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Thinking strategically, part four: Porter’s Five Forces

In part three of our startup strategy primer, we discussed the crucial difference between industry analysis and business strategy. Substituting industry analysis for business strategy is the most common — and most fatal — mistake entrepreneurs, solopreneurs, and online “strategy experts” make. The one and only purpose of industry analysis is to determine the “attractiveness” of an industry. Highly attractive industries, such as iPhone applications, are littered with failed startups like Bud cups at a Raider’s game. Industries that are unattractive in almost every way, such as automobile manufacturing, sometimes play host to wildly successful startups — witness the rise of Tesla in the last year. The difference is this: market entrants in a highly attractive industry can sometimes succeed — and succeed beyond their wildest dreams — with no initial strategy supplanted by an emergent strategy, that is, a strategy that gradually develops and evolves with the circumstances of the business. Entrants into an unattractive industry can’t even run in place without a sophisticated, game-changing strategy.

That being said, determining whether an industry is attractive is not as easy as reading Business Week. You may think that iPhone Apps are an attractive industry (they are), but by the time the industry crosses your radar, the ship may have sailed and the industry may no longer be attractive relative to your business’s resources and capabilities. Keep in mind that there is a significant lag time between the initial opening of an industry and the publicizing of that industry in the media.

By far the best tool for analyzing industry attractiveness is Michael Porter’s Five Forces. The goal of a Five Forces analysis is to get a snapshot of the entire industry, from consumers to competitors to suppliers, relative to your business or startup. That snapshot will illustrate the attractive aspects (those that ensure profitability) of the industry as well as the less attractive aspects (those that put up obstacles to profitability). That snapshot will give you a blueprint for developing strategy. Remember: business strategy is like poker. Your job is to win with a winning hand or convert a losing hand into a winning hand through game-playing strategy. The Five Forces are, as it were, the layout of the game table. Attractive aspects of the industry (let’s say, lack of competitors) are winning hands you’ve been dealt without even throwing money in the pot; unattractive aspects (say, lack of a market) are losing hands that require business strategy.

Since our upcoming book on startup business strategy deals with industry attractiveness and Porter’s Five Forces in detail, this blog can easily just sum up what the Five Forces are all about. So we’ll save the fancy pictures for later (you don’t need them), and just make you familiar with the table.

It’s helpful to think of the Five Forces as the game table you’re playing on (that’s how we deal with it in the book). Unlike poker or chess, business is a multi-dimensional game. You are playing against more than one set of players (if it were that easy, most of us would be rich). Rather, when you sit down to a game of business, you’re getting dealt into several games with different sets of opponents and different playing tables. Who are you playing against?

  • Competitors: Competitors, or direct rivals, are your most obvious opponent in the business game. If you develop a diet and exercise iPhone App, then you’re in the game with other iPhone App developers with the exact same idea (and if the industry is attractive, expect more and more competitors to sit at the table playing against you).
  • Consumers: That you’re in the game against consumers seems to be nonsensical, but you are. Unless you’re a utility or a garbage collector, your consumers have a choice. They can buy from you, buy from a competitor, buy a substitute, or buy nothing whatsoever.
  • Suppliers: When you play the business game, you’re also sitting at a competitive table with your suppliers of whatever sort. Now, if you’re doing iPhone Apps, you probably have no suppliers. But if you’re in the car-making business, then you’re at the mercy of the folks selling you brakes and axles and leather seats. Here’s the game suppliers play: they want to maximize their profits, which is a delicate game of getting you to buy from them, but getting you to buy on terms least favorable to you.
  • “Substitute” competitors: You’re playing a game against competitors and consumers, but there’s yet another opponent to worry about: substitutes. A substitute is any product like yours that a consumer could choose instead of you. Not a rival product, but a similar product. For instance, you’ve gone out and developed a killer diet iPhone App and you have two direct rivals. However, your prospective consumers could skip your app and buy a diet book, or a PC diet app, or a DVD. Like the competitors, substitute competitors can suddenly and unexpectedly sit down and start wiping you out. For instance, for many years, the cable industry had to compete against substitutes such as DVDs and video rentals. And then free TV and movie Internet downloads (such as Hulu) sat down and started competing for the same customers . . . and cable had no game to play against them.
  • Distributors: Finally, every business game (except direct retail) involves a separate game with retailers and other distribution channels. If you’re in the iPhone App business, then you’re sitting at the table with a 9,000 pound distributor: Apple. And you play the game their way. Again, distributors play the game to maximize their gains, minimize their risk while at the same time minimizing your gains and maximizing your risk (as anyone can attest who’s had the psychically traumatizing experience of sitting across from WalMart at one of their Nazi negotiation rooms in Bentonville!)

    Those are your primary opponents in the game of business. There are, of course, others, such as government. And sometimes, your competitors will team up with other opponents — for instance, your competitors might team up with government to make it more difficult or costly for you to start up your business (nobody loves business regulation more than business because it stifles competition).

    If those are your opponents, think of Porter’s Five Forces as the five games you play with your opponents:

  • Rivalry: “Rivalry” is the central game you play in business and the one where you face off directly with your competitors. “Rivalry,” as a game of strategy and luck, is about product differentiation, brand power, exit costs (the higher the exit costs, the more likely your competitors will stay in the game), concentration (is the industry concentrated in a few or many players — the greater the concentration, the harder it is to win the rivalry game), diversity of rivals, and so on. In the game of rivalry, a powerful brand is a winning hand; industry concentration is a winning hand.
  • Buyer power: The “Buyer Power” business game faces you off with your buyers and consumers. Buyers can actually win this game and suck up (all) your profits. Buyer power includes the ability to negotiate (buyer power in the auto industry is at an all-time high), the choices buyers have, their expectations, price expectations (for instance, buyers expect iPhone Apps to be cheap or free, thus eroding the profitability of the industry). The more power consumers have (that is, the better the hand they’re dealt), the less profitable the industry will be. Just look at the auto industry today.
  • Supplier power: The “Supplier Power” game pits you against all those folks who make the things you need to make the things you sell. Suppliers usually want to do business with you, but they also want to win as much money on the table as possible through high margins, high credit prices, long delivery times, and onerous restrictions or expectations. The better the hand they’re dealt (or, alternatively, the more losing a hand you’re dealt), the less profitable you will be. Supplier power includes concentration (the more suppliers who are competing with one another, the better for you), supplier switching costs (how much it would cost you to switch suppliers — the higher the cost, the worse off for you), the presence of volume buyers (if there are high volume buyers, you will be stiffed if you’re a low-volume buyer), forward integration (the possibility that your suppliers will become your direct competitors by entering your industry — if that happens, you’re pretty screwed).
  • Threat of substitutes: The “Threat Of Substitutes” game, like the rivalry game, is a dangerous and highly volatile game that can crash even the highest flyers. The Threat Of Substitutes is a different game than Rivalry. Substitutes are products made in other industries that your customers could switch to. The more substitutes there are in an industry, the less profitable your startup or business will be — or the less likely to succeed. Substitutes aren’t merely measured by their presence, but the price and performance trade-off (downloaded video may be free, but is it as good as cable video?), the ease of substitution (switching to downloaded video involves not an insignificant amount of frustration and confusion), and switching costs (how much it costs the buyer to switch from your product to a substitute product).
  • Barriers to entry: The “Barriers To Entry” game pits you against several players, such as government and your rivals. But the biggest players at the table are usually distributors; distribution channels, after all, are often the only way to reach a customer. Simply put, barriers to entry make it relatively more difficult to start a business in one industry versus another. The barriers to entry, for instance, in the auto industry are infinitely greater than the barriers to entry in iPhone Apps — in fact, the barriers to entry in iPhone Apps are practically zero. Barriers to entry include capitalization costs, regulations, economies of scale, and expected retaliations from your rivals.

    These then are your primary opponents (competitors, consumers, suppliers, substitutes competitors, and distributors) and the games you play (rivalry, buyer power, supplier power, threat of substitutes, and barriers to entry). You can win on one table and still be profitable; but the biggest pot goes to the players who can win big on all five tables against all five opponents.

    The purpose of the analysis is to determine your best game play. If you can’t win at the supplier game, you’re going to have to play a stronger game elsewhere. If you’re up against stronger rivals, you’re going to have to develop a game-changing strategy that turns their winning hands into losing hands.

    In other words, a Five Forces analysis is the first step in putting together your strategy. You identify where you’re at in each game you have to play and whether you should win, convert your hand to a winning hand, cut your losses, or fold out of the game (so you have to win at another game). It’s the start of your strategic thinking, not the end.

    But before we start on your game, I want to detour on to one other aspect of industry analysis — value. And for that, we’ll be returning to Seignor Porter and his method for determining value: the Value Chain Analysis. This is more than just MBA stuff. A value chain analysis tells you where the money is. So if you’re in the game playing for a pot of money, you want to play for the biggest pot possible.

    Other articles in our strategy series:

  • Part One: The Lottery Strategy
  • Part Two: Core Competencies and Competitive Advantage
  • Part Three: Industry Attractiveness and Competitive Advantage
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