so let’s get right underway.
Model Claims — The Canvas
Pricing enables you to recover a slice of the value you deliver your customers. A well architected pricing scheme attracts customers while assuring the customer relationship is profitable. Your pricing scheme is a big deal; the claims you make about pricing are fundamental claims. It’s important to test them before fully committing to them.
During Phase I, the “discovery of a value breakthrough” phase, your first job is to attract early adopter customers. Your initial pricing scheme will be simple. A proper price point will make the purchase decision a “no brainer”. On the canvas, post claims for the following consideration topics:
- Who pays?
- What is the mode of pricing — one-time transaction? License? Subscription?
- What is the unit of pricing?
- What is the price point?
- What is the length of commitment?
A key consideration, of course, is the price point. Your goal is to price to maximize the area under the demand curve. But that isn’t simple to do. It requires you to estimate price sensitivity, which is tricky. No prospect wants to reveal to you what she might be willing to pay. She might not even know herself, until forced to decide.
As a general rule, price sensitivity is highest with low-cost products. In the case of an annual subscription for a consumer product, demand at $49 a year might be 40% greater than demand at $59 a year. Whereas with a large enterprise sale, the difference in demand between a $5M a year price and a $6M a year price might be modest. Since you want to capture the maximum area under the demand curve, understanding the relationship between price and demand is critical.
Just to make things a bit more complicated, segment differences may cause demand curves to vary. Sometimes they are very flat — where a slight change in price significantly affects the quantity. Flat demand curves are more likely at lower price points, or where competition is high and competitive pricing is visible. Commodities, consumer packaged goods and many online consumer and SMB subscription products all tend to show flat demand curves. Sometimes they are steep — where demand is relatively insensitive to price. This is more likely to occur at higher price points, particularly when competitive alternatives are not obvious. Mission critical enterprise systems with little competitive pressure can exhibit steep demand curves.
What drives the slope of the demand curve? Here are the factors:
- The degree of pain being experienced
- The capacity of the product to solve that pain
- The economic value of relieving that pain
- The substitutability of competitive alternatives, and price visibility of alternatives
- Ability to pay
- The personas of the buyer, influencers, and users
Your determination of the demand curve will be an educated guess (a hypothesis). But there are practical steps you can take to ensure more “educated” and less “guess.” For each of your top priority segments:
- If possible, calculate the financial ROI of your product at different price points
- Plot competitor pricing on a graph
- Assess your degree of problem solution advantage vs. competitors
- Consider the references your customer will use to price compare — i.e. “my ERP costs this much per month, therefore this CRM should cost less”
- Assess the customer’s ability to pay — are there natural price ceilings?
- Determine whether there are persona-based factors that might impact your assessment of the demand curve: for instance, are your buyers innovators, early adopters, early majority buyers, late majority buyers or laggards?
To test price sensitivity hypotheses in your top priority segments, you can ask your prospects reference questions:
- “Would you expect our product to cost more or less per seat than Salesforce.com? How much more / less in percentage terms?”
- “Here is our product. Here is adjacent category Product B. Which would you expect costs more? “
- “If you had to choose our product with ‘abc’ features for $1000 a month, Competitor B with ‘bcd’ features for $1500 a month, Competitor C with ‘def’ features for $500 a month, or Competitor D with ‘ghi’ features at $2000 a month, which would you choose?” (Conjoint Analysis)
Steve Blank, in Four Steps to the Epiphany, suggested the following two questions:
- If I gave you this product for free, would you take it?
- If I charged you $1 million a year for the product, would you buy it?¹
Blank asserts that answers to these two questions (such as, “What are you, crazy? I’d never pay more than $400,000 per year”) will provide insight into the customer’s price sensitivity. I’m not quite so sure that customers will be that transparent, but the idea of juxtaposing an “extreme low” and an “extreme high” price to gauge reactions is compelling.
Ask enough of these questions to enough customers, and patterns will emerge. Once you have plotted the demand curve, you can quickly determine the price / quantity / commitment package that seems optimal for each segment. Before full rollout of any pricing scheme, be sure to test your “educated guess”.
A key factor to consider is the substitutability of competitive products. If your product is so unique that no competitor is even close to matching its value, you will have more price flexibility. But if your objective value is not markedly greater than that of your competitor, you will need to price well below the competitor to gain purchase.
Once your product has launched and you’ve begun to sell it, of course, you will begin to gain more concrete validation of your pricing claims.
During Phase I, cash flow considerations are dominated by questions of funding and spending — not business model. You don’t yet know how quickly you will add new customers. Nor can you be sure of the average price they will pay. So you can only speculate on cash inflows from operations. But you do need to determine how much cash you can count on to help you get to a value breakthrough. In this phase, cash flow claims must address:
- Your monthly burn rate
- Your cash out date
- The date by which you need to close the next funding round
- Your fundability
Your monthly burn decision will be influenced by cash on hand and your fundability. Do you boast a sufficient traction and opportunity story to be able to count on a successful financing round at the time of your choosing?
These are fundamental claims. They will impact the size of the team you build, and the reach of your new product features.
In the first company-building phase, your customer acquisition approach is straightforward. If your product exhibits a very low LTV (lifetime value) profile, you will be seeking to generate online traction. One venture capitalist referred to the continuous online testing and iterating done by early-stage companies with low-LTV profiles as “fruit fly experiments”. If your company has a higher LTV profile, then customer acquisition will be a human endeavor.
The first purpose of customer acquisition efforts during this phase is, of course, to sell customers. The ability to acquire customers is a key proof point in verifying that you have achieved a value breakthrough. But that’s not the only purpose. Your attempts to acquire customers will also inform product priorities, segmentation, the value proposition and messaging.
Your customer acquisition claims should address how you will acquire customers within your top priority segment, and what your key messages will be. These fundamental claims will be subjected to the live-fire test of actual selling. The lessons learned will help you iterate towards truth.
The Other Two Subdomains
In Phase I, your claims in the remaining two subdomains (Unit Economics and Competitive Moat) will be pure guesses. You can’t yet calculate LTV with precision, so your unit economics claims will be speculative. So too with your claims in the Competitive Moat subdomain. You haven’t even proven an initial value breakthrough, so the path to sustainable competitive advantage will be murky. Especially during the Minimum Viable Concept stage, you’ll need to venture a guess on these two — but don’t overthink it.
Concentrate your energies on Pricing, Cash Flow and Customer Acquisition Method. They are the most important in Phase I.
Model Claims — The Spreadsheet
In the second phase of company-building, all subdomains that make up the Model domain demand thoughtful consideration. Your mission is to build a value-enhancing, competitive advantage-creating business model. It takes work in all five of the subdomains: Pricing, Unit Economics, Customer Acquisition Method, Cash Flow and Competitive Moat. Let’s go through each.
Earlier in this chapter I identified five pricing subdomain consideration topics to be addressed in Phase I. Now, in Phase II, the list of consideration topics grows:
- Should we bundle features or products together, or provide a la carte pricing?
- What pricing tiers should we offer?
- How should introductory pricing work?
- How should expansion pricing work?
- Should pricing vary by segment?
- How do we price through channels?
In the spreadsheet, the taxonomy of the Pricing subdomain might look something like this:
Your decision as to “who to charge” might be simple or complicated, depending on the particulars of your business. If yours is a B2B SaaS product, your customer is obvious: it’s the company that gains benefit from your product. That company will be charged. So too with a B2C ecommerce site, or a gaming company. You’ll charge the consumer. It becomes more complicated when you have more than one option. This is the case with media businesses and marketplaces.
If you are a media website, you could charge the viewer, via a subscription — as does the New York Times (nytimes.com). Or you might offer your content for free, and then charge advertisers — as does Healthline.com. To illustrate the tradeoff, let’s assume that the going rate advertisers will pay for 1000 viewer impressions on your media website is $5.00. That’s $0.005 per viewer impression. Let’s also assume that a regular viewer might generate 100 impressions a month, or (under an advertising-based model) $0.50 value per month, or $6.00 a year. If a site like nytimes.com can charge the consumer more than $6.00 per year without reducing visitor count, then it is more profitable to charge the subscriber than to charge advertisers. But if charging a subscription fee results in a precipitous enough drop in regular viewers, there comes a point where an advertising-based model would be more profitable.
Marketplaces exhibit their own unique pricing dynamics. If yours is an online marketplace, you might just charge a transaction fee for a purchase. This is called “the rake”, and is employed by most two-sided marketplaces — such as eBay, Expedia, Etsy, and Wayfair. Or you might add other fees for buyers or sellers. Amazon does that, charging $119 a year to consumers for Amazon Prime and then charging purchase transaction fees. Similarly, when an office space rental is executed on its platform, LiquidSpace charges the landlord a transaction fee. For large landlords it also charges a SaaS subscription fee in return for extra services. Birchbox, the B2C subscription box company, does the same. The company charges the consumer a subscription to receive a monthly box with beauty product samples inside. Then, if a beauty product catches the subscriber’s fancy, she can go to an ecommerce site to buy a full supply. A transaction fee is charged. In the offline world, Costco charges consumers $60 a year for a membership — and then makes money off of every item bought in the store. Consumers believe the products in a Costco store are significantly less expensive than they would be elsewhere, so they are willing to pay the membership fee to participate in the savings.
Things get even more interesting if your marketplace has three or more sides. For instance, student-focused LendTech businesses bring together students (who seek the loan), schools (who seek to offer students education financing options) and financial entities (who lend the money). In some situations, the transaction fee is borne by the student and financial entity. In other situations, the school may also participate by offsetting loan risk — for instance, to secure student financing and placement. Similarly, Houzz is a three-sided marketplace that brings together home-buying consumers, home and building product manufacturers and professionals (such as architects, builders, subcontractors and landscapers). In such situations the question of “who pays what” becomes more complicated.
Regardless of your initial “who pays” hypothesis, it should be verified through a combination of primary research and sample testing before you fully commit.
The Unit of Pricing
As the value you deliver a customer rises, the price should rise. As delivered value falls, the price should fall. But how will you achieve that objective? Should you charge per square foot? Per store? Per employee? Per truck? Per user? Per item? Number of impressions? Number of monthly unique visitors? Clicks? Percent of transaction value? These questions pertain to the unit of pricing, another important question in the design of your pricing scheme.
In pricing, you seek to minimize purchase friction while maximizing profitability. In the optimal design, these two conflicting objectives fight each other to a draw. A customer who seeks to determine the reasonableness of your price will compare it to the price of reference products he knows. For instance, if the unit of pricing in an adjacent reference product is “number of employees”, and your price points compare favorably, then you should probably choose “number of employees” for your unit of pricing. You will need to identify a unit of pricing closely associated with the value that is delivered, one that is easy for the customer to understand and assess.
The Price Point
During the “discovery of a value breakthrough” phase, you tested the price point for one segment and one product. Now that you are in the “value optimization and sustainable advantage” phase, you have extended your reach. Price points must be built to address all prioritized segments. You may introduce pricing tiers; each tier will need a price point. You may now offer multiple products. Research methods are the same as with the first phase, but you must now apply them across a broader array of contexts.
Bundles or A La Carte
At the time of this writing, a McDonald’s Big Mac Value Meal costs $5.99. With that, you can get a Big Mac, a soda and either french fries or a salad. But how much of the $5.99 is allocated to the Big Mac vs. the french fries vs. the soda? Perhaps the better question is: “who cares?”. If your company offers a range of products, you will confront the question of whether to offer these products a la carte, or bundled, or some mix of both. The mission, of course, is to optimize profitability by maximizing the area under the demand curve. But how? You must consider the price sensitivity of each product, by segment.
Let’s say three of your products are highly complementary: customers seeking one of these products are likely to seek all three. Perhaps one of the three products is easily substituted with a competitive product, making it price sensitive. But let’s presume that the other two products you offer face less competitive pressure, and therefore are much less price sensitive. In such a situation, bundling may make sense. With all three products sold together for one bundled price, it’s not easy for the customer to compare your price sensitive product against its competitive alternative.
On the other hand, a la carte pricing increases customer flexibility. Each customer can buy what they want, and configure accordingly. So to test your hypothesis you will need to consider both price sensitivity factors and demand factors.
Pricing tiers exist for multiple reasons. First off, customers of different sizes may require different volumes of your product. The local SMB business will need fewer Salesforce seats than the global enterprise business. But pricing tiers also provide a means by which new customers can test out your product at low volume before fully committing and expanding to a full-scale commitment level.
The choice of tier thresholds should align with the requirements of your size-based segments, or should create reasonable stepping-stone commitment levels as customers move from testing to expansion, or both. Test your hypotheses through research and small-sample tests before you fully commit.
Especially with new products and / or new companies, prospective customers wrestle with doubt about the promise of your product versus its reality. To reduce the friction created by doubt, you may offer ways for customers to test your product at a low cost (in money and commitment level) before they are fully committed and fully charged. There are a variety of introductory pricing schemes, including:
- Free trial
- Proof of concept trial
With the freemium model, a customer can use the product for free, up to a certain level of usage. With the free trial model, the product is free — but just for a defined period of time. Keep it after the trial is over and you must begin to pay. In a proof of concept (POC) trial, the product is sold at full price, but just for a limited test — at a low volume, for a limited time. The customer pays for the limited test so as to confirm that the product delivers the promised value. If the POC proves successful, the customer increases the purchase level significantly.
To test introductory pricing schemes, consider the reference products your prospects have identified. These are the products they consider to be priced similarly to you. What introductory pricing schemes do these reference products exhibit?
Ultimately, the most definitive test will be a live-fire test — when you push your pricing scheme into the market. Hopefully it’s possible to do this with a small sample first.
The easier it is for your customer to increase spending, the better. Don’t make your customer sign another agreement to buy more. Build expansion into your initial agreement. One expansion pricing scheme is to offer a flat-price usage package for use up to a certain threshold, and then charge “x” amount per “y” volume for overages. That’s how cell phone data plans and data storage plans work.
Research shows that it is 40% less expensive to expand the spending of an existing customer than it is to acquire a new customer. Given its cost efficiency, a pricing and packaging scheme optimized for expansion is powerful.
Of course, you will have to hypothesize and test the specific expansion spending plan.
Length of purchase commitment is another important variable. A one-year or multiyear commitment makes sense when your product value advantage is significant and the pain your product solves is high. In such situations, you may have the capacity to demand that longer commitment.
You can test this by offering a price discount for the longer commitment. You’ll learn a lot about your pricing power by the size of the discount you must offer.
Demand curves can vary by segment. This fact may open the door to profit optimization via differential pricing by segment. But segment-based pricing only works when sufficient segment separation exists (e.g., national boundaries — higher price in Canada than the US). Be careful: the buyer in a high price segment won’t take kindly to seeing similar customers in an adjacent segment receiving a lower price.
Airlines have figured out how to get away with significant segment-based price variation for the same product. The weekday warrior business traveler segment pays top dollar. The consumer traveler pays a lot less, if and only if they include a Saturday in the trip (the normal family vacation / weekend getaway use case). Airlines have succeeded in capturing additional volume at a lower price without driving down the high paying customer segment’s price. Uber differentiates pricing based on demand / supply dynamics. When there is high demand, Uber institutes surge pricing. If you choose to vary price by vertical or use case segment, find some credible basis of price differentiation, as Uber and the airlines have done.
State your segment-based pricing scheme as a hypothesis, and validate it in small tests before you fully roll it out.
Pricing Through Channels
If you have identified potential channel partners through which your product can be sold, you will also need to address channel pricing. As you consider the ultimate customer’s price, all of the considerations noted above still apply. But with a channel partner you must also take into account other factors, such as:
- Your capacity to control the end-customer price (limited, if your partner is a reseller)
- Rules for mitigating price-based channel conflict
- The net revenue and profit you will earn from a sale, given the pricing and revenue share rules
Channel pricing hypotheses are best tested with your channel partner. While you will argue over the share of revenue each claims from a sale, it’s in both of your interests in pricing decisions to maximize the area under the demand curve. So if possible, work together to test and optimize end-customer pricing.
A Final Word on Pricing Research
Far too often, executives don’t research pricing — they just wing it. That’s foolhardy. Researching the customer’s price sensitivity is difficult but important. Research methods were discussed earlier above, under the Canvas section of this chapter. The point is that it’s important to do the research. Your pricing scheme is a hypothesis until it is proven.
Two unit economics measures reveal a company’s financial health and viability:
- The ratio of an incremental unit’s lifetime gross profit (LTV) to its selling cost (CAC)
- The payback period on CAC
Investors are delighted with a company that exhibits LTV / CAC > 3, and a Magic Number > 1. The “Magic Number” calculation takes the growth in gross profit in the current quarter versus the previous quarter multiplied by 4, then divides that number by the marketing, sales and retention costs (CAC) of the prior period. If that calculation > 1, you have a payback period of under a year.
If you outperform these thresholds, you should hit the gas. If you underperform (after the initial ramp-up and testing phase), you should hit the brakes, test and iterate with small teams and small budgets until your performance rises above these thresholds.
Here is how the Unit Economics subdomain can be expressed in the framework spreadsheet:
Unit economics claims can be validated by tracking the factors that contribute to it. These include both revenue drivers and cost drivers.
- Average initial deal size
- Repeat purchases
- Upsells (expansion) in dollars
- Downsells (contraction) in dollars
- Cross-sells in dollars
Cost of Goods Sold
- Launch cost per customer
- Support cost per customer
- Customer success cost per customer
- Product-related vendor costs per customer
- Storage costs per customer
This list of revenue and cost drivers is too detailed to go into your framework spreadsheet. In this tool, the higher-level unit economics components are sufficient. However, they should be built into your financial plan, and tracked in a KPI metrics dashboard. They are the drivers of unit economics.
One important note. If yours is a subscription business, your least certain claim is likely to be your retention rate. That’s because churn tends to be a lagging indicator that can shift over time. You can strengthen this claim by assessing proxies for retention, such as:
- Product usage
- Percent of intended users utilizing
- Percent of features being used
- Level of reported customer satisfaction
- Customer’s business outcomes from using the product
CAC is a measure of reach and conversion efficiency. As with LTV, there are multiple contributors to CAC. At a high level, these are:
- Top of funnel costs (marketing)
- Mid and bottom funnel costs (sales)
- Channel partnership costs
Unit economics can affect prioritization of customer segments, and decisions in product development, customer acquisition and cash management. Your teams in marketing, sales, customer success and product, along with the exec team, should closely track the veracity of your claims in the Unit Economics subdomain, so as to optimize profitability and growth.
Customer Acquisition Method
In the Customer Acquisition Method subdomain, your job is to stipulate your acquisition channels, and then within them address how acquisition will occur — at the top of the funnel, mid funnel and bottom funnel. In the spreadsheet, the taxonomy of your consideration topics might look something like this:
Since LTV / CAC must be >=3 at scale, this impacts the methods of customer acquisition available to you. Healthline is the largest consumer health website in the US. For Healthline the LTV of each newly acquired consumer is $0.09. So its customer acquisition method is dominated by organic SEO. As such, Healthline is one of the most sophisticated companies in the world in optimizing to maximize Google search results.
On the other end of the spectrum there’s Lumiata. This company sells predictive medicine solutions to health insurers. A new customer for Lumiata delivers an LTV greater than $1M. As a result, over $300,000 can be spent to acquire each new customer. Here, a named accounts approach is the right customer acquisition method. Prospects are prioritized based on fit and their readiness to buy. The customer engagement approach is multi-dimensional, targeting people throughout the prospect company, in various functions and multiple levels. When a business exhibits a Very High LTV profile, it makes total sense to spend months creating a custom white paper or to facilitate a half-day team-based assessment meeting for a single prospect.
The point is that the design of your revenue engine is a function of your LTV profile. For more details on revenue engine design, read my book Scaling the Revenue Engine.
An important business model consideration is the timing of cash flows — both incoming and outgoing. The architecture of the Cash Flow subdomain in the spreadsheet looks something like this:
Cash flows are impacted by the rate at which you spend ahead of revenue, funding events and cash flows from revenue transactions. Let’s go through each.
Rate of Spending
When a company achieves a value breakthrough and embarks on the scaling path, the race is on to win the market. In such situations it is not uncommon for VCs to write large checks, and to challenge CEOs to hit the gas — to spend aggressively ahead of revenue so as to capture first-mover advantage and win dominant market share. This makes sense if and only if customer-defined value is transformative, and your company is operationally ready to scale fast. In order to commit to a “hit the gas” growth strategy, a CEO must have high confidence she can raise the next funding round at a strong pre-money valuation. Before you open the floodgates of spending, test and confirm the hypothesis.
Incoming cash flows swell every time you close a funding round. But your cash position can run precariously low if you spend under the assumption that a funding round will close, only to find that it doesn’t. Such miscalculations are all too frequent in the startup world. So it’s important to hypothesize the timing of the next funding round, and the traction outcomes and opportunity pathways you must prove to trigger investor enthusiasm. These should be tested with investors before you ramp up spending and run down your cash.
Cash Flow from Revenue Transactions
Say you are a B2B SaaS business. It is B2B SaaS gospel that annual contracts with upfront payments are better than annual contracts with month-to-month payments. Without month-to-month payments, you may need to raise a lot more money than would be the case with annual upfront payments. Nino Marakovic, from Sapphire Ventures, in a TechCrunch article on Jan 12, 2015, titled “Getting More Cash out of SaaS: Timing is Everything”4, modeled two identical SaaS companies whose only variation was annual cash up front vs. paid monthly. Both companies shared the exact same GAAP bookings, revenue, and operating income:
But Company A required customers to pay cash up front for the annual subscription. Company M billed monthly. Here’s the cash effect:
In this example, the increase in cash required to support the monthly pay model — i.e. the additional funding requirement — was $39M.
On the other hand, some companies (such as the logistics company DispatchTrack) have gained a relative competitive advantage by offering month-to-month pricing. This increased flexibility is prized by the customer, so much so that it drives demand.
Different business models have different cash flow impacts. If you are a lending platform that matches up consumers seeking loans to banks, your agreement with these banks may require your company to co-invest in the loans. While the unit economics of doing so may ultimately be quite positive, you will face a significant negative cash flow impact at the outset. Similarly, if you are an ecommerce site that offers a physical product line, your investment in inventory may require significant upfront cash.
The point is that you need to identify the cash flow implications of your business model design, and build and test hypotheses as to how you will meet these requirements.
The fifth and final subdomain is an important one: Competitive Moat. To build an iconic global enterprise, you must achieve a value breakthrough, optimize that value and build a path to sustainable competitive advantage. This third requirement — finding a path to sustainable advantage — is your competitive moat.
When an investor assesses enterprise value, he considers today’s profit, the potential for profit growth in the short term given your position in the market and its size, and the sustainability of your profit over time (discounted for net present value). Profit sustainability is assured when you have a big competitive moat that protects your advantage.
In his book Seven Powers, Hamilton Helmer articulated seven pathways to sustainable competitive advantage:
- Cornered Resources
- Network Effects
- Switching Costs
- Scale Economies
- Systems Power
In building out your business model claims, it’s important to consider these seven pathways. Which ones are relevant at this time? Given your stage, what moves are available to you to advance that competitive advantage? In building your competitive moat, there can be significant lag between your building efforts and the beneficial outcome of those efforts.
The work of building competitive advantage begins in the early stages of company-building. The benefits of that work increase over time. It’s like a vintner, who tills the fields, nurtures the grapes and then perfects the wine in barrels. The fruit of his work comes years later, but it makes all the work more than worth the wait. So too with competitive advantage. It works like this:
As to the taxonomy for this subdomain inside the spreadsheet, it will look something like this:
Let’s go through each of the seven pathways to competitive advantage.
Perhaps you have acquired an important patent. Maybe your company has secured exclusive long-term access to the most significant sales channel in the market. Or it might be that you have secured an exclusive long-term relationship with a key technology partner whose technology complements yours in a competitively advantaged way. It might even be that one of your top team members is the world’s leading expert in the technology or data domain your product lives in. All of these examples can be described as “cornered resources”. They are vital to your success, and only you possess them.
Do you have any cornered resources? Can you acquire any? What is your claim as to how powerful these resources might be in keeping competitors at bay? How can you test that claim?
Counter-positioning is an interesting pathway to sustainable competitive advantage. With counter-positioning, you adopt a superior business model that your competitor can’t adopt because to do so would exact too much collateral damage to its existing business. Early on, Netflix announced that it would not charge late fees. Blockbuster couldn’t follow, because late fees were too central to its profitability. In a year that Blockbuster was valued at $3 billion, its late fee revenue alone constituted $800M. By removing late fees, Netflix created a superior customer offering. This price change precipitated a steady multi-year shift in market share from Blockbuster to Netflix. Blockbuster waited far too long to capitulate on late fees, and it eventually descended into bankruptcy.
A counter-positioning strategy is competitor-specific. As you think about your competitors, consider whether any of them have made themselves vulnerable to a counter-positioning move by you. But remember that these strategies begin as claims. They should be tested and validated before you act on them.
Successful network effect businesses exhibit persistent competitive advantage, because they tend to be “winner take all” businesses. A network effect is operative when every new user delivers increased value to all existing users. Facebook, eBay, Uber, and all successful marketplace businesses exhibit network effects. To instigate and build a network effect business requires a carefully orchestrated set of moves. As a general rule, in an n-sided marketplace the idea is to solve for the hardest side of the market first. You start by delivering value to that side that does not require anything from the other side of the marketplace — such as with a SaaS tool.
For each side, you want to discover the “white hot center” — the segments within which the value from the other side is greatest. As you build your hypotheses for how to advance network effects, consider how you might test them. Network effects businesses require continuous testing and iterating.
To learn more about the power of network effects, check out the excellent research and papers on the subject, written by James Currier and Pete Flint, at NFX.com.
Switching costs exist when the pain of leaving your product to go to a competitor’s product is high. This happens with products that:
- Perform mission critical business functions, where the risk of a failed switch to a competitive platform is high
- Make a whole class of work much simpler in a way that no competitive product can replicate without significant operational disruption
- Enable completion of many adjacent steps via one solution, whereas the competitor can only do a subset of these
Switching costs apply just to your own existing customer base, so they don’t become strategically significant until you have achieved meaningful scale. As you develop a switching costs claims, consider whether there is anything you could to increase the stickiness of your product. How will you test this claim?
As you scale, you will gain ever-increasing buying power. Furthermore, your fixed costs will be spread across an ever-growing revenue stream. Both of these factors create cost leverage — scale economies. Assuming you become big before your competitor does, this should deliver you another form of competitive advantage.
Hamilton Helmer titles this power “Process Power”. He refers to the example of Toyota, which created the “Toyota Production System”. This system incorporated automation, an employee-involved continuous improvement discipline, and just-in-time inventory management. The system was so effective it delivered sustainably superior quality and operational efficiency in comparison to other auto manufacturers such as Ford, GM and Chrysler. These companies took decades to narrow the gap.
But “process” is too limiting a word for this power. A process is a set of steps that can be made more efficient. “Systems” is a better word. In the socio-technical sense, a business “system” is made up of people, workflows, technology and money flows. The most cutting-edge companies gain sustainable competitive advantage by the way they organize their socio-technical systems.
For instance, many Fortune 500 incumbents are stuck with monolithic technology and hierarchical organizations. If a new entrant is leveraging cloud-based technology, architected via microservices, with big data / fast data applications managed by squad-based cross-functional teams, it will be able to run circles around the incumbent.
The same is true with superior data infrastructure. New technologies, new organizational forms and decentralized cultures create the capacity for vastly greater productivity and flexibility. Systems can be a source of powerful and sustainable advantage.
Brand becomes a source of sustainable competitive advantage only after your company has achieved a level of reputation advantage well in excess of the objective value difference between your product and that of competitors. With a strong brand, you can extract a pricing premium or leverage it to gain market share, or both.
The power of your brand to deliver competitive advantage rises as you scale, but the work to build it begins early on. What is the essence of your brand identity? How do you know? How can you confirm that your identity resonates with your key target audiences? Brand must be continuously nurtured and protected. One wrong move can destroy a brand, as Volkswagen found when it cheated on US emissions tests. That’s why it’s so important to build thoughtful brand claims and think through how you will test them.
My first book, Scaling the Revenue Engine, explores what it takes to define your value proposition, clarify your competitive positioning, build a sound brand identity architecture, and translate that into a messaging schema that communicates your brand clearly and effectively to your target audiences. If you want to learn more about brand development, check it out.
Successful companies work with vigilance to optimize their business models. They engage in smart claims development, and then leverage KPIs and metrics dashboards to test, iterate and optimize. The effectiveness of your pricing, status of your unit economics, customer acquisition performance, cash flow status and progress in building your competitive moat can all be tracked via KPIs. These feedback loops, if properly acted upon, will enable you to test your claims, iterate and continuously improve — in all five Model subdomains.
As you move from Phase I to Phase II, your business model emerges as a first-order concern. At global scale, it will be the primary factor driving your enterprise value. Successful enterprises go to great pains to optimize it.
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- Blank, Steve. 2013. Four Steps to the Epiphany, K & S Ranch Press Publishing.
- Helmer, Hamilton. 2016. 7 Powers: The Foundations of Business Strategy, Deep Strategy Publishing.