This article is the sixth in an ongoing series on Due Diligence. To learn more about performing due diligence quickly and effectively, download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.
How many times have you heard an entrepreneur say they have no competition? After hearing thousands of investor pitches over the years, my rough estimate is that I hear it about 25% of the time. When I hear a CEO blurt this out, I chuckle to myself and think, well, maybe there isn’t a need for their product. Or, maybe the CEO is just clueless about their target market.
Competition for new “Need to Have” products always exists. Researching the competition and providing reasonably detailed discussions about the competition will be a joint effort between the company and the due diligence team. Moreover, even the best of startup teams will learn valuable information as they review the competition and better understand their own uniqueness in their target market.
Q: Christopher, how do you kick off a competitive review?
In most cases, you can start by asking the company to provide a detailed list of competitors. Don’t accept the company’s list without checking the ecosystem they live in to find competitors they might have left out. And, once you’ve built up this additional list, make sure the company provides you with their key differentiators.
It is also important to use a “mindshare” or “walletshare” lens when thinking about competition. The four fiercest competitors most products face are;
Ignorance about your product (they might like it, but they have just not been educated yet)
Alternates/substitutes from other categories (i.e. not movie A vs movie B, but dinner out instead of a movie)
Fear of change (which is how everyone except the early adopters thinks)
The inertia of “good enough” (which requires a major catalyst to overcome)
The existence of these four tough competitors drives a harsh reality: just because the new product is better than the competing products, doesn’t mean it will sell. As noted, it often needs to be 10X better.
Q: During your customer reference checks, the feedback indicated that the entrepreneur is selling a real “Need to Have” product. How do you determine if the product is differentiated and defensible?
First of all, to determine if the product is differentiated, we do a competitive analysis that combines our own research along with market outreach to customers and prospects. During our reference calls, we ask the following questions:
How are you solving your problem today?
Have you used similar products before?
Did you look at any competitive products?
Are you considering any alternative ways of solving the problem?
It’s important during this stage of due diligence that you have one or two market experts helping with your research. You don’t want to be blindsided by a competitor that was already very well-established in the market.
The key when looking for differentiation is to look for distinctions that matter to the customer. Founders are in love with their product. They know every detail. They are really close to the nitty gritty - usually too close. When asked about differentiation, founders won’t hesitate to cite differences which are extremely nuanced. Even if they can even be detected by the typical hurried customer, they often will not be a major value driver from the customer’s perspective. The investor’s job is to figure out the differentiators that matter to the customer and make sure they are present in the product.
Q: OK, so how do you determine if the product is defensible?
To determine if the product is defensible, we need to look at three basic questions:
Can the hard won customers be retained?
Will pricing power hold up over time?
Are the margins in the business likely to be squeezed by competitive or environmental factors?
Retaining customers is all about delivering a strong value-proposition relative to your price and relative to the other things on the market. You need to get to a bottom line: does the company have a compelling offering?
Defending pricing and margins usually takes one of two forms: either keeping competitors out through some sort of blocking rights like intellectual property (e.g. public forms such as patents, trademarks, copyright or private forms such as trade secrets or proprietary know how), or finding ways to keep customers in.
Keeping customers in requires some form of the classic economic concept of high-switching costs. In the case of Facebook, the high switching costs would be all the friends, updates, photos and data you have collected on the system and cannot figure out how to move elsewhere. On a personal computer platform it might be all the software you have invested in which is only compatible with that platform. In cameras, it might be getting someone to invest in a lot of Nikon lenses over time so they will never switch camera brands. In case it is not obvious, businesses with high switching costs are not that easy to build, especially in today’s internet-centric world where competitors’ products are just a quick Google search away. It is also worth noting in the context of forecasting that more often than not, efforts to bake in switching costs just come across as product limitations which irritate consumers and slow adoption. Consumers are pretty savvy at avoiding lock-in and format wars when they can. As much as it hurts to admit it, sometimes the best lock-ins are an accident, or at least very subtle and sneaky in the beginning.
One closing thought here: “first mover advantage” is not a type of defensibility. Entrepreneurs cite it all the time, but as we have discussed in the past, getting an actual advantage from being a first mover is really rare and really hard.
Q: How do you determine the level of competitive intensity and noise in a market?
Silly as it sounds, in today’s world, searching the web is a good place to start. The entrepreneur will generally include a slide with competitors and a slide with potential acquirers, so you always have a place to start. Checking out those companies’ websites to get a sense of the level of marketing sophistication and effort will give you a good sense of what the start-up is up against. These websites will also give you a sense of key features being touted and sometimes even competitive pricing information.
In more mature industries there may be third party analyst reports such as the classic industry analyst magic quadrant, studies, forecasts and journalism. These can be excellent sources of information to help you understand who the players are, what the customer dynamics are, and what the main selling points seem to be.
And finally, speaking with the customer references about the market and the competitors and the value proposition can be incredibly enlightening. It is amazing what people will open up and tell you if you just take the time to ask in a nice way.
Q: So let’s assume that the company has a solid lead in the market. How do you factor in issues such as defensibility of market share and price/margins?
It is very important to look at company growth forecasts in the context of the overall growth of the market. It is not uncommon for companies to give you projections that have them owning ridiculous amounts of market share. Every market is different, and some newer markets will grow much faster than more mature markets, so you need to look at the plan and understand what the revenue forecasts imply. Put another way, it is great that a company says they are doubling every year, but if their market share would actually be shrinking over the same period, that has some pretty major implications. Likewise, if that doubling growth rate implies that they are going to be going from 20% to 60% to 80% market share, you might want to dig a little deeper into the projections. It pays to keep in mind that the faster your company projects it can grow, the more likely that is going to be an attractive market into which new forms of competition will flow. And it won’t always be companies just like yours - it will often be much deeper pocketed companies who suddenly wake up to the strategic importance of the market and are not only able, but happy to subsidize their solution to gain share quickly. In short, market conditions are like the weather - it can change very quickly.
Q: Where do substitutes and/or adjacent solutions fit into your competitive review?
As noted above, it is very important to understand that very meaningful competition can come not only from similar products but also doing it an entirely different way, or even not doing it at all. Founders who are very close to the product, virtually steeped in nuances that may or may not ultimately matter to customers, can have a very skewed, but also very contagious perspective. And it is not helped by the fact that customer conversations at this stage are exclusively with early adopters.
You need to step back and find out what people are doing now, what other alternatives they have to the company’s proposed solution and what benefits (as opposed to features or nuances) they bring to the party. Competitors will be going out of their way to provide alternatives to the product, history and inertia will provide substitutes for the product, and established players will extend their product suites to provide weak but trusted counterfeits of the product. Your job is to figure out how much those alternative paths matter; does the company have something that provides really compelling value?
Q: Do impact investors approach the issue of competition differently?
As I noted in this discussion of market size and competition, if the need is being completely met by existing players in the market, then there is little point (or rather, little impact to be had) in adding more investment to that market. However, in markets that are not saturated, impact investors may be slightly more tolerant of competition if there is still room for meaningful marginal impact.
Impact investors think less about competition through the traditional lens of pricing power and the ability to sustain margins, and more through the lens of efficiency - maximum impact per dollar invested. Yes, the company has to have healthy enough unit economics to be able to survive and grow, but it is not necessarily expected to achieve hypergrowth or spin off tons of free cashflow. For many impact investors, success is a healthy business that creates jobs, serves all its stakeholders, and efficiently delivers the desired impact. It does not matter if some competitor is getting more buzz or a higher valuation on a VC round. The focus is on the health of the business, the health of the stakeholders and the economic efficiency of the impact.
Q: Do you spend much time thinking about prospective competitors OR new technologies that might disrupt the market?
Yes, depending on the industry, that can be time well spent. For example, Cisco paid a half a billion dollars for a stand-alone video camera company (Flip Video) at a time when cell phones already had crude cameras. It would be one thing if phones didn’t yet have cameras, but many would argue the rapid demise of Flip was totally foreseeable had Cisco only taking the trouble to think about it. Taking a moment to look at the technology in the market, not as a lake of standing water but as a river of moving water (or if you want a more apt analogy, as a movie not a snapshot), can allow you to see not where things are, but where things are going.
In other words, you should be thinking not about where the company is competing, but where it is going to be competing. For example, in today’s world, there are dozens of businesses that were recently eaten by the smartphone with its sensors, always-on connectivity and powerfully flexible UI. Just look at Garmin’s several hundred million dollar per year stand-alone GPS business - poof; gone overnight. Same thing with MP3 players and iPods - poof. In fact, virtually anybody who launched in the last 10 years and who underestimated the speed at which smartphones were going to improve, quickly got crushed. There is a great story from a watershed moment when the CEO of RIM/Blackberry first heard about the iPhone. Up to that time, the entire industry had been trying to scale up and do more with weak low power mobile chips and mobile operating systems (OS). When the CEO heard what the iPhone could do, he realized with a chilling shudder that Apple had gone in a completely opposite direction - they had shrunk a desktop computer and OS. And it was game over for all the heritage product lines virtually overnight.
The lesson here is to try to escape the present and project some of the more obvious new behaviors and technologies farther out into the future. Perhaps the most powerful example of this thinking is Google’s tendency to look at problems by asking “what would you do to solve this if bandwidth and computing power were infinite and free? They soon will be, so go do it now.”
Footnote: This answer would not be complete if it did not point out that it is possible to get badly burned by overestimating the rate of change too. Many investors have been badly burned by assuming things will be adopted more quickly than they are. So how does an investor reconcile that contradiction? By recognizing that different assumptions are at play. Technology almost always moves quickly, but changes in customer behavior almost never do (at least until they reach a critical tipping point). Nobody ever got rich overestimating the customer’s speed of adoption nor underestimating the pace of technological change.
Q: How does a competitive review inform your view on the strength of the CEO?
Two very important ways:
First, it provides an insight into their knowledge of the market - do they know who the competitors are, are they keeping tabs, have they studied customer needs closely. If a CEO cannot add value and perspective to the competitive assessment, or doesn’t seem interested, that is a major red flag.
Second, it gives you a gauge of their ability to be visionary and deal with abstractions and hypotheticals. Some people are plodders - content to optimize for the here and now. Great CEOs are not satisfied with the status quo - they are looking way ahead and determined to drive things forward.
Want to learn more about performing due diligence quickly and effectively? Download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.