Porter’s Five Forces Analysis of Your Startup Business

So who is Porter, and what the heck do his five forces have to do with your busi­ness? Just about everything! Michael Porter of the Harvard Business School developed the five forces model in 1979 to help determine the competitive intensity of a specific market. In turn, he believed that this model also identified how attractive a specific market is to enter into. Attractiveness, of course, leads to potentially more entrants into the market—more competition for you as you work to maintain your existing clients and grow into new businesses through expansion.

In the true sense of the entrepreneurial spirit, attractiveness refers to an industry or market that can turn a good profit; an unattractive market is one in which profitability is poised downward or is currently down with limited chance of revival. For instance, in 2008, Blockbuster was deemed no longer a good model, as online rivals took over and cable companies offered on-demand access to movies.

On the contrary, Virgin Money is a new up-and- coming business model that uses the Internet and the need for consumers to borrow to afford businesses, cars, and houses—while still giving those that lend the feeling they have borrower accountability. One uses old-school methods and technology and relies on a dying business model, while the other embraces everything about the Internet, Gen Yers, and the older generations that want more security—everything that embraces positive change in almost all demographics.

Porter, like many before and after him, refers to both the micro and macro envi­ronment. As we discussed in Chapter 10, the macro environment is the environ­ment at large (legislation, economic prosperity, taxes, job rates, etc.—the bigger picture) and micro deals with the specific things related to your industry, like rising cost of goods, production rates, and so on.

Many strategists—in fact some would argue most strategists—use Porter’s Five Forces in their arsenal of weapons to help assess any given company—and many venture capitalists will use it to determine your business’s potential attractiveness.

Keep this specifically in mind when you are preparing to approach any VC or angel investor. If you have already prepared a thorough analysis based on Porter’s Five Forces, you will be in a better position to demonstrate your knowledge and understanding of the business you are looking for help financing.

These are the five forces in Porter’s model:

• Supplier power (the power that suppliers have over you and your costs)
• Threat of substitutes (substitute goods or services)
• Barriers to entry (into your market)
• Buyer power (the power your customers have over you)
• Rivalry—this is at the center of everything!

Taking each one independently, first we can examine the variables that go into supplier power. In general here we refer to the power that suppliers have over you, the business owner. The more power they have over you, the worse your position.

Supplier power also refers to the costs the suppliers have to create a product or supply raw materials, the costs they can pass along to the buyer (you and your business), how high switching costs are within the industry (how easy it is for you to switch suppliers—the harder it is, the more leverage they have over you), and what alternatives you have (if you have few substitutes, they again have more leverage over you—one reason that competitiveness is so healthy and necessary to keep prices low and the marketplace healthy).

We know that the supplier is weak if, among other things …

• They have competitors to supply goods.
• They have weak customers. Customers that are at risk of going out of business cannot afford higher prices, so the suppliers feel threatened and keep prices low to keep business coming into them.
• They purchase commodity products.

The above conditions are what you want to look for when you hunt for suppliers— they are to your benefit!

We know that suppliers are powerful (which we don’t want) when …

• There is a significant cost for buyers to switch suppliers. (That locks you, the business owner, into that one supplier.)
• There is limited competition in their market; they’re a single source or one of only a couple of sources to supply what you need.
• They collude—while illegal, any suppliers fixing prices hurts competition.
• They have powerful customers—like Wal-Mart—that can dictate what they want because they bring so much business into the company.

Barriers to entry is also another big force playing into competition and rivalry.

In the section that follows, we will discuss their impact on your business and how you can use them to your advantage to put a protective ring around your business circle.

For now though, we will discuss a fundamental of the model—buyer’s power. Buyer’s power isn’t what power you have over your customers. It is what your customers have over you. If your customers have leverage over you, then you are in a position of weakness.

Buyers—the customers—are powerful if they are concentrated or if they buy a lot. Government contracts are a great example here because the government spends so much in contractors that they have the upper hand in many negotia­tions (whether they use it or not is another story!).

Buyers are weak if there are a lot of them with no influence over the product or price, or if they cannot affect distribution in any way. From a purely strategic sense, this is where you want to keep your buyers.

Just to make sure that I haven’t lost you, I will provide you with an example that demonstrates everything that we just discussed, using Wal-Mart again as the main player.

Wal-Mart’s customers are powerful in the sense that they are large in number and loyal because of what the company offers them. Wal-Mart would not be nearly the giant they are without them, which means that they can’t afford to lose those customers; which in turn means they will typically do what the con­sumer demands for fear of alienating their client base.

In order to maintain the contentment of their customers, they provide large amounts of products at extremely discounted costs, which they create by demanding low price-per-unit costs from their vendors. Being that Wal-Mart places such large orders to keep their shelves stocked, their vendors and suppli­ers are in a position to oblige their demands for a lower unit price in order to keep the business. Some vendors complain about literally making a penny on each item that they sell to Wal-Mart because of the force that they have in the marketplace.

In Wal-Mart’s case, their vendors are weak, their customers are powerful, and Wal-Mart themselves are both powerful and weak, depending on which side of the coin you look at. You probably won’t be Wal-Mart—there are only a few in each generation—but you can still look for these same qualities and positions of leverage with your suppliers. In the section below on retaining the clients you have, we will go into this in detail. In that section, too, we will discuss the threat of substitute goods and how to keep them off of your business’s scary monster list.

All of this centers around rivalry. For most industries, your rivals in the mar­ketplace will determine your profit margins, your customers’ options, and the barriers to entry. The things that affect rivalry include: the number of competi­tors, how diverse the competitors’ product offerings are, how expensive it is to advertise, how easy it is to get out of the market or business (should you choose to or need to), the number of still other competitors, and the growth rate of the industry as a whole.

The more firms there are competing, the more the rivalry intensifies. We often see companies, like banks and airlines, taken over, bought out, or merging with competitors.

The higher the costs are in obtaining supply to sell, the more a business must sell large quantities of it to make a reasonable profit, unless the profit margin is very high. This leads to a fight for market share among rivals or competitors. Market share is the percentage of the potential market that your particular business has captured and maintained. If a business loses market share, it is losing business to others, as a percent of total sales in that industry. If it is increasing market share, it is selling to more of the potential client base than it has in the past.

Remember also that low switching costs will also create more rivalries because consumers can easily move from one business to another without much sacrifice. The less differentiated your brand is, the more rivalry will take hold and try to take away what business you do have. And of course, not least of all, the more profit there is to be made the more you can expect new entrants (new competitors) into the market! All of this leads you to do one major thing and that is— protect your business!

1. Protecting Your Business

Many companies are quite concerned, and rightfully so, about knockoff products. Louis Vuitton and Tiffany have both sued eBay because of their volume of knockoffs for sale—but courts have overturned the rulings and have found eBay not responsible for what buyers put up for sale on the auction system.

Knockoffs tarnish a company’s brand image and water down the brand, making its worth—which is partly dependent on its value as a status symbol—less worthy. These are the sorts of things you want to watch out for in the marketplace. Competitors get tricky—often naming products similar names and even making similar patterns on products to those of the known brand. If you are that known brand, do your best to protect your company’s image and reputation. You need to
be sure you have filed for copyrights and patents if you have a product or service that is extraordinarily unique. High-end luxury items deal with this all the time with people selling knockoffs particularly on eBay, and it’s damaged the business of big companies like Louis Vuitton, Tiffany, even Stuart Weitzman, the shoe company. Many are finding themselves creating exceedingly unique products just to keep the knockoff creators on hold a bit longer.

2. Keeping Competitors Out

There are lots of entities and individuals that create barriers to entry. The government creates barriers even though one of its mandates is to preserve com­petition (by using antitrust and antimonopolization practices and legislation). Regulation can help create barriers into new marketplaces. For instance, in 2007 and 2008 it was nearly impossible to become a mortgage broker because of the regulation required for new entrants.

Patents also help to create a barrier to entry. If you have a brilliant idea—or just a unique one—a patent can help keep new entrants out of your market. Provisional patents are good for one year, which gives you time to file a full patent, but note that they cannot be renewed, contrary to popular opinion and urban myth.

Note that any witnesses must have reviewed and understood your patent; they cannot merely sign without that understanding. Generally family members are considered disinterested parties and lawyers are considered biased, so as you file for patent, keep these tips in mind. Friends or colleagues that are distant but educated on the topic are good selections. Also note that in this country, we award patents to the “first to invent,” not the “first to file.” This can be tough to determine, though, without proper documentation.

Internal efficiencies are those things that are built into your business that make it efficient. It might be the equipment that you purchased or the technology that you use, or even your calendaring system that you require your staff to contend

with. Internal efficiencies help create barriers for new entrants, too. Every time you increase the amount of product you buy (and the more you buy from a single supplier), the more efficient you become—to a point.

Remember, it is easy to enter a market if you have common technology, very easy access to channels of distribution, and an unknown and unbranded name (lack of name recognition). It is difficult for a new company to enter a market if an existing company (hopefully yours!) has patents or trademarks, if it will cost customers a lot to switch to their product (high switching costs), and if channels of distribution are restricted. This is why some buyers that have large purchasing power require suppliers to sign noncompete agreements. When this occurs, the buyer requires that the supplier not sell to competitors, or that the supplier not offer competitors the same price that they get.

3. Retaining the Clients You Have

No doubt you want to grow your business—but do you want to lose the clients you have in the process? Probably not—since at this rate, you are merely “stand­ing still”! (Unless they are considered “bad customers,” as we discussed in Chapter 10.)

You have the power over your customers if your customers are …

• Not sensitive to price.
• Not affected by economic downturns.
• Unable to bargain with you.
• Needing your product, regardless of price.
• Offered incentives to come to you.
• Offered different or unique products than your competitors’.

You also have the power if there are no substitute products available, which will help you keep your existing clients while you grow your client base for new ones. Anytime there is a close substitute potential, it increases the likelihood that customers can go elsewhere and that someone else can run with your idea or product or service. Anytime you are able to increase the costs to the consumer of switching providers, the more secure you are. (The happier the customer? Not necessarily.)

4. Developing Relationships

Developing strong relationships is another thing you can do to help keep entrants out and customers in. The stronger the relationships you have with suppliers and the stronger your relationship with customers, the more likely you are to retain both. When negotiations come for new pricing strategies, both will be more willing to work with you if you have a good relationship going in.

Perhaps equally important is your relationship with like-minded or similar busi­ness partners. When new competitors come onto the horizon, “attacking them” with more than just your own resources can prove beneficial, so strategic alli­ances are very important to your success.

5. Creating Ways to Keep Competitors Out

Another vital facet in the Porter model is barriers to entry—many say it is the most important force of them all.

Generally a specific business has unique character­istics that keep consumers buying, and that helps to create a barrier to entry for those that might try and enter your market space. The more unique your business—the more competitive advantage your business has—the harder it will be for competitors to take away your customers. This is the heart of the barriers to entry component of Porter’s Five Forces.

Here are some things to look out for to protect your business as you evaluate your company and look to the Porter model for evaluation:

• The profitability of your particular industry going up substantially. We saw this with the “green movement”—suddenly anything green was getting VC money hand over fist, and companies offering green prod­ucts or clean energy saw their stock prices soar on nothing more than speculation.
• Startup costs becoming lower. When startup costs are higher, there are fewer new entrants into the market. When costs are lower, more will come into the market.
• Certainty in the market. The more certain the market is, the more com­petitors. The more uncertain, the fewer competitors—everyone likes a “sure thing.”

In your business, you want to keep the barriers to entry high to lessen competi­tion. You can do this by investing in such high-end technology to create efficien­cies that it becomes very expensive to enter into your market space or to copy you—at least for a while. You can do this by having incredible access to exclusive distribution, and by selecting a business that has a steep learning curve so that others require time, which will then be on your side, to be successful or to enter your market. You do this by making it very expensive for customers to go with the “other guy,” and by creating brand equity—perceived differentiation that your product is simply better. You can also do this through government lobbying and policies.

Source: Babb Danielle (2009), The Accidental Startup: How to Realize Your True Potential by Becoming Your Own Boss. Alpha.