business

Business Model Analysis, Part 9: Outsourcing

This post is part of a series on business model analysis for entrepreneurs. The first post in the series presents a comprehensive list of issues (available as a downloadable PDF) entrepreneurs should consider when designing a business model. Others delve into specific issues; this one looks at factors that determine whether a startup should keep key activities in-house, versus outsourcing them.

The key word in the last sentence is "key." Serial entrepreneur Furqan Nazeeri has argued that startups, because they are resource constrained, should outsource all activities that do not contribute to long term, sustainable competitive advantage. VC Fred Wilson generally agrees, and notes that startups often make the mistake of outsourcing product development due to a lack of in-house skill, but in doing so they sacrifice the crucial ability to iterate the product designs (a point echoed by Vivek Wadhwa). Wilson also says that startups often outsource customer service due to perceived cost savings, but in doing so they forfeit valuable customer feedback.
Another consideration in deciding whether to outsource key activities is the prospect of asymmetry in bargaining between a startup and powerful partners. HubSpot's Dharmesh Shah has warned about the many risks that a startup confronts when negotiating with big companies. Serial entrepreneur and VC Marc Andreesen has likened dealing with big companies to the long, frustrating, and harrowing pursuit of Moby Dick.

I won't try to expand on those insights here. Rather, I'll focus on the microeconomics of in-house vs. outsource decisions, which, in economists' parlance, are choices about vertical integration. According to Yale Professor Oliver Williamson, there are economic advantages to completing transactions between two units within a vertically integrated company—rather than between two independent firms—when the transactions entail high levels of uncertainty, small numbers bargaining, and asset specificity. With transactions between independent firms, uncertainty makes it difficult to draft a contract that specifies each party’s obligations under any contingency that might arise. Absent a complete contract, the parties periodically will need to renegotiate transaction terms. If either party is subject to “small numbers bargaining,” that is, if it has few potential transaction partners, then that party may be vulnerable to hold-up when it renegotiates. Finally, if either party’s assets are tailored for a specific transaction type and cannot be redeployed into other uses, then failing to complete a crucial transaction—for example, securing an input required for production—may lead to bankruptcy with little liquidation value.

Startups frequently face the conditions that encourage vertical integration. By definition, they confront high levels of uncertainty. Also, when they target new markets with radical innovations, startups may require access to idiosyncratic assets controlled by only a few potential partners.

However, vertical integration poses challenges for resource-constrained startups, because it often requires major investments. Cake Financial, a service that gave investment advice to consumers based on analysis of their online stock trades, illustrates this dilemma. Cake’s founder had a choice between building software that could extract a customer’s trading data (with their permission) from their online brokerage accounts, or licensing access to the data from a firm that had already developed similar software. Concerned about that firm’s fees and whether it would be responsive to a small startup’s needs, Cake’s founder chose to build the software. This consumed most of the $9 million in venture capital that Cake had raised, and put the startup in a precarious position when demand for its service was slow to emerge and then capital markets slammed shut during the 2008 global economic crisis.

Business Model Analysis, Part 8: Crossing the Chasm

In his classic book on hi-tech marketing, Moore observed that customer adoption of revolutionary new technology products follows a predictable life cycle. Early adopters, according to Moore, are visionaries seeking breakthroughs; they can imagine the new product’s benefits before they have been proven. Because they are tech-savvy, early adopters can self-assemble complementary hardware, software, and services needed to use the new product, and can cope with its inevitable initial bugs. In the next stage of the product life cycle, the early majority—a much larger group—are pragmatists who will only buy a standardized product that has clearly proven benefits. They demand a “whole product solution”—an easy-to-use, reliable bundle of all necessary hardware, software, and services—supported by a reputable firm.

Moore observed that peer-to-peer references are crucial in driving technology purchase decisions. However, early adopters are not considered to be credible references by the early majority: there is a chasm separating the two groups because they rely upon such different purchasing criteria. As a result, new products that are successful with early adopters often stall when startups try to sell them to the early majority.

Moore’s prescription for crossing the chasm is to target a single segment within the early majority; to engineer a whole product solution with clear benefits for this segment; and to overwhelm the segment with an integrated, intensive marketing campaign. From this beachhead, the firm can then leverage referrals to capture other early majority market segments. Moore likens this strategy to World War II’s D-Day, when the Allies landed a massive force at Normandy as the first step in their invasion of Europe.

Most startups targeting fundamentally new markets will not encounter the chasm until they are a few years old; in the meantime, they will be busy cultivating early adopters. Consequently, seed-stage ventures can probably ignore the chasm risk as Steve Blank points out in Four Steps to the Epiphany. However, a “D-Day” strategy requires plenty of planning, so entrepreneurs should begin to watch for the chasm as their startup matures.

Business Model Analysis, Part 7: Bundling

Bundling entails selling, in a single transaction, two or more items that could conceivably be sold separately. A printed newspaper, for example, is a bundle of news stories, classified ads, comics, obituaries, stock tables, sports scores, etc. Microsoft Office bundles several productivity applications in a software suite.

The ubiquity of bundling is not an accident: the strategy can provide significant benefits, including superior surplus extraction (i.e., capturing a greater share of customers’ willingness to pay), economies of scope, product design improvements, and strategic advantages.

However, pursuing a bundling strategy can be challenging for a resource-constrained startup Most early-stage ventures strain their capabilities to develop and sell a single product, so bundling multiple products from the outset may not be an option. Nevertheless, entrepreneurs should keep the potential benefits from bundling in mind as they design their business models and plan for future product launches.

These benefits include :

Surplus Extraction. Economists define consumer surplus as the difference between a customer’s willingness-to-pay (WTP) for a product and its price. When a firm offers the same price to all customers (i.e., when it does not engage in price discrimination via negotiated pricing, auctions, etc.), bundling two or more products may allow the firm to extract a larger share of total available consumer surplus — and earn higher profits — than it would from selling the items separately. To illustrate this potential benefit, consider an example with two customers, Jack and Jill, and two products, A and B, each sold by the same monopolist. A and B both have zero marginal cost (as with many information goods), and the firm must offer a single price for each product to all customers. Jack’s maximum WTP is $10 for A and $4 for B. Jill’s maximum WTP is the reverse: $4 for A and $10 for B. If the firm sells A and B separately for $4 each, it will sell one unit of each product to both customers and earn total profits of $16. By pricing each product at $10, it will sell one unit of A to Jack and one unit of B to Jill and earn profits of $20. However, if the firm offers an A+B bundle for $14, it will sell the bundle to both customers and earn profits of $28. Bundling is more likely to increase profits in this way when: 1) the marginal cost of bundled items is low or zero; and 2) the correlation of consumers’ valuations for individual items is weak. Weak correlation means that when customers evaluate the items in a bundle, they don't all have the same favorites. Real world examples of surplus extraction through bundling abound. Some HBO subscribers, for example, value its recent theatrical films highly; others love its original series (e.g., True Blood, Entourage); still others are drawn to HBO's boxing matches or concerts. This varied programming mix allows customers with very different preferences to each justify paying a $10 monthly subscription fee.

Economies of Scope. Compared to selling items separately, bundling can also reduce a firm’s costs. Firms can realize economies of scope in customer acquisition activities because they can sell the bundle with a single marketing message, rather than two separate ads or two sales calls for two distinct products. Likewise, economies of scope in production are available when integrated designs leverage shared components (e.g., a single screen and battery when combining a cell phone and MP3 player).

Product Design. Integrated designs may also yield quality advantages through simplification of interfaces, as with Google’s use of a common password across all of its applications and its integration of Gmail into its search service.

Strategic Advantages. Under certain conditions (described in this academic paper), bundling may allow a company that monopolizes a market for one product (call it "A") to profitably leverage its way into the market for a crucial complement to A (call it "B") which previously was supplied only by independent companies. Products are complements when they are frequently or always consumed in tandem (e.g., browsers and PCs; beer and pizza). By offering only an A+B bundle (i.e., "tying" A and B and not allowing customers to buy A separately), the market A monopolist forecloses access to its customers, denying standalone suppliers of B the opportunity to sell to them. The resulting reduction in revenue weakens the standalone suppliers of B and may even force them to exit the market. Of course, such a strategy can run afoul of antitrust law, as Microsoft discovered when it tied the Internet Explorer browser to its monopoly Windows operating system.