By Michael Woloszynowicz

By Michael Woloszynowicz

Wednesday, October 13, 2010

Porter's Five Forces, Web 2.0 Style

Michael Porter’s Five Forces framework has become the de-facto tool for performing a strategic analysis of your industry or business and determining its overall attractiveness/profitablity. While it is quite universal, its application varies across industries, particularly for a web 2.0 business. This post is intended to be a brief primer on the strategic elements to consider when applying the framework to your web business. It is by no means all-encompassing as many of the standard measures in the framework still apply and are already well documented.

Degree of Rivalry
Typical considerations such as excess capacity and exit barriers can be ignored here so the only factors are: is the market you are service particularly popular and thus saturated with lots of new entrants, how similar are the offerings provided by them, and how similar are their strategies or target markets (e.g. demographics, location, etc.).

Supplier Power:
Since web businesses revolve around virtual goods or services there are very few suppliers involved, thus this category can largely be ignored. The one exception is if your application built on top of a 3rd party API (e.g. Twitter or Facebook). If this is the case then you have to be aware of the possibility of your supplier forward integrating and encroaching on your business. We’ve seen this happen a great deal recently as Twitter has increasingly added functionality that is currently being provided by third-parties (e.g. link shortening, photos, and multiple clients).

Barriers to Entry:
This is the largest category to consider as there are numerous elements in the Web 2.0 space that increase barriers to entry. Simultaneously there are also many elements that disguise themselves as barriers, but aren’t necessarily so.

What applies?
First off, does your application require a great deal of time and money to build? More specifically, does the minimum viable product version of your offering require a significant amount effort to bring to life, and there are no pieces of your product that can be separated from the whole. If this is the case then any competitor would have to dedicate a great deal of time to match your offering, at which point you are moving forward with more functionality, improving your offering, and learning about your market, thus creating a moderate barrier. A similar but more powerful barrier is created if your product’s technology is difficult to replicate (e.g. Google’s search), or if you hold patents on key aspects of your offering. Marketing can also become a barrier if your brand name becomes synonymous with a particular market or product type as you become the logical choice to service a clients needs. This is especially true in enterprise software for as the old adage goes, “nobody ever got fired for buying IBM”. If your product exhibits a high degree of network effects (e.g. Twitter, Facebook), namely the value of your offering grows exponentially with the number of people using it, and you have established a sizable user base, a very strong barrier is formed. While we have shown that building on top of an API can be risky, being the API provider has a number of advantages. If a number of businesses are based on your platform then value of your product is greater than its core functionality, the third parties are indirectly promoting your product on an ongoing basis, and user switching costs increase drastically.
Some other quick barriers include:

  • Does the value of your product rely on a great deal of data that is acquired over time?
  • Is the market that you serve highly complex and takes years to learn? If so then you have a path dependency (learning curve advantages) that others would have to go through in order to match your value proposition.
  • Owning a key distribution channel (e.g. being first in the organic search results of Google)

What doesn't apply?
Infrastructure requirements are no longer a barrier to entry as cloud computing services have removed high upfront costs and turned them into variable costs that grow along with the success of ones product. Similarly, economies of scale don't apply as cloud services scale and reduce automatically. While it’s natural to think that having a highly viral application is a barrier as it helps you to grow your user base rapidly, it also helps your competitors grow. Therefore it is more logical to think of a lack of virility as a barrier as organic user base growth is much more difficult and time consuming to replicate. Another non-existent factor is high marketing/promotion costs. Although it may have cost you a great deal of money to market your business, social networking tools have drastically driven down the cost of promotion, allowing bootstrapped startups to effectively advertise their product with only a bit of patience and creativity. This may not apply as much to enterprise software providers as social media is not as powerful in this space and sales are made largely on reputation. In case you haven't noticed, enterprise software is a difficult market to service.

Buyer Power
Buyer power boils down to more traditional considerations such as the number of substitutes available for your product. When thinking about this it is important to look beyond your way of servicing the user’s need, perhaps there is a completely different way of achieving the end goal. In addition, if you are in the enterprise SaaS space, is your business reliant on a small number of large buyers? The final consideration is the switching cost of your product. These don’t necessarily need to be monetary costs, as the “cost” of switching can be a loss in value such as having less people to connect to, no longer being part of a community, or having to build up your persona or position/ranking from scratch. For example, if a user has a high standing on a site like stack overflow, he/she is unlikely to switch to a new and similar offering as they would have to build this position up from scratch.

Threat of Substitutes
Largely similar to what has already been discussed, threat of substitutes effectively reduces to the switching cost of your product as well as it’s price and performance compared to other offerings that solve the same problem.

Keep in mind that most Web 2.0 firms do not benefit from any of the above barriers but still remain successful so don’t fret if you score poorly on these measures. A low barrier to entry is simply a characteristic of the web based software industry, as open source tools and cheap outsourcing allow nearly any entrepreneur with a great idea to bring it into fruition. Your main defense against competition is to stay ahead, create a product that your clients love to use, and most importantly know your customer and market. Always bear in mind that when performing the above analysis, you have to correctly identify the market your are analyzing. Look at all firms that help service a customers “job” in any way possible, not just your way of doing so.

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