Estimating Wrong and Estimating the Wrong Metric

In business, large enterprise or startup, we make many estimates in our roles. Be it market size, addressable market,  penetration, market share growth, effect of a marketing campaign etc.

In the absence of clear data we make assumptions, look at past performance, compare to similar entities and try to estimate the metric we are interested in. In this process we make process errors – errors in spreadsheet, coding, data entry – errors that are avoidable with stricter framework or can be weeded out with a review process.

What is more dangerous are the bias driven errors that cannot be caught by any review process because we all share the same view and biases.

Here are those estimation errors that we are oblivious to. For a vivid illustration of these errors see  this story on museum visits.

Museums take pains to make the past come alive, but many are out of their depth when looking into the future.

When selling plans for a new building or a blockbuster exhibit, civic leaders and museum officials typically cite projected visitor counts. These numbers can be effective in securing funding and public support. As predictions, however, they often are less successful.

1. Estimating Exact Numbers – Estimating a single exact number with certainty because we look down on those who don’t do that as diffident.
2. Comparison Error – Making estimates based on other similar projects but err by choosing the most successful ones (not to mention what is available and recent).
3. Atypical Scenarios – Making estimates not based on what is most common and most likely to happen but on atypical scenarios.
4. Context Error – Ignoring the state of your business (stage in growth cycle etc), market, dynamics, customer segment etc.
5. Attribution Error – Attributing someone’s success to wrong traits and making our own estimates because of shared traits.
6. Using Lore – Using very large number from the past because it is part of the organization’s shared lore – never stopping to question, “Where did we get that number?”
7. Ignoring Externalities – Making estimates without regard to economic factors, disruptions, what the competitors would do
8. Underestimation –  Deliberately estimating low in order to exceed expectations

 

Finally to top all these errors, the biggest of them all is to estimate the completely irrelevant and wrong metric because it is easy —  page views, number of retweets, user base etc. So even if you fix all the above errors you end up with perfectly estimated wrong metric. I have written in detail about this here.

Do you know your estimation errors?

Walk away, don’t play chicken with Amazon

I do not know why businesses refuse to learn from the past and why they insist they are different from all others who came before them. Admit it now, it is okay, no business can take on Mr. Bezos and Amazon on price leadership at the low end. Don’t get into the ring. Don’t wage a war. It won’t be a war, it will be quick skirmish in which  you will be thoroughly destroyed and forced to issue statements like,

“it was an experiment and we achieved what we set out to achieve”

This time the brave new knight to get into price war with Amazon is OverStock.com. They announced a daring campaign – a promise to sell books 10% below Amazon. Not just match prices, which would have been a signal to Amazon to not drop prices but sell 10% below. And what did Amazon do? GigaOm reports

Amazon is quietly slashing its own prices on print books. In a special report over the weekend, trade publication Shelf Awareness noted that Amazon has begun “discounting many best-selling hardcover titles between 50 percent and 65 percent, levels we’ve never seen in the history of Amazon or in the bricks-and-mortar price wars of the past.”

These are far greater than the usual 40-50% discount Amazon usually does. Where does that leave OverStock.com? Is it ready to sell below the 65% discount Amazon offers?

When it comes to price setting there are two kinds of companies – Price Setters and Price Takers. Apple is a Price Setter at the high end. Amazon is the undisputed Price Setter at the low end. A rational low end Price Setter may look at cost advantages to maintain leadership. But Amazon is no rational player. At least that is what they want all of the market to think.

Amazon has adopted a deliberate irrational strategy, signaling others they are not going to play by someone’s rational expectations.  You should be careful in waging price wars with such irrational players.

if you are playing a game of chicken in cars, if you were to break the steering wheel and toss it out the window in front of your opponent then he knows you are not going to swerve. (source: Art and Science of Negotiation). That is strategic irrationality.

In the game of chicken played in retail prices, Amazon is such a strategically irrational player. Mr.Bezos has signaled to all other players that he has thrown away his steering-wheel and placed a brick on his gas pedal. They are not going to let up on lowering prices and they can keep at it as long as they can because they have the full trust of their shareholders.

Even this morning CNBC’s David Faber was talking about Amazon stock prices and investor behavior. Even after Amazon reported a loss its stock did not suffer much. Faber quipped, “may be Amazon should have reported larger loss so its stock could have gone  higher”.

In 1999 Barron’s magazine warned investors about Amazon. Then its market cap was $19B, now it is $141B.  Amazon practices strategic irrationality while investors seem to be equally irrational, strategic or not.  There is no expectation what so ever from investors on profit.

Let me repeat my advice. Don’t bother. Don’t get into price war with Amazon. Walk away. You are not going to dismantle Amazon as Price Setter at low end. Instead focus on customer segmentation, product mix and differentiation. You have far better chance of succeeding there because your competitors there are far more likely to be rational.

Finally, let me predict something for Google Nexus 7 – the next Kindl Fire is going to force it to slash prices.

Books on Chocolate – Strategy, Competition, Family and the Dark Side

Here are some books on chocolate I read and I like and recommend all of them. Two of the books are about Cadbury, a brand that is now part of Kraft.

1. Business Strategy  — Cadbury’s Purple Reign: I was very impressed by this book and its dissection of how business decisions on product strategy, segmentation, positioning and sales enablement was done in the early years of Cadbury’s. I could not help but wonder how much of that was revisionist history, how much of that is my own biases in reading more into it than there is and real business history.
   Nevertheless, the book backed up its stories with news clips and quotes from sales meetings that add to its credibility. One notable brave business decision that caught my mind is Cadbury’s decision to give up its old product versions when they switched to pure 100% cocoa.
   Another one was their decision to switch direction again when the competitors were caught up with 100% purity and the customers demanded more than just 100% purity.
2. Competition — The Emperor’s of Chocolate: This is a history of the battle between the two chocolate giants of America – Mars and Hershey’s. When reading the closed culture of Mars and the business idiosyncrasies of both brands I can see parallel to many present day tech brands.
   One thing that caught my mind was,  going to market  with highest quality and full featured product is not as important as having a good enough product but a superb control over messaging and positioning.
3. Family — Chocolate Wars : Don’t be thrown off by title or the sub-title. This books is very much about the Cadbury family, their values, morals, struggles, ups- and downs. The author is more effective when she covers these aspects than the business aspects. She is also the author The Lost Prince (and says in that book Marie Antoinette never said, “Let them eat cake”). I enjoyed reading the personal side of the business folks who appear larger than life in The Purple Reign. Read the chapter that talks about Cadbury’s first store design and experience – you will find where Apple Stores got their inspiration.
4. The Dark Side — Bitter Chocolate: This is the dark side of the romantic story, the backoffice story that never gets told until an author like Carol Off takes the time to travel to the cocoa producing countries and write about the state of the cocoa farmers. I was surprised to hear that the poor families that worked on cocoa farmers did not know the use of cocoa beans or what chocolate was.
   This calls into question my own beliefs about, “Business of business is business and not social responsibility”.  While cost is irrelevant to pricing, ignoring externalities artificially reduces the cost to marketers and enables them to sell the product at much lower prices than they would.

I am a big  fan of 85% and above cocoa, so next time you see me remember that.

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.