- October 21, 2022
- Posted by: Ramkumar
- Category: Strategy
Last Mover Advantage VS First Mover Advantage
A typical conversation with Venture Capitalist firms or startup founders is about how their business can become a monopoly by escaping competition or killing competition. So when a founder pitches their idea to a potential VC investor, the founder first addresses the potential TAM their product/service caters to, as the higher the TAM, the higher the probability of funding. The next point is how their services will disrupt the existing markets. Finally, founders ask for funding because they assume they have a first-mover advantage and should exploit the same by scaling. In this post, I provide my insights on whether these points of discussion bring value creation to investors or if the founders are missing the point here.
Escaping competition/killing competition will help a startup only if they have a sound business model that is durable. For instance, let us compare two deals – Jeff Bezos acquiring the Washington Post for $250 million and Elon Musk buying Twitter for $44 billion. Both firms are in the media industry, and as of 2022 Washington Post has higher EBITDA margins than Twitter. However, Twitter has a higher value than Washington Post because Musk is confident he can turn around Twitter, generate future cash flows, and capture monopoly profits. However, the monopoly days of newspaper and print media are over compared to social media. The difference between a Washington Post and Twitter is that for a mature firm like Washington Post, most of its value is in the near term, but its cash flows will dwindle in the long term when customers move from print media to social media. A high-growth startup follows the opposite trajectory; it will lose money initially as it will spend its initial period in investments and customer acquisition. For instance, Linkedin’s market cap in 2014 was $24.5 billion when it had $1 billion in revenues and $21.6 million in earnings. Its high valuation is because of its higher potential future cash flows.
Growth VS Durability
A founder should decide whether near-term growth is essential or durability. They need to question whether their business model is durable and whether it will exist for the next 10-15 years. Technology startups that have become monopolies in the last decade have the following characteristics:
- Proprietary Technology
- Network effects
- Economies of Scale
A proprietary technology becomes a competitive advantage for a startup when its competitors find it difficult to replicate. Again, we have examples from Google’s search algorithm to Facebook’s social media platform. They were successful because these firms invented something new not addressed earlier, and their solution was way better than its competitors. We can extend the same example to Apple, which had a superior integrated design for tablets and consequently captured a monopoly share in the tablet segment.
Firms have network effects when more people use their products; it does not happen unless the users perceive the products as valuable. The firm can focus on the scale when the network effects improve by spreading its fixed costs. As the marginal cost of incremental sales is almost zero, firms having network effects enjoy superior economies of scale. Facebook, Microsoft Office and Google are notable instances of firms enjoying network effects. These firms scale but still enjoy superior margins. On the other hand, services businesses rarely enjoy network effects because as they expand, they need to invest by adding employees or offices, consequently impacting their margins.
Brand plays a decisive role in a firm becoming a monopoly. Coke and Apple are examples. Apple’s minimalist design, combined with customer experience, advertising campaigns and price positioning as makers of premium products, contributes to the perception that Apple’s products are in a league of their own. Apple’s competitors have replicated its branding strategy but struggle to displace their status because Apple’s proprietary technologies in hardware and software complement each other. In addition, as Apple enjoys network effects in its content ecosystem, developers build apps for Apple’s ecosystem, and its customer’s strong loyalty towards Apple products improves its stickiness. Thus, branding combined with superior products helps firms become a monopoly.
Does Higher TAM Build A Monopoly
Monopoly firms like Apple, Google and Amazon that dominate a large share of their market started with a small market because it is easier to dominate a small market than the large one. Thus, the perfect market for a startup is a small market that is concentrated and has no competitors. On the other hand, if a startup goes after a big market that the competitors already serve, it is a flawed strategy. I have observed founders stating in their pitch deck the TAM size is $100 billion, and they intend to capture 1% of the market share. If the competition already serves this market, higher competition will squeeze the profits. We see this phenomenon playing in ride-sharing and food delivery business models. Thus, a startup should start with a small concentrated market, dominate it, and gradually expand to related markets. Amazon employed this strategy beautifully when it started with an online bookstore, dominated that segment and then slowly moved to related markets like CDs, videos and software. Successful monopolies always dominate a specific niche and then scale to adjacent markets to scale.
Is Disruption Good?
Every startup in its pitch deck uses the term “disruption”. Disruption, coined by Clayton Christensen, refers to the art where a startup can use new technology to introduce a low-end product at low prices, then improve the product over time and eventually surpass the premium products that incumbent firms offer using an older technology. Typical examples were when personal computers disrupted mainframe computers and mobile phones disrupted the PC market.
For startups, disruption is not good because it attracts undue attention from the competition, especially when the firm intends to disrupt a matured market. Here, the startup has to win market share at the expense of the incumbent leading to low margins. However, the disruption is good if a firm disrupts a market with a new technology that expands the overall TAM. For instance, when PayPal popularized internet payments instead of VISA cards, it expanded the overall TAM of the payment/fintech business, giving VISA more business. However, ride-sharing and food delivery markets have disrupted the already matured markets inviting retaliation from the hotels/cab business. Thus, though Uber decimated the medallion business, it is still facing profitability issues because most of its focus was on tackling litigation and competitor reactions instead of refining its platform. Therefore, for startups intending to scale, it is better to avoid competition as far as possible.
VC firms pushing startups to gain first-mover advantage and market share quickly may not always work. First-mover advantage is a tactic and not a goal. The focus for startups is to generate future cash flows, so a first-mover advantage will not work if another firm comes and replaces you. On the contrary, it is better to be the last mover, make great strides in a specific market, enjoy decades of monopoly profits by dominating a small niche, and then scale up toward the ambitious long-term vision.
In many ways, scaling a startup is similar to chess. As a chess player, I remember Jose Raul Capablanca’s words, “To succeed, you must study the end game before anything else”. So likewise, a startup intending to become a monopoly in profits must follow this adage.