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Competitive Advantage

Most markets in which startups operate are highly competitive. It's an old investor saying: If there is no competition, there is no market, no customers, no opportunity for growth. Attractive markets automatically attract new entrants and therefore competition.

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A standard way for VCs to decline an investment opportunity is by pointing out that the market is too competitive. The real reason is that the investor didn't understand how the startup plans to stand out against competition.

The mere existence of competition is not a limiting factor for success — Google entered the market when there were already over 20 search engines in the market, but it had a unique and better product and different form of monetization.

Three classic dimensions

It is therefore an essential task for any startup to understand and improve its competitive advantage, often also referred to as competitive "moat".

The three classic dimensions of competitive advantage according to Michael Porter are:

  1. Cost leadership: If your business is able to produce its product or service at a lower cost than competitors, it enables you to either sell the product at a lower price than competitors can or use the high gross margin to grow more aggressively.
  2. Differentiation: If your product is clearly different than competitors', you have an advantage. Examples include higher quality, unique product capabilities that others can't easily copy, or a novel and better way of delivering the product.
  3. Focus: This approach tries to produce the best possible product not for the broader market, but for a particular niche, therefore setting the company apart from broad-based competitors. This can be an interesting entry point into a market from where to expand more broadly as the startup grows. The danger is to get stuck in the niche, which might limit further growth.

These three dimensions are universally applicable to competitive differentiation, but they are of course very hard to pull off. Cost leadership for example is very desirable, but being able to achieve a true cost advantage is one of the hardest management task.

Startup management teams therefore should think frequently about their competitive differentiation and how to improve it.

Effectual reasoning

The three dimensions explained above are taking a top-down view of generating and sustaining a competitive advantage, and they are most easily applied to more mature markets. However, it is more typical for startups to begin their journey at a specific point where they have a small, but distinctive advantage and then build the business on this particular resource. They also tend to operate in newly emerging markets where points of differentiation are not clear yet.

It is therefore useful to turn the thinking about advantages around and analyze the options that a startup has from the point of view of its existing resources. This view was captured by researcher Saras D. Sarasvathy and described as "Effectual Reasoning".

The key pattern is to first understand what the startup's founding team (or its current state as a company) possesses in terms of unique resources. Normally startups are, unlike big corporations, not rich in financial resources, but instead they might have

  • unique skills (e.g. from years of university research or experience in an industry)
  • a fresh look at a market
  • a particularly deep understanding of a target customer group
  • a unique network in a relevant sector, etc.

Effectual Reasoning then takes these unique advantages and imagines a set of possible future states that could be be achieved by leveraging these resources. This view accepts that you can't know the outcome in a new market and that there are many uncontrollable external factors, so setting a pre-defined goal is often pointless. Instead, effectual reasoning suggest a rapid iterative process that aims to leverage and expand the existing resources in order to create competitive advantage.

Effectuation doesn't replace traditional methods of thinking about competitive advantage, but it is a particularly useful method for startups, particularly at their early stages. Much too often startups set themselves ambitious goals that can only be achieved by resources that they don't have yet, and failure to get these resources can mean failure of the company. Effectual reasoning instead uses a "bird in hand" way of thinking to leverage an existing advantage and build the business from there.

Useful Resources

Porter: Competitive Advantage

The classic book of the sector, still worth reading today.

Society for Effectual Action

Blank: The Four Steps to the Epiphany

A startup is an organization trying to find product-market-fit. Here's how to do it.