FIT: The Most Important Thing in Business?

I can't recall how the topic came up, but the other day someone asked me if it bothered me to lose clients.

My answer: "it depends."

If the loss is due to poor service quality or slow response, I hate it.  Fortunately, this has been rare, mainly because my staff works hard to make sure that any problems that arise get fixed ASAP.  We also do root cause analysis to figure out ways to prevent it happening again.

But if the loss is because our services are a poor fit with a client's needs, then I'm fine with losing them.  In fact, at some point, if our clients are successful, their needs outgrow our ability to provide effective service.  Rather than attempt to hold onto them or expand our services, we encourage them to "graduate" which usually means helping them hire their own, dedicated staff as our replacements.

In terms of new customer acquisition, because we aren't under pressure from investors for fast growth, we don't try to work with everyone.  Instead we focus on determining if there is a good fit between what we can do vs. what the client needs.  I estimate that I end up declining (or referring where possible) about 25% of the prospects who approach us because of poor fit.  "Poor fit: doesn't mean that the client is bad (although "nice people" is one of our fit criteria).  It means that after 5+ years doing this, we have a pretty good idea of who we can help vs. who we can't and have experienced the consequence of working with clients with whom we were poor fit. So while it means we may be giving up revenue, it also means we give up:

• Conflicts with clients who have different expectations about the work being done.
• Overextending ourselves into areas where we lack expertise.
• Arguments about our fees.

We look for fit along the following dimensions:

• Fit to our standard offerings vs. having to develop custom capability. 
• Fit to our flat fee revenue model vs. traditionally hourly billing
• Fit between our people and the client (i.e. we don't work with people we don't like)
• Fit between our response time capabilities and the client's response time expectation
• Fit between our quality levels and the client's expectations

And I don't think it actually has hurt our revenue growth.  For the past three years, we've actually grown our business at rates even a VC would find acceptable.  In fact, paradoxically, our focus on fit may have actually contributed because:

• Our sales cycles are short because we have a sharp focus on the value we can provide and what we cannot. We try to be clear telling new prospects what we do, and more importantly to them, what we don't do.
• Our standard operations are tailored to deliver that value making it easier to scale.
• It allows us to focus on improving adding new capabilities valued by the majority of our clients (vs. one offs) in a way which is clear to both parties that these are *WARNING* new services.
• We have high client satisfaction and loyalty which fuels referrals.  In fact we are at the point that over 95% of our new business is by client referral.  This is actually one of the metrics indicative that a business has achieved product/market fit.

In order to adopt a focus on fit, you first must accept the fact that not all revenue is good for your business!  That's tough to do when you are short on sales.  Then you must have an idea of what  your target customer profile is AND what value you provide.  For specifics on how to do this, see two earlier posts:

• Developing a Customer Profile
• Applying the Customer Profile

The Good Problem (is Still a Problem)

I'm back! (I think...)












Since my last "real" blog post in March 4, 2012 (Pushing Past the Growth Plateau), I've been dealing with the "good problem" of rapid growth.  For Silicon Valley startups, these are the good times, and for my company - which provides services to startups - it's been challenging to keep up!  In the last 18 months, we've doubled in size, launched an entirely new line of marketing services, and entered a new customer segment.  It's a good problem to have, as everyone likes to remind me and which I wholeheartedly agree.

But it's still a problem!

How can growth be a problem?

• Growth consumes cash:  In a seminar I give to entrepreneurs on cash management, one of the more eye opening exercises is where I show how fast growth can drive them straight into bankruptcy even when the P&L says they're turning a profit.  (I also show them simple steps they can take to reduce this.)
• Growth strains systems:  This in turn, leads to service problems, which can quickly stall growth.  Memory is no longer good enough to track the exploding detail.  Processes have to be defined to ensure all the bases are covered, in the proper order. 
• Growth strains your people:  And hiring actually increases the strain on your people.  New hires have to be trained and fixing the inevitable newbie mistakes creates more work.  Relationships shift and confusion increases as job duties are shifted away from existing staff to new people.
• Growth can lead you off track:  New customers can place new demands on the business.  It's easy to drift into new products and services in the name of customer service.  Whether this is positive or negative depends on how well they align with the startup's vision.  Not all revenue is good revenue!

So what are the keys to overcoming this?

• ADD:  Automate, Diversify, Delegate.  See my previous post, Pushing Past the Growth Plateau.
• Focus on Fit:  The first step is to acknowledge that not all revenue is good revenue.  So what is good revenue?  It's revenue which your company is designed to deliver and comes from adding new customers that meet your target customer profile, which means you have to know what your ideal customer looks like.  While this sounds simple, what makes it challenging is recognizing when off-target revenue represents an unanticipated, lucrative opportunity or is merely off-target and a drain on resources.  I'll have more to say about fit in a future post.

Stay tuned!

Fourth Time Shameless Pitch: BUS213 is Now a Featured Course!

It won't go away!  For the fourth year in a row, I'll be teaching BUS213-Principles of Product/Market Fit at Stanford Continuing Studies this Fall.  Now featured as part of the "Mastering Marketing" track, this six week course starts on September 25, 2012 and is held Wednesday evenings from 7:00-8:50 pm.

Signs ups are happening now.
(https://continuingstudies.stanford.edu/courses/course.php?cid=20131_BUS+213)

Third Time Shameless Pitch: BUS213 is On Again!

Yes, it's back!  For the third year in a row, I'll be teaching BUS213-Validating Business Models: Principles of Product/Market Fit at Stanford Continuing Studies (http://bit.ly/O5GXw7).  This six week course starts on September 26, 2012 and is held Wednesday evenings from 7:00-8:50 pm. 

Signs ups are happening now.

Shameless Pitch II: Stanford Marketing Course, BUS213

I'm back (more on this next post) and it's back!

What's "it"?

Starting September 28, 2011 I'll once again be teaching a six week evening course called "Monetizing Business Models" (Course Code: BUS213) as part of Stanford University's Continuing Studies program.  An improved version of the course taught earlier this winter, BUS213 will cover strategic marketing concepts and frameworks that can be used to evaluate the money making potential of a new business idea, whether as a startup, a new venture inside a corporation, or as an investment.  And per student request, we'll be going into more depth with respect to price setting strategies and tactics.

We'll be covering product/market fit and exploring different ways to analyze business models.  The course assumes no previous experience in marketing. We'll be using Customer Development as the backbone methodology, focusing primarily on the Customer Discovery phase.  Our course text is a great little book called The Entrepreneur's Guide to Customer Development, by Brant Cooper and Patrick Vlaskovits.

If you're interested, you can register online starting August 22, 2011 at the Stanford Continuing Studies website.  Here is the direct link to the course.

Hope to see you there!

How to Set Prices: Customer Value Analysis

5th and final post in a series on How to Set Pricing

I first learned about value pricing as a product manager at Metcal.  At that time the company was a startup making high end hand soldering equipment for PCB assembly houses.  To give you an idea of how high end, at that time a Metcal soldering station sold for 5x that of competitive units, and the consumable tips were 10-15x that of the competition in what most would call a commodity market.  Yet, in eight years, the company went from being the #8 to #2 market share player.

Now while there were many reasons for the company's success  - superior technology, ergonomically friendly design, robust product quality, etc. - the killer app in the company's sales arsenal was a customer value analysis created by one of the sales managers.  This simple spreadsheet model translated the product's feature/benefits into a quantified customer value proposition.

When distilled to the basics, B2B customers buy products and services for three ultimate value objectives:

• Reduce costs
• Increase revenues
• Reduce risks

Faster speed, greater convenience, and growth usually translate into one of these three.  In Metcal's case, the product features translated into the following benefits:

• Superior solder joint quality (reduced defect costs and risk)
• Faster soldering time (reduced labor cost)
• Elimination of calibration (reduced labor cost)
• Faster operator training time (reduced labor cost)

Metcal's value analysis was an Excel spreadsheet that allowed customers to input their time, process, and cost data, compare them against the cost of acquiring new solder stations and more expensive consumables and see the return on investment, payback, and net present value figures associated with the value created.  On top of that, the value analysis often prompted customers to consider factors that they may not have thought of, like training time.  The financial decision makers inside the customer quickly saw that the acquisition cost for Metcal's products was a relatively small percentage of the overall value created (in this case reduced costs), the essence of value pricing.

The main idea behind value pricing is that if your offering creates value, you price such that you and the customer share it.  Normally, this is not 50/50 but weighted in the favor of the customer;  the more value the customer captures, the stronger the value proposition.


Value pricing is widely practiced in B2B markets, especially where relationships are complex and long term.  Examples include logistics outsourcing where the supplier is paid on the basis of procurement costs reduced; SaaS vendors often price their subscription services to capture 10-30% of value created for customers over a three year time horizon vs. using a traditional enterprise software solution.

To create a value analysis requires a deep understanding of how your offering impacts a customer's business economics.  Gaining this insight takes time.  For a startup to gain this insight, it typically must have access to a someone with extensive, specific domain expertise, one who understands the customer's business model well enough to know where the lever points are that have the greatest potential to affect profitability and growth.

Creating a Value Analysis
In order to create a value analysis, you need to know the following well enough to code it into a spreadsheet:

• What is the main value proposition you are offering to your target customer?  Lower costs, higher revenues, lower risk?  For Metcal it was mainly lowering the per unit cost of production.
• How does this tie into the customer's value calculation? For Metcal, this had a direct impact on the direct labor line in cost of goods sold on a P&L.
  
• What are the factors used by the customer to assess value?  For Metcal, production rate, labor cost, defect rate, calibration and setup time were input factors in assessing value.
• What factors are not used by the customer to assess value and should be?  For Metcal, many customers neglected to factor in operator training time.
• What is the feature => benefit => value proposition chain for each of your offering's features?  For example, Metcal's superior technology => x% defect rate reduction => y% less rework => z% lower cost.
• What is the relevant payback factor used by the customer?  Is it payback time?  IRR?
• What is the relevant payback time used by the customer? 

Assuming that you can create a value analysis, two value methods can be used to set  pricing.


Method 8:  Share of Value Pricing
In this method, a "typical" customer use case is created using the value analysis.  Pricing is then set at 10-30% of the value, adjusted as needed for competitive market conditions.  This method is practiced by many SaaS companies relative to traditional enterprise software offerings.

Method 9:  Performance Pricing
Alternatively, for a specific customer, using the value analysis, compensation is based on a defined percentage of the value created (i.e. savings or revenue growth).  This method is often practiced by industrial logistics suppliers, auto parts suppliers, electronic contract manufacturers., and cost-control consultants.  Think of it as the corporate equivalent of a commission plan.  Because payment is dependent on performance, using this method requires you to have a good handle not only on the customer's economics, but your own.

Summary of Pricing Methods
To summarize the nine different pricing methods discussed, they are:

1. Cost Plus Pricing
2. Direct Market Competitive Pricing
3. Competitive Substitute Pricing
4. Target Customer Survey
5. Price Bracketing
6. Price/Feature Stripping
7. Customer Set Pricing
8. Share of Value Pricing
9. Performance Pricing

Happy pricing!

How to Set Prices: Value Pricing Methods

4th in a series on How to Set Pricing

Last post we discussed tangible pricing methods.  We now turn to value pricing methods.  Simply put, value pricing methods seek to establish a price based on some percentage of the value perceived by the customer.  While this seems straight forward in theory, this can be difficult to establish in practice for the following reasons:

• One must understand what the customer perceives as value in your offering
• One must understand the customer's time frame over which value is calculated
• The full value may be in intangible areas that the customer may not be aware of

Customer Perception of Value
In order to determine what percentage of value you can capture in your pricing, you must first understand what your offering's value is to the customer. This means you must first understand who your customers are.  Again, while this seems like a no brainer, I've found that for most startups, while they have strong beliefs about who their customers are and what value they are offering to them, they actually have NO CLUE.  Beliefs unsupported by data means NO CLUE!

Does that sound harsh?  See if you can answer the following question about your customer value:

• What is the demographic profile of your target customer?  What hard evidence do you have to support this?  Can you put this on paper?
• What are their acute pains in ranked order and what is your supporting data?
• How does your offering's features address each acute pain and what customer evidence do you have to prove this? (Not what hypothetical, logical reasoning you have that it should address this?)
• What competitive substitutes are your target customers using today to address their acute pain and how do you know this?
• What does your customer's life look like before they start using your offering?  How is it different afterwards?  What facts do you have to support this?
• Can you construct a mathematical model for value analysis that shows how different levels of acute pain reduction translate into customer value?  (This will be the subject of the last post in this series.)

If you can't answer these questions, I would argue that you don't truly understand the value of what you are offering your customers.  For help on this, see my previous post "Developing a Customer Profile".  A large part of the value of Steve Blank's customer development methodology is to convert these customer beliefs into customer facts.

There are a couple of methods that can be used to collect value data.  But unlike the four tangible pricing methods discussed previously, value pricing methods require (1) talking directly with individual target customers (2) an attempt to close a sale and (3) involve the risk of alienating a target customer to get the data.
The reason for this is that the only form of validated value data is a sale or other binding purchase commitment.  What people tell you they will pay in conversation is very different than when you ask them to sign a purchase order.

Each of the methods described below requires that you:

1. Know and have access to customers who fit your target profile
2. Have a hypothesis about your offering value that you can quickly communicate to customers (see my post on "Focused Selling")
3. Have hypotheses about how different features of your offering address target customer acute pain

Method 5:  Price Bracketing
Start discussion with an initial set of target customers.  Once you think you have a good understanding of the reasons the customer might buy and they have a good understanding of what you have to offer, to get an initial feel for value, ask two questions:

• Below what price would this be a "no-brainer" purchase that you could commit to today?
• Above what price would there be no chance of them ever buying and why?

Once you've determined this, tell the customer your pricing is coming in at a figure that is 75% of the range (i.e. if the "no brainer" price is $100 and the "no way" price is $1100, the 75% figure is $850).  Try to close the sale.  Most likely when (not if) they balk, find out what's stopping them from making a commitment today and pay attention.  Assuming you still can't close the deal, thank them for the valuable information and let them know that you obviously have some work to do on your costs and find out if they would be willing to talk again in the future.  Most likely, if you do this with 3-5 target customers, you'll quickly be able to determine what parts of your value proposition are holding up and which need adjustment.  Adjust accordingly.

Method 6:  Price/Feature Stripping
Armed with a new offering presentation from Method 5, ideally meet with a different set of target customers.  (If you are in a small B2B market with a restricted set of target customers, you may need to go back to the first set).  This time, once you think you have a good understanding of the reason the customer might buy and they have a good understanding of what you have to offer, try to close a sale at the 75% price number from Method 5.  Depending on which reaction you get do the following:

• Customer Accepts:  Congratulations, you've gotten a sale...but you haven't learned much.  Raise the price by 20% before you talk to the next target customer.
• Customer Rejects:  Understand why.  Then get a counter-offer.  Once you have it, talk about which features you can strip to get to the counter-offered price.  As you have the feature stripping discussion, you should get a feel for the relative value of each feature.

Again, 3-5 target customers should give you a good feel for how your value proposition should be adjusted.  It should also give you a feel for your minimum viable product.

At this point, go back to the first set of target customers and let them know that you've found some ways to work the cost issue both internally and by removal of certain features to get closer to the the previously discussed "no brainer" price.  See if you can close the sale again, this time at the average counter-offer price from the second set of target customers.  You will then get one of two reactions;

• Customer Accepts:  Congratulations, you've gotten a sale and validated the feature/value hypotheses.
• Customer Rejects:  Understand why.  In many cases, the new objections won't be price based, but will be sales process based.  Congratulations, you can now move forward to address the non-price related set of impediments to gaining market traction.

Method 7:  Customer Set Pricing
One alternate method for determining value is to let customers set their own price.  Examples of this include self-published e-books where the author request that people pay what they think the item is worth and museums, which request visitor set donations in lieu of an admission fee.  The most obvious risk of letting customers set prices is not being able to set prices adequate to cover costs, but depending on the nature of your offering this method may work for you.  To be viable it helps to have:

• Large potential customer base where the volume of payers is likely to be large enough to offset the inevitable free riders.
• Target customer base has some social or peer pressure element to pay something - This works for many charitable organization and the museum example cited earlier.
• Low or no incremental cost to delivering additional offering vs. probability having more paying users - In the case of the museum whether they have 500 or 5000 visitors a day does not change their operating cost but greatly increases the likelihood of donations.  For the e-book author, once the book is written, delivering additional copies across the web is pretty cheap.

There is one final method for setting value based pricing.  This involves the creation and development of a mathematical customer value analysis.  Pricing is then based on some percentage of this calculated value.  This will be the subject of the final post in this series.

Next post:  Customer Value Analysis

How to Set Prices: Tangible Pricing Methods

3rd in a series on How to Set Pricing

In order to set pricing, certain decisions need to be made with respect to:

1. Pricing Strategy
2. Business Revenue Model
3. Pricing Mechanisms

As discussed in the prior two posts, these three elements can be combined in many different ways; arriving at the proper combination is part planning, part art, and part trial and error.  But assuming you've gotten this far, it still leaves the question of what price to charge? 

First, let me state that I've been pricing goods and services for many years and for those of you who like precision and certainty, the pricing process is messy and imperfect.  Nevertheless, there are several methods that can be used to establish initial pricing.  These tend to fall into two group:  tangible pricing and value pricing.  Tangible price methods stem from obtainable data.  Value price methods require more exploratory efforts.  This post will deal with tangible price methods.

Method 1: Cost Plus Pricing
The most basic and simplest to understand is cost plus pricing.  This is where you add up your costs, tack on your target margin to set a price.  Remember that one of the key objectives in pricing is to charge enough to cover your costs and make a profit.  At least on the surface, this would seem to address the issue.  However, cost plus pricing often results in a price that is not competitive in the market place (i.e. think $500 screwdrivers for the government).  So what to do?

First, you cannot ignore cost but there are two kinds of cost:  direct and indirect.  Direct costs, typically classed as Cost of Goods Sold (COGS), are the immediate costs tied to delivering a unit of product or service.  For example, if you're selling a widget, the cost of the parts in the widget plus the amount of labor time to build the widget plus the cost to ship it are direct costs.

 Your pricing must be greater than the direct cost.  Otherwise you are shipping dollar bills out with each unit.

On the other hand indirect costs are not directly tied to the cost of delivering a specific unit, though they may be needed for producing the product or service.  Often times they are relatively fixed costs like engineering wages, rent, or electricity.  They are real costs needed to support operations but not directly assignable to a specific unit of product or service.

These costs are often allocated across the total units produced. For example, if you have $500/month in rent and build 5000 units/month, you might allocate $0.10 of this cost to each unit built.  But if you only build 500 units/month, you would allocate $1.00 of this cost to each unit.  And this is what complicates cost plus pricing.  To cover this, do you charge $0.10 or $1.00?

Not only must you charge more than the direct cost, in order to make a profit, you must charge enough more to cover the indirect costs at a particular volume level.

To further complicate the picture, the line between a direct cost and indirect cost is often murky.

The bottom line is that you should not use cost as the sole means of establishing price, but you cannot ignore it either.  And if you find that you can't price high enough to cover all of your costs or reduce your costs sufficiently, you may have a more fundamental business model problem.

Method 2: Direct Market Competitive Pricing
If you have direct competition for your product or service, one way to establish a reference price point is by surveying the competition.  Where prices are posted (e.g. for retail goods) this is easy to do.  For services, where prices are often not posted, there are a couple of ways to get prices:

• Ask people who use the services what they are paying
• Attempt to contract for the service to get a quote
• Get a friend with a business to attempt to contract for the service to get a quote

5-10 quotes should enable you to get a feel for the average and range of competitive market pricing.  Keep in mind that this just establishes a reference point.  Depending on your pricing strategy, you may choose to price higher or lower than market.

Method 3:  Competitive Substitute Pricing
In some cases, there may not be a directly competitive product or service to your offering.  In this case, you should look at pricing for competitive substitutes.  Competitive substitutes are products or services that in combination with other things allow the buyer to gain the same functionality or achieve the same goal as your product or service would directly.  As an example, if I need to add up a bunch of numbers, I can use a calculator, my computer, my cell phone, my digital watch, a pen & paper, an abacus, or just do it in my head.  All are competitive substitutes to each other with different costs associated with purchasing the different items.

Depending on the strength of the competitive substitute in achieving the buyer's purchase objective vs. your product or service, the price being charged may limit the premium you can charge.

For example, lets assume that high speed rail service between San Jose, CA and Los Angeles actually becomes a reality in my lifetime.  If I have to price the service, three competitive substitutes are plane, car, or bus.  Transit time by high speed rail is 3 hours, plane is 1.5 hours, car is 6 hours, and bus 7 hours.

Assuming I own a car, this is the cheapest in dollars, involving maybe $50 in gas.  The bus is about $55 and I don't have to drive;  I can spend the time reading or on my laptop courtesy of mobile Wi-Fi.  The plane is ostensibly the fastest but when you add all the security and boarding issues associated with air travel, total time is probably closer to 3-3.5 hours for a ticket price of $120.

So what should the price of a train ticket be?  You can definitely charge more than the car or bus because of the speed advantage.  The plane is the nearest serious competitor so a floor reference price would be $120 per ticket.  Could it be more?  Absolutely.  It depends on how well the train positions its value to its target ridership;  this moves into the realm of value pricing.

Tangible price methods make it relatively easy to determine a current market reference point.  But if your product is meant to be a superior solution to the market, it does not help you determine what premium over market you might be able to charge.  (This is less of an issue if your product is meant to be a cheaper solution to the market.)

Method 4:  Target Customer Survey
While method's 2 & 3 look at competitive pricing, another way to determine pricing is to survey potential buyers.  This first involves understanding who are your target customers.

Customer surveys work best for familiar product categories with fewer options.  Most people find it difficult to establish an anchor price point for innovative or unfamiliar product categories and will therefore skew answers low.  Products with many features can be confusing, although conjoint analysis can help establish  feature/price tradeoffs.  It also helps to have product samples or some kind of demo; people give better feedback with things they can see or touch versus abstract concepts and ideas.

But one potential strength of this method is that it may tell you something about the nature of the price-demand curve.  Why is this important?  Let's look at two price-demand curves.  The one on the left is a stereotypical commodity demand curve where demand falls with increasing unit price.  The one on the right is typical of many branded goods where too low or too high a price can cause demand to fall (e.g. the Mercedes C-Class example mentioned in the first post in the series).

As you can see, depending on what the nature of the curve might be, and where you are on the curve a decrease in price may or may not improve demand.

The other pro of this method might be to identify the existence of an optimum price point different from the current competitive market price.  For example, when LCD TVs first came out, a 42" model was ~$4500.  But the LCD TV makers knew this was not the optimum point; it was a price constrained by their costs.  By conducting customer surveys, they determined that $1000 was the magic inflection point at which demand would skyrocket.  They worked diligently to drive costs down so as to be able to price to this point.  Sure enough, 42" LCD TVs hit the $1000 retail point in 2008 and took off, in spite of the fact that a global recession was underway.

Next post:  Value Pricing Methods

How to Set Prices: Revenue Models and Pricing Mechanisms

2nd in a series on How to Set Pricing

In setting prices, three major elements need to be considered:

1. Pricing Strategy
2. Business Revenue Model
3. Pricing Mechanisms

Last post, we discussed Pricing Strategy.  This post, we give an overview of Revenue Models and Pricing Mechanisms to show how they impact pricing decisions.

FULL DISCLOSURE:  Most of this information has been paraphrased from Business Model Generation by Alexander Oesterwalder and Yves Pigneur.  If you are interested in business models, I highly recommend this book.

Revenue Models
As with pricing strategies, while there are many variations, the most common generic revenue strategies are as follows:

• Title Passes to Buyer
• Asset Sale - The straightforward one.  Buyer pays Seller; Seller gives Buyer the goods which the Buyer then owns.
• Title Stays with Seller
• Usage Fee - Buyer consumes a service.  The more consumed, the more paid.  Example:  telephone minutes.
• Subscription Fee - Buyer pays for time based access to a service.  Example:  gym memberships, Netflix streaming
• Renting - Similar to a usage fee but in this case Buyer pays for temporary exclusive access to an asset.  Example:  office rental, car rental
• Licensing - Buyer pays for right to use intellectual property owned by Seller.  Example:  media rights
• Middleman
• Brokerage Fee - Company takes a fee for providing services to connect two or more parties.  Example:  real estate, credit card issuers
• Advertising Fee - Company takes a fee for providing and promoting Buyer access to a prospective Seller base

The different pricing strategies discussed before - predatory, skimming, bundling, and multi-tier - can be applied to each of the revenue models.  For example, American Express pursues a premium brokerage fee pricing model and strategy vs. Visa which pursues a more mainstream brokerage fee model.  Both charge fee for card usage but American Express's is substantially higher than Visa's.  This fits American Express's strategy of going after higher net worth individuals.  In line with this strategy, American Express also charges a relatively high annual subscription fee for card access vs. Visa, which in many cases does not charge any annual fee.  This goes hand-in-hand with American Express's travel and other services most likely to be of interest to higher net worth consumers.

Pricing Mechanisms
Once you understand the revenue model and pricing strategy you wish to pursue, you need to decide on the actual mechanism of how you will charge.  Once again, while may variations and combinations are possible, the generic options are:

• Fixed Pricing
• List - The basic one.  Fixed price for an individual product or service.
• Feature Priced - Price depends on the number, quality or type of features offered.  The default mechanism used with a bundling pricing strategy.
• Segmented Discriminated  - Price depends on the type of customer being targeted.  The default mechanism used with a multi-tier pricing strategy.
• Volume Based - Price is a function of the quantity purchased with price usually decreasing with increasing volume.
• Dynamic Pricing
• Negotiated - Price is set by active negotiation between Buyer and Seller.
• Yield Management - Price depends on inventory and time of purchase.  Often used where capacity is fixed and perishable.  Example:  airline seats
• Real-time Market - Price is based on supply and demand usually facilitated by an active exchange.  Example:  stocks
• Auctions - Price determined by competitive bidding.  An auctioneer often establishes a floor reference price then facilitates the bidding up process.  In the case of a reverse auction, a Buyer sets a ceiling reference price, then facilitates a bidding down process.  The reverse auction is only possible where the Buyer has unique leverage over a group of Sellers.

Again, it is possible to combine any of the pricing mechanisms with any of the price strategies and revenue models, although in this case, some price strategies fit together better with some price mechanisms (e.g. bundling with feature pricing).

Once a decision has been made with respect to pricing strategy, revenue model, and pricing mechanism, the final decision that needs to be made is what price to charge.  In the case of dynamic pricing, the question is what reference price to open with as the final price will be ultimately be determined by the market.

Next blog post:  Tangible Pricing Methods

How to Set Prices: Pricing Strategy

1st in a series on How to Set Pricing

I recently received the student feedback from BUS213:  Monetizing Marketing Models, the course I taught for Stanford Continuing Studies during the Winter 2011 quarter.  Overall, the course was well received.  But the number one area where students would have liked to go deeper was in how to set pricing.

So for those of my former students who may be reading this blog,  I've decided to do a series of in-depth posts that I hope will be helpful in this area. The first few posts will deal with an overview and frameworks.  The last with tactics and practical tips.

Pricing Overview
As anyone who has studied Marketing 101 knows, Price is one of the classic "4Ps" of the marketing mix (the others being Product, Promotion, and Place).  In setting prices, three major elements need to be considered:

1. Pricing Strategy
2. Business Revenue Model
3. Pricing Mechanisms

Setting prices can be a fairly technical marketing specialty, particularly in well established consumer product categories like packaged goods, the travel industries, and commodities.  For the purposes of this discussion, I will focus on the less scientific and more "seat-of-the-pants" situations encountered by entrepreneurs in less well defined B2B and B2C markets.

Pricing Objectives
There are three main objectives to be considered in setting prices:

1. Cost/profit - Pricing must be set sufficient to cover costs and generate a sufficient profit to support and grow the business.   What complicates this is the nature of the revenue model and time frame over which profits are generated.
2. Market positioning - Prices are a key signal to prospective buyers of a product or businesses market position.  In known product categories, they can establish buyer expectations for the product.  For example, if a car sells for $90,000 and another sells for $15,000 a buyer will have a certain image of what one car is versus the other.  Where a product category is new to the buyer, pricing can establish a reference point for comparative expectation versus competitive substitutes.  The main thing to remember is that pricing should be set consistent with a company's brand and market positioning.
3. Market share - Pricing can affect the rate at which a product penetrates a market.  In general, cheaper pricing creates less buyer resistance during the sale process and promotes faster product adoption and share growth.  But not always.  When Mercedes first released the C-Class with pricing in the low $30,000s, because the price was so counter to the company's luxury brand image, it actually impeded consumer acceptance.  The other factor here is what competitors are charging.  Depending on the nature of competition within an industry, this may limit what prices can be set.  For example, in commodity businesses, it is almost impossible to establish premium pricing due the existence of interchangeable competitive substitutes.  And price decreases are matched almost instantly by competitors.  But in luxury goods, where the value of the products are more intangible, a wide variation in pricing can exist.

Ideally, prices should be set to maximize business profitability over time.  Profit over time is a function of unit price, unit volume (i.e. share), and time.

Pricing Strategies
A company's price strategy is the way in which it decides how to blend the tradeoffs between the various objectives above.  It must be set as part of a company's overall competitive strategy.  For example, if the company is in a new technology sector with low barriers to entry (i.e. social media) where much of its value is based on its network, it may need to pursue a first to market, fast growth approach. In this case, it may want to pursue a loss leader price strategy in order to facilitate this.

While the variations are endless, the most common generic price strategies are:

• Predatory - This is where a company prices its product at very low margin, or even at cost* in order to gain entry into a new market. Over time, as the company establishes a more dominant share position, it increases prices to be more in line with its target brand position.  This often used where a new entrant is seeking entry into an existing market with established competition.  Predatory pricing is not without its pitfalls including:
• Sending the wrong positioning signal to the market
• Difficulty in raising prices due to customer backlash
• Sacrificing negotiating room
• Leaving money on the table
• Difficulty in covering costs
• Skimming - At the opposite end of the spectrum, this is where a company prices at a premium to capture the high end segments first.  Then as it saturates a buyer segment, it drops prices to appeal to new buyer segments.  This strategy requires that some meaningful differentiation exists to support a premium price segment.  Skimming also has its pitfalls including:
• Increases sales resistance, lowers demand, and slows sales adoption
• Creates an umbrella for competitive entry
• Creates customer "ill will"
• Gives customers an incentive to search for alternatives
• Bundling - This is an intermediate strategy where a company groups together different products and features in such a way that it can offer variations at different prices.  This gives the company great flexibility to offer a combination of features that appeals most to different buyer segments while maximizing the profitability of the various offerings.  An example of this is the automobile industry where the variety of packages can be overwhelming.  By bundling together desirable but costly features (e.g. automotive transmission) with less desirable but more profitable features (e.g. "all weather" package), the overall profitability of the car can be optimized.
• Multi-tier  - This is another intermediate strategy where the company offers distinct product categories at different price segments to appeal to different buyers.  Again, an example from the auto industry is Toyota used to offer a mainstream (Toyota) and luxury (Lexus) model under different brands for substantially the same car (Camry vs. ES300).  Another example would be the freemium model practiced by the SaaS industry where it is common to offer both a basic free version and a premium paid version.

Next post:  Revenue Models and Price Mechanisms

*  Note:  Setting prices below direct costs is illegal in many countries. While often difficult to prove given the creativity in cost accounting allocations, the practice of "dumping" or predatory share pricing has been the subject of several WTC actions in the past.  One such high-profile case involved the sale of Korean DRAM memory chips to the U.S. in the 1990s.

Secret to Growth: The Power of No, Part 2

Last week, we told the sad tale of Stone Soup: The Sequel, where Hok failed to exercise the power of no in decision making.  This week, we have our second tale about the constraining power of no....

The Tale of Cinderedna
Once upon a time in 16th century France, there were two cousins, Ella and Edna.  Now as tended to happen back then, a terrible plague ravaged the land.  Ella's mother and both Edna's parents died.  In Ella's case, her father remarried and her story has since become well known.

In Edna's case, being an orphan, she was shuttled from relative to relative until she eventually found a home with a distant uncle, a wealthy merchant.  The merchant and his wife had a daughter about Edna's age named Prosperia.

But the upbringing of the two girls could not have been more different.  While Prosperia lacked for nothing, Edna had little but the clothes upon her back.  But being a resourceful girl, she learned how to do things for others in exchange for things she needed.  She would make deliveries for the local tailor, who in turn, taught her how to sew and provided her with leftover cloth from his workshop.  Where others saw scraps, she saw opportunities.

Whereas Prosperia lived in a beautiful, spacious room, Edna lived in a windowless, converted pantry.  But Edna, being a creative girl, did laundry for a local painter who in turn provided her with pigments and lessons.  Soon her tiny room was brightened up by beautiful murals and designs.

While Prosperia ate only the best and as much of anything she wanted, Edna had to make due with leftovers from the family meal, usually vegetables that Prosperia wouldn't eat in favor of the cakes, pastries, and meats she preferred.  Combined with the fact that Edna worked very hard doing most of the family's cleaning, laundry, and other chores, as Edna got older, she grew into a slender, healthy young woman.

Her cousin, on the other hand, grew fat and soft, catching frequent colds that caused her to miss school often.  (Edna, of course, was not allowed to go to school.)  To compensate, Edna was forced to fetch Prosperia's books and assignments from school and help her cousin with her studies.  Thus Edna taught herself to read and gained an education.

Prosperia had plenty of idle time with which to amuse herself.  And she frittered most of it away on frivolous play. Easily bored, Prosperia tended to drop things when they became difficult, preferring to flit to the next amusement.  Edna, with little free time, learned to set goals, plan ahead, and use her time effectively.  She learned how to persevere when things became difficult, and thus became quite skilled in many things.

Eventually, the two girls grew up.  Edna left home and became a successful dressmaker.  Her designs became legendary and eventually caught the attention of the King of France, who invited her to court.  There she captivated the heart of one of the king's younger sons and eventually married him.  And after a long and happy life, she died at the ripe old age of 96.

Prosperia, on the other hand, never left home.  In spite of the efforts of her parents to introduce her to court, having never cultivated any but the most superficial education, no skills, and only the most trivial interests, her rather dull personality failed to attract any suitors.  Because of her sickly constitution, she eventually caught pneumonia and died at the rather young age of 32.

Constraints force efficiencies and remove potential distractions.  Constraints force decisions to be made.  By forcing choices, constraints foster focus and an understanding of what is core to success.  Constraints are the external no's by which creativity is unleashed in a startup.

Related Posts:
The Power of Yes
Secret to Growth:  The Power of No, Part 1

Secret to Growth: The Power of No, Part 1

In my last post of 2010, The Power of Yes, I talked about the power of yes in the exploratory phase of a venture. The power of yes is the means by which entrepreneurs create something from nothing;  it is the means by which they create a business system which enables the resources of others to be transformed into value that is mutually beneficial to all of the contributors and beyond.

Yet, as a venture moves out of exploration and into growth mode, the power of yes can cripple it.  Instead, a different power, one I call the power of no, must be invoked.

The power of no comes in two flavors.  One is a decision and comes from within.  The other is constraining and comes from without.  To see how these work, I bring you two lesser known sequels to two popular tales.  Today's tale deals with the power of no and decisions.

Stone Soup: The Sequel*
While the story of Stone Soup is well known, what is less known is what happened afterwards. Here is that tale:

Not long afterwards, Hok decided to set off on his own.  Saying goodbye to Lok and Siew, he traveled deeper into the mountains.  After several days, he came across another village, just as war ravaged and frightened of strangers as the last.  Remembering what he had learned from Lok and Siew, he proceeded to the town square where he met a young boy.  Soon, just as before, Hok had a huge pot of water and began to build a fire underneath it.  And just as before, each villager, curious as to how one could make soup out of stones, thought of something that would make the soup even tastier and would run off to fetch it.

As the villagers returned with vegetables, herbs, meat, and all sorts of supplies, three soldiers approached Hok and asked what he was doing.

"Making stone soup," replied Hok.  

"Hmm," said one of the soldiers looking at the food piling up near the pot, "You know that there are dangerous bandits just outside the village that might steal all that has been gathered.  They are probably watching right now.  I'll tell you what, give us something to eat and a share of the soup when it's finished  and we'll guard the square for you and make sure nothing happens."

"That sounds reasonable," agreed Hok.  So the soldiers took some of the food and posted themselves around the square, looking fierce.  And the soldiers having large appetites, periodically helped themselves to the food being prepared for cooking.

Shortly thereafter, Hok was approached by an earnest young man.  "Please sir, we have the makings of a great feast and my brothers and I have been tasked with setting the tables.  The tables would look much nicer with some festive decorations.  We could carve some of the carrots and potatoes into beautiful table sculptures if you would give us some!"

"Of course!" said Hok. And soon the young man and his fourteen brothers were carving basketfuls of carrots and potatoes into beautiful statues of dragons and tigers and fish for laying out on the festively adorned tables.

Next, one of the village merchants approached Hok.  "Young monk, I know where we can get wonderful crabs that would make this stone soup fit for the Emperor's table!  There is a fishing village just fifty miles over the ridge that in exchange for some of our vegetables would sell us these crabs.  I've much experience trading with this village and can guarantee that these crabs are the tastiest in all China.  What do you say?"  Hok thought about it and nodded, and the merchant quickly loaded up most of the vegetables gathered in his cart and set off.

Finally, the water began to boil, and Hok began to add the food to the pot.  Strangely, the pile of food had dwindled to a few carrots, an onion or two, a couple of strands of noodle, and a small piece of beef.  The soup looked much less rich and the aroma wasn't quite as tantalizing as Hok remembered.  "Maybe it just needs to cook longer," he thought.

So Hok cooked the soup for hours.  The sun set as the soup continued to bubble.  The aroma, while thin, was still enough to whet everyone's appetite and soon the grumbling began.

"When is the soup going to be ready?" whined one.

"Doesn't look like much of a soup to me,"  said another.

"I knew the idea of cooking stones was too good to be true,"  grumbled an old man.

"Where is that merchant with the crabs?" wondered an old woman.  "Right now, I'd rather have the vegetables he took cooking in the soup than the promise of crabs that aren't here!"

"Let's add the table decorations to the pot!"  said one child.  "There's plenty there to make a good soup!"

"No!" cried the young man and his brothers,"  Then the table will be dull and lifeless for the feast!"

"What feast fools?" cried the old man.  "The feast is sitting in the bellies of these soldiers guarding against what?  Not only do we not have stone soup, but there is no more food in the village!"

"It's the monk's fault!"  yelled one of the soldiers.  "It was his idea.  He swindled us with his idea that we could make soup out of stones!  Let's stone him!"

With that, Hok leapt up and ran as the villagers began to pelt him with stones.  He ran all night, not stopping until he was back in the safety of the monastery.  Sad and confused, he spent many months pondering what had gone wrong.

It is a well known tenet of strategic planning that strategy is about no, not yes.  Where resources are limited, focus is key to ensuring that they are deployed effectively.  Why the power of no is so important for entrepreneurs is that by nature, entrepreneurs see opportunity everywhere.  While a strength in the startup phase when one is trying to discover and create a business, it can be a liability in the growth phase which is about executing the business model.  By seeing opportunity everywhere, the entrepreneur can fritter away precious resources on possibilities instead of using them to advance the opportunity that has been vetted.

So how does one invoke the power of no?  Here are some tips on that subject.

Stay tuned for next week's tale about the constraining power of no.

* My apologies to Jon J. Muth

The Power of "Yes"

As a corporate manager, one of the things that used to amaze me was how certain entrepreneurs had the ability to create something out of nothing.  It used to baffle me how someone with just an idea and no other resources could end up creating a multimillion dollar enterprise three years later.  I, on the other hand, could make things happen as long as I had resources to work with but creating something from nothing was beyond me.

And then I met "The Chief."

The Chief was a serial entrepreneur with an uncanny ability to create value out of thin air.  I met the Chief when he hired me to be manage the operational side of his startup.  We used to joke that while I could take the bricks lying around and build a house, he could conjure up bricks out of thin air.  Now, I had a chance to learn how it was done.

So I watched him for a year.
I watched how he pulled in investors.
I studied how he pulled in specialists.
I worked with him as he created partnerships and deals and alliances.

What was the secret?  Vision was certainly part of it, but not sufficient unto itself.  His people skills? Ditto.  Confidence?  Communication skills?   Ditto, ditto.  Then finally, I figured it out; how he pulled rabbits out of a hat.

Underlying all was the power of yes.

How to describe the power of yes?  Partially a decision mindset, partially a habit, it worked like this:

• Say yes to a lot of meetings - The Chief met with anybody and everybody that took an interest in, or could potentially advance the vision.  He never failed to take something away in terms of knowledge or revised thinking from every meeting.  And while many of these meetings never developed into a working relationship, he always left the door open for future contact.
• Say yes to some uneconomic opportunities  - Especially in the beginning, the Chief said yes to a few economically marginal projects just to get a working relationship going, to start exercising the company's operations, and to get us down the learning curve.  To use an analogy, the Chief understood that to learn to sail, you eventually have to put the book down and get into the boat.
• Say yes to seemingly unrelated opportunities - In defiance of conventional target marketing wisdom, the Chief said yes to many seemingly unrelated projects.  The reason? To create a critical mass of experiences that enabled him to take the next step which was to...
• ...create interconnections between opportunities - With a broad enough set of experiences, the Chief was then able to see the interrelationships and patterns between them.  Doing this enabled him to strategically determine which ones to pursue and which to abandon going forward.
• Follow up on the ones that gained traction - The other advantage of working a broader scope of opportunities was that while some inevitably fizzled out, others gained momentum, opening the door to new opportunities.  The Chief didn't worry about the ones that fizzled out.  And he alwas left the door to them reigniting.
• Say yes to incorporating the vision of employees, partners, investors into the grand vision - By being open to the influence of others, the Chief gained their buy-in and their voluntary contribution of creativity, time, skills, and money.  The Chief was able to get hundreds of thousands of dollars worth of expert technical advice and the use of multimillion dollar facilities for a fraction of the true value, all because he allowed our vision to be their vision.

In short, the Chief had mastered the practice of Stone Soup.

Several years later, when I decided to start my current business, I applied the power of yes.  With just a vision - that I could improve a startup's chance of success by providing expert, affordable back office services on a timeshare basis - I started to meet with prospective clients and partners to talk about the idea.  One meeting, led to my finding my business partner.

Further discussions led to our first lead clients, whom we offered highly competitive deals just to get going.  As we worked, we found ourselves developing capabilities in areas we had expected, dropping them in others, and creating service offerings in unexpected places.  We began to acquire clients with more demanding requirements, further enhancing our capabilities.  And as critical mass built, we were able to start connecting client and partner opportunities, improving economies of scale start and operational efficiency.

Today, while the vision remains the same, the implementation of the vision with respect to our service offerings is different than what we had predicted.  But that's okay because at the end of day, we now have a stable, core business model on which to base future growth.

Is the power of yes always appropriate?  The answer is no.  Yes has power is when you are trying to to create your business model or in business development when you are trying to establish a new partnership.  It is for the Stone Soup phase of a project.  But once the business model is known or the partnership established, it takes a different power to execute and scale it.  In fact, in the growth phase, the power of yes can be deadly.

So what is the secret to growth?  Stay tuned for my next post...in 2011.

Merry Christmas and Happy New Year!

Activity is Not the Same as Effectiveness

"It is not good to have zeal without knowledge, nor to be hasty and miss the way." - Proverbs 19:2

The other day, I received an email from a client with whom we are working to develop an appropriate strategy to unblock sales growth.  We've completed a preliminary analysis indicating probable root causes and, as these things usually go, several potential tactical actions have popped out of the study.  The email was to tell me that they've already put these latter into action.  Great right?

Groan. Here we go again.

One of the biggest frustrations of doing strategy consulting is having clients rush into action before the full analysis is done?  Why?  Because without a comprehensive review, it won't be clear what the actual root cause issues are vs. aren't.  Strategy issues almost always have surface symptoms which can be caused by several different root causes.  For example, take the common problem of stagnant sales.  First of all, is it a strategy or execution issue?  If strategic, is the problem caused by poor product/market fit, misaligned channel strategy, shift in the competitive market dynamics, etc. etc?  It does no good to change one's product targeting if the channel strategy is wrong! A proper diagnoses is critical to determining an effective course of action.

Inevitably, when I explain this to clients, they all nod their heads vigorously then most of them promptly leap into action anyways.  The result in most cases?  NOTHING happens.  No impact.  Just money out the door.

So why does this happen?  In my experience, for three reasons:

• Confusing operational speed vs. strategic speed - A recent Harvard Business Review article⁽¹⁾ "Need Speed? Slow Down,"  addresses this well.  Operational speed is simply moving faster. But this assumes that one is doing the right things. Strategic speed means reducing the time it takes to deliver value.  It's about making sure you are doing the right things.  The key to this is holistic alignment - of initiatives, elements, resources, and priorities. 
• Action is exciting, thinking is not - Action is exciting, visible, fun, satisfying, and worst of all, it's easy.  It gives the illusion of solving a problem when in actuality, all you may be doing is going nowhere fast or even worse, swiftly scaling the wrong wall.  Thinking, on the other hand, is unglamorous, boring, and hard.  Substituting action for thinking just because it feels good has a name:  laziness.
• Buying into the Conventional Wisdom of Ready, Fire, Aim - Reinforcing the second point, particularly with Silicon Valley startups, is the idea that "ready, fire, aim" is a virtue (don't get me started on this one...).  There is a definite bias towards action (not a bad thing), a disdain for big company "analysis paralysis" (also not a bad thing), and the urgency to move fast, fast, fast.  We celebrate the entrepreneur who has ten meetings before noon followed by another ten before the evening networking event and then codes all night.  We love the caffeine buzz which keeps the fifty coffee houses in downtown Palo Alto in business.

Unfortunately for many of the adrenaline junkies, activity is not the same as effectiveness.  Many startups would be better served by ceasing all work for four hours, sitting down, and really think through what they're doing.  Good strategic thinking is a resource multiplier; one effective action is worth 100 pointless ones and a darn sight cheaper.

Now don't get me wrong.  This is not to imply that there isn't a lot of work in a startup and that effective strategic thinking is going to make it all go away.  The fact of the matter is that there is a lot of work, where cranking out the volume is necessary, but it only makes a difference if they are directed at advancing the company's goals.

So instead of booking those ten angel meetings to raise another $250K so that you can hire five more people to handle all the work, it might be worth turning off the email, silencing the cell phone, and locking yourself in a quiet room with a whiteboard and marker and think.  Make sure you're scaling the right wall.

You might not need that $250K after all.

Footnotes:

1. Davis, Jocelyn and Atkinson, Tom, "Need Speed?  Slow Down," Harvard Business Review Reprint F1005E (May, 2010).

Shameless Pitch: Stanford Marketing Course, BUS213

Starting January 11, 2011 I'll be teaching a six week evening course called "Monetizing Marketing Models" (Course Code: BUS213) as part of Stanford University's Continuing Studies program.  The course is designed to teach strategic marketing concepts and frameworks that can be used to evaluate the money making potential of a new business idea, whether as a startup, a new venture inside a corporation, or as an investment.

We'll be covering product/market fit and exploring different ways to analyze business models.  The course assumes no previous experience in marketing. We'll be using Customer Development as the backbone methodology, focusing primarily on the Customer Discovery phase.  Our course text will be a great little book called The Entrepreneur's Guide to Customer Development, by Brant Cooper and Patrick Vlaskovits, both of whom will be speaking at the final course session on February 16th.

If you're interested, you can register online starting November 29, 2010 at the Stanford Continuing Studies website.  Here is the direct link to the course.

Hope to see you there!

Determining Your "Natural" Growth Rate

4th and final post in a series on Strategic Growth

As we close this series on Strategic Growth, the question arises, how does one determine a company's inherent growth rate?  While the answer "it depends" is accurate, it's not terribly useful.  To get a useful answer, let's ask the question "what typically constrains company growth?"

In most cases, the answer is hiring and growth capital, with the latter often, but not always, being the restriction on the former.  Given this, there is a financial planning tool called the Sales Sustainable Growth Rate Model that can be used, under certain conditions, to give a rough estimate of the funds required for growth,

******** ALGEBRA ALERT! ********

The Sales Sustainable Growth Rate (SSGR) Model

The model stems from the premise that the supply of funds must equal or exceed the demand.  Demand for funds is caused by growth (SSGR).  Dissecting equation (3), the sources of funds are retained earnings, invested assets, debt, and new equity.  All figures are calculated as percentages.

The main limitations of the model are that the ratio of sales to assets (or investments) is relatively stable over the planning horizon.  This means that the model degrades if there is a large build up in capital assets (causes the model to overestimate SSGR), high inflation, or time horizons over five years. Note that this model is most useful for a company with existing operations and operating cashflow vs. an early stage company still trying to reach cashflow breakeven.

The net upshot of the model is that the growth in the total equity base must meet or exceed the growth in sales.

Equation (1) shows that SSGR can be financed from two sources:  funds raised from equity (NER) and "internal" funds (earnings and debt). 

The Internally Sustainable Growth Rate (ISGR) in Equation (2) represents the sustainable growth that the company can get without giving up control to external shareholders.

Equation (3) shows how ROE is related to profit after taxes, debt financing level, and interest paid on the debt.  Debt is commonly used to lever up ROE. (Because debt does not result in ownership transfer, it is considered internal financing.)

Internally Sustainable Growth Rate
For reasons that will be made clear, growth funds for an early stage startup almost always need to come from a new equity infusion, whether it is "friends and family" or institutional money.  But for cash generating businesses, growth can potentially be funded internally.

Focusing on ISGR and rearranging key terms as in equations (4) to (7), ISGR can be increased by:

• Increasing profit after tax
• Decreasing or eliminating dividend payouts
• Increase financial leverage (more debt)
• Increase operating leverage (e.g. improving inventory turns)

Obviously except for operating leverage, none of this works for early stage startups running a loss without access to debt (and consequently not making dividend payouts), hence the need for new equity issuances.

How Google Stacks Up:  An Example
To show you how it works, I've plugged Google's numbers into the model.

From a financial perspective at least, Google has sufficient resources to fund its projected growth without needing to issue additional stock with perhaps a bit of headroom.  Does this indicate that Google could be more aggressive or that some other constraint is holding them back?  Maybe.  Or maybe Google management is just erring on the conservative side in preserving cash for downside risk management in the still uncertain economy or to retain flexibility in its acquisition strategy.

Strategic Growth in Summary
To conclude, the question you should be asked yourself is what is the right growth rate for my company?

• What are my industry competitive dynamics?  Do they require fast growth? Or do we have a decision to make?
• If controlled growth is an option, what are our barriers to entry?  Or what barriers do we need to erect?
• Is controlled growth desirable?  Why or why not?
• If controlled growth is our objective, how will we limit customer acquisition?
• If fast growth is our objective, are our business systems, people, and finances adequate to support it?  What plan is in place to ensure that we don't allow product/service quality to fall apart?

Finally, remember to revisit this question periodically.  Your company and your industry will evolve over time.

The Conditions for Controlled Growth

4th in a series on Strategic Growth

In last week's post we discussed the case for pursuing controlled growth.  But is controlled growth always viable?  No.  So what are the conditions necessary to viability?

First, you can't be in an industry where fast growth is a necessity.  These conditions were discussed in a previous post The Rationale Behind Fast Growth.

Assuming that these don't apply, the main condition for being able to pursue controlled growth is a company's ability to erect competitive barriers to entry or, in other words, the ability to create long term sustainable competitive advantages (LTSCA for short).  This term is most associated with Michael Porter, author of Competitive Advantage and develop of the Five Forces competitive strategy framework.

Creating Barriers to Entry

Creating a barrier to entry starts by first accepting the fact that you have competition.  Not that you might have competition in the future.  Not that you will have competition.  But rather that you have competition right now, right out of the gate.  Why the distinction?

Because I've noticed that entrepreneurs who don't believe they have competition right now (i.e. "there's nothing like it out in the market!") are vulnerable to problems associated with competitive substitutes.  A competitive substitute is a set of products or services that, when combined together, can serve the same function as your product solution.  For example, if I need to tally up a long string of numbers, I generally use a calculator.  But I could also use the calculator application on my smartphone, a digital watch, an abacus, a pencil & paper, or just my head.  All are competitive substitutes to the calculator.

What problems?

• Weak relative value proposition - In the quest for product/market fit, there are two elements of value that must be established.  The first is the intrinsic value to the customer - the value received by the customer using your solution to address a need.  The second is the relative competitive value of your solution versus an alternative.  By not downplaying competitive substitutes, these same entrepreneurs are then surprised when customer adoption is slower than it "should be."  Remember, status quo and doing nothing are legitimate customer purchase behaviors.
• Neglecting to search for barriers other than first mover advantage and scale - So what happens if the company can't grow as quickly as expected?  Does this mean the business is not viable?  A good question to ask is "assuming that someone else reaches the market first and grows faster, how would we then compete?"  This may uncover potentially lucrative sources of LTSCA.
• Surprised by fast followers or disruptive technologies - As discussed in a previous post, being a fast follower is at least as viable a route to market leadership as being a first mover.  Many times, fast followers come from fringe products that don't directly compete...at first.  This is classic Innovator's Dilemma.

It is not a goal of business to eliminate all competition;  this is impossible.  But one business goal should be to establish a defensible perimeter large enough and profitable enough inside of which it can thrive.  It's not good enough to play great offense;  a business needs to be able to play defense too.

Sources of Long Term Sustainable Competitive Advantage
So what makes an ideal LTSCA and where do they come from?  Ideally, an LTSCA must have significant value but be hard to replicate.  Without going into detail, here is a quick listof sources:

• Size - market share, financial deep pockets, economies of scale
• Lowest Cost - from superior operational efficiency
• Superior Capability - organizational performance, product leadership, technology
• Control of Limited Resources - natural resource (e.g. mines, oil), suppliers, sales channel, shelfspace, parter and customer networks, unique information, technical skills
• Switching Costs - functional (e.g. unique part), retraining, work habits, sunk costs
• Loyalty - brand, customer
• Legal - patents, trademarks, favorable regulations (e.g. electric power utilities)

Aside from size, one does not need to be IBM to cultivate the development of one or more of these LTSCAs.

LTSCAs generally build over time.  If a company sets out with the intention that every year it will continuously enhance its capabilities in a lasting way, over time, this can result in a formidable barrier to entry.  This incremental approach is often more robust than embarking on the massive change initiative of the year approach practiced by many companies.  This is the idea behind Jim Collins's Flywheel concept from Good to Great.  Small actions timed right can build lasting momentum.

So what does controlled growth mean?  Is it revenue growth of 5% per year or 50%?  The useless answer:  it depends.  It depends on your industry and your business.  The final post in this series will look at the useful answer.

Next week:  Determining Your "Natural" Growth Rate

The Case for Controlled Growth

3rd in a series on Strategic Growth

Last week we discussed some of the reasons that justify a fast growth approach.  This week, we discuss some of the reasons to pursue a controlled growth strategy, which I define as one where management restricts the growth of the business to be within the constraints of its ability to internally generate growth capital, hire the right people, and adsorb lessons.  Restrict the business?  How does one do that?

By limiting the acquisition of new customers (pause)....Are you out of your #$!$@!# mind!?

Before you answer that, let me digress to on the lessons taught by one of today's classic business books, Good to Great by Jim Collins.

Lessons from Good to Great
Good to Great is a favorite on most manager's reading lists.  While there are a lot of takeaways from the book, I want to focus on just a few relevant to growth.  First, Collins shows the hockey stick pattern that he uses to characterize good-to-great companies vs. standard comparables.  In this case, he uses a stock price chart as an indicator of growth:

Source:  Collins, James, Good to Great, Harper Collins, New York (2001), p.4.

Now the hockey stick forecast is a long standing joke of corporate forecasting, but strangely enough it does happen.  Here is a revenue case if you don't buy into stock prices as an indicator of growth:

Data from http://commons.wikimedia.org/wiki/File:Ipod_sales_per_quarter.svg

Collins then goes on to create the diagram below which represents his Good to Great framework:

Source:  Collins, James, Good to Great, Harper Collins, New York (2001), p.12.

What is significant about the hockey stick pattern is the existence of the buildup phase prior to breakthrough.  One message here is that high growth stems from what the company does during the buildup phase.  Collins describes these concepts Level 5 Leadership, First Who...Then What, Confront the Brutal Facts, and as the company achieves breakthrough, the Hedgehog Concept.  Read the book if you want more detail.

Depending on the nature of the business, the buildup phase can be quite long.  Why and what are the key reasons behind this?  My purely empirical observations:

• The ability to grow is dependent on the quality and robustness of the business model - By business model, I mean how a company delivers value to acquire customers, generate profits, and what the scaling factors are.
• The business model and its execution are dependent on the quality, creativity, and productivity of the company's people - They are the ones who tweak the model, build and deliver the product, service the customer, improve the system, and eliminate waste.
• It takes time to get the people right - It takes time to hire and to train.  It takes time for people to learn and master their jobs within the specific context of your business.  And it takes time to figure out who is working out and replace those who aren't.
• It takes time to forge people into a team - Creativity and productivity depend on having more than just a collection of talented individuals.  They need to be blended and forged into a team where one can reap the benefits of esprit-de-corp, shorthand communication, reinforcing work styles, and knowing how their teammates think.  This comes when people work together, fight with each, and reconcile with each other.

The common element is time.  Money is only a partial substitute to the degree that it allows you to hire experts (who have already put in their 10,000 hours towards mastery) or accelerate learning and experimentation.

Limiting Customers Acquisition
This brings us back to limiting customer acquisition.  When does this become important?  It's important when a particular customer brings "just revenue" that detracts from getting the business model and people right.  I'm not being flip about "just revenue."  There is a chicken and egg issue here that requires judgment.

In order to develop and tune the business model, you need some customer traction.  For a pre-revenue early stage startup, it's not a question of limiting customer acquisition.  Customer acquisition is the name of the game but more as validation of product/market fit than for the dollars, which are almost always small to start.

But once customers have been acquired and the company is attempting to validate and tune a scalable business model, the desire to prematurely scale, usually driven by dwindling cash and insufficient resources can lead a company to grasp for any customer.  This is where limiting customers becomes important.  A company at this stage needs to make sure it's accepting the right customers (i.e. target customers).  Not all revenue is created equal.

Taking on the wrong customers just for revenue can pull a company away from its core strengths and out to the fringes of your business model.  And projects operating on the fringes usually tie up a disproportionate amount of resources resulting in little net gain.  (After all, if a fringe project is highly lucrative, you might want to reexamine your business to see if this should be the business!) You need to say no to these customers.  The essence of niche segmentation and Collins's Hedgehog Concept is focusing to deliver superior value to the target customer set.

But what if they are the target customer?  Should you turn them away?  This is a matter of resources.  If by adding another target customer, you outstrip your ability to maintain the quality of your offering, then you need to seriously consider this.  It is true that if you don't accept the customer, they will probably end up with a competitor, so one must take into account the strategic ramifications (i.e. are they a marquee account).  But outstripping your ability means that you won't be able to sustain superior value to your existing customers, leaving yourself vulnerable to the competition.  And it is a sales truism that retaining an existing customer is easier than winning a new one.

Is Controlled Growth the Path to High Growth?
If controlled growth fosters the success of the buildup phase which Good to Great implies is the path to sustainable high growth, does this mean controlled growth is the secret to high growth?  Not necessarily.  First, for a variety of reasons, some businesses may never have the potential for high growth (e.g. limited market, regulation, high fragmentation).  Second, external financing can accelerate the buildup phase; in fact this is what angels investors and venture capitalists seek to do.

Third, the ability to pursue controlled growth is dependent on a number of conditions.  This will be the subject of the next post.

Next week:  The Conditions for Controlled Growth