Strategy, Business Model, and Product

It has been a week of arguing which sequence is right. Is it

Product > Strategy > Business Model

or

Strategy > Business Model > Product

For most people in the valley – running startups, working for them or mentoring them to become insanely successful – the sequence is clear. There is no argument. Anyone who says otherwise simply doesn’t get it.

Wouldn’t it help if we all understand and speak the same thing when we say  Strategy, Product or Business Model?

Here is a very simple definition for these terms. Not made up, not changed to fit present day mania. These are well established definitions for running any business. And those disrupting status quo to create frictionless something or the other are not exempt from these definitions.

Strategy – Here is a simpler and relatable definition – Strategy is about making choices under constraints (and most times under uncertainty). Choosing the only option available to you (say going for 4th and 24 with 7 points down and 20 seconds on the clock) is not strategy. Choosing all options available because you are not resource constrained is not strategy. Strategy is making hard choice, under limited resources (there are only situations with limited resources) and the outcome is far from known.

For a VC firm their strategy could be the type of ventures they even want to consider, be it the pedigree or market it plans to play in. For accelerators it would appear they could fund anything and everything from enterprise to social media startups but their choice is to limit investment choices based on the stage of the startup.

For a startup (or more generally, a business) the choices start with which customer segment and need they want to target first – a segment with compelling unaddressed need, that is not only big enough but also had big growth opportunity. You can serve all customers and all needs. The old adage about being all things to all people goes well here.

For example, Salesforce.com choosing to serve enterprise customers with significant pain-points  (and IT budget to spend) and reach them through highly effective direct sales team vs. building out Chatter as competition for Facebook is their strategy. Another example is Netflix choosing streaming over DVD by mail as the future.

Strategy does not end with the first choice. If you have to make a hard choice among available options (and most times under uncertainty) then it is strategy. First it is the segment to target, then there are choices on routes to market, product, product features and when to deliver, pricing  and communication.

That is strategy.

Business Model -  You can do a Google search on all kinds of theoretical works on business model. In practical terms, business model is answering two questions

1. How are you creating value to your customers? (see value equation)
2. How are you capturing your fair share of that value created? (see Value Step function)

Together these two constitute your business model. You could be like some of the group buying sites and take a share of value you did not help create. Or you could be miss out getting your fair share. In either case your business will sooner or later will fail because it runs out of value to take or in latter case run out of cash.

You could introduce a third party (or fourth, or fifth) in the value flow – say advertisers, content producers – and decide to capture value indirectly. If your product adds compelling net new value to customers you chose to serve, charging for it remains the simplest of all business models.

And as an astute reader you noticed there are choices to make in defining the business model. It could be in how best to deliver value or how to capture value, whether to capture value upfront or align with value deliver (subscription). That is strategy does not go away when you move to business model.

Product - What is a product? Are your customers buying products? Ted Levitt said,

“Customers are not buying quarter inch drills but quarter inch holes”

Clayton Christensen said,

“customers have jobs to be done and they hire products for those jobs”

So we could say product is the value delivery medium. This is not to trivialize it. Product offers the greatest opportunity to innovate – to deliver something that does the ‘job’ better than any other alternatives available to customers, to deliver most natural way to use it, to do so in the most cost effective way for the venture that is building the product, to make it sticky, etc.

Again there are choices to make – what to build, when, how etc. More strategy in building the right product.

Given these, you decide whether one is greater than the other.  For startups, Fred Wilson argues finding the product-market fit first, deciding on strategy then business model.

For startups that begin as a personal problem the founder is trying to solve with the assumption that there are many others with the same problem it would appear

1. start with the initial iteration
2. keep refining it through user discovery
3. build a large enough user base, getting early adopters to spread the word
4. worry about monetization later

… is not only the only recipe but one that is guaranteed to deliver success (can you say Facebook, Twitter, Instagram, Pinterest?)

The argument for product first approach should not be because of what we know to be successful startups or because of one’s inability to start with strategy first.

Did you consider the possibility that when you do thousands of experiments – thousands of founders with the same personal problem, trying to address it in thousands of different ways – some experiments are going to succeed?

Product, Strategy, Business Model and Two ‘>’ Symbols

Quick! Write an inequality equation using two ‘>’ (greater than) signs and

1. Product
2. Strategy
3. Business Model

Depending on where you stand and which articles you read recently there are six possible permutations.  If you had recently read what Fred Wilson, a Venture Capitalist, wrote you are  mostly likely to write down

Product > Strategy > Business Model

Is that all to it?  According to research done by four business schools, this permutation defines only one of two classes of VCs. More precisely, there are two schools of thoughts of how VCs make investing decisions. The second class of VCs believe the right permutation is,

Strategy > Business Model > Product

While Fred Wilson makes a compelling case to get product-market fit correct, then define your strategy and then worry about making money, a VC who falls in the second category will argue, equally eloquently, strategy (making choices about segmentation and needs to serve) first, finding how you add and capture value (business model) is next and what the offering (product) is last.

The two ways of reasoning are called  Effectual and Causal reasoning respectively.

Effectual – Instead of doing market research, competitive analysis, value analysis etc, go build something and keep iterating on it and building a growing customer base. Then worry about strategy and business model.

Causal: Start with customer segmentations and their unmet needs (or jobs to be done).  Make choices on the right segment you should target first and understand its value perception, alternatives and willingness to pay. Define a product version that serves that segment and offer at a price they are willing to pay.

There exists a class of VCs who apply effectual reasoning and there exists another that applies causal reasoning. You can see Fred Wilson falls in the effectual bucket.

So when you have two classes of entrepreneurs and two classes of VCs, the next obvious question is which pair would work together well. The aforementioned research suggests, cognitive similarity (“I like how you think”) was a decisive factor in how VCs decide choose to invest in startups.

Their study was conducted on 49 partners from different VC firms, by presenting them 16 different hypothetical investment opportunities and asking them to rate how likely are they to fund these ventures. From these 784 data points, the researchers employed conjoint analysis to tease out the influence of individual factors on VC’s decision. This is approach is far better than stated preference studies that ask VCs for their rating and data mining studies that succumb to data errors.

 

The number one deciding factor?  How similar the thought process is between the VC and the founder. The researchers call this cognitive similarity, which has nothing to do race, national, education, gender or other physical characteristics. It is how a founder thinks and how similar it is to VC’s thought process. Higher the similarity, greater the chances of getting funding.

Everything else, including the perception of the team, its experience and commitment (human capital) are influenced by VC’s reading of founder’s thought process.

“A founder who demonstrates cognitive similarity with a VC is more likely to be perceived in a positive light, and viewed as better positioned to make effective use of his or her human capital”

All other positive attributes we hear about, the product’s competitive advantage, scalability, founding team’s ability to hustle, their focus etc seem to be bestowed after the fact.

What does this mean to you as a startup founder seeking venture funding?
You are better off seeking those VCs who think like you do in terms of product, strategy and business model. If you think market demand and opportunity size first and pitch to Fred Wilson you are most likely going to come back empty. On the other hand you at least get to play if you think product-market fit first. So knowing how you reason and seeking as venture partners only those who think like yourself saves lots of wasted time and agony.

Will Fred Wilson and other VCs admit to this influence of cognitive similarity in their investment decisions?  More broadly, do VCs know and admit to the influence of cognitive similarity on their funding decisions?

No, they do not recognize this hidden factor. And I expect comments from a few stating so. In the same study that teased out this hidden factor, the researchers asked an explicit question on how much weight VCs place on cognitive similarity with founders.  VCs rated this as the the least important factor, but when they had to place a bet given a profile of venture and its founders, the hidden influence of cognitive similarity came out loud and clear.

Finally, is Fred Wilson right? Is effectual better than causal?  The proponent of this classification, Professor Saras Sarasvathy, goes one step beyond this mere classification.  She argues great entrepreneurs are ‘effectual’. They opt for doing things vs. analyzing things.  I do not subscribe to this latter part of her theory regarding what defines entrepreneurial greatness.

How do you reason?

Do you worry about your customer end use?

Here is what a business owner said two years ago about selling to new customers who caused a surge in demand that depleted supply at the expense of his current customers,

“Business is business.  If you sell prime rib, do you care if they’re going to make goulash out of it?”

Does it matter to you what your customers do with your products?

Before you answer, think about these different but related questions,

What job is your customer hiring your product for?
What job  do you want your customers to hire your product for?

Let us get some more context here. This quote comes from a 2011 story on the rooster feather fashion trend. People started a new fashion trend of putting rooster feathers as hair extensions. Soon salons all over the country started stocking up on rooster feathers, offering it as fashionable hair trend to their customers.

Before this hair craze the only known segment that hired rooster feathers was fly-fishers.

Fly-fishers prize Whiting saddles because they have a pliable center shaft and can be wound around fly-fishing lures.

“A pattern that creates the illusion of wings fluttering on the end of your line, if you tie it right.

“So you’d actually lash it in, tie it to the hook, and then you would wrap the stem of the feather…”

Fly-fishers hired the product for a specific job, reasoned with both utilitarian and emotional components. Thanks to their needs and user behavior business for rooster feathers were predictable. Then the surge happened with hairdressers.

The hairdressers. They call multiple times a day. They walk in off the street.
…
“I like that it’s really low maintenance,” a end user said. “You can straighten it and curl it, and it’s not permanent.”

With hairdressers came different prices. Feather prices saw 500%-1000% price increase as hairdressers were willing to take all the feathers they could because their end customers were willing to pay $50 per extension.

“That’s probably, maybe $300 or $400 worth of hackle, as it used to sit. And it’s probably $3,000 or $4,000 worth of hair extensions now”

With the new segment and its job to be done the same product assumed new value and a new price. Should the fly-fishing shops and rooster farms take advantage of it? Given limited supply and time it takes to produce (the roosters take time to produce feathers) should they embrace the new segment at the expense of current segment?

See this scenario in the context of the job-to-be-done growth matrix I created.

Fly-fishing shops and rooster feather farms have started in top left quadrant. There was one segment with well defined job to be done and a price to go with it. And without any deliberate action from their part the bottom right quadrant developed – new customers and new jobs. The choice, under constraints, is to whether to move to that quadrant  and not serve the current segment.

It is one thing to make deliberate strategy choice to grow your business by finding new customers and new jobs and serve those with product pivots and product innovations. It is another to handle an uncertain new growth opportunity thrust upon your business. Businesses need to ask,

1. Do we understand the new customers and their new jobs well?
2. Is our product the right candidate for that job, today? Will it remain so tomorrow?
3. What other alternatives do these new customers have for the job to be done?
4. Are my current customers and their job to be done changing?
5. If I choose the new segment, will my current one exist when the new demand dries up?
6. Will our new customers take you in a direction you did not plan on?
7. Will you have competitive advantage when serving new jobs of new customers?

So to answer the questions I posed in the beginning of the article, yes you should worry about how your customers use your product. To be precise, what job they are hiring it for. That drives not only product innovation but also your strategic growth decisions.

Some see the big upside from new customers and are ready to overlook the uncertainties in demand and the risk it poses to core customers. Others ask the right questions (like the seven questions above) and stick with serving jobs they understand and know they can serve successfully, far into the future. Like this other fly-fish shop owner who is refusing to sell to hairdressers and de-marketing to turn away new customers.

There’s no actual evidence, but he’s hoping to start a rumor the feathers cause balding.

 

 

 

The $10,000 Smartphone

Print version of Fortune poses the question to its readers,

Are you ready for $10,000 smartphone?

Then teases us with a promise to answer

Who buys these phones and why?

Un-Fortun(e)-ately it is asking the wrong question and fails to answer who and why in its article. The digital version does not commit these mistakes opting for a benign informational title.

Asking its readers whether they are ready for $10,000 smartphone is wrong because that’s not whom Vertu is targeting. Opinions of the columnist or the comments of their readers are irrelevant. You should consider the possibility Vertu understands

1. Who their target customers are? (Hint: Not Fortune readers, likely Richistan )
2. What job are they hiring the luxury phones for? (Hint: conspicuous consumption)
3. What is their phone’s competition? (Hint: not $650 iPhone, likely other luxury products)
4. What their willingness to pay and wherewithal to pay are? (Hint: No pricing pressure here)
5. What budget will customers pay from? (Hint: not their smartphone budget)
6. How to reach them? (Hint: Not through Fortune magazine)

Fortune quotes McKinsey study (don’t you love those sentences that start with, “McKinsey study states …”),

brand needs to continue building on its heritage — highlighting the skill of its craftsmen

And guess what? Each Vertu phone is assembled by a single craftsman and Vertu shows it off to its customers at its manufacturing site.

You don’t believe $10,000 price tab is due to the labor cost, do you? Or that the craftsmen are more precise and produce better quality smartphone than the automated machinery that can assemble parts with near perfect precision? In this case McKinsey finding is partly correct.

It is true Vertu wants to highlight the skill of craftsmen but not to the target segment buying the watch  but to us in the peanut gallery (and Fortune readers) how great the craftsmanship is so our admiration makes it worth it for those buying the $10,000 smartphone.

Finally an IDC analyst interviewed for the story states,

“even capturing 1% of the $295 billion global smartphone business would be an achievement for the firm”

If you followed the real target segment and understand the job they are hiring Vertu for you will see how irrelevant the size of smartphone market is or the share to capture. Vertu is not competing for the job of iPhone/Galaxy and customers are not paying for it from their budget for smartphone (as a utilitarian device).

The real market size should be based on luxury spend and the market share question is how much of that spend on Gucci handbags and Tiffany’s diamonds can Vertu capture.

The moral of the story is, your understanding of business opportunity, market size, market share, competition, pricing and likelihood of success will all be wrong if you do not start with customer segment and what they are trying to get done.

How do you size your business opportunity?

 

 

Do you need to maintain pricing parity across all channels?

Let us look at this case study:

Airport terminals are not gourmet ghettos. We mostly get a food court with the usual chain restaurants. Wouldn’t it be great to give the travelers – locals, those in transit, and visitors – a taste of the local flair? Phoenix airport is trying to do exactly that. They are giving the local coffee shops, bakeries and restaurants an opportunity to open their shop at the airport terminal.

It does provide the local businesses a new revenue opportunity by adding a new sales channel. Forty million people pass through Phoenix airport every year. That is a large Target Addressable Market (TAM), even a 5% conversion with average tab of $8 means adding another $16 million in new revenue from one location. There is also the positive side effect of marketing exposure.

But it does come with many drawbacks.

First the rent at airport can be up to 10 times what these local restaurants pay in city locations. Second the hassle and costs associated with security and regulations. Third the additional infrastructure cost in equipment and other things to make the place resemble the city location. Lastly, customers want to pay same price they pay at city locations.

There are many questions here. Primarily should a business consider adding airport location given the huge exposure and opportunity. That is a topic for another day or you can hire me to help you with the analysis. Here I want to address just the last drawback

Customers want to pay same price they pay at city locations. One restaurant decided to do just that,

what you pay for a salad at Chelsea’s original Phoenix location is what you’ll pay at the airport.

Is that the right thing to do? Doesn’t it matter that the restaurants incur significant incremental costs when they open a sales channel in airports? Shouldn’t that costs be offset with a price markup on products? How should the pricing be for a new sales channel?

If you know the answers you can skip the rest of the article.

Here is what you need to consider.

Where do you start for pricing? You start with customer segments based on their needs. In airports you have

1. Those who hire your restaurant as a better (healthier, tastier, fresher …) alternative to greasier and generic options available. This segment includes some members from all travelers.
2. Your loyal locals who are happy to have their favorite option available before they board the plane (without having to make a side trip).
3. Those who hire products simply based on price.
4. Those who hire products based on brand – a local restaurant likely has no brand recognition outside of locals going through the airport
5. Lastly, most ignore this segment, those who work at the airport and need better options for their meals.

This is a case of adding top-right and bottom-left quadrants from Customer Jobs Growth Matrix.

The question of price parity does not come into play with (3) and (4) and anyone that is not local in (1). Stated another way you only need to worry about pricing parity if they already have a reference price – what they pay at your city locations.

Your options?

You could maintain pricing parity as long as the profits far outweigh profits from opening other city locations for the same investment. That is consider your opportunity costs. But don’t charge same price because it is the “right” thing to do or your locals demand that. This is as bad as simply adding your airport cost overheads to your local prices.

You have access to a segment (likely large and constantly refreshed) who value the better options at airports and have higher willingness to pay. You should find a way to capture this value with better pricing.

If only you could do third degree price discrimination – say asking for driver’s license – and give a price discount to locals you are good. But that is a hassle and mostly not something you want to do because of overall customer experience.

That leaves you the following options to capture additional value from customers choosing your restaurant in the airport location (that flows from the recommendations in the Growth Matrix)

1. Price Higher and Use Cost Argument – Recognize it is okay to not serve all customers. Don’t focus on 40 million customers, ficus on who perceive higher value from our offerings. Do a marketing research if need be. You may want to give up on some of your locals buying at airport and choose to target only those with higher willingness to pay.
   Most times you can convince locals of hardships in running your restaurant in airports and charge a premium over your city location prices. You are not doing cost based pricing – you will set prices based on what customers are willing to pay at airports – you are only using cost to justify higher prices.
2. Product Mix – Play with your product mix. Add newer options that are available only in airport locations and charge a premium for them. These could be simple variations of your menu choices. You should do this even if you don’t have pricing pressure.
3. Creative Packaging – Consider different sizes – think smaller for same prices as city locations. A 10-20% decrease in marginal cost can stand in for not raising prices. Apply creative messaging like -ToGo, OnAir etc. You should do this even if you don’t have pricing pressure.

The cardinal rule however is start with customer segments before you decide on pricing. Be it opening an airport location, adding food cart version of your restaurant or serving down markets with your enterprise products – start with customer segments, their needs and their current alternatives.

How do you set pricing for your different sales channels?

Serving New Jobs of Customers You Already Have

Let us look at this news story that is more than three years old and comes to us from NPR on a story on how Holywood gets fed.

In the old days, craft service  didn’t deal with food at all, because there was no free food service on the studio sets. Actors simply brought their own food in brown bags, and there was a break for lunch.

But then hours on set really began to stretch out. ”Now you get into issues of people being tired, being hungry,” Conover says. “Well, who’s gonna order the pizza? We’ll have the craft service guy do it.” Craft service was already doing odd jobs: digging a hole to place a camera at ground level, laying out protective material on sets — and cleanups, too. (Source: NPR)

Previously I discussed a real simple yet powerful variation of Ansoff Growth Matrix – one that is fitted to look at customers and customer jobs instead of markets and products. Customer jobs in its essence is a customer need (utilitarian or hedonistic) and customers buy products (or hire them) to fulfill those needs.

Here is how the growth matrix looks like with customers and jobs.

 Any business that is either trying to break in (startup) or trying to expand (enterprises) has four paths based on this matrix and related actions that go with those options. One of the options is:  Serving new jobs of customers you already have (that is jobs you did not serve in top left quadrant).

When customers already hire your products for certain jobs you have an incredible opportunity to understand  rest of their jobs and identify those that you could serve with simple product pivot. You can’t go after every job. Strategy is about making choices. Your choice has to be based on opportunity size, your cost to fill that job better than what customers hire to do the job and your likelihood of success.

In the case of Craft Service featured in the NPR story their customers originally had hired them for different job. The new job of feeding the production crew did not exist or had alternatives (brown-bagging). A change in environment created this new job that needed addressing.

It is likely Craft Service did not actively make a strategic decision to take on food service. But they did their current job so well that their customers sought them out to fill new jobs. As managing food service fit  within the realm of what Craft Service was doing it was a right product pivot.

While Craft Service got lucky, if we want to take this path to grow our business we must be constantly engaging with our customers to surface new jobs that our offerings would serve better than current alternatives while making a profit for us. Sometimes better product positioning would suffice, other times product pivots are required.

How do you find the jobs your customers hiring products for?