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Finding fertile ground: Identifying extraordinary opportunities for new ventures

Book cover

by Scott A. Shane, Wharton School Publishing, 2005.

Abstract

Although we live in an entrepreneurial age, most entrepreneurial activity ends in "dismal failure". This book offers the first complete framework for entrepreneurs who want to start high technology businesses. Anyone can become a successful entrepreneur; it is the business opportunity a person chooses to pursue that matters most. The book suggests ten key rules for developing a business concept for a successful high-technology company.

(Summarised by Kevin Barham August 2006)

(These book summaries aim to represent some of the key aspects of what the author has written. They do not necessarily represent the views of the summariser or of Ashridge. Equally the author of the book summarised must not be held responsible for any misperceptions of the summariser. A summary does not have space for all the illustrative cases which provide the richness of a book and there is no substitute for reading the whole book. There is an element of simplification in a summary so that the message may seem more obvious than it necessarily is, though the most powerful ideas are often simple and obvious in their essence.)

Introduction

Scott Shane claims that his book is the first complete framework for entrepreneurs who want to start high technology businesses. Shane is a professor at the Weatherhead School of Management at Case Western Reserve University. He points out that, while we live in an entrepreneurial age, where successful entrepreneurs like Bill Gates and Sam Walton have achieved icon-like status, most entrepreneurial activity ends in "dismal failure". Forty per cent of all new businesses started in the US do not live one year, more than two thirds die before their fifth birthday, and only 25% survive for eight years. And most entrepreneurs make very little money – on average, those few who survive ten years make only 65% of the real earnings they made in their previous employment.

Shane identifies what he believes is the key difference between entrepreneurial successes and failures – the selection of the right business concept to exploit a valuable opportunity. He focuses on technology because evidence shows that on average entrepreneurs are more successful if they create high-technology start-ups than if they initiate firms based on low-technology. Entrepreneurs typically choose to start businesses in the wrong industries – often in retail or restaurants where the failure rate is highest and average profits are lowest.

So, if you’re starting a business, your best odds of success are in high technology industries; not just computing and telecom but also biotech, aerospace, electronics, manufacturing and materials, medical devices, pharmaceuticals, robotics, and other knowledge-intensive fields.

The author has found that most books discuss entrepreneurship in general, without considering the special nature of high technology. He says that his focus is on what matters most for successful entrepreneurship – picking a good opportunity for starting a new business – rather than the attributes of successful entrepreneurs. Despite all the effort that has gone into identifying the special features of successful entrepreneurs, there really are none. Anyone can become a successful entrepreneur. It is the business opportunity a person chooses to pursue that matters most.

There are ten key rules for developing a business concept for a successful high-technology company.

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1. Select the right industry

Some industries are simply better than others for the creation of new companies so you will be more successful if you select the right industry in which to start your company. The performance of new firms varies significantly across industries and choice of industry can influence by up to a factor of 1,000 the probability that an entrepreneur will grow a successful business.

Five dimensions of industry differences influence the relative performance of new firms: knowledge conditions, demand conditions, industry life cycles, the presence or absence of a dominant design, and industry structure.

Industry knowledge conditions have the following effects:

  • New firms perform poorly in industries in which the production process is complex and requires sophisticated organisation structures to co-ordinate it.
  • New firms do not do well where the amount of new knowledge created in an industry is high as they don’t have the internal cash flow to invest in basic research.
  • Where industry knowledge is well codified (written down) rather than tacit (residing in the heads of a few), it is available to the entrepreneur who does not have direct operating experience of the industry. The learning curve is less proprietary, making it easier for new firms to learn what predecessors have learned and catch up in terms of performance.
  • In some industries, firms and their customers and suppliers generate most innovations. New firms do better in industries where the locus of innovation is outside the value chain, eg in universities or public research bodies which are less concerned than firms about stopping valuable knowledge from leaking out.
  • New firms tend to perform poorly in industries in which manufacturing and marketing account for most of the value added as they are often inefficient in these areas.

Where industry demand conditions are concerned:

  • New firms perform well in large markets because of the fixed costs they incur to produce a product to meet demand. The new firm’s average cost of meeting demand is lower in a larger market than a small one. The cost gap between new and established firms (who have already incurred the fixed cost and can meet demand at marginal cost) will be smaller.
  • Markets that are growing quickly are better for new firms as the more rapidly the market grows, the less a new firm needs to serve the customers of existing firms and the lower the level of competition will be.
  • Heavily segmented markets give new firms an opportunity to enter with small-scale production and serve the underserved niches.

The industry life cycle affects relative performance as new firms perform better when industries are younger because they face fewer competitors and it is easier to attract customers when demand growth is highest. They also perform better when a dominant design does not exist in the industry as they are not constrained to designs that are consistent with the dominant standard.

New firms perform better under certain types of Industry structure. They do better in labour intensive industries than capital intensive ones because at the time they are founded they lack cash flow from existing operations and borrowing from the capital markets is expensive due to the risk premium they have to pay.

New firms are disadvantaged in advertising-intensive industries because of the time it takes to build a brand name and because economies of scale mean their per unit advertising costs are higher than established firms. New firms also do poorly in concentrated industries where the largest companies with their high market share can use their market power to deter entry.

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2. Identify valuable opportunities

To be successful, you need to start your new business in response to an opportunity to create a new product or service which meets customer needs that have not been satisfied adequately, or which satisfies them in a much better way than established firms do.

The first step is to locate the source of the opportunity whether this is technological change, political/regulatory change, social/demographic change, or change in industrial structure.

The second step is to figure out the form that efforts to exploit the opportunity will take. Opportunities do not have to take the form of new products and services. They can also take the form of new markets, new raw materials, new production processes, or new ways of organising. (Some of these are easier to keep secret than new products so they reduce the chances of imitation.)

Matching the opportunity to specific, appropriate types of innovations is a key issue. For example, altering product dimensions or physical properties of products are more likely to lead to new products. Automation or mechanisation generates opportunities in production processes. Changes in scale or form of production generate opportunities for new ways to organise. Designing for new market segments and customisation results in opportunities to create new markets. You must be aware of how different innovations affect forms of opportunity. Otherwise, you may try to develop opportunities for new products and services when that form of opportunity is inappropriate for the type of innovation that is driving it.

You also have to identify where in the "innovation chain" the change occurs. Innovation occurs in different entities that form a chain running from universities and public research labs carrying out basic research at one end to final customers at the other. In the middle are producers and suppliers of inputs and raw materials. Successful entrepreneurs tend to focus on innovations in basic research or among suppliers and customers, leaving innovation by producers and their customers aside, unless it exploits a weakness of established firms.

Different industries generate innovations at different stages of the chain, again indicating that some industries are better for establishing new firms than others.

The final step is to understand how individuals identify opportunities for new businesses. Key factors here are access to information and information-processing capability. Some people are more likely than others to gain access to the information that signals the presence of an entrepreneurial opportunity because of their position in social networks, their jobs and life experience, and the targeted search processes they adopt. One of the lessons, if you want to be a successful entrepreneur, is to make sure you choose jobs, social networks and life activities that keep you in the flow of information about new business opportunities. Some people also process information in a way that helps them identify entrepreneurial opportunities because their mindset sees information as generating opportunities rather than creating risks.

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3. Manage technological transitions

Technological development follows an evolutionary pattern in which scientists and engineers work within frameworks that limit problem-solving approaches to a prevailing paradigm. At certain points in time, new technologies appear that radically shift the underlying technological paradigm.

These radical shifts provide an excellent opportunity for entrepreneurs to enter industries, provided they can manage the technological transition. This first requires an understanding of the "S-curve" of technological development. This shows that technologies initially experience slow performance improvement because of the learning process. Then breakthroughs are made and technologies improve dramatically. In the final phase, improvement slows as laws of diminishing returns kick in. At this point a new technology often appears, leading to a new S-curve.

The transition to a new S-curve is almost always undertaken by new firms rather than established firms as the latter have little incentive to make the transition. The new technology generally begins with worse performance than the old technology, making it very difficult for the new firm to compete initially with established firms. The timing of new firm entry is important. Too early means technology improvement will be too slow for new firms to be competitive with established firms using the old technology. Too late and the opportunity is missed to other entrepreneurs entering with the new technology.

It is also important to understand dominant designs and how they influence competition by new and established firms. Once a dominant design emerges, firms can no longer compete on the basis of variation in design and must instead compete on cost. A dominant design allows firms to exploit economies of scale and become efficient in manufacturing, making it hard for new firms to match the advantages of existing firms. New firms tend to perform better before a dominant design has been established than afterwards because at this stage, barriers to entry are low, product competition is strong, learning curves are limited, efficiency is relatively unimportant, and organisational hierarchies are not effective in the predominant design phase.

Establishing your product as the technical standard generates large financial returns. Successful entrepreneurs often take specific strategic actions to make their product a technical standard: adopting a low price, making their new products and services work effectively with complementary technologies, and launching simple products.

You must also understand the differences in managing businesses with increasing and decreasing returns. Increasing returns businesses are those in which the benefits of something increase as the volume of production increases. Businesses have increasing returns when:

  • Up-front costs are high relative to marginal costs (so unit costs drop dramatically as volume increases)
  • "Network externalities" are present (i.e. when the value of a product increases with the number of people using it)
  • Complementary technologies are important to the effective use of a product or service
  • Producer learning is strong (lowering costs and increasing margins)
  • The costs for customers of switching to another product are high.

Under conditions of increasing returns, an effective entrepreneurial strategy involves achieving a first mover advantage, partnering early with the producers of complementary technologies and betting aggressively. You have to attract customers first and make profits second so new firms will experience high levels of negative cash flow. These businesses need "deep-pocketed" investors who will bet significant amounts of money on the business. Such businesses "are not for the faint of heart".

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4. Identify and satisfy real market needs

You need to identify real customer needs: eg something that must be solved, often because of a problem that the customer has. The best clue is a customer complaint as it indicates that a potential customer is unhappy with the status quo.

Evaluating customer preferences for established products is easy because you can use surveys and focus groups to find what customers want. When products or services are new, however, these techniques are often ineffective. You need to find out about the context in which the product will be used, so deep involvement with lead users is required.

Ensure your products and services meet customer needs in an economic manner and in a way that is better than the approach offered by the competition. To make money from a new product or service, it must be produced for less than the cost at which it can be sold. Many entrepreneurs have problems here. Some entrepreneurs lose money on the initial transactions but find transactions undertaken at higher volume to be profitable. The ability to make this happen is not always there because it is often difficult to obtain enough cash to create a business that produces at the volume at which transactions become profitable.

Beware of overestimating how much better your solution is than your competitors’. Entrepreneurs need to be optimistic but this makes it difficult for them to assess their products realistically. Use your social network to find out about possible competitors and competing products and talk to venture capitalists and potential customers.

Don’t expect your new product to sell itself. Marketing in new firms relies very heavily on personal selling by entrepreneurs because new firms don’t have brand name recognition or the superior distribution channels of established firms.

You need to get the prices right for new products. This is another difficult task because many of these products have high fixed costs and it is easy to underestimate the volume required to cover them. Hidden costs (such as providing credit to customers) also complicate the calculation.

The industry environment for high-technology products makes it difficult to introduce a product at a price that does not fall into the same range as existing products. You must be aware of the range of prices and be sure that your possible prices are sufficient to generate positive margins. To charge higher prices than the standard range, you must truly have a radically new product and a compelling argument for the customer.

Customers trade off price against product/service attributes and some may be willing to pay a higher price for a product than others because of its different attributes. But it is difficult to know how much each additional feature is worth to customers and to set the price accordingly.

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5. Understand customer adoption

You need to understand the patterns underlying the dynamics of markets for new technology products and services.

Adopters of new products and services fall into three categories of customers. A small proportion (the "innovators") make the adoption decision early, a small proportion (the "laggards") make the adoption decision late, while most adopters make the decision in the middle of the process. Each group has different motivations and preferences. Innovators have a need to explore new technology and are typically price insensitive. The majority require more information about value to make purchasing decisions. The laggards are very resistant and often adopt products simply because they have no choice due to product replacement. Gathering information from innovators who are existing customers may not be helpful in telling you what you need to know to satisfy the majority and may lead you astray.

The transition from innovators to the majority is important because most entrepreneurs need widespread adoption of their products to earn sufficient returns to survive. To transition successfully, you must adapt your product to the different demands of the majority of customers, provide evidence of the value of the new product, and offer a complete package that solves customer problems.

You must also target the right customers to transition to the majority of the market – those for whom the new product or service will increase productivity, cut costs, or provide the ability to do something they otherwise could not do.

Markets are dynamic so static estimates of markets (as used by many entrepreneurs) are not very useful. Understanding diffusion and substitution patterns is crucial. To estimate market size correctly at different points in time, you need to estimate how fast a new technology product will diffuse (i.e. be adopted by potential users). Products that diffuse faster are ones that don’t depend on the development of complementary technologies, are based on less expensive technologies, offer greater advantages to users, and are easier to understand.

The characteristics of the target market matter. Wealthier people and organisations adopt technology more readily because wealth provides a cushion that facilitates adoption. Tolerance of uncertainty speeds diffusion as does a market with greater interconnection of potential adopters where information about products will spread more easily.

The rate of diffusion is also affected by substitution – replacing one product with another to achieve the same goal. This can make the investments of established firms obsolete and is a particularly valuable strategy in industries with significant economies of scale. As the new technology substitutes for the old one, established firms suffer from increases in their costs because substitution erodes their scale economies. Estimating time to substitution is an important skill for the entrepreneur. It means a balancing act between creating enough supply to meet demand and preclude the entry of competitors, and not creating so much supply that cash is exhausted before demand appears.

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6. Exploit established company weaknesses

Don’t try to go head-to-head with existing companies. Target their weaknesses.

Established firms win most of the time when new firms try to compete without targeting their weaknesses. The incumbents are better at exploiting new opportunities because of their advantages – they are further up the learning curve and have a stronger reputation, positive cash flow, scale economies, and complementary assets in manufacturing, marketing and distribution. They also suffer, however, from the following weaknesses:

  • Their focus on efficiency may create blinders to new product and service opportunities. They may reward their people for doing their existing jobs rather than for innovation.
  • Their focus on generating value from existing capabilities rather than creating new capabilities may lead them to discount opportunities where new capabilities need to be created.
  • Their need to satisfy existing customers may mean they neglect new market segments.
  • Their existing organisational structures constrain communication patterns and information flow and make it difficult to exploit new opportunities. The hierarchies for managing existing operations inhibit new product development.

Opportunities with certain characteristics are also better for new firms to exploit:

  • "Discrete" technologies can be exploited without replicating an existing firm’s system of assets. ("Discrete" technologies are things that stand alone such as a drug, as opposed to "systemic" technologies, like computer software, which can only be used in conjunction with other things.)
  • Opportunities embedded in human capital – this is more easily moved than physical capital from established to new firms.
  • General purpose (rather than single purpose) technologies offer new firms strategic flexibility which helps with raising money and managing risks. General purpose technologies often require established firms to invest in markets and production processes outside their current capabilities, which they are rarely willing to do.
  • New firms perform better with uncertain opportunities because these demand different market research techniques other than the survey and focus group approaches typical of large firms.

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7. Manage intellectual property

Most new products and services are easy to imitate, especially by large established companies. They can reverse engineer new products, hire employees who previously worked for the innovating company to gather information about the new product, or they can look at patent documents and other written sources. They may already be working on similar projects and can bring their better R&D, manufacturing and marketing capabilities to bear.

To be successful, you must minimise imitation by using secrecy and patenting. Secrecy is effective as a strategy when there are few alternative sources other than the entrepreneur to learn about the new product, when the product is complex, when there are limited numbers of people who could make use of the information to replicate it, and when the knowledge necessary to create the product is tacit.

Patents can be valuable for deterring imitation but have some limitations. Ideas are not patentable, hindering the ability to patent most services. You have to demonstrate that the new product is a significant improvement over previous inventions. Patenting is expensive given the frequent need for multiple patents to protect a single product and to seek patent protection in multiple countries. Patents also require disclosure of the invention. They are not very effective in many industries, especially mechanical or electrical technology.

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8. Create barriers to imitation

In addition to secrecy and patents, there are other mechanisms firms can use to capture the returns from introducing new products and services and create barriers to imitation. These may work better for established firms but the entrepreneur needs to be aware of them.

Controlling resources is a strategy in which you buy up or contract for the key sources of supply for producing the new product or service. This strategy is most effective when there is a bottleneck in the production process, making one resource crucial and rare.

Establishing a reputation is a strategy in which you advertise to create a brand name. The brand name deters customers from shifting to competing products by creating the perception that the entrepreneur‘s product has features that make it worth an additional cost. However, because advertising takes time to work and is subject to economies of scale, this does not work well for most technology entrepreneurs.

Exploiting the learning curve is a strategy in which one firm moves ahead of other firms in terms of efficiency as a result of learning from the process of delivering a product or service. This is most effective as a strategy when an entrepreneur is an early entrant in an industry and when the knowledge gained from experience is proprietary. It is not likely to be an effective strategy when you first establish your firm.

Being the first mover is a strategy in which you benefit from being the first provider of a product or service, even when there is nothing to be gained from experience. It is an advantage when "network externalities" exist – when, in other words, the value of a product or service increases with the number of people using it (e.g. eBay). It also works well when real or psychological switching costs are high. A follower product has to be more than marginally better in terms of quality and features than a first product to make customers switch to it.

Exploiting complementary assets (other assets used jointly to deliver a new product or service) is most effective when patent protection in an industry is weak and the industry has converged on a dominant design. In general, a technology entrepreneur will have a hard time competing in industries where complementary assets are important because he is unlikely to have these assets in place at the time he founds his company. If these assets are not specialised, you may be able to contract for them. However, when the complementary assets are specialised (such as manufacturing equipment that can only be used to produce a particular product), you stand virtually no chance of success because you cannot obtain control over those assets through contracting. This leaves you without a way to obtain them before established firms imitate your new product or service.

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9. Choose the right organisational form

You do not always have to create a new company that owns all the stages of the value chain from product development to manufacturing and distribution. Instead of this "hierarchical" mode of opportunity exploitation, you can also use market-based ("contractual") modes such as licensing and strategic alliances. These are particularly important when the technology opportunities are capital intensive and the lack of cash flow from existing activities means you must obtain capital from financial markets.

Contractual modes are more effective when technologies are discrete (stand-alone), while hierarchical modes are more effective when technologies are systemic (have to be used in conjunction with other things, such as computer software). Systemic technologies require the sort of coordination provided by hierarchical modes of organisation.

Contractual modes are also good to use when opportunities are expensive to exploit, when you need to exploit opportunities quickly, and don’t have time to build the value chain from scratch.

You should use hierarchical modes of opportunity exploitation when the technologies you are exploiting are systemic, based on tacit knowledge, face no technical standards, and where complementary assets are specialised. Hierarchical modes are better when you need to keep information about your opportunity secret. They also help to prevent the problem of "holdup" (which occurs when one party tries to take advantage of another’s vulnerabilities to renegotiate an agreement to its benefit).

Contractual modes of opportunity exploitation increase the problem of "free riding" – the tendency of one party to let everybody else do the work necessary to receive a benefit (such as letting one party pay for all the advertising). But contractual modes like franchising (which increase people’s incentives to perform by replacing wages with a share of profits) can help to avoid the problem of employees shirking effort.

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10. Manage risk and uncertainty

When you set up a new technology company you will face various sources of uncertainty that need to be managed. The market may not yet exist for your new product or service. You may not know how to create that product or service, and you will face competitive uncertainty because you cannot know for sure whether you can capture the returns for introducing it or whether those returns will flow to competitors.

The more uncertainty you face, the greater the returns that investors and other stakeholders will demand to provide the resources you need. You can give stakeholders greater equity in the new venture or you can adopt strategies to manage uncertainty. Successful entrepreneurs prefer the latter.

You can reduce risk by searching for additional information, minimising investment, and maintaining flexibility. Unsuccessful entrepreneurs often fire before they take aim. They bear unnecessary risks that could be easily avoided by searching for additional information and formulating a business plan. Looking for disconfirming information which suggests why the venture will not work, rather than seeking information that shows why it will work.

Minimise investments in assets with low salvage value. Investing in assets with high asset value means the value of the investment will be recouped, even if the venture is unsuccessful. Use standard inputs rather than customised ones. Borrow or lease assets rather than buying them. Invest in variable costs that depend on the production of a good or service rather than fixed costs which involve up-front expenditures that may never be made up.

Maintain flexibility so you can change direction rapidly if necessary, being prepared to shift target market segments to find customers interested in your offering.

Reallocate risk to those parties better able to manage risk. This includes transferring risk to diversified investors like venture capital firms who can bear a level of risk for a given return that is not possible for individual entrepreneurs to bear. Or, you can transfer risk to specialised stakeholders who have information that makes the risk less for them than for you (such as selling your accounts receivable to a factor). You can also reallocate risk to stakeholders who are risk seeking – such as "business angels" (these are wealthy, entrepreneurial individuals who provide capital in return for a proportion of the equity and take a high personal risk in the expectation of owning part of a growing and successful business).

You can also reduce your stakeholders’ perceptions of risk, perhaps by seeking endorsement of your venture by high-status players. Ways to do this include entering a strategic alliance with an established firm or getting the government or the press to endorse you. Making sure your venture conforms to the rules and procedures of the status quo will also mitigate perceptions of risk.

Successful entrepreneurs use two financial tools to evaluate opportunities: real options and scenario analysis. Real options analysis helps to make accurate decisions under uncertainty by not requiring the evaluation of things that are truly unknown and by permitting evaluation in successive stages. Scenario analysis helps to make accurate decisions by allowing evaluation in terms of ranges rather than point estimates and by allowing the identification of key assumptions about the relationships between variables.

Real options and scenario analysis help make more accurate decisions under uncertainty. They overcome the disadvantages of more standard estimates of discounted cash flow (DCF) based on net present value calculations. Because they rely on point estimates, standard net present value calculations do not deal well with uncertainty or a range of possibilities.

Successful entrepreneurs also convince stakeholders to bear some of the risk by sharing rewards with them fairly and by honouring implicit and explicit contracts. They have social relationships with their stakeholders which build trust and make stakeholders feel more comfortable bearing the risk.

Successful entrepreneurs approach stakeholders like customers and suppliers simultaneously, rather than sequentially. Doing this encourages stakeholders to bear risk because it leads each one to believe that other stakeholders are already on board. Successful entrepreneurs also get stakeholders to escalate their commitment by asking them to make small step-by-step increases in commitment. These appear less risky to stakeholders than if they were asked to make the overall commitment in one step.

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Being a good gambler

Ultimately, says the author, being a successful entrepreneur is much like being a good professional gambler. If you know the games where the odds are least stacked in favour of the house, and you understand the rules of the game you are playing, you can greatly improve your chances of winning.

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