[This post is to help first-time entrepreneurs on how to develop their idea and how to think about the business case around it. For those of you who are new to this series, please read what these posts are about here. This post is long, so you might want to stretch your legs every few minutes to avoid deep vein thrombosis. Ready, set, go…]
Your idea might be revolutionary and disruptive, but then again you don’t necessarily need such types of ideas to create a lot of value for yourself and your investors. In either case, it will probably help you to do some critical thinking on your idea regarding the following:
- what is the problem you are trying to solve and how big is your addressable target market
- where do you fit into the value chain of your chosen industry
- who are your competitors and what will give you an edge over their competing offerings
- what are the economics of your proposed business – how will you make money
Many first-time entrepreneurs in India ignore thinking about these basic issues. Even if you do this exercise briefly, such thinking will help you to better articulate what you are getting into, as well as make you aware of some of the business and operating challenges that could exist, rather than be completely be blindsided by them. If you are thinking of raising VC or institutional funding, these investors would expect you to have thought about these items. You might not know all the answers to all the issues, but at least you can become familiar with the critical ones.
Whats Your Problem?
Here is one way I find useful to think about ideas. Whatever your idea is, ultimately you are solving a problem for some target customer. If these customers see value in your solution, they ought to be willing to pay you something for it. So, articulate what is the problem that exists, and what is your proposed solution.
Additionally, get a feel for how many people face this problem. If you are solving a problem that millions of people face, you could be on the way to creating a lot of value.
Cancer Drugs vs. Toothbrushes
Get a feel for the size of the market and even more importantly what is the section of the market that you are directly going to be able to address. Big markets can often accommodate many different players. They also give you room to make mistakes and try out different things, giving you the opportunity to reinvent yourself if your initial strategy and operating model do not work.
Lets discuss this further using a couple of examples. So I have an idea regarding a medicine for Cancer that I want to offer all over India. The full treatment is for 6 months and costs Rs. 12 lakhs in total. At the face of it, I expect my target market to be large in a country as big as India. However, that does not mean that all 1 billion people in India will buy my drug. Clearly, my addressable market is only that section of the population that suffers from this life threatening disease.
Next, I need to identify how many people fall into this category. For the sake of this stylized example lets assume a figure of 1% (in the real world you should research and understand a little bit more diligently what the addressable market is). That means that my addressable market is 10 million people. But, can all these 10 million people afford a treatment that costs Rs. 12 lakhs? I don’t think so. But could all these people have health insurance that covers some kind of treatment for Cancer? Again, I don’t think so because the penetration of health insurance in the country is very low.
So where does that leave me regarding my addressable market? I started with a 1 billion population, but am down to only 10 million people who could be suffering from Cancer at any point in time. But only a fraction of these patients can afford my treatment. So, my addressable market is even smaller than 10 million. Who knows, it could be as small as only 100,000 people. This might not make the market totally unexciting, especially if I am the only drug in the market and the drug does not cost me much to make or distribute. But, clearly if anyone got overexcited at the thought that the target market for a Cancer drug in India is 1 billion people it shows poor thinking on their part.
Compare this to another idea I have to manufacture toothbrushes and sell them at Rs. 10 per unit. The problem I am addressing is a universal one – personal and dental hygiene affects everyone in the population. My solution is a cheap toothbrush that experts have certified is more efficient and the Indian Dental Association has endorsed. Assuming even 40% of Indians use toothbrushes, my addressable market could be as high as 400 million people.
How many of these people can afford to buy a toothbrush for Rs. 10? One can realistically make the case that it could be almost all the 400 million (we are talking about affordability and not willingness to buy here). I might not be able to zoom in on the exact number, but even if its 200 million people, its a large market (again, I’d suggest you need to exercise some more diligence on sizing the market). And if this market follows the Dental Association’s advice and starts using a new brush every 6 months, the market is even bigger than the 200 million units.
What if I am wrong and the toothbrush market is not 200 million, but only half of that. Well, 100 million people buying toothbrushes at least once a year is still a large. The large size of toothbrush market gives me enough margin for error. Even if there are other competitors in the market, I could argue that by virtue of a better product I should get some market share even in a crowded market. Even if my initial product is a disaster, because I would have already gained some experience in toothbrushes, I could adapt my plan to recover from my initial mistakes.
Maybe I could brand/position myself in the niche for toothbrushes for children or for those with soft gums. The market is big enough to accommodate my initial false start. Compare this to a similar error in estimating the addressable market for patients who can afford my cancer medicine. What if my initial estimate of 100,000 patients is wrong and the number is actually only 50,000. Suddenly, there is less margin for error.
To summarize, bring some analytical rigour to you thinking. When you get deeper into analyzing your addressable market, it might not be as large as your initial exuberance might have led you to believe.
Beta Testing, Charles Darwin And Henry Ford
Once you have done your initial thinking on the idea, it always helps to validate your idea. It will give you a chance to test your hypothesis, see if your technology works or get some initial feedback from customers. Your plans on paper are not going to get you very far. No plan will survive the first contact with customers, so see what customers think about your service, product or technology. If you are not from the industry, then you will also be able to clarify some pre-existing notions you might have had about your adopted new industry.
How do you validate your idea? It depends upon the type of idea that you have. If your plan is to build an ecommerce website, put the site up and see if you can get traffic which results in actual transactions. If you want to open a chain of fast food kiosks in malls, open a couple of kiosks in a mall to test whether your format and menu will be accepted by customers. Use these experiments to understand how the supply chain and operations might work.
If your plan is to open a power plant that will cost Rs. 1,000 crores, you are screwed if you want to test your hypothesis and operating plan. Stop reading now and re-join this series when we start talking about how to raise money in a couple of weeks.
In addition to prototyping or beta testing you can: talk to people in the industry, do mystery shopping, study competing websites and their user experience, seek out experts who know something about the industry, ask lots of questions to potential customers, attend industry conferences, read the trade magazines, talk to your college professors or you seniors who can help develop your thinking…you get the drift.
Understand what is missing from the service offerings of the competition and how you can plug this gap. Be open to ideas and see if a pattern is emerging in all the feedback that you are getting. Is there something you need to change or adapt in your idea. Don’t be stubborn about sticking to your initial thinking. Nothing should be sacred. To paraphrase Charles Darwin, in the context of what we are talking about, its not the strongest of the initial plans that will survive, but those plans that are most responsive to change and contact with customers.
Its also worth highlighting that many of you might have an idea that could truly be ahead of its times. There might be no context for you to test your idea, or experts who can validate your thinking. In fact, you might have many people who shoot your idea down or just don’t understand it because they cannot relate to it. If you feel you are a pioneer with a truly novel and world changing idea, this quote from Henry Ford, pioneer of popular motoring at the start of the 20th century, is worth thinking about:
“If I’d asked customers what they wanted, they would have said faster horses.”
Often customers or industry participants might not have your foresight or ability to spot opportunities. Customers might be stuck in the old way of doing things and don’t see the need to change. Even as recently as ten years ago, companies in the Western Hemisphere would have laughed at the idea of outsourcing their mission critical processes to some BPO in India. Guess who’s laughing now?
So just because you initially get negative feedback or resistance, it does not necessarily mean that your thinking is flawed. But, it could mean that getting people to switch habits might be a bigger challenge than you had previously estimated. You might need to think a lot harder about how to drive adoption of your service or product. Or, you have to make it so compelling that customers feel they are losing out if they do not switch to your offering.
May The Force Be With You
Just like every parent thinks that their baby is the cutest in the world, entrepreneurs can also get high on their own kool-aid and think that their idea is the best idea in the world. Entrepreneurs start believing that their idea is truly going to turn into the next billion dollar company coming out of India. Hate to break this to you, so let me be gentle – its probably not going to be true for most of us (even though your baby might still be the cutest kid on earth, if that makes you feel better).
Sustainable businesses that reach a billion dollar valuation need something special – whether its the idea, execution, opportunity, team or just the confluence of various factors. Often you’ll get asked the question by customers or potential investors – whats so special about what you are doing, why will you stand out from the competition. Here are some things to help you think about how to identify what is your edge over other similar businesses and how to go about building an edge.
Lets talk about framework that some of you might already be familiar with. Professor Michael Porter put forward his highly popular Five Forces framework of analyzing industries a few decades ago. Its a very user friendly way to think about your business, where it fits into the industry structure that you are operating in and analyzing whether you really have an edge or not. Here are the Five Forces (for those interested in a more detailed study on this, please refer to his numerous books, especially Competitive Strategy):
- Buyer power
- Supplier power
- Threat of new entrants – barriers to entry
- Threat of substitutes
- Competition within the industry
- Regulatory environment (a sixth force since added to this framework)
I’d hasten to add that in the Indian context its worth also thinking about the threat of copycats. You’ll be surprised at how good and quick we are at copying other people’s ideas. There is nothing wrong in this as long as you are not stealing anyone’s intellectual property. Competition from other start-ups is something that is a universal phenomenon. The unique Indian flavour is that there are very large companies that are cash and resource rich, and they are not shy of diversifying into areas that are totally unrelated to their core businesses. If you are onto something that shows potential, then these big companies can very easily come in and crowd you out.
For instance, there are large industrial houses in India that have started retail stores to sell mobile phones, social networking sites and gaming software companies – all of these are sectors where India has seen a lot of start-up activity. So just be aware that your competition might not necessarily come from other start-ups, but more likely from a fearsome large conglomerate.
Ideally, your business should have a competitive advantage that is sustainable. However, history has shown that there are very few businesses or industries where you can maintain a competitive advantage in the long run. Not something that you want to sweat over in the early months of your start-up, but nevertheless don’t totally ignore thinking about your competitive advantage. However, you will be forced to do thinking on this at some point in time – if not by your investors, then definitely by your customers who’ll need some reason to choose you over the rest of the competition.
Lets get back to the toothbrush industry and analyze it using this Five Froces framework.
We had assumed that there are a 100 million buyers of toothbrushes in India. These buyers are highly fragmented – all my neighbours and I don’t consolidate our orders when shopping for toothbrushes. But what if all the toothbrushes were bought in wholesale just by the top 5 retail chains before they get bought by customers like you and I? Well then the buyer power is quite concentrated, and this could be a risk to my business. The risk could be even higher if there is intense rivalry and competition in the toothbrush manufacturing industry in India.
The top 5 retail chains could play all the competing toothbrush manufacturers against each other in order to buy toothbrushes at the lowest cost, thus reducing my manufacturing profit margins. Could I recover this from my suppliers by paying a lower price for raw materials such as plastic handles, bristles and the paper packaging? If I have very high order volumes, then maybe I can exercise my buyer power over them. But if the suppliers are highly consolidated, then I cannot play one supplier against the other.
The toothbrush industry is about as low-tech a sector as low-tech can go (we’re not talking about the battery operated brushes here). There’s been no major change in basic toothbrush design for at least the three and half decades that I have been using such an instrument. What does this imply for barriers to entry? There’s no major R&D investment required. Without this deterrent, maybe its easy to get into the toothbrush industry because the barriers to entry might be low. Also, unlike say manufacturing semiconductor chips in a fab plant, it doesn’t take much to manufacture toothbrushes.
The toothbrush manufacturing process does not sound that complicated. Maybe one doesn’t need too much capital investment either to set up the toothbrush factory. A possible barrier to entry could be having access to a pan-India distribution network that can get my product close to my addressable market.
And because this is India, how can we ignore azadirachta indica? For those of you like me who use toothbrushes and aren’t familiar with technical names for trees, this is the Latin name for Neem. Aren’t Neem stems a substitute for toothbrushes? They sure are. If the toothbrush industry prices each unit not at Rs. 10 but at Rs. 100, many consumers might switch to Neem stems as a cheaper substitute.
Under normal circumstances, we don’t expect a lot of consumers using toothbrushes to shift to Neem stems. But if it happens the other way around, it can help grow the number of the units sold. I don’t only have to rely on price increases for revenue growth, my industry could experience strong unit growth as well.
But what about the regulatory environment in India and the influence that it can have on toothbrushes in India? What if the government insists that the Dental Association enforce the Toothbrush and Dental Hygiene Act 1932 by mandating that all toothbrushes must not use any plastic because its not biodegradable but be made out of wood because the latter is more eco friendly (not going to happen but I am using this example to show you the effect that all regulations can have on my manufacturing business; also if there are Constitutional experts reading, yes I know there is no such Parliamentary Act, I am just using this as a stylized example).
Suddenly, I have to retrofit all my manufacturing machines and reorganize my supply chain. This exposes me to business continuity risk. What if the regulator accepts my argument about business disruption and so allows me and other the plastic manufacturers to continue, but on the condition that we pay an additional tax for the continued use of plastic. This changes the economics of my business and could dramatically reduce my profitability, which could threaten the existence of my business.
As you can see, this framework is quite handy to use to understand industries and your competitive position within the industry. You can do a high level analysis very quickly. Whether you use this framework or any other, make sure you spend at least some time thinking about your business, the industry it operates in and the different aspects of your business that give you a competitive advantage.
Finally lets talk about how can you create an edge over your competition? If you own intellectual property (IP) maybe you have a patent over your technology that you can earn license fees on from other users of your technology. Companies like Qualcomm that own a lot of IP in mobile telephony are very successful by monetizing their IP very profitably. Alternatively, if there is a scarce asset in your industry, maybe you can get special rights or access to it by tying up the scarce asset for a long-term. This could be anything from signing an exclusive agreement with the only supplier of key raw material in your industry to signing a distribution agreement with the key platform that no else can then have access to.
We have talked above about having a competitive advantage in your business. There are some sectors in India today where in the near term you needn’t worry about competitive advantage, but might win out because you are setting up new and desperately needed capacity where none or grossly inadequate capacity has previously existed. Some sectors and their numerous derived industries that are opportunity rich are: Power, Commercial Real Estate, Highways, Retail, Restaurant Chains, Furniture, Hospitals, Healthcare Document Management, Online Publishers, Local Search, Trade Journals, Vocational Training and so on. In the land grab that exists in these sectors there are huge rewards for early movers who are creating markets where none existed before. Of course, if you have access to cheap capital, that in itself could be a competitive advantage.
Its About The Economics Of Your Business, Stupid
With due apologies to Bill Clinton’s 1992 election slogan, your venture’s future will ultimately depends upon the economics of your business. The economics are partly driven by the industry structure as well, about which we talked about in the above section.
Some industries are genetically programmed to destroy value and bleed money. The airline industry is one such example – its highly fragmented, suffers from irrational pricing and very high fixed costs, is at the mercy of oil prices and unionized labour. On the other hand, there are some industries that are highly value creating. For instance, the manufacturing and servicing of aircraft engines is a highly profitable business – its highly consolidated global business that serves highly fragmented buyers, requires enormous amount of specialized R&D, with the opportunity for an almost guaranteed recurring revenue stream of at least 25 years on every engine sold.
During the early stages of your business, you might not have a microscopic view on the economics of your business. But you need to at least have some basic understanding of whether the economics of your business could end up like the economics of an airline business or an engine manufacturer. This will directly impact how much money you need to invest in the business and to what extent you can absorb the losses that you might suffer.
At a very basic level, you must understand:
- How are you going to make money? Presumably you are building a business to earn revenues. You ought to have a feel for who will pay you for your services and then how much it costs to offer these services. How are you going to organize the activities which will over time create a positive spread between the revenues you earn and the costs you incur. So, if I am setting up a mobile phone company, I know that I will offer my services to customers and charge them for the minutes of use, in addition to a monthly fixed fee. On the costs side, I have to pay salaries to staff (engineering, network maintenance, distribution, accounts etc.), pay to advertise my service and incur some costs related to the capital investment I have made in the business (whether that is maintenance expenses or depreciation)
- Does my business have pricing power – i.e., do I have the ability to raise prices regularly at a rate that is higher than the inflation rate. Using the same mobile phone services example, all of us as consumers have been paying less and less for every call that we make or minute that we talk for with every passing year. This has not just happened in India, but is a universal phenomenon giving us enough evidence to suggest that in a deregulated mobile phone market there is very little pricing power that operators have on the cost of a call or minute of talk time. Understand whether your business is such that the price you charge customers goes up or goes down over time
- What are the fixed costs in the business – costs you will incur whether you have any revenue or not. Again using the mobile network as an example, whether customers talk on the network for 1 minute or 100 minutes per day, at a minimum the entire network has to be up and running. Also think about what kind of fixed costs you will incur as you scale your business. Costs you incur during your prototyping or beta testing phase might be wholly unrepresentative of actual costs when you begin scaling up your business
- How much capital does your business need. Often growth in the business can occur only when you add new capacity (all things being equal and assuming you have no pricing power). For instance, when I first started operating my mobile network, I had to buy the license for a few circles. All that money had to paid upfront, before I had even a single customer or any revenue. I got the license for three circles in West India and invested to build my network in this geography.
Over time I acquired 2 million customers in this zone. But, now that I have been allowed to expand out of this zone to grow my business in North India, I have to invest in building a network in this new geographical area. So I can grow, but it requires new investments. Sometimes I might need to invest even though its not going to result in business growth. For instance, I will need to regularly replacing my existing hardware or be forced to upgrade my network to a new technology standard, like say 2G to 3G. Understand whether your business is of the type that will need regular investments just to stay in the game.
- What kind of cash flow characteristics does your industry have in terms of payment terms and the amount of inventory you need to hold for expected demand. In technical terms, this is called working capital. If your business uses up a lot of working capital that could be a problem just in terms of managing your cashflow. For instance, a business has to pay its rent and suppliers on the first of every month, but it doesn’t get paid by its customers until 60 days after the sale of the product.
Do you have the capacity to fund this mismatch in the timing of your cash outflows and inflows. This is especially important for start-up companies to manage. Even though your sales might be growing well, there might not be enough money in company’s bank account because your entire customer base has not paid you. Do you understand how this can affect your business and what vulnerabilities does this exposes you to?
If you don’t understand the economics of your business, does that mean that you aren’t ready to start your business? Not at all. You’d be foolish not to go ahead just because you don’t understand what the working capital characteristics of your industry/business are. But, you’d be equally foolish if you don’t get someone on your team or a mentor or investor who can help you think through some basic things about the economics of your business. Otherwise, for all you know you could be selling your product/service at a huge discount to your costs with the hope that you will make it up on volume.
Equally, there might be many businesses where the economics do not become clear until after a few years of existence because the industry is still evolving. All I can say is that you better have enough money in the bank or a very patient investor to be able to absorb the losses that you will incur while you waiting to figure out what your revenue and business model is going to be.
If you have not had deep vein thrombosis while reading this post and reached this far, hold on tight. We are 60 seconds away from finishing.
Things To Remember
- Frame the problem and your solution to it – how many people can you solve this problem for
- Get some evidence to validate your idea and the thinking around it, but be prepared to face resistance if your idea is something people can’t relate to
- Understand where your business fits into the industry you operating in – how and why you will be able to capture value
- Make yourself aware of the economics of the business and how you will make money
- Your baby is cutest baby in the world
If you have any questions or comments, feel free to send them via email to startup@iTrust.in. See you next week when we will talk about basic activities for you do in the early stages of your venture.
(In 2006, Forbes carried interviews with self-made billionaires in its Forbes 400 Richest in America issue. One of the questions was “What is more important – the idea or the execution.” We talked a lot about the importance of developing your idea, but have so far not talked at all about execution. Read these interviews and form your own views whether the idea is more important than execution.)
(Professor Tarun Khanna of Harvard Business School just launched his latest book last week. It’s a very entertaining and informative read on how to entrepreneurs in India and China are building businesses and changing the economic topography of the Eastern hemisphere. Topical, so I wanted to share this link this week. The Indian edition is published by Penguin and available for approximately Rs. 500.)
(This is an interview with one of the UK’s greatest living inventors/engineers, Sir James Dyson. The Henry Ford quote I refer to above I read once again in his interview. Its worth reading the entire interview transcript.)
The author is a co-founder of a financial services start-up, www.iTrust.in.