Venture Design

3rd Edition

Anne Marie Knott
Washington University in St. Louis

Copyright © 2012 Anne Marie Knott

All rights reserved. No part of this book may be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without permission in writing from the publisher.

For information:

Anne Marie Knott

Washington University

One Brookings Drive, Campus Box 1133

St Louis, MO 63130

Library of Congress Cataloging-in-Publication Data

Knott, Anne Marie.

Venture design/Anne Marie Knott.—3rd ed.

p. cm.

Includes index.

ISBN 0971307602

1. Entrepreneurship. 2. Business planning. 3. New business enterprises. I. Title.

HB615.K624 2008

658.1′1—dc22    2007050202

08 09 10 11 10 9 8 7 6 5 4 3 2 1

Contents

Acknowledgments

1. Introduction: The Decision-Making Perspective

PART I Raw Ingredients

2. The Entrepreneur

3. The Venture Idea

Part II Assessing Feasibility

4. Industry Analysis

5. Perceptual Mapping

6. Characterizing Demand

Part III Designing the Venture

7. Competitive Strategy

8. The Distribution Channel Decision

9. Advertising Decisions

10. Dynamic Demand Forecast

11. Scope of Operations

Part IV Determining Requirements

12. Resource Requirements and Capacity Planning

13. Valuation and Financial Requirements

Part V Putting It All Together

14. A Business Plan for Venture Capital

Index

About the Author

Acknowledgments

I would like to thank the following faculty for very helpful comments on the original -manuscript for this book: Richard Arend, New York University; David Audretsch, Indiana University; Henry H. Beam, Western Michigan University; Michael Card, University of South Dakota; Ed Chung, St. Norbert College; Robert D’Intino, Penn State University, Capital College School of Business; Harry Domicone, California Lutheran University; James Fiet, University of Louisville; Brenda Flannery, Minnesota State University; Daniel Forbes, University of Minnesota, Carlson School; Lisa Gundry, DePaul University; David Hoopes, Southern Methodist University; Michael Leiblein, Ohio State University, Fisher College of Business; Ugbo Mallam, Jarvis Christian College; Thaddeus McEwen, North Carolina A&T State University; David Olson, California State University, Bakersfield; John O’Neil, Johnson and Wales University; Michael Rubach, University of Central Arkansas; Peter Russo, Boston University; and Elton Scifres, Stephen F. Austin State University. They have made many suggestions for additional material that could not be incorporated in this edition; thus, all errors and omissions are mine. I would also like to thank the anonymous reviewers for their helpful (and more blunt) comments. Most of all, I want to thank Nicholas Pulos for support during the writing process and all else.

CHAPTER 1

Introduction: The Decision-Making Perspective

Let me start by saying something about the heroics of entrepreneurship. Entrepreneurs are heroes. The Olim brothers started CDNow because they were sitting in Providence, Rhode Island, without access to music stores and felt they could solve the problem through the nascent Internet. While most of us recognize that the structure of the industry was such that this was a short-term play, it was a wonderful short-term play. CDNow and subsequent entrants into the field have forced the adoption of Internet distribution by the established firms. Almost immediately after the birth of the firm, the entire distribution of who purchased music changed because people now had an easy means to locate and purchase more obscure works. Not all ventures are as heroic, but I think most of you are creating something of value beyond profits.

INSPIRATION VERSUS PERSPIRATION[1]

What makes entrepreneurship heroic is not the idea. Students have been trained to think that their ideas are the source of value in new ventures. They take great pains to protect their idea—asking for nondisclosure agreements from faculty, students, and investors. The fact of the matter is that few ideas are unique. Venture capitalists (VCs) claim that they see 30 versions of most ideas. Often, they view this multiplicity as a good thing—a sign that there is critical mass for industry emergence. Moreover, even if the initial idea is unique, it is rarely preserved in its original state. You will see this evolution of an idea in the case that is carried throughout the text. You are also likely to witness it in your own ventures.

While you need an idea, it is the entrepreneur rather than the idea that is the source of value. This was nicely demonstrated in two recent books that examine the origins of successful firms: Collins and Porras’, Built to Last,[2] and Amir Bhide’s, The Origin and Evolution of New Businesses.[3] None of the 18 visionary companies in Built to Last started with a unique idea, and only 6% of the 100 firms in Origin and Evolution of New Businesses started with a unique idea. Yet all these firms were tremendously successful.

This relative insignificance of the idea is not merely a recent phenomenon. As early as 1942, Joseph Schumpeter in his book Capitalism, Socialism and Democracy[4] characterized entrepreneurship in much the same way:

We have seen that the function of entrepreneurs is to reform or revolutionize the pattern of production by exploiting an invention or, more generally, an untried technological possibility for producing a new commodity or producing an old one in a new way, by opening up a new source of supply or materials or a new outlet for products, by reorganizing an industry and so on.

. . . To undertake such new things is difficult and constitutes a distinct economic function, first, because they lie outside of the routine tasks which everybody understands and secondly, because the environment resists in many ways that vary according to social conditions from simple refusal either to finance or to buy a new thing, to physical attack on the man who tries to produce it. To act with confidence beyond the range of familiar beacons and to overcome that resistance requires aptitudes that are present in only a small fraction of the population and that define the entrepreneurial type as well as the entrepreneurial function. This function does not essentially consist in either inventing anything or otherwise creating the conditions which the enterprise exploits. It consists in getting things done. (p. 132)

VCs embody this thinking in the decision criteria they use for selecting which ventures to fund. A proprietary idea ranks 10th out of 24 criteria.[5] Ranking above the idea are three criteria dealing with the entrepreneur’s personality (capable of sustained effort, able to evaluate and respond to risk, articulate in discussing venture), and three more dealing with the entrepreneur’s experience. Thus VCs are looking for evidence that the entrepreneur can indeed get things done.

Then Why Do I Need a Course in Entrepreneurship?

In many cases you don’t. When I’ve asked students who have taken other introductory entrepreneurship courses whether they liked the class, they’ve emphatically said, “Yes.” They say they love the stories, and they enjoy hearing about other students’ ventures, and hearing the students’ and professors’ comments on their own ventures. But usually within a few minutes, they all add that they didn’t really learn anything. This was made most salient when I brought a former student from a different class to guest lecture for my course. She too answered that she loved the traditional entrepreneurship class, but said it hadn’t helped her in her new venture. She said that for the first month of the venture, the three-person team was completely immobilized—there was so much to do, they didn’t know where to start. Having taken the traditional introductory course had not prepared her for entrepreneurship. While 1 month of immobilization may not seem critical, the team and its investors felt that the venture started only 2 months ahead of its rivals in a setting with first mover advantages. The immobilization cut that lead in half.

I had to agree with the student. When I taught the course in a traditional way, I found that students had great ideas, but by the end of the semester they weren’t any more developed than they were at the beginning. In short, it appeared that students were unable to make the link between their ideas and all the coursework that ought to translate those ideas into outstanding ventures.

Since what I would love most is to see that all students start their ventures, I redesigned the course to increase the likelihood that actually happens. The revised course captured in this text is a mechanism for breaking down the vast challenge of designing a venture into a sequence of critical decisions. Each decision takes advantage of tools developed in other parts of the BBA and MBA curriculum. The text reviews these tools, shows you how these are applied to new ventures, then links the decisions and tools to demonstrate how a decision made in one part of the venture design flows through to other parts of the design.

The theme of the text is that thoughtful experimentation with your venture design is healthy but that it is most healthy when that experimentation takes place on paper rather than in the real world. When the experimentation takes place on paper it is costless (more or less)—thus, you will do more of it and will, ultimately, arrive at a better design. If you were to introduce an arbitrary venture design into the real world, that initial design would be in essence an experiment. You would need to expend substantial funds to conduct that experiment, and if it was a poor design, you might not have enough funds to support the second experiment. Not only is real world experimentation costly to conduct but it may also lead to irreparable confusion on the part of the customer. This may render all subsequent experimentation infeasible.

Thus, this course takes a “learning before doing” approach. Studies of firms that learn before doing indicate that they not only start with better competitive postures, they actually learn faster than their rivals, and respond better to change.[6] Thus, firms that learn before doing are also better at learning while doing.

While the most visible output of the text will be a business plan, the most valuable output will be the venture simulation you will have created to support your decision making. By the end of the text, you will have a set of spreadsheets that stretch from the demand curve for your product or service to the valuation for the entire venture. If you want to modify your strategy at any point in the future, you can test that change in the simulation in minutes before you test it in the real world. If a new competitor enters your market with a different product configuration, you can go back to your raw data to see which product each customer will choose. You can do that not only for your current product configuration/price but also for testing alternative configurations/prices. This kind of costless experimentation makes adaptation far more likely and effective. This is one tangible component of why learning before doing might produce learning while doing.

Finally, one subtle role of the book is that by forcing you to actually do much of the venture design work, it will give you momentum. You will find that you have a substantial sunk investment in your venture by the end of the text. Accordingly, you may decide that the marginal effort to start the venture is relatively minor. If so, the book will have exceeded its goals!

Note that this text ends with a paper design. While this will be of tremendous value, and will have required considerable work, this is only the beginning of the entrepreneurial process. Once you move from design to implementation, you will need additional skills to actually acquire and manage the resources you identify in the plan. These are the subject of entrepreneurial implementation texts.

WHY THE DECISION-MAKING APPROACH?

This book offers a decision-making approach to venture design. The basic premise of the approach is that the quality of a venture is in essence the sum of its decisions. Decisions, in turn, are a function of the depth of information applied to each decision and the adequacy of the tools used to interpret that information. The basis for this perspective comes from “success curves.”

A success curve is a means of depicting the survival odds of venture ideas as they pass through stages of development. The conventional wisdom from evaluating success curves across several industries is that it takes 3,000 raw ideas to produce one new commercial success.[7] This general ratio seems to hold not only for new product development (NPD) inside large firms but also for venture ideas posed by entrepreneurs. Exhibit 1.1 compares the success curves for the venture capital (VC) process against those for large firm NPD. The interesting distinction between the VC and NPD processes is that the VC “failures” take place on paper rather than in the lab. Thus, they are costless. While the VC process thus seems harsher (funding fewer projects), large firms maintain the intellectual capital (both knowledge and people who have developed that knowledge) that is created as a by-product of the NPD process. This knowledge has spillover benefits to other projects inside the firm, effectively increasing the returns to any project. This is not the case for VC—once a venture fails, the associated intellectual capital is dispersed.

EXHIBIT 1.1   Venture Success Curves

Source: Stevens, G. A., & Burley, J. (1997). 3,000 raw ideas = 1 commercial success. Research Technology Management, May-June, 16–27.

Good decision making allows you to distinguish good ideas from lesser ideas and also to enhance the execution of the ideas that are carried forward to launched ventures. The success curves in Exhibit 1.1 are close to ideal. These are the curves for organizations with well-honed decision-making skills whose main charter is discriminating between good and bad ideas—VCs and large firm NPDs. Such decision-making skills shift the timing of “failure.” NPD functions recognize early that a venture will inevitably fail and thus never launch it—the venture fails on paper or in the lab rather than in the market. Thus, 60% of their launches become economically profitable,[8] whereas only 20% of independent firms survive past year 8.[9] The contrast is understandable. Entrepreneurs may only attempt one new venture. Accordingly, they have not developed the discrimination capability of VCs and large firm NPD.

Our goal in this book is to translate the collective wisdom of VCs and large firm NPD into decision-making skills that help you enjoy their success curves rather than that of independent firms.

COMPETITIVE ADVANTAGE FROM DECISION MAKING

Exploiting Decision Biases

One of the things that I find when I ask students about their willingness to invest in various ventures is that they tend to reject ventures. While the 1:2,999 odds of success suggest that students aren’t out of line, often the ventures that they reject are the ones that in fact have already succeeded. Since the students who take the course are by self-selection those most likely to become entrepreneurs or VCs, the tendency to reject ventures is a little unsettling.

The problem in some sense is that we get students too late in the curriculum. While completing the core curriculum ensures that students have the requisite skills, it also means that they have adopted a large firm bias in favor of rejecting ideas. This bias is best described in terms of Type I and Type II errors of decision making. The Type I/Type II error framework compares decisions against outcomes (Exhibit 1.2). Type I error is rejecting a venture that ultimately would have succeeded. Type II error is pursuing a venture that ultimately will fail. A perfect decision maker makes no errors—he or she accepts all ventures that ultimately succeed and rejects all ventures that ultimately fail (or would have failed). Unfortunately, as seen earlier in the success curves, not even a seasoned venture capitalist, whose job it is to discriminate between good and bad ventures, is a perfect decision maker. VCs need to extract 50% to 70% annual expected returns across all ventures to compensate for those ventures on which they lose their initial investment.

Thus, decision makers are characterized by their bias toward Type I versus Type II error. Type II error is an acceptance bias—in an effort to be a perfect decision maker, you are happier accepting ideas that ultimately fail than rejecting ideas that ultimately succeed. VCs tend to favor Type II error.

Type I error, in contrast is a rejection bias—in an effort to be a perfect decision maker, you prefer rejecting ideas that ultimately succeed to accepting ideas that ultimately fail. This rejection bias is characteristic of large firms. A number of hypotheses have been set forth to explain the bias: reward systems with short time horizons, greater stock market penalties for poor performance than gains for comparable improvement in performance, and catastrophic impact (termination for managers with visible failures). We are less interested in what causes the bias than in its regularity.

EXHIBIT 1.2   Decision Errors

α = P(Funding a venture that ultimately fails), Type II Error

β = P(Rejecting a venture that ultimately succeeds), Type I Error

A perfect decision-maker is one where α and β are BOTH 0

(Can always make one 0 by either accepting all ideas (α = 0) or rejecting all ideas (β = 0)

What is most alarming is that the bias seems to be inculcated in the MBA program itself. The most notable source is industry analysis. In general, the conclusion that students reach from industry analysis is that either the market is unattractive because it is too easy to enter or it is attractive because it has formidable entry barriers. In the first instance, you can enter but don’t want to; in the latter, you want to enter but can’t. This tends to mean that there is no opportunity for entrepreneurs. In the early days of examining CDNow, for example, students felt that the firm was doomed because established music retailers would ultimately displace the firm. What they ignored was the fact that in the meantime, CDNow could be quite profitable. Perhaps less foreseeable was the ultimate outcome—the firm had developed Internet resources that were easier for competitors to obtain via wholesale acquisition of firms than by internal development. Thus, CDNow was acquired by Bertelsmann in September 2000 for $117 million.

While we will address this “entry barrier paradox” in the Chapter 4, the point here is that part of the mission of this book is to reverse the large firm bias—to make students more sanguine about the fate of new ventures.

Fortunately, the large firm rejection bias is one of the major sources of entrepreneurial opportunity. Large firms reject new ventures for two reasons: risk aversion and unattractive scale. Risk aversion offers temporary advantage: large firms will wait to invest until the payoff uncertainty is reduced. Entrepreneurs who perceive venture payoffs with greater certainty have an opportunity to establish footholds in new markets before large firms enter. Often, when such firms do enter, they do so through acquisition rather than through greenfield start-up. Thus, not only do the new ventures enjoy an uncontested market for a short period of time (and the associated monopoly profits) but they may also find that acquirers pay them the net present value of uneroded future profits.

While the risk aversion of large firms creates temporary opportunity, the small-scale aversion of large firms creates durable opportunity. Large firms leave several otherwise attractive opportunities on the table because the market is too small. Manufacturers of ethical drug equipment sell high-priced, large-capacity equipment to pharmaceutical firms. They were unwilling to develop a lower-priced, lower-capacity machine for pharmacy schools and small labs because the total market was only $10 million. This $10 million market, while trivial for large firms, created a very attractive opportunity for a student entrepreneur. Moreover, this initial opportunity may provide a stepping-stone to follow-on products for the same market. In an interesting irony, Xerox sold off several of its own internal ventures due to the scale bias. In a recent study, it was shown that the market capitalization of these abandoned ventures actually exceeded that of Xerox.[10]

These large firm (and consequently MBA curriculum) biases against small and finite (no replacement) markets manifest themselves in a student evaluation of the potential for phyto-remediation technology developed at the University of Pennsylvania. The technology used plants to remediate sites with environmental problems. The student team was asked to assess whether the University Center for Technology Transfer should create a venture around this technology or whether they should license it to a large firm. Ultimately, the students concluded that while the technology was superior to other technologies currently available for remediating or cleaning hazardous waste sites, that is, that the Penn technology would remediate sites for lower cost and at less risk, the venture was unattractive. The primary reason for rejecting the venture was that the market was finite and shrinking. While it was true that the market was finite and shrinking (fortunately we are generating less hazardous waste), the size of the market was $300 billion!

Exploiting Raw Data

One of the conclusions that I have reached as a result of several years’ industry and teaching experience is that few people look at data, and therefore, there is tremendous advantage for anyone willing to do so. I don’t mean a career of data management but rather data examination as means to superior decision making. This conclusion hit home first when I worked at Hughes Aircraft (now part of Raytheon). Once General Motors purchased Hughes, the company began to cut R&D spending, particularly for early stage projects. Such projects are the ones for which the commercial potential is at least 10 years in the future, are highly uncertain, and for which the government requires coinvestment by the contractor. My concern with the cutbacks was that failure to participate in the early stages was mortgaging the future—without early stage experience, we would be unqualified to participate in the later stage developments. To determine if this was the case, I wanted to understand the “demand” for early stage projects. This, in essence, is the inverse of what has come to be called the success curve—I wanted to know how many early stage projects Hughes needed now to ensure a single commercial success 10 years in the future. I initially assumed that someone in marketing would have computed success probabilities from one stage to the next. Not only was that untrue, but worse, the raw data from which the probabilities could be computed was almost irretrievable.

Hughes is not the exception. People are far too willing to trust their level of knowledge. In a really nice experiment[11] students took on the role of hotel managers and were asked to choose a firm strategy. The two strategies were having independent names or sharing a common brand. Students were given an initial strategy, provided hotel performance data, then asked whether they wished to change their strategy. There were two stages to the experiment. In the first stage, the data were raw—tables where each row represented one hotel. Each hotel was identified as being either independent or chain, and a number of metrics were given for its performance. In the second stage, the same data were presented as summary bar charts of chain versus independent performance. In both stages, students received cash awards for making the correct decision.

The experimental results indicated that in the second stage, almost all the students made the correct choice because the figure made the advantage of chains obvious. In the first stage however, almost all students ignored the raw data and retained their initial strategy. Students were unwilling to make the effort to look at the data despite the fact that it was well organized, that the experiment had no time constraint, and that they obtained a higher cash award if they chose the correct strategy in the first stage.

The implication is that because information flow is not efficient, there is entrepreneurial opportunity in exploiting even publicly available information. Most people are unwilling to analyze data, much less gather it. Persuaded by information efficiency arguments, they tend to believe that they already know everything they need to know—that if anything really important were in the data, it would make its way to them. In other words, there can’t be a $20 bill lying on the ground. We know however from Billy Beane’s strategy documented in Moneyball,[12] that $20 bills can lie on the ground for more than 40 years.

This then is the theme of the book: that you as an independent entrepreneur can approach the new venture success of NPD organizations and VCs. This is possible through an information-intensive and analytically rigorous approach to decision making using tools you likely already possess. The remainder of the book steps through each of these decisions so (1) you can see how to apply each tool to a new venture design and (2) you can see how the venture design evolves with each new tool. Each chapter is devoted to a particular decision and is organized as follows: goals of the chapter, theoretical principles underpinning the decision and the analytical approach, the actual steps in the decision process, and finally application of the decision process to the Epigraphs example.

FLOW OF THE BOOK

As mentioned previously, the book is organized around the decisions that an entrepreneur faces in designing a venture. Each chapter in the book corresponds to a particular decision and the tools facilitating that decision. These decisions are nested, such that the outputs from each chapter feed into the decisions of subsequent chapters. These decisions and their interactions are captured in some detail in Exhibit 1.3.

However, prior to making the first decision, we want to say something about the raw resources that are brought to the venture. These are the entrepreneur and the idea. Chapters 2 and 3 discuss characteristics of each that are associated with venture success.

EXHIBIT 1.3   Entrepreneurs’ Decision Flow

The next three chapters help you evaluate your venture idea. Chapters 4 through 6 are considered feasibility assessments. They involve early and reasonably inexpensive methods for determining whether there is an opportunity worth pursuing: Will the industry support entry? Is there an unmet need in the market? Is there profitable demand for that unmet need?

Chapters 7 through 10 involve strategic decisions for the firm: what are the optimal price and configuration for your offering, what distribution channel and advertising program best exploit the potential demand, and what activities should the firm outsource versus conduct in-house.

Having made the strategic decisions (venture design), Chapters 12 and 13 define the resources necessary to implement that design (human and physical as well as financial). Finally, Chapter 14 ties all the analyses, decisions, and designs into a single document, the business plan. A sample plan is presented in Appendix 14.1. We now discuss each of these chapters in a little greater detail.

Chapter 2 discusses the first and the most important raw ingredient—the entrepreneur. What, if anything, distinguishes entrepreneurs from the rest of the labor force? The goals of the chapter are to provide a better sense of whether entrepreneurship is for you and, more important, offer suggestions for a pre-entrepreneurial career that better positions you to both make the leap and increase the odds of success once you do.

Chapter 3 discusses the second raw ingredient in the venture—the idea. The chapter discusses where venture ideas typically come from and describes the psychology and sociology of idea generation. Both discussions condition you to discover ideas you’d be willing to devote a career to. In addition, the chapter offers some quick-start tools to facilitate finding an idea for the semester.

Chapter 4 is the first stage in assessing the feasibility of your venture. The goals of industry analysis are twofold. The first goal is to assess whether the industry will be hospitable to your particular venture. If so, and this is likely for most ventures, the subsequent role of industry analysis is to immerse yourself in the operational and competitive details of the industry. These details inform later decisions.

Chapter 5 is the second stage in the feasibility analysis. Perceptual mapping is a tool to characterize the way customers view your offering relative to competing or substitute offerings. The goal of perceptual maps is to determine if the proposed offering satisfies a clear, but currently unmet need. The chapter introduces two tools: the perceptual map itself and focus groups—the technique used to gather the primary data from which the perceptual map is derived.

Conjoint analysis, the technique introduced in Chapter 6, is the centerpiece of the venture design process. Its use marks the transition from feasibility analysis to venture design. Conjoint analysis is an extremely powerful tool consisting of primary survey data and corresponding statistical analysis. Conjoint analysis closes feasibility analysis by defining whether the unmet need identified in the perceptual map has sufficient demand at a profitable price. Conjoint analysis opens venture design by characterizing the demand curve for the product as a whole as well as each of its attributes.

Chapter 7 uses the demand curves derived from conjoint analysis to choose the optimal price and product configuration for the venture. The basic premise underlying the analysis is that as a new venture, you will have some market power. The chapter applies principles of decision theory and game theory to a variety of industry conditions. With these tools you can determine whether to use market power to maximize current profits, or to condition entry, and thereby maximize lifetime profits.

Chapter 8 deals with the choice of marketing channel (one of two choices involving the level of vertical integration). The chapter reviews principles from the vertical contracting literature in economics and the distribution channel literature from marketing. These qualitative insights are combined with quantitative techniques such as optimization and breakeven analysis using the demand curves from Chapter 6 to derive a distribution strategy that maximizes lifetime profits.

The ultimate goal of the advertising program (Chapter 9) is to stimulate purchase through a paid program of communication to the target market. In the context of our venture, conjoint analysis reveals potential demand to a group of customers who are fully aware and informed about the product. The advertising program ensures that the target market is aware and fully informed about the product. A single chapter is insufficient to provide enough guidance to develop a complete advertising campaign. However, we review the micro principles of individual decision making and the macro principles of diffusion to help the entrepreneur become a sophisticated buyer of advertising: define the campaign goals, characterize their impact on demand, specify a budget likely to accomplish those goals, and understand message design and characteristics of advertising vehicles.

Demand forecasting (Chapter 10) is the linchpin of the entire business plan. The goal of demand forecasting is to generate reliable estimates of future revenues and to support well-informed decisions about the levels of physical, human, and financial resources. Because the demand forecast is so critical, we tackle it from two different analytical approaches: a bottom-up approach that applies the reach of the distribution channel and the awareness from the advertising program to the “potential demand” from conjoint analysis to unfold demand over time. The second, top-down, approach is historical analogy to the diffusion of prior comparable products. Comparison of the two approaches not only leads to forecasts with higher reliability but also provides insights into how demand can best be manipulated to the benefit of the venture.

One of the most important strategic decisions that a firm makes is that of its operational scope (Chapter 11)—which activities should the firm execute internally versus outsource to other firms? What makes the scope decision strategically important are the facts that it is largely irreversible and that it affects the long-term viability of the firm. The chapter draws on vertical contracting theory, transaction cost economics, and resource-based theories to develop a framework for determining which activities to outsource and which to execute internally. The objective in making the decision is to provide reliable provision of high-quality goods and services at the lowest cost today, while building/preserving the capabilities that lead to sustained competitive advantage in the future.

While Chapters 6 to 11 deal with strategic decisions (whom to target, with what product, at what price, through what distribution channel, and advertising medium, and with what internal operations), Chapters 12 and 13 treat their implementation—given the decisions we have made, what resources are required to execute them.

Chapter 12 considers physical and human resource requirements. The goal of careful resource planning is avoiding both underinvestment (which renders the firm unable to satisfy demand and thereby leads to permanent losses in market share) and overinvestment (with attendant high carrying costs that could strangle an otherwise healthy venture). The chapter reviews tools such as operating cycles, bills of capacity and master output schedule and applies them to the demand forecast (Chapter 8) to specify calendarized resource requirements. These tools ensure that internal resources are commensurate with demand.

Chapter 13 translates the decisions in all the preceding chapters into a cash flow statement for the firm. This cash flow statement defines the finances required for implementing the venture design and provides the foundation for a valuation. Since the valuation is the basis for equity financing, the cash flow statement (in conjunction with standard discount rates for various funding sources) also defines the amount of equity the venture must exchange for the needed funds.

Chapter 14 ties together all the prior feasibility analysis, strategic decisions, and resource requirements into a single document. The business plan basically serves two purposes for the venture—as a planning tool for the founders and as a sales document for potential investors and other resources. This leads many people to conclude that there should be two separate documents—one that provides substance (the planning tool) and the other that provides flash (the sales document). We argue, however, that given the criteria of VCs, the well-conceived planning tool is also the best sales document. To make this argument, we first review the decision criteria of VCs in an effort to characterize what would make a good sales tool. We then review the elements of an effective planning tool. Finally, we show how all the tools in this book form a business plan that satisfies both objectives.

EPIGRAPHS

Epigraphs is a new venture that was developed in conjunction with the book. Its purpose is to provide a fairly straightforward venture with which to demonstrate the tools in the book. Thus, you will see not only how to execute each of the tools but also how the tools are linked—how, for example, the survey results translate into product designs: how these designs translate into demand forecasts and how the demand forecasts translate into resource requirements and ultimately valuation. While this is depicted graphically in Exhibit 1.3, the case will provide nuts and bolts detail of how the spreadsheets are linked.

Because you will be living with the case over the next several weeks, we thought it would be worthwhile and possibly fun to know something about the venture’s inception and the actual timeline of development. In fact, we even thought about subtitling the book, The 100 Hour Venture. Ultimately we concluded that the 100 hours in the title might convey the wrong message. Our real message is that the quality of the venture is a function of the qualities of the information and the decision making. The subtext is that each of these can be accomplished within a reasonable length of time, that is, good design does not take significantly more time than weak design.

What is Epigraphs? Epigraphs is a substitute for wallpaper that can be applied to painted walls to create a custom look. Epigraphs have the look of stencils but with less repetition and far less work. Single lines of the product can be used as an accent, or several lines can be used in lieu of wallpaper to create a whimsical room.

Epigraphs come in strips of self-stick graphics ready for installation. The product is applied dry, so it has none of the mess of stencils, borders, or wallpaper, nor any of the rush to apply the product before it dries. Furthermore, because there is space between words, Epigraphs do not have the alignment and abutment problems of wallpaper. This leads to two advantages over wallpaper: (1) Epigraphs tolerate minor installation problems that wallpaper won’t and (2) there is no need to buy 20% extra product to compensate for matching problems and waste around doors and windows. Experience indicates that an entire 10 ft × 15 ft room (400 sq ft of wall) can be installed in less than 8 hours.

Epigraphs come in seven standard colors and five standard themes. For each of the standard colors, Epigraphs has identified coordinating paints for three different looks: tone-on-tone (a very subtle look), complementary (a subdued look), and contrasting. These combinations create 105 different patterns. While this is a good deal of variety, there is also an option to create your own unique look with custom colors and graphics.

What follows in the succeeding chapters is the process of converting the venture need into a comprehensive venture design. Exhibit 1.4 chronicles the process. In all, the process took approximately 100 hours extended over several months. This process can be compressed (and will be for a semester long course). Part of what extended the process is the fact that I was refining the process and documenting it for this manuscript, concurrently with designing the venture.

EXHIBIT 1.4   Diary of the Epigraphs Venture

Date

Event

Aug 22

Need recognition (Original search for wallpaper/attempt to measure wall)

Aug 22–25

Consider alternative solutions: hand-painting, stenciling
Begin collecting quotes in Palm Pilot

Aug 26

Venture idea: Combine need with Gerber technology
Map out venture schedule

Sept 7

Initial e-mail to Kyle

Sept 7

Online research of wallcovering industry using library

Oct 1

Initial meeting with Kyle—layout schedule

Oct 4

Industry analysis using secondary data

Oct 7

Obtain estimate for focus group cost

Oct 11

Obtain materials samples, place order for prototype quotes

Oct 11

Complete moderator guide and screener for focus group

Oct 12–19

Recruit participants for focus group

Oct 13–15

Obtain mail list for consumers

Oct 22

Create prototypes by mounting quotes on mat board

Oct 25

Focus group with interior designers

Nov 1

Analyze focus group data—create perceptual map

Nov 4

Create draft of conjoint survey

Nov 8

Distribute survey: Create/print cover letter mail merge, copy survey, mail

Nov 10–30

Surveys returned

Nov 22

Marketing channel analysis

Nov 29–Dec 2

Regression analysis of survey data

Dec 2

Optimal price and product configuration analysis

Dec 4

Meet with manufacturer to obtain production cost estimates
Develop resource requirements
Create demand forecasts/financial forecasts

Dec 8

Media kits from advertising media

I should note that this is the length of the process for someone engaged in something else full-time, for example, where venture design is done in stolen hours. This is likely the case for full-time students and is certainly the case for someone who is currently employed but contemplating one’s own venture.

While it is possible that the process could be compressed even further, I believe the venture design improves if it has a chance to let information, analysis results, and design alternatives incubate. Two of the critical decisions for Epigraphs were changed: the distribution channel and the product technology. Not only did they change from my initial intuition but they also changed from the decision reached from the corresponding analysis.

The implications are that (1) good designs evolve and (2) it is better to have the venture evolve on paper than in practice. If I had committed to the technology or the distribution channel at the initial decision point, I might have wasted critical resources. Even worse, I might have committed myself to an inferior design.

NOTES

1. Edison, T. A. (1932). Genius is one percent inspiration and ninety-nine percent perspiration. Life.

2. Collins, J. C., & Porras, J. I. (1994). Built to last: Successful habits of visionary companies. New York: HarperBusiness.

3. Bhide, A. V. (2000). The origin and evolution of new businesses. New York: Oxford University Press.

4. Schumpeter, J. A. (1942). Capitalism, socialism and democracy. New York: Harper & Brothers.

5. Macmillan, I., Siegel, R., & Subba Narashima, P. N. (1985). Criteria used by venture capitalists to evaluate new venture proposals. Journal of Business Venturing, 1, 119–128.

6. Pisano, G. (1997). The development factory: Unlocking the potential of process innovation. Boston: Harvard Business School Press.

7. Stevens, G. A., & Burley, J. (1997). 3,000 raw ideas = 1 commercial success. Research Technology Management, May-June, 16–27.

8. Stevens and Burley (1997). Cited above.

9. Headd, B. (2003). Redefining business success: Distinguishing between closure and failure, Journal of Small Business Economics, 21, 51–61.

10. Chesbrough, H. (2000). Creating and capturing value from research spillovers: The case of Xerox’s technology spin-off companies. Harvard Business School Working Paper.

11. Ingram, P., & Bhardwaj, G. (1998). Strategic persistence in the face of contrary industry experience: Two experiments on the failure to learn from others. Columbia University Working Paper.

12. Lewis, M. (2003). Moneyball: The art of winning an unfair game. New York: W. W. Norton.

PART I

Raw Ingredients

CHAPTER 2

The Entrepreneur

The two raw ingredients in a venture are the entrepreneur and the idea. In this chapter, we will examine the first and most important of the ingredients, the entrepreneur. We examine inherent and developmental characteristics of entrepreneurs and ask the question, “Are entrepreneurs different from the rest of the population?” Given an individual’s potential for entrepreneurship, we next examine when they take the leap, “What factors push them over the edge from salaried jobs to self-employment?” Finally, given the high rate of entrepreneurial failure we ask the question, “Should we prevent entrepreneurs from taking that leap? How far do they really fall, and is there anything to be gained from that fall?”

The intent in each of these questions is to give you a better sense of whether entrepreneurship is for you. More important, however, if it is for you, the discussions offer road maps for a pre-entrepreneurial career that better positions you to take the leap.

ARE ENTREPRENEURS DIFFERENT?

As we saw in Chapter 1, Schumpeter believed that entrepreneurial aptitude was present in only a small fraction of the population. Is he right? Is there some test we should take to determine if we have entrepreneurial mettle?

The simple answer to the first question is probably “yes.” At any given time, only 12% to 13% of the nonagricultural work force is self-employed,[1] which is a small fraction. The good news is that there is considerable movement in and out of self-employment. Typically, 2% to 3% of the workforce becomes entrepreneurs each year, and as a result, over their entire careers approximately 30% test the entrepreneurial waters at some point.

This is still a minority, so the question is, “Are these individuals somehow different from the general population?” The answer is that while they are different from the general population, they aren’t very different from managers, so they probably aren’t very different from anyone reading this book.

Exhibit 2.1 shows the relationship between some demographic characteristics and the likelihood of becoming self-employed. Looking first at education, Exhibit 2.1a indicates that there are basically two groups of entrepreneurs—those with low human capital (the economic term for earning/productive capacity), who have trouble finding traditional employment, and those with high human capital. Looking next at age (Exhibit 2.1b), we see that there is a window between starting your career and mid-30s where the likelihood of becoming an entrepreneur is highest, beyond that the cost of switching from wage employment (with vested benefits and perquisites) to entrepreneurship is likely too high. Next, looking at spouse’s earnings (Exhibit 2.1c), we see that being married suppresses entrepreneurship until the spouse’s earnings are sufficient to support the family during the start-up. It is worth noting that each dependent decreases the likelihood of entrepreneurship by an additional -0.05, suggesting a maintenance cost of approximately $3,000 in 1982 dollars. Finally, and relatedly, wealth (Exhibit 2.1d) increases the likelihood of becoming an entrepreneur at a rate roughly equivalent to half that of spouse’s earnings. In other words, a spouse earning $10,000 is equivalent to $20,000 in existing assets.

EXHIBIT 2.1   Factors Affecting the Likelihood of Entrepreneurship

In addition to these basic demographics, coming from a family of entrepreneurs makes you almost twice as likely to become an entrepreneur yourself.[2] A small part of this can be attributed to the fact that entrepreneurial parents have greater wealth and can therefore help fund your venture; another small part can be attributed to those who inherit their parents business, but the greater part appears to be explained by the fact that children of entrepreneurs “inherit” entrepreneurial aptitude. They likely spend time in the business and thus have a sense of what entrepreneurship actually entails. In addition, they have an existing adviser network they can access.

The good news from these studies is that education, wealth, and experience are all things you can accumulate. Thus, there is substantial evidence that entrepreneurs can be made. What about innate differences? Are some people “born entrepreneurs?” Some insight for this comes from a clever experiment involving individuals who were terminated from their jobs and enrolled in an outplacement service by their former employers.[3] The subjects had all been managers at their prior employer and were of comparable age and experience (10 years average tenure in prior job, $81,237 average salary, roughly half were from finance/accounting, while another fourth were from sales/marketing). Thus, the main differences remaining were personality, which is presumed to be innate. The study then examined which of these former managers reentered the traditional workforce versus which of these former managers became entrepreneurs.

What is exciting about the main results is that 37% of these former managers started new ventures within 6 months of being displaced. This is 12 times the normal rate of transition. The main purpose of the study, however, was to assess personality traits across the two groups (the entrepreneurs vs. the wage earners). There were two sets of traits: those common to the two groups, but which distinguish them from the population generally (Exhibit 2.2) and those that distinguish the two groups from each other (Exhibit 2.3). While the second comparison is of greatest interest, the first was important because most psychological tests of entrepreneurs indicate that many of the attributes that set them apart from the population generally are also traits that set managers apart.

Exhibit 2.2 indicates that attributes common to managers and entrepreneurs but distinct from the population generally are intelligence, assertiveness, trust, forthrightness, and resourcefulness. These traits are functional. They allow managers and entrepreneurs to solve problems (intelligence, resourcefulness), to induce others to contribute effort (trust, forthrightness), and to ensure that things get done (assertiveness). These are traits you likely share.

Looking next at the traits in Exhibit 2.3, which distinguish entrepreneurs from managers, we see that entrepreneurs exhibit emotional stability, disregard for rules, self-reliance, and skepticism. These traits also play a functional role. Emotional stability allows individuals to deal with the vicissitudes of entrepreneurship and to persevere when others dismiss the venture idea (and most do); disregard for rules prompts individuals to offer the new combination rather than following the status quo; self-reliance is necessary because the nascent firm has no internal resources—the entrepreneur must create a network of resources from the market. Skepticism is interesting and less easily explained. What it probably reflects is more careful decision making—the theme of this book.

What is conspicuously absent from this list is the trait everyone mentions first when asked about entrepreneurial characteristics—risk taking! While entrepreneurs do indeed bear risk—51% of firms fail within their first 4 years[4]—most tests indicate that if anything entrepreneurs are risk averse relative to wage earners. This has always been a puzzle. The solution to the puzzle comes from a recent study that distinguishes two types of uncertainty: uncontrollable uncertainty, such as economic fluctuations, and seemingly controllable uncertainty, pertaining to relative ability.[5] The study finds that entrepreneurs are risk averse with respect to uncontrollable uncertainty—they are less likely to enter markets with volatile economic conditions. The study also finds, however, that they are risk seeking or overconfident with respect to seemingly controllable uncertainty—they are more likely to enter markets with high dispersion in ability.

EXHIBIT 2.2   Personality Traits Common Between Entrepreneurs and Managers (in italics)

Low Sten Score

High Sten Score

Reserved, detached, critical, cool, impersonal

Warmhearted, outgoing, participating, interested in people, easy-going

Less intelligent, concrete-thinking, lower scholastic mental capacity

More intelligent, abstract-thinking, bright, higher scholastic mental capacity

Affected by feelings, emotionally less stable, easily upset, changeable

Emotionally stable, mature, faces reality, calm, patient

Humble, mild, accommodating, conforming, easily led, submissive

Assertive, aggressive, authoritative, competitive, stubborn, dominate

Sober, prudent, serious, taciturn

Happy-go-lucky, impulsively lively, enthusiastic, heedless

Expedient, disregards rules, feels few obligations

Conscientious, persevering, proper, moralistic, rule-bound

Shy, restrained, threat-sensitive, timid

Venturesome, socially sensitive, bold, uninhibited, spontaneous

Tough-minded, self-reliant, realistic, no-nonsense

Tender-minded, intuitive, unrealistic, sensitive

Trusting, adaptable, free of jealousy, easy to get on with

Suspicious, self-opinionated, hard to fool, skeptical, questioning

Practical, careful, conventional, regulated by external realities

Imaginative, careless of practical matters, unconventional, absent-minded

Forthright, natural, genuine, unpretentious

Shrewd, calculating, socially alert, insightful

Unperturbed, self-assured, confident, secure, self-satisfied

Apprehensive, self-reproaching, troubled

Conservation, respecting established ideas, tolerant of traditional difficulties

Experimenting, liberal, analytical, likes innovation

Group-oriented, a joiner and sound follower, group adherence

Resourceful, prefers own decisions, self-sufficiency

Undisciplined self-conflict, careless of protocol, follows own urges

Controlled, socially precise, following self-image

Relaxed, tranquil, torpid, unfrustrated

Tense, frustrated, driven, restless, overwrought

EXHIBIT 2.3   Personality Traits That Distinguish Entrepreneurs From Managers (in italics)

Low Sten Score

High Sten Score

Reserved, detached, critical, cool, impersonal

Warmhearted, outgoing, participating, interested in people, easy-going

Less intelligent, concrete–thinking, lower scholastic menatl capacity

More intelligent, abstract-thinking, bright, higher scholastic mental capacity

Affected by feelings, emotionally less stable, easily upset, changeable

Emotionally stable, mature, faces reality, calm, patient

Humble, mild, accommodating, conforming, easily led, submissive

Assertive, aggressive, authoritative, competitive, stubborn, dominate

Sober, prudent, serious, taciturn

Happy-go-lucky, impulsively lively, enthusiastic, heedless

Expedient, disregards rules, feels few obligations

Conscientious, persevering, proper, moralistic, rule-bound

Shy, restrained, threat-sensitive, timid

Venturesome, socially sensitive, bold, uninhibited, spontaneous

Tough-minded, self-reliant, realistic, no-nonsense

Tender-minded, intuitive, unrealistic, sensitive

Trusting, adaptable, free of jealousy, easy to get on with

Suspicious, self-opinionated, hard to fool, skeptical, questioning

Practical, careful, conventional, regulated by external realities

Imaginative, careless of practical matters, unconventional, absent-minded

Forthright, natural, genuine, unpretentious

Shrewd, calculating, socially alert, insightful

Unperturbed, self-assured, confident, secure, self-satisfied

Apprehensive, self-reproaching, troubled

Conservation, respecting established ideas, tolerant of traditional difficulties

Experimenting, liberal, analytical, likes innovation

Group-oriented, a joiner and sound follower, group adherence

Resourceful, prefers own decisions, self-sufficiency

Undisciplined self-conflict, careless of protocol, follows own urges

Controlled, socially precise, following self-image

Relaxed, tranquil, torpid, unfrustrated

Tense, frustrated, driven, restless, overwrought

This overconfidence bias is known as the “Lake Wobegon” or “better-than-average” effect,[6] where Lake Wobegon refers to Garrison Keillor’s fictional hometown in Minnesota where “all the children are above average.” Incidentally, the overconfidence effect is not restricted to entrepreneurs. We are all prone to overconfidence in some domain. A frequently cited example is that 60% of high school seniors believe that they are in the top 10% in ability to get along with others, while 25% believe they are in the top 1%.[7] If we extrapolate these numbers, it appears that the entire population of seniors believes it is in the top 20% (Exhibit 2.4). This implies that the bottom 80% is overconfident, and we know from the earlier statistic that the remaining 20% (plus another 5%) believes it is in the top 1%, and thus also overconfident. In short, all but the top 1% of high school seniors (and therefore all of us) are overconfident in some dimension.

The problem this raises for entrepreneurs is “reference group neglect.”[8] While entrepreneurs’ industry expertise is certainly above the general population, for roughly half it is below the average entrants. Accordingly, most industries have excess entry and subsequent failure.

So we see that entrepreneurs are different, but not that different. We’ve also seen that they bear risk as a byproduct of their overconfidence. The remaining questions are (1) “What pushes them over the edge?” and (2) “Given the high rates of failure, should we protect them from taking the leap?”

EXHIBIT 2.4   Overconfidence in High School Seniors’ Assessments of Their Ability to Get Along With Others

TAKING THE LEAP

We saw in the previous section that a number of factors affect an individual’s propensity to become an entrepreneur. A related question is, “What pushes them over the edge? When do they actually take the leap?” A hint at the general answer comes from the outplacement study discussed earlier. We saw that while the normal transition rate from wage employment to self-employment is 3% in a given year, for the outplacement group it was twelve times that, 37%. So being terminated from your job is a major impetus for starting a venture.

Termination typically implies you have two ingredients necessary for a new venture: industry experience and financial capital (the severance package). As an example, Michael Bloomberg was an extremely successful equities trader before he was terminated by Salomon Brothers. With his $10 million severance package, he started Bloomberg Financial Markets, which has grown to become a $3.5 billion financial media empire (see Inset 2.1).

Inset 2.1

Bloomberg (Michael Bloomberg)

On Saturday, August 1, 1981, I was terminated from the only full-time job I’d ever known “Salomon Brothers” and from the high-pressure life I loved. . . . Of course, there was the $10 million I was getting. America’s a wonderful country.

The prospect of working for someone else wasn’t exciting. As to retiring, I’ve always been too restless. So the last option, chasing the great American dream, seemed all that was left. What would I do? Since I didn’t have the resources to start a steel mill, I ruled out that possibility. Having no musical abilities precluded starting a songwriting business. Lack of interest in retailing excluded competing with Wal-Mart. My impatience with government kept me away from politics. Should I start another securities trading firm. Been there. Done that. Maybe I could be a full-time consultant. Doing rather than advising others is for me. What did I have the resources, ability, interest and contacts to do. The question led me back to Wall Street. It was obvious the economy was changing and services were taking a bigger share of GDP. My talents, my experience, my financial resources, the momentum provided by the American economy—everything fit. I would start a company that would help financial organizations. There were better traders and salespeople. There were better managers and computer experts. But nobody had more knowledge of the securities and investment industries and of how technology could help them.

When it came to knowing the relative value of one security versus another, most of Wall Street in 1981 had pretty much remained where it was when I began as a clerk back in the mid-1960s: a bunch of guys using No. 2 pencils, chronicling the seat-of-the-pants guesses of too many bored traders. Something that could show instantly whether government bonds were appreciating at a faster rate than corporate bonds would make smart investors out of mediocre ones, and would create an enormous competitive advantage over anyone lacking these capabilities.

At great expense, each of the largest securities companies collected data independently. Worse, they were relying on small handheld calculators to manipulate that information. I could provide a far more sophisticated system at a fraction of the price. Sharing expenses over many users would give me a distinct cost advantage. And if most firms used my data and analysis, I would be creating an industrywide standard, something which for competitive reasons, the insiders themselves could never accomplish.

__________
Source: Bloomberg, M. (1997). Bloomberg by Bloomberg. New York: John Wiley, pp. 1, 2, 39, 41, 42.

In a similar phenomenon, studies in the biotech[9] and banking[10] industries indicate that startups in an industry increase with the number of acquisitions in that industry. Typically, what happens in an acquisition is that founding managers who are bought out receive substantial proceeds from the acquisition and are either immediately displaced or leave on their own accord because they are unhappy working for someone else. Acquisitions and terminations are probably the most powerful predictors of entrepreneurship, because they imply relevant experience and financial assets necessary to start a venture, but other transitions are predictive as well: divorce, graduation, leaving prison. Each of these transitions breaks inertia that otherwise keeps individuals in their current jobs. The inertia takes the form of giving up a steady income and known lifestyle versus making a substantial investment to obtain an uncertain income. Since breaking the steady income prompts entrepreneurship, it appears that giving up a sure thing is a larger component of the inertia than is making an investment or uncertain income.

The previous discussions suggest that the primary impetus for entrepreneurship is an economic push. Don’t some entrepreneurs respond to opportunity? The answer to that is certainly, “yes.” With the exception of Ben and Jerry, all the vignettes in Chapter 3 on venture ideas involve entrepreneurs responding to opportunity.

Most often, entrepreneurial ideas occur in the context of an existing job. When do these ideas become ventures rather than projects undertaken by the employer. Theory[11] suggests that ideas are more likely to become startups in legal environments that favor employee rights (e.g., California vs. Delaware) and in regions with substantial external resources, such as university research/students, start-up attorneys, venture capitalists, fluid labor markets (e.g., Silicon Valley vs. Boston). This theory appears to hold in practice.[12] Moreover, a study of laser companies finds that these spin-offs are more likely to come from young firms and successful firms.[13] This suggests that some employers serve as role models/incubators for “inherited” entrepreneurial talent, just as entrepreneurial parents do.

ARE ENTREPRENEURS MAKING A MISTAKE?

We saw that the failure rates for new firms are quite high (51% fail within their first 4 years). A logical question is whether we should protect entrepreneurs from making these mistakes (as we protect citizens from addictive drugs and automobile accidents). To answer that question, we need a sense of the costs to failed entry. These take on four forms: (1) lower entrepreneurial income, (2) long-term entrepreneur’s costs (decrease in earning potential), (3) unrecovered investments, and (4) social costs (those incurred by someone in the economy other than the entrepreneur).

Entrepreneurial Income

In a study comparing the income of entrepreneurs to wage earners with equivalent education and experience, Bart Hamilton found that entrepreneurs’ income (wages plus changes in equity) was higher than wage earners for the first 10 years of the venture.[14] Thus, there appears to be no income penalty for the 51% of entrepreneurial firms who fail within their first 4 years. Moreover, entrepreneurs have substantial flexibility to have the venture pay for personal expenses, such as automobiles and insurance, which means their realized wage is likely understated.

Earning Potential

The same study examined what happens to failed entrepreneurs’ income once they reenter the traditional workforce. Do entrepreneurs suffer an “out of the workforce” penalty. The study concluded, “no.” If anything, entrepreneurs enjoy a wage premium over having stayed in the traditional labor force.

Unrecovered Investment

So entrepreneurs’ income is comparable (if not slightly higher) than wage earners. What about their investment in the venture? We have less evidence on this, but one study in the banking industry indicates that on average there is no lost investment. Of the 1,580 firms that exited, on average founders increased their investment by $15 million over the firm’s existence.[15]

Direct Economic Losses

So entrepreneurs appear to fare well, but do they impose costs on others? The Internet boom/bust notwithstanding, the answer here also appears to be “no.” Only 6.3% of the firms that exited in 2003 filed bankruptcy, leaving creditors with unpaid debt.[16] The remaining firms are solvent at exit (which fits with the results in banking). In summary, there appear to be insignificant direct costs to failed ventures to the entrepreneur, his or her buyers/suppliers, or his or her investors.

Indirect Economic Impact

Are there indirect economic costs or benefits? Certainly the lore of entrepreneurship is that it benefits the economy. Each year the U.S. Small Business Administration compiles its Report to the President. One of the ancillary goals of this report is to document the economic benefits to entrepreneurship. One benefit of entrepreneurship is as a mechanism for labor force parity and mobility. You may remember from earlier discussion that entrepreneurship is highly likely among those with less than a high school education. This allows people locked out of the traditional workforce to earn a living wage. In addition, entrepreneurship is highly likely in immigrant populations. Some immigrants suffer from low education and thus fit within the previous category. However, even those with substantial education can have trouble entering traditional wage jobs because their foreign credentials aren’t transferable or because of language problems. Entrepreneurship provides a mechanism for them to earn a wage comparable to their human capital. As an example of the effectiveness of entrepreneurship in achieving this goal, the mean 1990 wage of immigrants in traditional wage jobs was 86.7% of native U.S. citizens ($25,479 vs. $29,378), while the mean entrepreneurial income of immigrants was 98.5% of native U.S. citizens ($41,364 vs. $41,993).[17] Thus, not only does entrepreneurship bring parity with natural born citizens but it also increases income, presumably in parity with immigrants’ human capital.

Finally, entrepreneurship has been associated with higher economic growth. Hicks in a study of Texas sales receipts found that regions of the state with the highest failure rates also had the highest wages and employment growth.[18] Does entrepreneurial activity convey these benefits, or is there something about the regions that produces both high levels of entrepreneurship along with high wages and employment growth? It appears that entrepreneurship does convey at least part of these benefits. In a study of entry in the banking industry, Knott and Posen found that the rate of new entry into a market affects firms’ efficiency and innovation.[19] It does so through three mechanisms. First, it provides the churning or creative destruction that Schumpeter describes: New firms with innovative methods displace old firms with less effective methods. Second, competition from the new entrants forces innovation by the older firms with sufficient resources. Finally, the entrants often introduce methods that diffuse among existing firms, even if the entrant ultimately fails. One such example mentioned in Chapter 1 was the adoption of Internet retailing by incumbent music firms following entry by CDNow. Consumers benefit from the higher valued offerings (either lower cost or higher quality) stimulated by all three mechanisms associated with entry. Thus, even failed entrepreneurs are heroic.

SUMMARY

There are some factors affecting entrepreneurship that you can do little about, such as personality traits and parents. There are however several factors you can control. The prior discussions suggest the following strategy for pursuing an entrepreneurial career. First, identify an industry that appeals to you. Those with considerable entrepreneurial activity are best, since they offer networks of suppliers and advisers to facilitate your ultimate start-up. As an example, the banking industry has so much entrepreneurial activity (much of it prompted by acquisitions) that there are even Web sites devoted to startups, for example, www.denovobanks.com. Pursue an education comparable to that of other founders in the industry, for example, bank founders typically have an MBA; founders of high-tech firms typically have advanced degrees in engineering. Pick a state and region that favors employee rights and itself has considerable entrepreneurial activity. Then work for a successful startup, stash away funds, and stay single (or marry someone with a nice income).

NOTES

1. Dunn, T., & Hotlz-Eakin, D. (2000). Financial capital, human capital and the transition to self-employment. Journal of Labor Economics, 18, 282–305.

2. Dunn & Holtz-Eakin (2000).

3. Wooten, K. C., Timmerman, T. A., & Folger, A. (1999). Use of personality and five factor model to predict new business ventures. Journal of Vocational Behavior, 54, 82–101.

4. Headd, B. (2003). Redefining business success: Distinguishing between closure and failure. Journal of Small Business Economics, 21, 51–61.

5. Wu, B. X., & Knott, A. M. (2005). Entrepreneurial risk and market entry. SBA Office of Economic Research. Working Paper No. 249.

6. Alicke, M. D., Klotz, M. L., Breitenbecher, D. L., Yurak, T. J., & Vredenburg, D. S. (1995). Personal contact, individuation and the better-than-average effect. Journal of Personality and Social Psychology, 68, 804–828.

7. College Entrance Exam Board.

8. Camerer, C., & Lovallo, D. (1999). Overconfidence and excess entry: An experimental approach. American Economic Review, 89, 306–318.

9. Stuart, T., & Sorenson, O. (2003). Liquidity events and the geographic distribution of entrepreneurial activity liquidity. Administrative Science Quarterly, 48, 175.

10. Wu & Knott (2005).

11. Hellman, T. (2002). When do employees become entrepreneurs. NBER Working Paper.

12. Stuart & Sorenson (2003).

13. Klepper, S., & Sleeper, S. (2005). Entry by spinoffs. Management Science, 51, 1291–1306.

14. Hamilton, B. (2000). Does entrepreneurship pay? An empirical analysis of the returns to self-employment. Journal of Political Economy, 108, 604–631.

15. Knott, A. M., & Posen, H. E. (2005). Is failure good? Strategic Management Journal, 26, 617–641.

16. http://app1.sba.gov/faqs/faqindex.cfm?areaID=24

17. Lofstrom, M. (2002). Labor market assimilation and the self-employment decision of immigrant entrepreneurs. Journal of Population Economics, 15, 83–114.

18. Hicks, D. A. (1993). A nanoeconomic perspective on the growth and development of the Texas Manufacturing Base, 1970–1991. A report prepared for the Office of the Comptroller, State of Texas.

19. Knott & Posen (2005).

CHAPTER 3

The Venture Idea

The best way to have a good idea is to have a lot of ideas.

Linus Pauling[1]

INTRODUCTION AND GOALS

The second raw ingredient in the venture is the idea. Some of you may be taking the course precisely because you have a venture idea, but the majority of students seem to struggle coming up with theirs. One reason for the struggle is that students will be married to the idea for a semester, so they don’t want to commit early to something that doesn’t spark enthusiasm. The problem with waiting for “the big idea,” however, is that each design decision takes time and builds on prior decisions, so each delay makes catching up increasingly difficult. While I argued in Chapter 1 that ideas play a relatively minor role in venture success, the fact of the matter is, you do need an idea on which to build a venture. This chapter helps you to find that idea.

This chapter has four goals. The first is to ease the stress of finding the big idea. The second is to give you a sense of where real venture ideas typically come from. The third is to describe the psychology and sociology of creativity, to condition you to discover ideas you’d be willing to devote a career to. Finally, the chapter provides some quick start methods for generating ideas you can pursue for the semester.

The chapter begins with a principles section that discusses the nature of ideas and the psychological and sociological means by which ideas emerge for creatives generally and entrepreneurs in particular. The process section translates the principles into a set of tools for generating venture ideas. The first set of “tools” offers a long-term approach to finding an idea that has enough commercial merit and personal appeal that you would be willing to commit several years of your life to it. The second set of tools offers two mechanisms for quick-starting your venture. The first mechanism involves brainstorming exercises. I discuss these exercises in sufficient detail for you to conduct them yourself. The second mechanism is buying ideas from an idea market. I identify the major idea markets, discuss their merits, and provide contact information to access them. Finally, I discuss the idea generation process for epigraphs.

PRINCIPLES

How Important Is the Basic Idea?

I want you to start thinking about the importance of the idea by giving you a simple example and having you work through the logic. Exhibit 3.1 presents the pattern of entry and shakeout for U.S. automobile manufacturers. The main plot (number of firms) shows that the industry began in 1895 with four entrants; the number of firms peaked in 1909 at 272, and by 1955, the industry had consolidated to the handful of firms we have today. Other plots show the number of entries and the number of exits over time. Summing the total number of entrants indicates that 725 unique firms entered for at least some period of time, and accordingly, 715 (98.6%) of them failed. These kinds of failure numbers are something you are going to confront time and again with respect to entrepreneurship. Fifty-one percent of new U.S. firms fail within their first 4 years.[2]

The main point from the figure, however, is that each of these 725 firms had the same basic idea—automobile manufacturing. So the first observation is that while extremely valuable economically, the basic idea of automobile manufacturing was hardly unique and rarely sustainable—less than 2% of firms who entered survived.

EXHIBIT 3.1   Trends in the Number of U.S. Automobile Manufacturers

The next thing I want you to think about is which of these 725 entrants survived to the final set of firms. One common answer is that it was the first entrants—reflecting “first mover” advantage. This answer is incorrect. While there are first mover advantages, they accrue to firms who move first with the correct configuration. Often several experiments within the basic industry fail before the first mover enters. We will discuss this phenomenon in greater detail in Chapter 3, but I want to illustrate the point in the automobile industry. Ford Motor Company was founded in 1903 after two prior failures by Henry Ford (the earliest of which was in 1899), and GM was founded by Bill Durant in 1908. All the manufacturers whose names you may remember—Olds, Stanley, Dodge, Mack, Jeep, Studebaker, and Chrysler—were founded after the turn of the century (5 years after industry founding).

What factors determined who succeeded? In a careful historical study of the entire automobile industry, Klepper[3] characterized the industrial heritage of all founders and examined the impact of heritage on survival. Exhibit 3.2 lists the factors in descending order of success. The exhibit indicates that the greatest chance of survival went to engineers who spun off from other successful automobile manufacturers in the Detroit area. This offers more than twofold advantage over the true first movers who generally came from bicycle manufacturers and founded their firms outside Detroit. Of particular note is that being an experienced entrepreneur is more valuable than being an experienced firm.

EXHIBIT 3.2   Factors Explaining Failure of Automobile Manufacturers

What do these observations suggest about the importance of ideas? First, as mentioned previously, having the basic idea, automobile manufacturing, was not that important. A total of 715 firms with that idea failed. Capturing the value of the auto idea required specialized training (engineering) and in-depth experience within the industry. This observation is consistent with the learning before doing idea in Chapter 1. Being trained as an engineer generated greater gains from the industry experience. (Note that the engineering result isn’t generalizable to all industries. It just happens to be the particular functional training with the greatest payoff in the automobile industry where both the product and its manufacture were engineering intensive.) This combination of training and experience allowed founders to see new combinations. Moreover, entrepreneurs were more likely than firms to bring forth these new combinations—precisely because they didn’t have prior investments in capital and labor that they tried to adapt to the evolving technology. These new combinations, such as mass production and standardization at Ford, and vertical product differentiation at GM, were more valuable to a firm than the basic idea. The main point is that while the idea is certainly important, there is something special about the combination of idea, its source, and the entrepreneur.

What If You Have a Unique Idea?

Students tend to think that the idea is main source of competitive advantage. They take great pains to protect their ideas—making everyone sign nondisclosure agreements. The fact of the matter is venture ideas are almost impossible to keep secret. To secure any resources for the new venture (employees, investors, and even suppliers), founders typically have to disclose their idea. Not only is it disclosed to each potential employee/investor but it is also disclosed to advisers who help identify the resources and put you in touch with them. Thus, most venture ideas are disclosed in some form to almost a hundred people prior to founding.

Certainly venture capitalists (VCs) and advisers rely on reputations of integrity. They would never be able to secure new clients otherwise. So it is unlikely that they appropriate a venture idea outright. It is more likely they are left with a collection of insights from the 3,000 business plans they see each year. These insights may influence the direction of ventures in their portfolio. One of the myriad fallouts of the burst tech bubble is lawsuits filed by unfunded ventures against VCs accused of stealing their venture ideas after rejecting them.

So the first lesson is that you won’t be able to keep your idea secret. If you can’t keep it secret, there are certainly other means to protect ideas through intellectual property (IP) rights, such as patents, copyrights, and trademarks. If you believe you have valid IP, you should certainly seek the advice of an IP attorney. What you should consider, however, is the fact that the cost of filing the IP rights is trivial compared with the cost of defending them. Microsoft’s legal expenses in its defense of Netscape’s infringement and anticompetitive behavior suit are estimated to exceed $100 million.[4] Microsoft will always have deeper pockets and can therefore protract the legal process until the new venture reaches the point of insolvency. Thus, the value of IP depends to a large extent on your capacity to defend it. Accordingly, inventors who have patentable ideas tend to license them to large firms rather than creating new ventures around them.[5]

If You Can’t Protect the Idea, What Role Does It Play?

We saw in Chapter 1 that very few successful firms rely on a unique idea. For example, none of the 18 visionary companies in Built to Last[6] started with a unique idea, and only 6% of the firms in Origin and Evolution of New Businesses[7] started with a unique idea. This view is echoed by VCs. VCs believe that every good idea they see, they tend to see 30 times.[8] In fact, they view the multiplicity as useful: (1) it provides an indication that there is momentum for the industry, and (2) while they don’t say so explicitly, seeing 30 versions of an idea allows them to identify which of the 30 proposals are among the top 10%.

One reason a unique idea is relatively unimportant is that very few ventures succeed with the original idea intact.[9] Rather, firms adapt the original idea to new information. (See Insets 3.1 and 3.2 for a nice story of idea adaptation.) This is likely why the idea is ranked only 10th out of 25 venture decision criteria.[10] VCs are far more interested in execution. While they can’t see execution of the venture before making their funding decision, they can see evidence of execution ability in the business plan. The plan will indicate how well you understand the general trends as well as the intricacies of the industry. Furthermore, since you will have already made several decisions to arrive at the venture design, they will be able to assess your decision-making capability.

Insets 3.1

The Evolution of SeaFax

In 1987 Neal Workman started Debt Management Services, a collection agency to help lobstermen chase deadbeats. One day after being thrown out of a Manhattan fish restaurant who refused to pay, he took a megaphone and informed all the patrons that the owner had stiffed the fisherman.

Workman realized early on that the information he was collecting was more valuable than the bills he was collecting, this led to his first knowledge product: A $1,000-a-year subscription to a fortnightly mailing that told fishermen which customers were slow to pay or wouldn’t pay.

The same facts that help fishermen avoid bad debt helped Workman collect it. “I’d bring my list of subscribers when I was on a collection call and say, ‘Before you throw me out, you should know these are the people who will be reading about what we decide today.’”

Workman began seeing fax machines everywhere he went. His second knowledge product was born: a faxed Flash Report. “I’d call from the airport back to Maine; I’d say, ‘Bob didn’t pay the eight grand—how many people can we fax this to?’” So successful was the Flash Report that in 1990 Workman renamed his company SeaFax.

Knowledge product No. 3 was a credit report. Brought Workman into direct competition with a company called Seafood Credit, which had several years’ head start—He sat down with groups of potential customers and asked them how Seafood Credit’s reports could be made better—more timely, with more credit references, including bank information—and then made a promise: an up-to-the-minute report faxed within 48 hours.

“When you backbone your business as an information business,” Workman says, “the opportunities hit you right between the running lights. You can just leverage and leverage and leverage.” For instance, people who buy lots of seafood also buy meat and poultry—so meat processors and poultry farmers became a new market for essentially the same credit information.

Because the database is live—worked with every day in the pursuit of collections—Workman says it’s fresher and more accurate than databases that aren’t compiled by people looking for money. So once a year stop, print up all the names, addresses, and phone numbers, sell ads, call it the SeaFax Red Book, and price it at $119. Do the same for meat and poultry. Then do it on CD-ROM. Build contact-management software into it, charge $1,995, more for updates.

Now SeaFax is making a bet—huge for a little company—that it can become the market itself. On the GoFish Web site, buyers—all of them vetted for creditworthiness by SeaFax—and sellers—all of them vetted for quality by SeaFax—can bid and ask for what they want and what they have. For sellers the credit database is the big-value added; for buyers will be able to report back on the quality and freshness of what they receive, creating a running tally for each seller is the big-value added.

The company is still small and privately held; sales are a bit under $6 million a year, with a pretax operating margin of about 18%. Collections produce 8% of SeaFax’s revenues—with huge margins—but occupy a 0% share of the owner’s mind. Approximately 300 buyers and sellers are using GoFish.

____________
Source: Stewart, T. (1998, August 3). Cold fish, hot data, new profits. Fortune Magazine, 138(3).

Insets 3.2

eBay (Pierre Omidyar)

When 3DO announced plans to go public in May 1993, Omidyar placed an order for stock through his Charles Schwab brokerage accounts . . . 3DO went public at $15 a share, but when Omidyar checked his account, he learned that the stock had soared 50 percent before his order had been filled . . . It struck him that this was not how a free market was supposed to operate—favored buyers paying one price, and ordinary people getting the same stock moments later at a sizeable markup.

Omidyar’s solution was an online auction.

Since he was still working at General Magic, Omidyar had to do the programming for his perfect marketplace in his spare time. He had already written a chess-by-mail program which he was offering for free over the Internet. He had also completed the coding for a program he was calling WebMail Service. More recently, he had created WebMail Watch Service.

With Labor Day 1995 approaching, Omidyar made the program for a perfect marketplace his project for the long weekend. On Friday afternoon he holed up in his home office . . . and began writing code. By Labor Day he had created AuctionWeb. Since he intended to offer its services for free, he cut costs by adding the site to his existing $30 per month ISP account, eBay.com.

____________
Source: Cohen, A. (2002). The perfect store. Boston: Back Bay Books, pp. 20–21.

So if having a unique idea is neither important nor feasible, what role does the idea play? The best perspective is to think of the basic idea as a platform—a domain with an identifiable need and a set of potential solutions, possibly even a leading candidate solution. This basic idea will become more refined and specific as you run it through the decisions in the book.

The main message is you don’t need to come up with the flying car. (Paul Moller has already done that and has been trying to develop and commercialize it since 1964.)[11] Rather, for the semester you merely need to come up with something that you can find interesting for 4 months. If you ultimately want to start a venture, you need something that interests you for several years. The sections that follow provide principles and tools for identifying both classes of ideas.

PRINCIPLES OF CREATIVITY

The creative process has two components: a psychological component, which focuses on the individual, and a sociological component, which focuses on context. At issue in both components is whether there are factors you can manipulate to stimulate the flow of ideas. Before discussing the psychology and sociology of creativity, however, we begin by considering them together—what does the inventive process look like?

Inventive Process

One of the most interesting studies of the creative process comes from Rossman’s Industrial Creativity. [12] I chose this study as a focal point because Rossman’s definition for invention is quite similar to Schumpeter’s definition of entrepreneurship that we saw in Chapter 1. Rossman defines invention as something new or novel that is applicable to any field. “The outstanding feature of inventions is that they give something which has not existed before. . . . Things or ideas are fitted together to produce results which are more than the details from which they are formed.”[13]

The most significant component of Rossman’s study was his survey of 710 inventors, each of whom had on average 39.3 patents. In the study, Rossman asked the inventors to describe their inventive process. Analysis of these descriptions revealed an underlying process common to all the inventors. The process consists of seven steps:

1. Observation of a need or difficulty. The inventor is a careful and keen observer who is on the alert to note defects or needs, whether they are obvious or dormant.[14]

2. Analysis of the need. Inventors clarify the objectives by putting their thoughts on paper and stating as clearly as possible what they hope to accomplish.

3. A survey of all available information. Inventors survey all available information bearing on the problem (in the case of a patent this would involve careful search of the technical literature and patents); discussions and conferences with experts and users.

4. A formulation of all objective solutions. Formulating (often with sketches) all possible means to satisfy the need. This is usually an iterative process where potential solutions lead to roadblocks that suggest alternative solutions.

5. A critical analysis of these solutions. Rigorous analysis of the technical and commercial feasibility of surviving solutions.

6. The birth of the new idea. This is the “aha” moment that occurs after the gestation process associated with Steps 4 and 5. “At this point, after the problem has been dealt with objectively and still is unsolved, a new idea flashes upon the mind. It is the new idea, the conception that is greater than the sum of the parts, . . . which is the invention.”[15] This moment of inspiration can occur at almost any time, but often occurs in moments when the mind wanders: while running, in the shower, at the theatre, on a train, or during a sermon.

7. Experimentation to test and refine the most promising solution.

The remaining chapters of the book provide tools for the analytical components of this process (analyzing the need, surveying information, formulating and analyzing solutions), so we focus here on the creative or insightful steps: (1) observing a need or difficulty and (6) the birth of the idea.

Observing the Need. The initial stimulus for any invention is observing a need or obstacle. Often, this stage is called opportunity recognition. An individual is confronted with a situation that frustrates him or her personally (waiting at stop lights when there is no cross traffic) or intellectually/socially (pharmaceutical firms charge less for exports than they do for domestic drugs). This frustration triggers creative effort.

In principle, we all observe obstacles constantly. Psychological studies (which we will discuss late in this chapter) indicate that inventors and creative workers are distinguished from the rest of their population by their emotional reaction to these obstacles. Ordinary obstacles are ignored by the average person; creatives, however, appear to have lower thresholds, which make them more likely to be frustrated by the obstacles (one reason for the attribution that they are temperamental). Moreover, they react to these frustrations with an emotional intensity often sufficient to produce an invention.

Discovering the Solution. The second creative process in invention is discovering the solution. Like need observation, this process occurs without warning. However, the likelihood of discovering a solution is conditioned on having a large toolkit of possible solutions. The size of this toolkit is determined by the variety and intensity of past experiences and by an ability to see patterns across these past experiences. Aristotle in his Art of Poetry has described genius as the power of seeing resemblances amid a multitude of differences. This is also true of the inventor who can see analogies, relations, and similarities where others can only see isolated facts and unrelated objects. “New syntheses are made difficult because we have become accustomed to ignore certain types of perceptions. In many respects, our conscious faculties are biased in favor of conservatism.”[16]

While these past experiences and the ability to synthesize them affect the likelihood of discovering a solution, the timing of the solution appears to be outside the control of the inventor. “Ideas often occur to me without conscious effort or concentration. It appears to be on the order of inspiration, usually when I am rested and allow my mind to wander at will.”[17] “Often a solution would come to mind suddenly sometime afterward when engaged in other work.”[18] “Ideas come in periods of relaxation such as riding home in a train . . . listening to a sermon.”[19]

Nevertheless, many inventors and creatives develop “expedients” to trigger creative states of mind. Think of these as the equivalent of a hypnotist’s pendulum. Ibsen kept a number of little images on his writing desk. Kant used a tower outside his window as a sort of mental focus. Shelley munched bread. Gutier used the smell of printer’s ink. “When I attempt a new invention I buy a small blank book and carry it continuously. I make notes and sketches as fast as ideas come.”[20]

What this process reveals is the details behind Thomas Edison’s remark, c. 1903, “Genius is one percent inspiration and ninety-nine percent perspiration.” There is synergy between insight and the hard work. Both the insightful stages rely on substantial knowledge. In the discovery stage, the ability to recognize something that can be improved often requires detailed knowledge of how the current function is performed. Similarly, the discovery of a novel solution reveals itself only after a number of more obvious solutions have been tested. The testing process reveals patterns about what is working versus what it not.

What Do We Know About Creativity?

Having discussed the inventive process, we now decompose it into its psychological and sociological components. We want to understand the factors affecting an individual’s level of creative output. Our goal is to determine if there are behavioral and environmental changes that will stimulate a greater flow of entrepreneurial ideas. Without discussing any of the psychological and sociological foundations of creativity, however, it is obvious from our prior discussion that one thing we can do to facilitate the production of useful entrepreneurial ideas is to immerse ourselves in the relevant industrial context. This provides the depth of knowledge that fuels both need observation and solution discovery.

Biological Bases of Creativity

A common characterization of creatives is that they are able to perceive and use information that others ignore. This characterization is rooted in real biological differences between creatives and others in greater right hemisphere activity (more fantasy), in higher basal arousal and in greater fluctuation in arousal (skin response, heart rate variability, EEG amplitude variability), and in latent inhibition (LI; frontal lobe activity). We focus on LI because it offers insights for idea generation strategies. What LI refers to is a capacity to screen stimuli previously found to be irrelevant.[21] It captures one factor that underlies learning curves. In early attempts at a task, individuals experiment to determine what works and what doesn’t. Over time, they learn what experiments fail, so they don’t repeat them, and as they abandon more “experiments,” they become faster at the task. This is functional so long as the task and environment remain unchanged, but if they do change, the “habituation” makes it difficult to recognize how the routine should be modified.

In principle, lower LI suggests that creatives are less susceptible to this habituation, so they learn a related subsequent task faster than do noncreatives. This principle was tested in an experiment with 86 undergraduate students who had been characterized by their creativity (using a Creative Achievement Questionnaire [CAQ]) and their IQ.[22]

The LI experiment had two phases: a “preexposed” audio phase and a “test” video phase. In the preexposed phase, subjects were presented with 30 nonsense syllables presented 5 times without break interspersed with white noise bursts presented 31 times at two thirds the volume of the syllables. The task in this phase was for subjects to identify how many times they heard a selected syllable. In the test phase, subjects were presented with an audio track identical to that in the preexposed phase, which ran concurrently with a video image where yellow disks would appear following the “target” syllable. The task in the second phase was to identify the syllable triggering the disks. A subject’s score was the number of trials to correctly identify the trigger. LI was deemed to exist when being preexposed affected the score in the test phase. Exhibit 3.3 provides the basic results from the test. The exhibit indicates two things of interest. First, those with high creative achievement (CAQ) took 14.3 trials to identify the trigger syllable regardless of whether they were preexposed. Thus, they do not exhibit LI. In contrast, subjects with low CAQ required 6 additional trials (41% more trials) to identify the trigger when they were preexposed relative to when they weren’t. Thus, subjects with low creativity do exhibit LI.

EXHIBIT 3.3   Comparing Latent Inhibition of Creatives Versus Noncreatives

The other observation of interest from the exhibit is that creatives are faster to recognize patterns generally. Even when non-preexposed, they require 8.4% fewer trials than noncreatives. In summary, creatives in this experiment differ from noncreatives in that they appear to have no LI—being preexposed has no effect on their ability to recognize patterns. Second, they are faster to recognize patterns—they are able “see” things others don’t (or before others do).

So far we have said little about IQ. The reason that IQ was included in the test is that low LI is also associated with psychosis.[23] The authors felt that IQ might determine when inability to screen irrelevant information would be functional (creativity) or dysfunctional (psychosis). High IQ individuals might have a means for mentally processing the extraneous signals that schizophrenics lack. Exhibit 3.4 presents the moderating effect of IQ on LI. The figure indicates that high LI (long time to recognize syllables) is associated with low creativity regardless of IQ. Interestingly, psychotics (low IQ and low LI) appear to be more creative than people with high LI, but there is a dramatic payoff to high IQ in those with low LI—almost tripled creativity. The implication here is that low sensory thresholds are good, but only if you can process the extra information. Intelligence is one means for processing information, but education and experience are both means for categorizing new information into meaningful patterns.

Psychology of Creativity: The Creative Personality

EXHIBIT 3.4   Impact of IQ and Latent Inhibition on Creativity

Psychological studies indicate that creativity has both a durable component (potential), the potential for creative work, as well as a malleable component (output), the actual rate and quality of work. We will consider both components. While the consideration of a durable component may seem pointless given our goal of increasing the number of venture ideas, the body has amazing plasticity. Most body components respond to exercise—muscle mass increases through physical exercise; brain function is enhanced through mental exercise. In other words, the best means to improve capacity is to use it. Thus, discussion of the first component is intended to increase your creative capacity. Discussion of the second component will offer suggestions on how to condition your environment to enhance your creative output during a particular session.

Nature: The Role of Genetics

While we tend to think of creativity as a personality trait, it is not a trait itself but rather corresponds to a constellation of personality traits. These traits have been identified by administering personality instruments (such as the 16PF) to highly creative individuals to determine characteristics that distinguish them from the population means. Results from these studies indicate that creative individuals exhibit the traits listed in Exhibit 3.5.

Many of these traits coincide with the discussion of the inventive process in the previous section. Open-mindedness, heightened perception, and curiosity give rise to problem identification and also suggest that knowledge or information regarding potential solutions is gathered at a more rapid rate than the population at large. Need for privacy and heightened perception often appear together. These traits characterize introverts. People with heightened perception need to be alone to limit the amount of stimuli (noise) they confront.

EXHIBIT 3.5   Personality Correlates of Creative Behaviori

Originality

Independence

Risk-taking

Personal energy

Curiosity

Humor

Attraction to complexity and novelty

Artistic sense

Open-mindedness

Need for privacy

Heightened perception

Source: Davis, G. A. (1999). Creativity is forever. Dubuque, IA: Kendall/Hunt.

Incidentally, Rossman, who is not a psychologist, conducted a similar survey in which he asked his 710 inventors and 176 patent attorneys to describe traits distinguishing inventors from the rest of the population. Exhibit 3.6 identifies the most frequently mentioned traits and quantifies the times mentioned by each group. Interestingly, the trait most frequently cited by patent attorneys, originality, is ranked only fifth by the inventors. Similarly, the trait most frequently cited by inventors, perseverance, is ranked fourth by attorneys. This reinforces the perspiration versus inspiration theme in Chapter 1.

EXHIBIT 3.6   Traits Distinguishing Inventors From Rest of Population

Trait

Times Cited by 176 Attorneys

Times Cited by 710 Inventors

Originality

64

151

Analytical ability

44

113

Imagination

34

207

Perseverance

20

503

Observation

18

61

Optimism/confidence

12

96

Mechanical ability

6

41

Knowledge and memory

0

183

Business ability

(lack of) 26

162

Common sense

0

134

What we observe by comparing Exhibits 3.5 and 3.6 is that about half the traits are common to both tables: originality/originality, risk-taking/overconfidence, personal energy/perseverance, artistic sense/imagination, and heightened perception/observation. What distinguishes Rossman’s traits from the psychologists’ traits are five factors that likely distinguish inventors and entrepreneurs from artists: analytical ability, mechanical ability, knowledge and memory, business ability, and common sense. Each of these traits is important to translate a raw idea into something commercially viable.

Nurture: The Role of Developmental Context

Creativity appears to have developmental attributes in addition to the inherent attributes discussed above. This is encouraging because it suggests the opportunity to affect levels of creative output. One developmental factor affecting creativity is birth order. Studies of eminent creatives indicate that incremental scientists and classical composers are more likely to be firstborns,[24] whereas revolutionary scientists, creative writers, and political leaders tend to be later-born. The main distinction between firstborns and later-borns is that firstborns tend to be approval seekers. Thus, they excel within approved domains.

A second developmental factor is environment. Creatives tend to come from marginalized home environments and nonmainstream educational and professional environments. Both these correlates suggest “nothing to lose” and/or “limited returns to conformity” (and possibly limited exposure to mainstream norms). In addition, creatives have high incidences of trauma during their childhood—such as loss of a parent. The role of trauma is unclear, but it may imply either a distrust of the established order or a void that needs to be filled.

The third developmental factor is age. Creative output increases with age, reaches a peak, and then decays. This pertains not only to the quantity of output but also to the creativity of the output. Individuals’ most important work typically coincides with their most prolific period.

Finally, creative output is affected by environmental stimuli. Eminent creatives tend to have a large number and diverse set of mentors (increasing the opportunity for a new combination). Moreover, the creativity of their output is enhanced by training and use. This seems to be true not only in humans but also in dolphins. Reinforcing novel behavior leads to progressively more novel behavior.

Sociology of Creativity: The Role of Immediate Context

The nature and nurture components of creativity both affect an individual’s propensity for creative work. The nature components exist at birth, while the nurture components enhance the natural propensity through developmental experience. Whether this creative potential is realized is affected by context. To understand the role of context we turn to sociological studies. These studies indicate that people are most original under moderate stress. Without any stress, nothing happens, and with too much stress people resort to comfortable routines of stereotypical behavior. Relatedly, noise and the presence of others both increase arousal (a form of stress) and tend to cause stereotypical behavior.

Criticism is certainly one source of stress. Studies indicate that when people know their work will be evaluated, they tend to focus on technical quality, which increases relative to conditions without evaluation. But the improvement in technical quality comes at the expense of creativity. If people are allowed to modify their work in response to the evaluation, studies show that negative criticism is best. Negative criticism leads to more original ideas, while positive criticism leads to more effective solutions.

Finally, greater opportunity for creativity seems to increase creativity. This has been shown for story completion studies. In these studies, subjects listen to an audio story or watch a video story. In both versions of the stories, subjects are asked to write an ending. Video stories tend to elicit less creative endings. It appears that having to create internal images of characters for the audio stories exercises the imagination. In contrast, video stories allow the viewer to be completely passive.

The last issue is whether creativity responds to incentives. Carl Viesti,[25] in an early study of incentives and insight, asked subjects to detect which of three complicated patterns was the odd one out. He then examined the extent to which performance improved over a series of tests. Those who were offered significant rewards for detection performed worse and learned less than those who were given only a token payment. This same counterproductive effect of incentives has been observed in the animal world. Rats and monkeys who must learn a skill to get food discover less about their environment if they are ravenous than if they are only mildly hungry. The more pressing the requirement to reach the goal, the less animals and humans attend to the overall patterns, and the more they pick up expedients to obtain the immediate reward. This behavior is adaptive to point but if the world changes there is less information to formulate a new routine.

PROCESSES (IDEA GENERATION)

We began this chapter with a discussion of venture ideas. Now that we understand general principles of idea generation and creativity, we return to the particulars of venture ideas. We first discuss where venture ideas come from (and why). We then translate our understanding of idea generation and creativity into strategies for generating your own venture idea.

Sources of Venture Ideas

Exhibit 3.7 identifies the sources of venture ideas for firms in the Inc. 500. Inc. is probably the premier magazine for entrepreneurship, and the Inc. 500 is an annual competition to identify the fastest growing privately held companies in America. The standards are tough. The base year revenues must exceed $200,000, and the relevant growth is the average rate over 5 years. The sustained growth rates of the top 10 firms are typically more than 1,000% per year, and the growth rates of even the bottom 10 firms (rank 491 to 500) are still more than 75% a year. (For reference, note that a 100% annual growth rate over 5 years would take a firm with base revenues of $200,000 to $6.4 million in year 5.)

EXHIBIT 3.7   Sources of Inc. 500 Ideas

Source: Based on data in Inc. magazine special issue: The Inc. 500 issue, Fall 2003, p. 34.

The exhibit indicates that the dominant source of venture ideas is prior employment. Fifty-two percent of new ventures are in the same industry as the previous employer, and another 17% are in adjacent industries (buyer or supplier). There are two things to be explained here. The first is why ideas come from past employment; the second is why the better ideas (the Inc. 500) come from past employment. We will discuss both of these in a moment, but before doing so, note that the other two sources are consumer experience (14%) and researched start-up ideas (5%). Another 12% are not categorized. Thus, it is possible for venture ideas to come from almost anywhere, but we will discuss the top three plus a fourth, importing, and provide examples of ventures coming from each source.

Prior Employment. One obvious reason prior employment figures so prominently in new venture ideas is that jobs occupy most of our waking hours—a 40-hour job plus lunch and commuting comprises 50 hours of 112 waking hours per week. Moreover, professional jobs, the ones that seem to stimulate the most entrepreneurship according to Chapter 2, typically require far more than 40 hours. Accordingly, our job is where the greatest opportunity for need observation occurs. The job is also what our stockpile of knowledge of solutions is typically built from.

The hours devoted to our jobs explain why venture ideas are most likely to come from prior employment, but the Inc. 500 is not merely the pool of all ideas, it is the pool of the most successful ideas. Accordingly, prior employment also explains the success of ideas. There are two principal reasons why ideas from prior employment are more successful. The first is that you fully understand the context. You have the requisite training as well as substantial experience in that setting. If you find an idea you believe is worth pursuing, it is probably the best out of hundreds of ideas that have occurred to you (this is the equivalent of VCs having 30 versions of an idea to compare). This advantage pertains to idea quality.

A second advantage pertains to execution. You know what resources are necessary, you know where they are and how to secure them, and you likely have developed relationships and a reputation that would induce those resources (buyers/suppliers) to commit to you whereas they wouldn’t commit to outsiders. Two prominent examples of ventures that grew from prior employment are Bloomberg (Inset 2.1) and McDonald’s (Inset 3.3).

Inset 3.3

McDonald’s (Ray Kroc)

The exodus from the old inner-city neighborhoods to the expansive suburbs was killing the corner drugstore soda fountains that had dominated the retail ice cream trade since Kroc had entered the market in the 1920s. During the decade after World War II, the hottest and most lucrative franchise operations in the country belonged to the biggest two names in soft-serve ice cream: market leader Dairy Queen and arch rival Tastee-Freez. The new soft-serve ice cream stands—with parking lots for fifteen or more cars and quick window service—were designed to serve a motorized suburban clientele . . . Kroc immediately sought Multimixer business from the Dairy Queen and Tastee-Freez operators who were replacing his soda fountain clients. Unfortunately, the soft-serve vendors were not nearly as interested in making milk shakes, because their profits were so high from the cones and sundaes they made simply by opening the spigot on their soft-serve machines . . . Kroc decided to work harder at finding a new market for his Multimixer, and the first order of business was to find out why two brothers in California were buying so many Mutimixers for their one small drive-in. He also realized that the McDonald’s drive-in at San Bernardino had sparked a number of imitators because he was getting calls from new hamburger drive-in operators asking for the same Multimixer that the McDonald brothers used.

When he saw the San Bernardino McDonald’s he knew. He also saw the potential of the new fast-food format even more clearly than did the McDonald brothers themselves. Kroc had experienced firsthand the market shifts that were creating an enormous opportunity for a new, convenient food service catering to automobile oriented suburban families.

Because of weakness in their franchising systems and limitations in their facilities most of the soft-serve operators had gone after only the ice cream trade of the drugstore soda fountains and had left the convenience food segment untouched. . . . Thus when Kroc saw his first McDonald’s he realized that it filled a huge void in the food service market. A McDonald’s could be opened for only $75,000, including building and land, which made it perfect for franchising. Kroc immediately saw the potential for expanding McDonald’s nationwide. Unlike the homebound McDonald’s, he had traveled extensively and he could envision hundreds of large and small markets where a McDonald’s could be located. He knew the existing food service businesses and understood how a McDonald’s unit could be a formidable competitor.

____________
Source: Love, J. (1986). McDonald’s: Behind the arches. New York: Bantam Books, pp. 36–40.

Consumer Experience. The second most common source of venture ideas is consumer experience. The need underpinning these ventures is typically acutely felt by the would-be entrepreneur. The entrepreneurs in these ventures are often enthusiasts with stringent demands, and they find that their demands are unsatisfied by existing products. In solving their own needs, they often find they satisfy the latent demands of a broader group of users.

Howard Head developed the metal ski because wood skis were too fragile for his skiing. After selling his company to AMF, he took up tennis and found that existing rackets were too unforgiving for his game, so he designed a racket with a larger sweet spot. Mark Thatcher developed the Teva sandal because there was no good footgear for river running (and rocky river beds): tennis shoes became waterlogged and heavy, while thongs slid off the feet and floated down the river. Ed Jarvis created the One Xcel sports visor after his son was blinded in one eye in a basketball game. His son still wanted to play ball, and Jarvis insisted on a visor, but found that standard visors scratched easily, tended to fog up on the court, distorted the view that players had of their opponents, and were uncomfortable, so he designed his own. Michael Dell realized that retail markup of PCs was 500% despite the fact that retail sales people lacked basic product knowledge (Inset 3.4).

Inset 3.4

Dell Computers (Michael Dell)

I bugged my parents repeatedly to let me buy my own computer and finally, for my fifteenth birthday, they agreed. . . . Once we pulled back into our driveway, I jumped out of the car, carried the precious cargo to my room, and with great relish, promptly took my new computer apart.

My parents were infuriated. An Apple cost a lot of money in those days. They thought I had demolished it. I just wanted to see how it worked. As had happened with stamps, my fascination with computers soon evolved from a hobby into a business opportunity. In 1981, IBM introduced the PC, and I soon switched from Apple to IBM. While the Apple had lots of games, at the time, the IBM was more powerful. It had software and programs for business usage, and although I didn’t have a lot of business experience, I had enough to know that this PC was going to be the choice for business in the future.

Eventually I save up enough money to buy a hard disk drive. I used it to set up a bulletin board system on which I exchanged messages with others interested in computers. And as I compared notes about PCs with other people, I found that there were real anomalies in the sales and markups of these machines.

An IBM PC typically sold in a store for about $3000. But the components could be purchased for around $600 or $700, and the technology wasn’t IBM’s. (I knew how much the components cost and who was making them because I was taking the computers apart and upgrading them.) That didn’t make a lot of sense to me.

Another thing that didn’t make sense was that the people operating the computer stores didn’t even know much about PCs. For the most part, they had previously sold stereos or cars, and thought that computers represented the next “big ticket” fad.

I knew the market would be huge. And I knew, based on my own experience as a user—and my limited experiences with customers (upgrading their computers in my dorm room)—that customers would become even more knowledgeable and demanding every year.

I started the business with a simple question: How can we make the process of buying a computer better? The answer was: Sell computers directly to the end customer. The $1000 required to capitalize a company in Texas was the extent of my initial start-up investment.

____________
Source: Dell, M., with C. Freidman (1999). Direct from Dell. New York: Harper Collins, pp. 6–12.

The advantage of consumer experience ventures is an acute need and in-depth understanding of its elements. The disadvantage is that the entrepreneur often works outside the industry and therefore lacks industry knowledge. Accordingly, he or she must learn from scratch about necessary resources and how to secure them. Furthermore, the entrepreneur must secure the resources without benefit of established industry relationships and reputation.

Imported Ideas. Another important source of successful ventures (a subset of the “other” category in Exhibit 3.7) is “importing” or replicating an idea that is successful elsewhere. Howard Schulz imported the idea for Starbucks from the ubiquitous coffee bars in Italy. Not only did they serve excellent espresso but they also served as public meeting places. Herb Kelleher imported the idea for Southwest Airlines in Texas from PSA airlines in California (Inset 3.5). Note that both these firms were more successful than the host firms they mimicked, so there is more to the importing strategy than simply moving an idea to a new location. Rather, each entrepreneur took the basic idea as a template, refined it, and tailored it to a new environment.

Inset 3.5

Southwest Airlines (Herb Kelleher)

Southwest Airlines was the brainchild of Rollin King, a San Antonio entrepreneur who owned a small commuter air service, and his banker, John Parker. Parker had complained to King that it was inconvenient and expensive to travel between Houston, Dallas and San Antonio and suggested starting an intrastate line . . . Houston, Dallas and San Antonio were experiencing rapid economic and population growth. They were also far enough apart to make travel by bus or automobile inconvenient. . . . King had studied another intrastate carrier, Pacific Southwest Airlines (PSA) in California. It was the perfect model. PSA was a successful intrastate airline operating in a state much like Texas—commercially booming, with cities far enough apart to make air travel an attractive alternative to cars and buses. On March 15, 1967, Kelleher filed the papers to incorporate Air Southwest Co. (later Southwest Airlines Co.)

____________
Source: Freiberg, K., &Freiberg, J. (1996). Nuts! Southwest Airlines’ crazy recipe for business and personal success. Austin, TX: Bard Press, pp. 13–15.

Researched Ideas. Finally, while in general venture ideas precede the decision to become an entrepreneur, in many cases the self-employment decision comes first. These entrepreneurs decide to take the leap (or are pushed), then decide where to land. This was true for Ben and Jerry, for Dan Pulos of S2KGraphics (Inset 3.6), and for the former managers in the outplacement study in Chapter 2. In some sense it is surprising that these ventures are successful at all since the entrepreneur lacks the industry experience and connections of the “prior employment” entrepreneurs, the strongly felt need of the “consumer experience entrepreneurs,” and the successful template of the “imported idea” entrepreneurs. These then are ventures where the entrepreneurs are truly extraordinary.

Inset 3.6

S2K Graphics (Dan Pulos)

Like Michael Bloomberg, Dan Pulos decided to become an entrepreneur while Kollmorgen was being acquired by Danaher Corp, leaving the merged company with two directors of acquisition. Dan took his silver seat belt (a stripped down version of a golden parachute) in search of a venture idea. Before initiating the search, however, he developed a list of criteria that would be important to him in any new venture in which he would be involved. These criteria were based on characteristics of his previous jobs that had appealed to him or not. There were 19 criteria on his list. These included

• Business-to-business

• Manufacturing, not service

• Some level of manufacturing sophistication or technology must be present

• Possesses a proprietary technology or process

• Service is very important to potential clients

• Quality is important to potential clients

• Small number of employees

• Teamwork and ethical behavior would be guiding precepts for his staff

With list in hand, Dan attended business expos, and met with business brokers. Ultimately he decided on a sign shop, similar to the franchise concept, FastSigns. The sign franchises were based on new plotter technology that allowed two-dimensional graphics (typically lettering) to be cut from sheets of vinyl, and then applied to vinyl banners, wood signs, or windows. This concept met all Dan’s criteria except for his desire for a proprietary technology. While the new technology employed in this process was available to all, the cost of the equipment was over $40,000, which created an effective barrier to entry for potential competitors. Dan figured he could live with that variance.

While there were several franchises offering sign shops, Dan knew he only needed the franchisor for startup assistance, so he didn’t want to be bound to long-term royalties, geographic restrictions and oversight. Dan conducted market research to identify the ideal location by looking for the greatest concentration of business currently being underserved by competitors (within an hour of his home). To learn more about the business, he visited a number of sign companies outside of his potential trading area that would not be competitors. He was particularly impressed with one firm [name must remain confidential] that appeared to be the best organized, was operating three separate retail locations and was enjoying success on many fronts. He approached them with an offer to pay them $10,000 in exchange for two weeks of on-site training, assistance in purchasing equipment & inventory and one year of unlimited consultation.

Today, S2K Graphics is one of the largest point-of-purchase companies in America and ranks within the top 8% of all sign companies for sales volume. It consistently tops $7 million in annual revenues, has won international awards for print quality, and is an approved supplier to some of the most prestigious names in the fast food, soft drink and business services industries.

Strategies for Finding Venture Ideas

We have identified the sources for the vast majority of venture ideas and have given you insights into general conditions that facilitate creativity and idea generation. We now translate the insights into specific strategies for finding venture ideas. We break these into long-term strategies (positioning yourself to be “struck” by an idea), medium-term strategies (how to conduct a search for venture ideas), and immediate strategies (finding an idea for the semester).

Long-Term Strategies. Venture ideas from prior employment, consumer experience, and importing share the feature that they occur unexpectedly. Somewhere in the course of performing your job, engaging in your hobbies, or otherwise executing your everyday life, you are struck by an obstacle (need) and are motivated to eradicate it (solution). Thus, strategies to help you find this class of venture ideas are ones that increase the probability of being struck.

The prior discussions on invention and creativity suggest a number of means for both increasing creative capacity and greater utilization of existing capacity.

1. Increase the variety and intensity of your experiences. This accomplishes two things. First, greater experience creates a better reference for what is normal, thus offering a better signal about what is abnormal (and worth paying attention to). Second, it increases the toolkit of potential solutions.

2. Suppress tendencies to ignore obstacles. Pay attention to them. Jot down the obstacles as well as random thoughts about how to tackle them. This practice develops a better connection between your subconscious, which tracks most activity, and your conscious, which acts on information. Gary Hoover, founder of Hoover’s online, as well as five prior ventures, has been recording venture ideas since he was a teenager. He currently has 70 ideas he is willing to share.[26] Remember the more ideas you generate the better the potential you will have and can identify ideas that are in the top 10%.

3. Engage in novel behaviors (creative capacity increases with use). Do new things, or do old things in new ways.

4. Seek out negative criticism and develop a tolerance for it.

5. Maintain a moderate degree of stress (if overstressed remove a commitment; if understressed add a commitment).

6. Carve out periods of solitude that allow your mind to wander. Some of these exist naturally: the shower, your commute, lectures/concerts.

7. Stay healthy (a means to forestall the decay in creativity as you age).

Medium-Term Strategies. If you have decided to become an entrepreneur within the next 6 months, you may not be allowing yourself enough time to be struck. In that case you may want to engage in an idea search. The easiest way to begin your search is to shop for existing businesses. One good means for getting a sense of the landscape is to attend a franchise fair (www.franchiseexpo.com). These franchise fairs are essentially trade fairs that match franchisor’s business concepts to prospective franchisees. While you might not want to become a franchisee because of the ongoing royalties or the corporate oversight, the fairs are useful in that they expose you to hundreds of business concepts within the course of a weekend. By perusing these concepts and paying attention to which appeal to you and which don’t, you develop a sense of what criteria are important to you in your new venture. With these criteria in mind you can join a franchise, mimic a franchise (see Inset 3.5) or buy an existing business.

Existing businesses are often advertised in the classified sections of local and national newspapers (particularly the Wall Street Journal) and business magazines (particularly Inc. magazine). The listings of privately held companies are typically handled by business brokers, although VCs will also broker businesses that fail to become initial public offering candidates. The listings of partial divestitures of public companies, for example, a former acquisition that never panned out, are typically handled by investment banks.

One often successful strategy for new ventures is acquiring an existing business with ongoing revenue streams, becoming immersed in its details, then using it as a platform you adapt to new opportunity. This was the strategy of Tom Monaghan, founder of Domino’s Pizza. In 1960, Tom bought DomiNick’s pizza in Ypsilanti, Michigan, for $500 and a $900 loan. The store was losing money from the start, but through trial and error Tom ultimately learned how to turn a profit. Today, Domino’s has 7,799 locations in 50 countries and $4 billion global retail sales.[27]

Immediate Strategies. If you need an idea within the next few weeks (for a class perhaps), then not only are you unlikely to be struck by an idea but you also don’t have much time to engage in search. In that case, there are some jumpstart strategies you can employ. These involve idea markets and brainstorming. Oddly, this form of jumpstarting will be a backwards version of the normal venture process in that the idea markets provide solutions and the brainstorming involves finding a market need to match the solution.

Idea Markets

A number of markets exist for licensing technology. For example, most universities maintain technology transfer offices whose job is to commercialize technologies developed by university faculty. Often these offices maintain Web sites listing the available technologies, such as www.ctt.upenn.edu for the University of Pennsylvania’s Office of Technology Transfer. For a sample technology posting, see Inset 3.7. The two challenges in licensing these technologies are (1) identifying a market need that the technology satisfies and (2) developing a physical implementation of the technology. Often, several needs can be addressed by a given technology. In a very interesting study, Scott Shane demonstrated that a single technology resulted in seven separate licenses each for a different application of the technology. In each case, the particular incarnation was derived from the prior experiences of the entrepreneur viewing the technology.[28]

Inset 3.7

Video Motion Capture From a Single Uncalibrated Image Stream

University of Pennsylvania researchers have developed an interactive tool that can be used to recover the motion of any articulated object from a video sequence acquired with a single uncalibrated camera. The system is based on a proprietary algorithm that has been developed for recovering the posture of articulated figures from single images (Penn Docket N2558). By selecting arbitrary markers in the initial figure, preferably at articulation points, the user can track the movement of the object throughout the entire video sequence and generate derivative images from it. Once the posture of the actor has been specified in the desired key frames, posture interpolation is used to fill in the object’s configuration in the intervening frames.

There are other markets for ideas. Presumably, these are the outlets for the ideas that inventors submit to 1–800 numbers offering to patent them. One such market is www.1000ventures.com/ten3_operations/Ten3_npif.html.

Finally, one innovative idea Web site is www.whynot.net, started by Ian Ayres and Barry Nalebuff (both Yale economists). (Incidentally, Barry Nalebuff is also cofounder of Honest Tea.) The Web site is an open-source approach to solving problems or to finding needs to match solutions.

Ideation

Once you have found a solution, the next challenge is finding a need. There are a number of “ideation” techniques for generating potential needs (and also for generating solutions if a need has been identified first). For the most part these techniques have been developed by practitioners, people in the business of generating new ideas, for example, those in advertising and new product development, rather than psychologists. Accordingly, there is limited “evidence” of their effectiveness. What this means is that psychologists have not conducted controlled tests of individuals’ creativity with and without use of the techniques. The techniques have, however, in many cases been tested by those who developed them. While we should be cautious in interpreting their results, because the developers have an economic interest in them, we should not reject them out of hand. Our approach is to discuss one well-known technique, brainstorming, and refer you to Web sites to investigate alternative techniques.[29]

Brainstorming[30] builds on three of the principles from our psychology discussion. First is the principle that greater opportunity for new combinations comes with breadth of experience. Brainstorming accomplishes this through use of a group. The second principle is that idea quality is driven by cumulativeness. This drives the brainstorming goal of having ideas build on prior ideas in the session. Finally, the third principle is that the best ideas require fermentation. This drives the one and a half-hour length of the session. Tests of brainstorming find that the number of ideas generated in the second half of a session are more numerous (78%) and of higher quality than those in the first half (much like the patterns in the careers of creatives).

One property of brainstorming that conflicts with the sociological studies is the rule of deferring judgment. Brainstorming is intended to be idea generation only. There is not supposed to be any evaluation of the ideas. Proponents of brainstorming argue that this increases output by 90%. The potential conflict is that the sociological work indicates that criticism leads to more novel ideas. The trade-off is thus between the principle that quantity leads quality versus the principle that criticism yields novelty.

Despite these concerns, brainstorming has achieved market acceptance. It is now a 50-year-old tool and continues to be popular today. A Google search of brainstorming yields 765,000 hits, plus two sponsored links to brainstorming tools.[31]

To conduct a brainstorming session, you recruit approximately 8 to 10 people immersed in the relevant domain and announce at the time of recruiting the purpose of the session. At the start of the session, you restate the problem and present the four basic rules:

• Criticism is ruled out

• Free-wheeling is sought

• Quantity is wanted

• Combination and improvement are sought

The process has two administrators: a moderator to manage the flow of discussion and a secretary to record the ideas. After announcing the rules, the moderator calls for suggestions and quickly recognizes raised hands. Ideas that build on previous ideas are announced with finger snaps and these have precedence over isolated ideas. The session continues for an hour and a half, which allows periods of inactivity (gestation), but ensures that the ideas generated during the gestation are recorded. The output is a list of ideas, which can then be evaluated for their feasibility.

EPIGRAPHS

The idea for Epigraphs came from some limitations of wallpaper. I had found a wallpaper to use in my library: Waverly’s Alphabet from their Renaissance collection. However, when I began estimating the amount of wallpaper needed, I noticed that the room was actually too “cut up” for wallpaper. In particular, there was ductwork that protruded along two of the walls, molding on some but not others, five windows, two large entry ways, and a fireplace. This meant that there would be lots of mismatching in the pattern, and tedious labor—almost no length of wallpaper could be applied without special cutouts. This problem defined the “need” for a new alternative.

Paint was an obvious solution, but I had grown attached to the look of the wallpaper. The next thought was that I could stencil letters of the alphabet on the painted wall. This took me in two directions. First, if I were daunted by the labor of wallpapering, I certainly should be more daunted by stenciling: what stencils, how many stencils, creating the stencils, and actually applying the stencils. The second direction was the expansive direction, “why be constrained by the repetition of wall covering?” Why not use whole quotes—favorite quotes from various sources? This implied hand-painting, which was far more effort than I was willing to expend.

I appeared stuck, so I quit thinking about the problem until one day when I was struck with the solution. What transpired in the intervening period was an incubation process. The incubation process of idea generation is often described as a garbage can approach.[32] At any given time you carry around a set of “needs,” such as how to decorate a wall, and a set of “solutions.” The set of solutions any individual carries is a function of prior education and experience. An “idea” is thus the matching of a need and a solution. In this case, the top of the head solutions were stenciling and hand painting, both of which were too labor intensive. The “Aha” solution was to take advantage of recent sign technology.

Because I had a friend who founded a sign company several years ago, I had fairly detailed knowledge of the technology. In particular, I knew that almost any graphic could be computer generated and cut from strips of self-adhesive vinyl. I could create a text file, choose a font and size, and the company could produce a set of quotes that could be applied to the wall. Thus, I could solve my own decorating problem, but since I was also working on the manuscript for this book, it occurred to me that perhaps this was an opportunity to solve similar problems of other consumers. This in short was the link between an individual problem and a venture idea.

SUMMARY

We began this chapter by explaining that having a proprietary idea is not very important to venture success. While idea quality explains very little of the performance differences between firms, the fact of the matter is you do need an idea to start a venture. This chapter was intended to help you find one. We did this in two ways. First, in the principles section, we discussed the psychological and sociological underpinnings of creativity. This was to provide a sense of the factors you could change to enhance your creativity. Next, in the processes section, we translated those principles into strategies. We discussed where venture ideas come from generally. We then offered three classes of strategies for finding your venture idea. These included long-term strategies for being struck with idea (the most common course), medium-term strategies of idea search for those who have decided to become an entrepreneur before discovering their idea, and jump-start strategies to find an acceptable idea within a few days. Finally, we described the idea generation process for epigraphs. Chapter 3 is the first step in assessing whether the idea you generate from this chapter is commercially feasible.

NOTES

1. Pauling, L. (1960). The nature of the chemical bond and the structure of molecules and crystals: An introduction to modern structural chemistry. Ithaca, NY: Cornell University Press.

2. Headd, B. (2003). Redefining business success: Distinguishing between closure and failure. Journal of Small Business Economics, 21, 51–61.

3. Klepper, S. (2002). The capabilities of new firms and the evolution of the U.S. automobile industry. Industrial and Corporate Change, 11, 645–666.

4. Borland, J. (2003, April 15). Victor: Software empire pays high price. CNET News.com, 4:00 a.m.

5. Gans, J., Hsu, D., & Stern, S. (2002). When does start-up innovation spur the gale of creative destruction? Rand Journal of Economics, 33, 571–586.

6. Collins, J., & Porras, J. (1994). Built to last: Successful habits of visionary companies. New York: HarperCollins.

7. Bhide, A. (2000). Origin and evolution of new businesses. New York: Oxford University Press.

8. Jerry Kaplan, founder GO Corp, former co-chairman Egghead.com, remarks to Wharton students, 2001.

9. Jesse True, domain Associates, remarks to Wharton Technology Ventures Conference.

10. MacMillan, I., & Narasimha, P. (1997). Distinguishing funded from unfunded business plans evaluated by venture capitalists. Strategic Management Journal, 8, 579–585.

11. www.moller.com/skycar

12. Rossman, J. (1964). Industrial creativity. New Hyde Park, NY: University Books.

13. Rossman, p. 9.

14. Rossman, p. 58.

15. Rossman, p. 61.

16. Usher, A. (1929). A history of mechanical invention. New York: McGraw-Hill, p. 28.

17. Benjamin (in Rossman, p. 70).

18. Hamilton (in Rossman, p. 105).

19. Miller (in Rossman, p. 104).

20. Miller (in Rossman, p. 104).

21. Lubow, R. E., & Gewirtz, J. C. (1995). Latent inhibition in humans: Data, theory, and implications for schizophrenia. Psychological Bulletin, 117, 87.

22. Carson, S., Peterson, J., & Higgins, D. (2003). Decreased latent inhibition is associated with increased creative achievement in high-functioning individuals. Journal of Personality and Social Psychology, 85, 499–506.

23. Baruch, I., Hemsley, D. R., & Gray, J. A. (1988a). Differential performance of acute and chronic schizophrenics in latent inhibition task. Journal of Nervous and Mental Disease, 176, 598–606. Baruch, I., Hemsley, D. R., & Gray, J. A. (1988b). Latent inhibition and psychotic proneness in normal subjects. Personality and Individual Differences, 9(44), 777–783.

24. Clark, R., & Rice, G. (1982). Family constellations and eminence: The birth orders of Nobel Prize winners. Journal of Psychology, 110, 281–287.

25. Viesti, C. (1971). Effect of monetary rewards on an insight learning task. Psychonomic Science, 23, 181–183.

26. archives.cnn.com/2002/BUSINESS/02/12/fsb.hoover

27. Sloane, J., Monaghan, T. (2003). Tom Monaghan Domino’s Pizza the pioneering pizza-delivery chain I Started almost didn’t make it out of the oven, Fortune Small Business Online September 1, 2003. Available at http://money.cnn.com/magazines/fsb/ fsb_archive/2003/09/01/350799/index.htm

28. Shane, S. (2000). Prior knowledge and the discovery of entrepreneurial opportunities. Organization Science, 11, 448–469.

29. For other tools, see www.innovationtools.com/resources/ideamgmt-details.asp?ContentID=80

30. Osborn, A. (1953). Applied imagination. New York: Scribner.

31. See, for example, www.brainstorming.co.uk/contents.html

32. March, J., & Olsen, J. (1976). Ambiguity and choice in organizations. Bergen, Norway: Univer sitetsforlaget.

PART II

Assessing Feasibility

CHAPTER 4

Industry Analysis

INTRODUCTION AND GOALS

Industry analysis is the first stage in assessing the feasibility of your venture. The goals of industry analysis are twofold. The first goal is to assess whether the industry will be hospitable to your particular venture. If so, and this is likely for most ventures, the subsequent role of industry analysis is to immerse yourself in the operational and competitive details of the industry. These details inform later decisions.

Up to 98% of firms involved in the creation of concentrated industries ultimately fail.[1] This kind of dramatic shakeout toward concentration occurred recently for Internet firms. While the Internet is more a distribution channel than an industry per se, the pattern of growth and shakeout in that sector resembled that of concentrated industries. The survivors in the Internet arena were firms who moved early in industries with classical “first mover advantages.” Two things should be noted here: one, first mover advantage doesn’t require moving first, and two, there are still transient opportunities for firms that ultimately fail. This chapter will help you understand whether an industry is likely to become concentrated, who is likely to survive, whether there are first mover advantages, and whether there is transient opportunity.

The chapter begins with a review of industry analysis techniques. In addition to the standard review, we discuss how the techniques can help identify entrepreneurial entry wedges. The discussion then shifts from principles to hands-on tools for gathering and analyzing industry data. Finally, we walk through data gathering and analysis for Epigraphs—to demonstrate that industry analysis is as much art as it is science.

PRINCIPLES

The most useful tool for assessing industry attractiveness is Porter’s Five Forces.[2] The Five Forces framework takes classical Industrial Organization (IO) economics, expands it, and turns it on its head. Whereas IO, taking the best interest of society as a whole, is concerned with minimizing anticompetitive structures, Porter recognizes that these same structures represent durable profit opportunity for firms. One way to frame IO and Porter’s work is to consider industries as being arrayed along a continuum, as shown in Exhibit 4.1, with perfect competition on the left-hand side, and monopoly on the right-hand side. Industries on the left earn zero profits; industries on the right earn monopoly profits. The vast majority of industries are oligopolies that lie somewhere between these extremes. The goal of IO is to identify those industries on the right-hand side and move them toward the left. The goal of Porter’s analysis is to determine where along the continuum an industry lies, as a means to assess the opportunity for supranormal (above cost of capital) returns.

EXHIBIT 4.1   Competitive Continuum

There is substantial empirical support for Porter’s prescription. For example, the 1987 Profit Impact of Market Strategy (PIMS) study[3] showed that the dominant predictor of accounting profits was market share. On average, each percentage point increase in share corresponded to a 0.56 percentage point increase in return on investment. A more recent study by Hou and Robinson[4] shows that firms in concentrated industries enjoy a 23.6% advantage in accounting profits (return on sales, ROS) over firms in competitive industries.

The irony is that while our dominant industry analysis tool, Five Forces, pertains to concentrated industries, less than 12% of firms are in such industries. The vast majority (76.4%) of firms are in competitive industries. The good news is that these firms are still profitable (11.0% ROS vs. 12.8% ROS for concentrated industries). The better news is that they actually have higher stock market returns (1.33% monthly returns growth vs. 1.09% for concentrated industries). A comparison of concentrated and competitive industries along these two dimensions is provided in Exhibit 4.2.

The points here are as follows: (1) There is lucrative opportunity outside concentrated industries. (2) This is a good thing because truly concentrated industries typically have entry barriers, which make them infeasible for entrepreneurial ventures. (3) The industries that are easiest to enter (competitive industries) exhibit higher growth rates. (4) Arguably, valuation growth is more important to entrepreneurs than are accounting profits. It certainly is more important to venture capitalists hoping to take ventures public.

Source: Hou and Robinson (2004).

Notes: All firms in both CRSP and Compustat (July 1963–December 2001). Size = stock price shares.

Concentrated industries and competitive industries are quite different. Indeed, Exhibit 4.1 treats them as polar opposites. Accordingly, we need separate techniques to analyze them. Despite the fact that concentrated industries are less prevalent, the tools for analyzing them are more fully developed. Accordingly, we will discuss them first using Porter’s Five Forces framework. Following that we provide some preliminary insights and tools regarding competitive industries.

Concentrated Industries: Five Forces Framework

Exhibit 4.3 lays out the Five Forces structure. The goal for each structural element is determining the extent to which that element has the power to limit profits of firms in the focal industry. The framework comprises two intersecting dimensions: a horizontal dimension that addresses scarcity and a vertical dimension that addresses competition. The primary issue in both dimensions is the ability of firms to maintain high margins: How strong are the forces driving price toward marginal cost?

The horizontal dimension of the framework examines the value chain— the sequence of activities comprising the conversion from raw inputs to final goods for the end user. The primary concern in examining the value chain is the extent to which other activities in the chain have the power to extract potential profits from the focal industry. This is largely an issue of relative scarcity—a sole source of supply (monopoly) or a sole customer (monopsony) has substantial bargaining power. A sole supplier may be able to charge its added value. Added value is the size of the pie when a player is in the game minus the size of the pie when the player leaves the game.[5] A sole customer may be able to force firms to price near marginal cost. While scarcity is the main factor in evaluating threats from the value chain, competition is also a factor. Suppliers may integrate forward to compete with you, while buyers may integrate backward to compete with you.

EXHIBIT 4.3   Porter’s Five Forces

The vertical dimension of the framework considers the level of competition. The main source of competition is from direct rivals in the focal industry (the center box). Porter, however, expands the notion of competition to include substitutes as well as potential entrants. Substitutes are similar products or services that customers can switch to if the prices in the focal industry become too high. Potential entrants refers to firms who could feasibly enter the industry. Analysis pertains not to the number or identity of those firms but rather to how attractive entry appears: Will profits remain high upon entry, and if so is there a means to enter? It is this expanded definition of competition (rivals plus substitutes and potential entrants) that needs to be considered in industry analysis.

The Five Forces framework provides a mechanism for organizing information about the industry. In part, this involves identifying the main firms in the focal industry as well as the adjacent industries (suppliers, buyers, and substitutes). Its real intent however is to infer the underlying economics affecting the way prices get set. This requires two things for each industry. The first is an understanding of demand: How large is the market? How steep is the demand curve? How similar is demand across the set of customers? Is this a durable good or a repeat good? Are there switching costs (or can they be created)? Are there complements?

The second major factor is industry technology governing its cost structure: Are there substantial sunk investments? What is the minimum efficient scale (MES)? What are the annual fixed costs? What is the marginal cost? What is the ratio between MES and demand? Once we understand these structural conditions we can analyze how likely it is that price will be driven to marginal cost.

The formal means for doing this for any specific set of conditions is game theory. Game theory is a tool for analyzing equilibrium strategies and outcomes in games of competitive interaction. Appendix 4.1 offers a primer on game theory for the classic games of industry competition. The primer takes a single demand curve and examines how the level of competition will vary with changes in cost, demand, and entry timing. The primer provides the intuition behind the general rules of competition we outline next. In Chapter 7, you will actually “solve” your own game via simulation. Thus, it is not necessary to understand game theory to design your venture. You do however want an intuitive sense of how changing the structure of competition changes the profitability of firms. We provide that intuition next.

Developing a Deeper Understanding of Structure and Behavior

We examine a series of market structures, beginning with the simplest structure, monopoly, and then proceeding to increasingly more complex structures. In all the structures firms attempt to maximize their profits by making decisions that take into account their beliefs about other firms’ decisions. We examine how the industry structures affect those decisions as well as the market outcomes. For each structure, we discuss what makes it distinctive, how firms behave, and the expected outcomes (price, output levels, and profits).

To make comparison easy, we use a single demand curve for all our structures. Remember that a demand curve is merely the relationship between price and demand. The principle behind a demand curve is that people differ in their willingness to buy your product. Some people love it and will pay handsomely for it. Others will only buy the product if the price drops substantially. High-definition televisions (HDTVs) are a current example of a product that is still high on its demand curve. While most people would prefer HDTV to their existing sets, they don’t see HDTV as being worth $2,500.

The particular demand curve we use throughout is Q = 120 − P, where Q is the total quantity of industry output and P is the price. For simplicity we will also assume that marginal cost and fixed costs are both zero.

Monopoly. A monopoly market is one in which a single producer faces the entire demand curve. The firm maximizes profits by choosing the level of output at which marginal revenue equals marginal price. The monopoly output for our demand curve, Q = 120 -P, is 60 units. (See Appendix 4.1 for details on how to find this level.) This output corresponds to a market price of $60 (120 - P = 120 - 60) and monopoly profits of $3,600 (P × Q = 60 × 60).

Monopolies are rare. Generally, the opportunity for monopoly emerges from underlying characteristics of the product or service. One such instance is a natural monopoly. A natural monopoly exists when there are high fixed costs and near-zero marginal costs. The underlying principle is that the fixed investments by the second firm are wasteful in that they cannot lead to lower unit costs. This is the case with most utilities. Once a company makes the infrastructure investments (water lines, cell phone towers), it is socially wasteful for a second company to duplicate those investments. In these instances, governments generally grant monopolies and then regulate prices.

A second instance is products or services with network externalities. A network externality exists when the value of a good to a customer increases with the number of other users of the good. A nice example of a market with network externalities is online auctions. eBay holds a near monopoly on consumer-to-consumer auctions because the price a seller obtains for a good increases with the number of bidders. Accordingly, each time someone considers selling on eBay versus a competitor, it prefers eBay because it has more users. Similarly, buyers know that sellers prefer eBay, and therefore if they only want to search one auction site to find a product, eBay is the one expected to have the largest set of offerings.

Finally, a local monopoly exists when local demand for a good is less than twice the minimum efficient scale (MES) for the industry’s technology and when the transportation costs to obtain the good elsewhere are substantial. The MES of a good is the smallest quantity at which the long-run average cost curve attains its minimum. Sam Walton’s initial strategy for Wal-Mart was one of creating local monopolies for discount retailing in rural towns. He chose towns that could support one discount retailer but were too small to support two. Wal-Mart’s strategy shifted only after it had exhausted these local monopoly opportunities.

Cartel. A cartel is cooperation among a group of producers to maximize industry profits by restricting output. In essence, a cartel is a group monopoly. The group as a whole faces the same decision as a monopolist. It attempts to maximize profits through choice of output. Since it operates as a single entity with multiple members, the cartel jointly produces the monopoly level of output. The firms in the cartel split the output, and each firm obtains monopoly price. For a two-firm cartel, each sells produces 30 units, sells at monopoly price of $60, and earns half of monopoly profits: $1,800. The classic examples of cartels are the Organization of Petroleum Exporting Countries’ (OPEC’s) oil cartel and DeBeers’ diamond cartel. The problem with cartels in the United States is that they violate antitrust laws. Even in instances where cartels are lawful, they are generally unstable, since each firm has an incentive to reduce price to capture the entire market. The notable exceptions to both the legality and the stability problems are the major sports franchises: the NFL, the NHL, the NBA, and MLB.

Since monopolies and cartels are rare, our main interest in them is establishing a reference for maximum profits. We therefore turn attention to the more likely scenario: oligopolies. The main analytical distinction between monopolies and oligopolies is that monopoly decisions are made without reference to other firms—they rely exclusively on the demand curve and the production function. For oligopolies, however, optimal pricing and output decisions depend not only on the demand curve and production function but also on assumptions regarding the behavior of other firms. We will treat four different oligopoly conditions: Bertrand competition, Cournot competition, Stackelberg competition, and Bertrand differentiation. For simplicity we treat competition between two firms (duopoly) rather than the general case of n firms. The basic intuition from the duopoly holds as the number of firms increases.

Betrand Competition.[6] In Bertrand competition, firms produce identical products and can’t commit in advance to a level of output. Under these circumstances, the sales distribution of the product is determined exclusively by its price. If one firm has a lower price than the other firm, then it captures the entire market. If both firms price identically, then the market is split evenly. This type of competition is characteristic of commodities, like wheat, cattle, and raw metals. In Bertrand competition, the equilibrium outcome is that both firms price at marginal cost, split the market output, and earn zero profits. For our example this means market price is $0 and each firm produces 60 units.

Bertrand competition is therefore the set of rules and behaviors that characterize what is typically referred to as perfect competition. Perfect competition is a market condition in which no buyer or supplier can affect market price. People tend to believe that to obtain perfect competition, a market needs a large number of competitors. Our example has shown that its main benefit (price equal to marginal cost) can be obtained with only two firms, so long as they offer identical products. Empirical studies of firms in rural markets have demonstrated this basic result for five “industries”: doctors, dentists, druggists, plumbers, and tire dealers.[7] Once a second firm has entered these markets, there appears to be very little competitive effect by the entry of additional firms.

Just as monopoly serves as best-case profits, Bertrand competition serves as worst-case profits. Accordingly firms want to avoid it. The remaining structures define conditions where firms can avoid Bertrand competition and therefore make positive profits. The challenge for your venture is determining if any of these conditions exist or can be created in your industry.

Cournot Competition.[8] In Cournot competition, firms can commit in advance to an output level. This structure would apply in settings where firms build manufacturing plants with fixed capacity, and it is costly to have excess capacity. Cournot competition assumes that firms move simultaneously to choose output (set capacity), and the sum of their output choices determines market price. Each firm recognizes its profits depend not only on its choice of output but also on that of the competitor. With our demand curve, each firm produces 40 units. This results in market price of $40 and profits for each firm of $1,600. These profits are lower than monopoly profits of $3,600 and profits for the two-firm cartel of $1,800; however, they are substantially higher than the zero profits of Bertrand competition.

The critical distinction between Bertrand and Cournot competitions is the Cournot assumption that firms can commit to output levels through investments in capacity. Thus, firms should earn positive profits even with identical products if the industry requires substantial capacity investments. This appears to be the case for chemical plants.[9]

Stackelberg Competition.[10] In Cournot competition, we assume that both firms move simultaneously in choosing capacity. This assumption of simultaneous moves can feel contrived. Generally, firms enter in sequence and later firms observe prior firms’ behavior before making their decisions. We want to examine what happens in those settings. Fortunately, we have a framework for doing so. In Stackelberg competition, the first mover chooses its capacity, and the follower gets to observe this decision before choosing its own capacity. The Stackelberg game allows us to examine the potential for first mover advantage. First mover advantage is a preferential market position that is sustained in the face of subsequent entry.

With our demand curve, the first mover chooses capacity of 60 units. The follower’s best response to that decision is to choose capacity of 30 units.

The corresponding market price for the combined market output of 90 units is $30. Accordingly, the first mover’s profits are $1,800, while those for the follower are $900.

A few things are interesting here. First, you might imagine that moving second is preferable to moving first. After all, you get to see what the first firm does and perhaps you can improve on that. The Stackelberg game tells us that this is not the case. The reason is that the first mover can anticipate what the best “wait and see” response is for each of its strategies. It then picks the first move that is most profitable taking all these responses into account. In so doing it preempts some of the follower’s opportunities. The second observation is the enormous advantage to moving first—the first mover captures twice the market of the follower and thus enjoys twice the profits. The third and perhaps most interesting observation is that Stackelberg output is the same as monopoly output. The first mover’s optimal preemptive strategy is identical to its monopoly strategy. Under Stackelberg competition there is no penalty for behaving like a monopolist. The only thing changing for the first mover after it is joined by the follower is that profits drop from $3,600 to $1,800. If there were fixed costs in this industry that exceeded the follower’s expected profits of $900, the follower would never enter. Then not only would the firm enjoy a first mover advantage, it would also have entry barrier allowing it to sustain monopoly output and profits without attracting entry. Remember that the structural feature supporting Stackelberg competition is the same as that for Cournot competition—substantial capacity commitments.

Bertrand Differentiation. In the games so far, the product is undifferentiated across firms, and customers’ tastes are assumed to be identical. Under Bertrand differentiation we maintain identical products and tastes but introduce switching costs as a means to achieve artificial differentiation between firms’ products. Switching costs are costs that customers incur by switching suppliers. The costs can be (1) real out of pocket expenditures, such as having to pay contract termination penalties to cell phone providers; (2) other economic costs, such as having to give all your friends the new cell phone number (in the days before number portability); or (3) they can be merely psychic costs—I keep the service I have because I know it’s tolerable, whereas I have doubts about any service I haven’t tried.

In this framework, customers randomly choose which of the two products to try first, but once they have tried a particular product, they slightly prefer it to the one they haven’t tried. To capture customer loyalty, we modify the demand function to include cross-price elasticity. Cross-price elasticity is the increase in demand for one product associated with a price change of another product. As an example, how much do sales of Crest increase when Colgate increases its price 10%. With the particular form of cross-price elasticity used in Appendix 4.1, we find that each firm chooses a price of $40. This results in output for each firm of 80 units and profits for each firm of $3,200—almost as high as monopoly and far better than the $0 profits of Bertrand competition.

This result explains why firms create loyalty programs (frequent flier miles) and long-term contracts, particularly for products that would otherwise be commodities.

Structure and Behavior Summary. We could continue to gradually expand the complexity of these games. However, most of the insights we wish to draw are already evident. In most markets, output, price, and product configuration decisions are interdependent. Moreover, the equilibrium values for firm output, market price, and firm profits vary substantially as the structure of technology and demand change. These differences are summarized in Exhibit 4.4.

The main insights are as follows:

1. Industries with undifferentiated products, where capacity can be expanded quickly and inexpensively (Bertrand competition) are likely to produce price competition and zero profits.

2. Having capacity constraints (Cournot competition) actually supports higher prices.

3. Product differentiation, either artificial (Bertrand differentiation) or through heterogeneous buyer tastes (Hotelling differentiation) evades price competition.

4. Moving first in settings with either capacity constraints (Stackelberg competition), switching costs, or product differentiation (Hotelling differentiation) can produce permanent share differences to first movers and sustainable profits for both the first mover and the follower.

5. In some cases, the monopoly choices of price, configuration, and output are also the best preemptive choices. In such cases there is no cost to behaving “strategically.”

You now have a fairly sophisticated understanding of how structure affects the behavior of firms and the potential for sustained profits. Whereas before you may have used rules of thumb (such as the number of rivals) to assess the level of competition in the industry, you now know that there are conditions in which industries are very competitive (no profits) with only two firms (Bertrand competition). You also see instances of numerous yet profitable firms (Hotelling differentiation). This level of understanding forces you to consider the structural characteristics (fixed investments, switching costs, customer tastes) that affect competition.

The Entrepreneur’s Paradox

The prior discussions reveal that the ideal industry from the standpoint of incumbents is one in which there is high growth, a small number of differentiated competitors, no close substitutes, high fixed costs with commodity inputs, and a mass market. The paradox from the standpoint of entrepreneurs is that a structurally attractive industry is one that almost by definition new firms cannot enter, that is, if they could do so profitably, so could anyone else, and thus profits should be driven to zero. Thus, an ideal industry from an entrepreneurial standpoint is one where there is either transient opportunity or where new firms can erect barriers behind them. As entrepreneurs we take a parallax view of industry analysis, trying to identify transient opportunity. To consider this we turn to the example of CDNow.

Industry analysis of CDNow at inception would conclude that Jason and Matthew Olim were entering an unattractive industry. This seemed evident even before the emergence of other music e-tailers. The conclusion was due to factors both in the competitive dimension and in the value chain dimension. In the competitive dimension there were no sunk investments in capacity and low fixed costs (the Olims themselves started in a basement with an initial investment of $1,500).[11] In addition, there were powerful substitutes including large music chains (Virgin, Sam Goody, Tower, and HMV) and record clubs (Columbia House and BMG). In the value chain dimension there were powerful suppliers. Major record labels each had monopolies over given artists and several had demonstrated interest and capability to integrate vertically. Virgin integrated backwards from retail sales into production, and Columbia integrated forward from production into retailing. While customers were numerous, they were well informed as to price. In fact, one of the first Internet shop bots was for CD prices. More important, however, the product was undifferentiated across retailers, and the market demand exceeded MES several times over. Thus in the long run, we would expect Bertrand competition such that price would fall to unit cost.

While music e-tailing was a classically unattractive industry (Bertrand competition), CDNow was a still a good entrepreneurial opportunity. CDNow was acquired by Bertelsmann in July 2000 for $117 million ($3.00 per share). Had the firm been acquired at the market peak, it would have obtained seven times that ($21.56 per share). Either amount represents a substantial return on the founders’ $1,500 initial investment.

What accounts for the transient opportunity? First, because CDNow did not hold inventory, it was able to create a broader product mix than existing retailers. This formed an initial basis of differentiation that attracted new consumers and created greater value for existing consumers (Hotelling differentiation). Second, CDNow created a new distribution technology with extremely low sunk costs (their initial investment was $1,500). Ultimately, they grew the capacity and functionality of the technology with the customer base, so what was once low-cost entry became very high cost entry (Bertrand competition to Cournot competition). However, the size of the market was so large that even with high sunk costs, the industry could still support multiple firms (demand is greater than two times MES). Finally, CDNow created a number of switching costs (Bertrand differentiation): (1) cookies that remembered customer credit card and shipping information so they didn’t have to reenter it for each transaction and (2) artificial intelligence programs that recognized customer tastes and recommended new albums. While large music incumbents could replicate this capability, the incumbents found that the cost to build their own technology and establish their own customer base was more costly than acquiring CDNow outright. Furthermore, acquiring CDNow reduced the set of rivals.

A Note on Complements

One important structural element of industry that is largely ignored by the Five Forces framework is complements. Complements are products/services whose sales positively affect and are positively affected by those of the focal product/service. The more people buy the complementary product, the more need they will have for the focal product and vice versa. Examples of complements are hamburger and hamburger buns, automobiles and gas stations, hardware and software, digital video discs (DVD) and DVD players, skis and bindings. Occasionally, products are their own complements. This is generally referred to as a network effect. What we mean by network effects is that users derive more utility from a given product as the number of other users increase. This is true for fax machines and e-mail. There is not much point in having a fax machine or e-mail if no one else does. Even products that don’t have obvious network properties can still exhibit network effects. The likelihood that someone will purchase a personal computer (PC) increases when family and friends have one. This is because they are able to see firsthand how to use a PC and what it is useful for. In addition, it provides someone to offer free training and advice when you run into difficulties.

Complements pose both opportunities and challenges to new ventures. The opportunity lies in the fact that there is a positive feedback loop by which sales of the complement increase the value of the focal product, which in turn increases focal product sales, and thereby the value of the complement. These higher sales for both the product and the complement lead to scale economies and learning that reduce the cost of each product and promote even higher sales.

The challenge posed by complements that is particularly acute for new ventures is one of critical mass. Until adoption of the complementary product has reached a particular level, customers have limited use for the focal product. Early adopters of video cassette recorders (VCRs) had to pay $100 for prerecorded tapes and had few alternatives to paying the $100 because the rental market had yet to be created. The markets for both VCRs and prerecorded tapes thus took some time to develop. Fortunately, an alternative use for VCRs, recording television programs for playback at a different time, provided some means to fuel early sales. This minimized the dependence of VCR sales on sales of prerecorded tapes. Once VCR sales took off, then so too did sales of the prerecorded tapes. Without the alternative use (recording television shows) for VCRs, neither market may have developed. We discuss some implications of complements in Chapter 8, Demand Forecasting, but for more comprehensive treatment of strategy in the face of complements, we recommend the book, Co-opetition.[12]

Not all industries have complements—in fact, most do not. The main point we make here is that complements, when they exist, will be the dominant factor in the industry. If your product does have a complement, and if that product is at an early stage of adoption, you probably want to treat the two products jointly in most analyses. For CDNow, CD players would be considered a complement. However, the player market was fairly mature at the time, thus the player market posed neither an opportunity nor a challenge to the venture.

Competitive Industries

The discussion so far has pertained to concentrated industries, but as we noted in the introduction these industries account for less than 12% of firms. We need a different set of tools for analyzing competitive industries. Note that we use the term competitive industries very differently than the classic description of zero profits. Remember from Exhibit 4.2 that even in the lowest concentration quintile, firms still earn profits, and more important, they have higher stock market returns than concentrated industries. It is clear that firms in these industries behave very differently than existing theory suggests. Accordingly we need new tools to guide analysis in these competitive industries. Unfortunately, there is less theory to guide us here than there is for concentrated industries.

What we have instead is rich description from two books that characterize behavior under innovation competitions: Porter’s Competitive Advantage of Nations and Saxenian’s Regional Advantage: Culture and Competition in Silicon Valley and Route 128,[13] followed by some preliminary theory and empirical evidence regarding the links between structure and behavior in these settings. Summarizing the discussion to follow, firms in competitive industries play by what we might call entrepreneurial rules. They have high levels of imitation (imitation is a viable entry wedge). This imitation erodes the competitive advantage of leaders. The erosion prompts leaders to innovate to restore the lost advantages, which in turn creates new sources of imitation.[14] These rules sound very much like Schumpeter’s creative destruction.[15]

In his book Competitive Advantage of Nations, [16] Porter asked the question, why do firms based in a particular nation come to dominate international markets in particular industries? To investigate the question, Porter and his team of researchers conducted in-depth case studies of more than 500 markets from 10 of the top trading nations. Each case study examined the history of competition in the market to understand the dynamic process by which competitive advantage was created. His primary conclusions from these case studies were (1) that competitive success requires either lower costs or differentiated products that command price premia. This prescription was the same as that from his 1980 book. His new insight was (2) that to sustain competitive success, firms must achieve more sophisticated bases of competitive advantage over time.

He synthesized his observations from the case studies by characterizing the attributes shaping the nature of competition and the pressure to innovate. The “four diamond determinants” of national advantage are (1) factor conditions, (2) demand conditions, (3) related and supplier industries, and (4) firm strategy, structure, and rivalry. The determinants in the diamond and their interactions shape the likelihood, direction, and speed of innovation.

The first determinant, factor conditions, is reminiscent of factor endowments in trade theory. The new insight is that it is not endowments of basic factors such as natural resources that matter for comparative advantage. Rather, it is the creation of advanced factors such as communications infrastructures. Indeed an abundance of basic factors may suppress incentives to invest in advanced factors. Demand conditions refers to the size, composition, and sophistication of local demand. While demand is also an element of classical trade theory, the conventional view is that a large domestic market stimulates investment. Porter’s view instead is that early saturation of a market is a stimulus to satisfying more sophisticated demand elsewhere. A diverse and sophisticated market of powerful buyers with stringent needs forces firms to perceive and satisfy new opportunity. Related and supplier industries determines the pool of technology on which firms in the focal industry can draw for innovation. The final determinant, firm strategy, structure, and rivalry is also the most important. Competition (the number of rivals) forces firms to create new advantages as fast as rivals replicate old ones.

The picture Porter paints is very similar to that in Saxenian’s book Regional Advantage: Culture and Competition in Silicon Valley and Route 128, which compares the clusters of electronics firms in Silicon Valley and along Route 128 outside Boston. Both clusters had similar origins in university-based research and cold-war military spending; both were the world’s leading centers of electronics innovation in the mid-1970s; and both lost considerable shares of their markets in the early 1980s (Silicon Valley lost its memory market to Japan; Route 128 lost its mini-computer market to personal computers and main-frames). Between 1986 and 1990, the two clusters diverged—the aggregate market capitalization of Silicon Valley firms increased at 25 times that of Route 128 firms; it generated 3 times as many new technical jobs, had twice the imports, and had 19 times the number of firms in the top 100 growth companies. Saxenian argues that what distinguished Silicon Valley from Route 128 was intense competition, shared learning through mediated relationships with suppliers and buyers, staying close to the customer to identify new trends and markets, and vertical disaggregation, which fueled reliance on a large and diverse set of suppliers, thereby exposing firms to the process of technical change outside corporate boundaries. In a conclusion very similar to that in Competitive Advantage of Nations, Saxenian argues that regions are best served by policies that help companies learn and respond quickly to changing conditions rather than policies that protect or isolate them from competition or external change.

While Porter and Saxenian both provide rich descriptions of innovation competitions, and while Porter outlines a “four determinants” framework for characterizing those competitions, both works fall short of making specific links between structural elements and firm behavior equivalent to the game theory of concentrated industries. Some recent theory picks up where Porter left off.[17] The theory models a Bertrand game of R&D investment by rivals with different marginal costs. Innovation is driven by erosion of past cost advantage by rival imitation. The “speed” of the resulting erosion-innovation cycle (equivalently the level of R&D investment) is affected by six forces. The first two forces pertain to rivals: Innovation intensity increases with the number of firms and the dispersion in firm cost. The second two forces pertain to demand: Innovation intensity increases with market size and price elasticity. The final two forces pertain to technology: Innovation intensity increases with ease of imitation (measured as output elasticity of the pool of rival R&D) but decreases with technological opportunity (measured as output elasticity of the firm’s own R&D). The reason ease of imitation increases innovation is that it causes faster erosion of leaders’ advantages and therefore forces them to innovate more rapidly. The reason technological opportunity acts counter to our expectations, decreasing innovation is that greater opportunity means firms don’t have to work as hard to restore lost advantage. These theoretical predictions have been demonstrated for the 25 most R&D intensive industries in the United States.[18]

Analytical Process Summary. You may note that the factors affecting firm behavior are similar across concentrated and competitive industries. Exhibit 4.5 is an effort to compare the factors and outcomes across the two settings. The exhibit uses Porter’s five force structure as a baseline then adds a sixth force, technology. For each force, the exhibit identifies both the profit predictions (P) arising from theories of concentrated industries, and the innovation/growth predictions (G) arising from theories of innovation competitions.

Looking first at rivals, the exhibit indicates that profits decrease with the number of rivals and increase with the diversity of rivals, whereas innovation/growth increases with both. Looking next at buyers, we see that profits and growth both increase with the number of buyers and their heterogeneity (price elasticity). Both profits and growth increase with the number of suppliers.[19] As noted in the discussion of five forces, substitutes and potential entrants are essentially means to expand the set of rivals, thus they behave similarly to rivals: profits decrease with substitutes while increasing with entry barriers. Conversely, growth increases with substitutes but decreases with entry barriers. Finally, we add the sixth force, technology. As noted in the previous discussion growth increases with the ease of imitation but decreases with technological opportunity (the effect of technology on profits is ambiguous).

EXHIBIT 4.5   Six Forces Analysis for Concentrated and Competitive Industries

ANALYZING YOUR OWN VENTURE

The analytical process for industry analysis involves rigorous mining of a wide array of secondary data. Fortunately, almost all of these data are available electronically with persistence. The data you gather will allow you to characterize the demand and cost structures for your industry. This assessment will be preliminary. The entire book will be refining these characterizations both because you come across better information and because you will be making decisions for your own venture that shape the industry at least in a small way. Our goal at this point is to determine whether entry is attractive and feasible given the preliminary characterizations. The process for analyzing your own industry involves four steps:

1. Defining the industry boundaries

2. Gathering raw data

3. Characterizing the industry graphically and quantitatively

4. Analyzing the potential for entry and sustained profitability

Defining the Industry Boundaries

Industry analysis is more art than science. Perhaps the most difficult challenge is defining the industry itself. For example, an entrepreneur who develops a new technology for skis, may question whether the relevant industry is skis, ski equipment, the ski industry (including resorts and apparel, as well as equipment), or sporting goods.

While there is probably value in examining each of the ski “industries” to get a sense of trends, the industry whose structure you would analyze is skis themselves. One means to assess where the bounds lie is to determine where cross-price elasticity is highest. Remember from an earlier section that cross-price elasticity is the impact of a price change in one product on the demand for an alternative product. Applying this notion to the ski example, ski apparel is probably outside the boundary: An increase in the price of ski jackets is unlikely to affect the likelihood I would buy Völkl skis. Equipment is closer: A substantial increase in the price of bindings may actually decrease the likelihood I buy skis at all. Bindings are complements to skis—neither is useful without the other. Other ski brands are closest—an increase in the price of Rossignol skis makes it more likely I will buy the Völkls.

In most cases, informed intuition, like the ski example we just outlined, ought to be sufficient to choose industry boundaries. The central question to ask in choosing the boundaries is “what products/services are a part of the customers’ choice set when they make the purchase decision?” While this is not always as simple as it sounds in industries with differentiated products, intuition is a good starting point. It can later be validated or refined by research.

In the case of the ski manufacturer, intuition would suggest that customers compare skis only to other skis in making their purchase decision—they don’t compare skis with boots, skis with resorts, or skis with jackets (even though all of these are subsets of the “ski industry”).

Gathering Raw Data

Much of the data needed for industry analysis are publicly available online. Where this is true, we have provided the URLs. Other data are publicly available but require subscriptions. Often these data will be available online through your university research library. If you are no longer a student, library privileges are usually available to alumni for a nominal fee. The general industry analysis process comprises nine steps.

Preliminary Steps

1. Naming the industry.

This is an important step because the name you use instinctively may not generate the set of rival firms you have in mind.

2. Try “googling” the name you think the industry should go by: “nameindustry” or “name market research”

Find the North American Industrial Classification System Codes (NAICS) used to designate your industry in the economic census and other large databases. www.census.gov/epcd/www/naicstab.htm

The Numbers

1. What are industry revenues?

www.census.gov/econ/census02/data/us/US000.HTM

2. What is the industry growth rate over the past few years?

Compare the data from the 2002 census (above) with data from the 1997 census. www.census.gov/epcd/ec97/us/US000.HTM

3. How many firms compete in the industry?

www.census.gov/econ/census02/data/us/US000.HTM

4. How profitable are they (what do their operating economics look like)? www.bizminer.com/index.asp (report available for a fee) “RMA Annual Statement Studies” (hard copy) Fleshing out the value chain

5. Identify the major competitors

www.zapdata.com (list of firms and their top level financials available for fee)

6. Characterize the buyers

This generally requires buying a market research report. To find them, try googling: industry “market research”

7. Characterize the distribution channels

“American Wholesalers and Distributors Directory” (hard copy)

Digging Deeper. Understanding what these firms really do and worry about

The first nine items allow us to flesh out the five forces. However, to make informed decisions about operating within the industry we need to understand the mechanics behind the raw numbers. We refine insights gained from the quantitative data, using market surveys, industry articles, and discussions with key informants

Market Research Companies. Most industries have industry associations and market research firms who conduct market research. The challenge in obtaining market research is knowing that it exists and from whom.

Industry Associations. Industry associations are valuable for a number of reasons beyond market research reports. They host annual meetings that provide information on the latest developments in the field, as well as opportunities to meet critical people. In addition, they generally produce journals that cover industry issues and trends.

Industry Articles. Perhaps the best means for developing a richer sense of an industry is to read articles in the trade journals or the business press. Industry articles should give you a better sense of norms, trends, developments, and common problems. Additionally, articles frequently identify key participants and consultants to the industry. Even advertisements provide valuable information flagging new products and identifying sources of supply.

Key Informants. At some point you will want to develop relationships with someone close to the industry. These experts are useful for clarifying remaining issues in the industry and for validating the conclusions you have drawn from secondary data. You can find such experts from the articles you have read and often through your school’s alumni network. Since these sources are providing information as a courtesy, you should develop a good understanding of the industry before you contact them. This focuses their valuable time on details not available in public sources and also demonstrates to them that you are serious.

1. Identify the main industry associations and journals

Try googling industry name association

2. Gale’s Ready Reference Shelf (hardcopy)

Identify the market research companies and analysts who cover the industry Try googling industry name market research

3. Green Book: International Directory of Marketing Research Houses and Services (hardcopy)

4. Find articles

Characterizing the Five Forces

Once you have gathered the raw data it is helpful to organize the main points in a single glance. This diagram will become your running record of the industry description. A straightforward way to do this is to flesh out the five forces diagram as we have done for Epigraphs in Exhibit 4.11. Insert all the important firm names and numbers in the appropriate block. You will update these basics as you gather additional data.

Feasibility Analysis: Is This industry Hospitable to Entry?

This analysis compares the industry cost structure with the demand structure to determine if you can enter at all, and if so, if there is a means for at least temporary profits. This analysis essentially compares your industry structure to those in Exhibit 4.5. To what extent does your industry exhibit characteristics that limit price competition or promote innovation and growth?

EPIGRAPHS

As mentioned in Chapter 1, we will be applying the tools in each chapter to a single case throughout the book: Epigraphs. Use of the single case is valuable for two reasons. First, it allows you to see how to use each tool. Perhaps more important, the Epigraphs example demonstrates over the set of chapters how a venture design evolves with new data and more refined analysis.

Defining the Industry Boundaries

The possible industry definitions are home decorating generally, wall treatments more specifically (paint and wallcoverings), or wallcoverings. Home decorating is far too broad as it includes furniture, kitchen remodeling, and so on. Even wall treatments are probably too broad, since the costs of paint versus wallpaper differ by a factor of 10. Accordingly, we define the industry as wallcoverings. Note we will pay attention to trends in all the industry definitions, but will restrict structural analysis to the wallcovering industry.

Gathering Raw Data

We follow the nine steps for gathering raw data.

1. Naming the industry.

Search on the term “wallpaper” ultimately led to the more common name for the industry classification, “wallcovering.”

2. Find the industry SIC codes (NAICS).

A search for “wallcovering” identified the manufacturers: 2679 Wallcovering: Paper, and the retailers: 5231 Wallcovering: Stores Retail. The new NAICS codes, which are broader are: 322222 for manufacturing, 424950 for wholesale, and 444120 for retail

3. What are industry revenues?

There are four major U.S. firms engaged in wallpaper manufacturing with a total wholesale value of $870 million.

4. What is the industry growth rate over the past few years?

At the top level NAICSs for wallcovering, retail revenues grew by 24.8% over 5 years (4.53% annual growth); wholesale revenues grew by 2.9% (0.57% annual growth); manufacturing revenues grew by 23.0% (4.23%)

5. How many firms compete in the industry?

There are four major U.S. wallpaper manufacturers (The number of manufacturers for NAICS 3222222, which includes many other types of coated paper is 541 firms with $11.8 billion revenues)

6. How profitable are they (what do their operating economics look like)?

Because the wallcovering industry is small, there were no ratio summaries of SIC 2679. As a substitute, we took the financial statements for the public firms found in step 3, and did our own ratio analysis (Exhibit 4.6). While these will be of greatest value later in informing operating decisions and generating operating economics, they are also important to industry analysis. In particular, ratios provide insight into the relative importance of inputs costs (materials cost ratio), the extent to which there are entry barriers (high fixed investment relative to marginal cost), or scale economics (significantly lower cost of goods sold [CGS] as firm size increases). Finally, profit ratios validate the results of our industry analysis. If we conclude an industry is attractive, it ought to exhibit high profit margins.

EXHIBIT 4.6   Comparison of Wallpaper Manufacturer and Retailer Ratios

Manufacturer

Retailer Chain

Income Statement Ratios

Sales

100.0%

100.0%

Cost of Goods Sold

60.2%

56.8%

R & D

1.5%

—

Sales, General % Admin

26.5%

32.4%

Depreciation & Amort

3.2%

—

Net Income

5.5%

5.5%

Operations Metrics

Inventory Turns

2.6

7.2

Performance Ratios

Return on Fixed Assets

48.7%

38.0%

Return on Equity

13.1%

15.9%

The ratios indicate that input costs are moderate to high (60% of sales) for the wallcovering manufacturer. Sales, general, and administrative expense (S&GA) is the other major cost element (26.5% of sales). The value of plant/property and equipment is low relative to sales, indicating that sunk investments are unlikely to serve as an entry barrier. The most salient element in the ratios is the inventory turns (2.6). On average, this particular firm is holding 4.6 months inventory. This is sizable. Not only does it imply large holding costs to finance the inventory, it also presents a substantial risk of write-offs from inventory obsolescence. If this ratio is truly representative, it appears that retailers are forcing manufacturers to hold inventory.

Industry profitability appears good. While return on sales is lackluster at 5.5%, the return on fixed assets is quite high at 48%.

7. Identify the major competitors.

The market leaders and their respective shares are given in Exhibit 4.7.

EXHIBIT 4.7   Market Shares of Wallpaper Manufactures

8. Characterize the buyers

Here, as in choosing industry boundaries, we needed to apply some intuition. Who is likely to buy wallpaper? Ignoring firms, and making the assumption that renters are unlikely to invest in renovations, the target market is owner-occupied households.

A search of U.S. census data revealed that there the number of owner occupied households is 63,544,000. It further revealed that annual painting expenditures by property owner were $6.5 billion growing at 12%.

These data are aggregate statistics of the market. Ultimately we want to know whom to target. To help with this, we augmented the online data with hard-copy data published in American Marketplace.[20] American Marketplace allows us to examine buying behavior as a function of consumer demographics. This is thus a first cut at segmentation data. As with the statistical abstract, there is no specific breakout for wallcovering. There are, however, data on home textiles, which is closer to wallpaper than is paint. We can compare the two sets of data to help refine estimates for wallpaper. These American Marketplace data (summarized in Exhibit 4.8) indicate that the dominant textile buyers are middle-aged married couples in the Northeast with incomes in excess of $70,000.

9. Characterize the distribution channels

A search identical to that in Step 3, for SIC 5231 found only one firm, Sherwin-Williams dedicated to paint/wallpaper (the firm also manufactures paint). The remaining eight firms sold building products more generally. Wallpaper is sold through three channels: paint/wallpaper chains, building supply/department stores, and independent retailers (through wholesalers). Shares of distribution through each channel are summarized in Exhibit 4.9.

EXHIBIT 4.8   Home Textile Customer Demographics

Source: From Heslop, J. (Ed.). The American marketplace: Demographics and spending patterns. Chapter 7: Spending patterns. Ithaca, NY: New Strategist.

10. Identify the main industry associations and journals

A search on wallcovering identified nine associations. A review of their Web sites revealed that the most promising was Wallcoverings Association (120 members). Its members include both manufacturers and wholesalers but exclude decorators and paper-hangers. Unfortunately, their only publication appears to be a membership directory, thus they weren’t a source of market surveys.

11. Identify the market research companies and analysts who cover the industry

EXHIBIT 4.9   Retail Shares of Distribution Channels

12. Find articles

A search on “wallcovering market” identified a number of articles. Review of those articles offered the following insights:

• Consolidation is taking place

• There is a trend toward licensing agreements with designer brands

• The industry is estimated at $1 billion but sales have been declining over the last 3 years at the rate of 7% per year

• Imperial Home Décor Group (IHDC) has 48% share

• Wallcoverings account for 6% of U.K. “Do-It Yourself” (DIY) spending

• U.K. DIY superstores account for 56% of wallcovering sales

• Wallcovering SIC is 267952

• Wallpaper stores is 523035 (6-digit vs. 4-digit SIC)

• U.K. customers are attracted to independent outlets because they expect it is less likely to see the same wallpaper in their neighbor’s house

• 10% of purchases are ordered from pattern books; 84% are sold from stock

• Independents share of the market is increasing at the expense of chains (U.S. estimate at 37.9%)

• “4500 books of Royal Doullon Collection Sold” raises question: Are pattern books sold to the retailers

• 90% of American walls are painted (rather than papered)

• Wallcovering industry estimated at $2 billion retail

• Attributes of wallpaper that lead to preference for paint:

Fear of hanging own paper

Confusing instructions

Poor merchandising

• Wallpaper designs are lagging behind other parts of home decorating industry

• Trend toward “coordinating wallpaper with other home decorating products (room in a bag) to create room themes (linens, drapes, etc.)

• High end doing well (this may be pattern books)

• Sidewall sales (whole walls) slipping at expense of border sales

• Borders now account for 50% of wallcovering sales

• Borders are inexpensive per room ($40) and easily applied

Key Informants

In addition to providing the information above, articles also identified industry consultants who might be used as key informants. We attempted to contact them after we had completed industry analysis using published sources. Unfortunately, the consultants we contacted were not interested in providing information for free. We had much greater success contacting manufacturers and retailers directly.

The main information we lacked was at the product level: What is the typical life cycle for a wallpaper pattern? What is the distribution of sales for wallpaper patterns? Through the key informants we learned the following:

• The life of a typical collection (set of coordinating patterns/colors) is 3 years.

• The minimum life cycle is 1 year; the maximum is 10 years.

• Sixty percent of a collection’s lifetime sales occur in the first year.

• Average lifetime sales for a collection is 7 million single rolls.

Combining this information, and doing some curve-fitting, yields the sales profile in Exhibit 4.10. The exhibit indicates sales for a new wallcovering peak in the third quarter following introduction.

In addition to the product details, the interviews provided information on general trends in the industry. Many of these corroborate information we had found publicly:

• Sales have been declining steadily over the past 10 years—both wallpaper and borders are out of style.

• The retail channel (bypassing wholesalers) is becoming more important to manufacturers because the margins are higher.

EXHIBIT 4.10   Wallpaper Sales Profile Over the Life Cycle

• Manufacturers are attempting to differentiate on service and availability. Therefore, they are

– Providing 24-hour delivery for book orders

– Pushing in-stock sales so the product is available when customers want it

– Accordingly, they are offering 30% discount to retailers for stocking a 24-roll minimum inventory

• Typical payment terms: Net 30.

Characterizing the Five Forces

Exhibit 4.11 fleshes out the five forces for the wallcovering industry using the secondary data we have gathered. We walk through each of these forces, discussing the data, and deriving conclusions.

Rivals. This appears be a mature industry of good size. The maturity conclusion is based on the recent steady sales decline (7% in each of the last 3 years) and the trend toward consolidation. Behavior of rivals does not appear to be particularly competitive. If the industry were competitive we would expect to see greater advertising expenditures (currently less than 1% of sales), and greater innovation. The fact that “the product was sorely lagging behind other home textiles in terms of trends” is evidence that there isn’t sufficient innovation. One of the reasons rivalry is likely to be suppressed in the industry is that the product is highly differentiated. There are hundreds of patterns, no two of which are perfect substitutes.

EXHIBIT 4.11   Wallcovering Five Forces

Suppliers. We don’t dwell on suppliers since the new product uses vastly different materials and technology than conventional wall coverings. The relatively low cost of materials in the wallcovering industry tends to suggest that suppliers have little impact on industry profitability.

Buyers. Consumers themselves have little power by virtue of sheer number (64 million households). The marginal value of a single customer is quite low. There is however, potentially some power in the distribution channel. The research indicates that there are roughly three channels for reaching consumers:

– Direct to paint and wallcovering chains (approximately 29% of output)

– Direct to chain department stores (approximately 33% of output)

– Through distributors to independent paint and wallcovering retailers (approximately 38% of output)

The relative balance between the various channels tends to suggest that no single channel is crucial to the success of a manufacturer. However, there are dominant players in two of the channels: Home Depot in the “department stores” and Sherwin-Williams in the paint/wallcovering chains. It is possible that there are also dominant wholesalers in the independent channel as well. The fact that retailers have to buy pattern books is some evidence of limited channel power. However, this should be offset by the evidence that the manufacturer holds large inventories.

Substitutes. The trade journal articles were the only source of information on substitutes. The dominant substitute is paint, “Approximately 90% of American walls are painted.” The other substitute is borders (a subset of the wallcovering industry distinct from “sidewalls”). Currently, 50% of wallcovering sales are borders. It is unclear whether border sales have increased total wallcovering sales to enhance what would have been painted walls or whether borders have cannibalized sidewall sales. The tone of the articles and the recent sales decline suggest the latter. Because borders are a subset of the wallcovering industry it makes little sense to consider them here as a competitive product. We will treat them later in perceptual mapping.

The main substitute is paint. To assess the power of a substitute we consider cross-price elasticity—to what extent does a change in the price of paint change demand for wallcovering. Since the prices are so widely divergent to begin with, it seems unlikely that demand for wallpaper is affected by a decrease in the price of paint. Paint is roughly $20 for 400 sq ft of coverage (exclusive of labor). In contrast, wallcovering is approximately $200 for the same coverage (exclusive of labor). This conclusion can be evaluated via primary market research. At the current prevailing prices, paint is not a close substitute for wallcovering.

Complements. One important complement to wallcovering is installation. While some segment of the market installs its own paper, a sizable portion hires paperhangers. Paperhangers are a critical element of the industry structure for two reasons. First, without paperhangers, some sales would never materialize. Second, buyers who don’t do their own installation, consider the combined cost of the product and installation when they make their decisions. In most cases, the cost of installation exceeds that of the product.

Epigraphs installation is different from wallpaper. In fact, the impetus for the product was to provide a less labor intensive alternative to wallpaper. Nevertheless, it is likely that some segments of the target market will not want to install the product themselves. Important issues for venture design then, are as follows: How large is this group? What alternatives exist for installation? How will these alternatives be priced?

Entry Barriers. The final consideration is entry barriers. To what extent are there factors keeping the industry profitable precisely because they preclude entry. The most likely barrier candidates are generally high fixed cost, significant scale economies or learning curves, early mover advantages in building brand, or control of scarce resources. None of these seem to be present in the wallcovering industry. Fixed costs are minimal (sales/fixed assets = 1,000%). Production scale economies also seem to be minimal (this makes sense given the fact that product variety is wide—if there were large-scale economies we would expect to see fewer wallcovering patterns). Branding does not seem to be terribly important given that advertising expenditures are low ( 1% of sales). It appears rather that consumers rely on the brand of the retailer for quality assurance.

The most scarce resource seems to be access to the distribution channels, but as mentioned previously, there are multiple channels.

Summary: Is This Industry Hospitable to Entry?

This question faces squarely into the entrepreneurial paradox. Is this an industry that is profitable to incumbents, yet accommodating to entrants? The preliminary conclusion to the analysis is that this is an attractive industry. There is limited competition among existing rivals, little threat from suppliers and buyers, and no close substitutes. Ratio analysis confirms this: ROS is 5.5%; return on fixed assets is 48%.

The paradox here is that there appear to be minimal entry barriers. Normally, the absence of barriers would tend to suppress industry profitability. The dominant entry barrier appears to be a relatively high minimum scale and scope of entry. Scope (variety of patterns) is required to make your offering attractive to retailers; scale is required to fill the distribution channels.

Thus entry into this attractive industry is feasible for large-scale ventures (a large firm play) or for small ventures that innovate around the distribution system. Some feasible innovations are forming an exclusive arrangement with a single chain, working through designers rather than retailers, or selling direct to consumers.

In designing the distribution system it is important to recall that 90% of sales are from stock; only 10% are from books. There is probably high correlation between the type of product, the type of sale (book vs. stock), and the distribution channel. For example, high-end papers may be sold predominantly from books, which in turn are sold predominantly by independents. Thus, the product characteristics will need to be consistent with the channel chosen.

CONCLUSION

This chapter introduced you to the first stage in assessing venture feasibility: industry analysis. Industry analysis aids venture design in two ways. The primary role is to assess whether the industry will be hospitable to your particular venture. The secondary role, and the one that actually weaves through the rest of your venture design, is immersion in the details of the industry. The chapter began with a review of industry analysis techniques. In addition to the standard review from strategy classes that focus on large corporations, we discussed how the techniques can help identify entrepreneurial entry wedges. The discussion then shifted from analytical principles to hands-on tools for gathering and analyzing industry data. Finally, we walked through the data gathering and analysis for Epigraphs—to demonstrate how industry analysis is as much art as it is science. The worksheet in this chapter allows you to repeat the analysis for your own venture. The next chapter continues the data gathering and analysis but shifts from use of secondary data to the collection of primary data on customer preferences.

APPENDIX 4.1: A Primer on Game Theory

This appendix provides some basic principles from decision theory and game theory to help you (1) understand the links between industry structure, firm behavior, and profitability and (2) find your own optimal behavior in any setting.

Firms in all markets attempt to maximize their profits by making decisions that take into account their beliefs about what other firms will do. In a traditional approach, referred to as decision theory, the manager making the decision treats the behavior of other firms as given. This approach is reasonable when the industry has been operating for a considerable period and there is not much strategic interaction between firms. However, you will be starting a new firm, possibly in a new industry, and therefore you want a method that takes into account how your behavior will affect the behavior of other firms and vice versa. This is the intent of game theory.

We begin our discussion by first defining specific demand and cost conditions that will be common across all these analyses. Keeping these conditions fixed allows us to focus on the influence of structure. Once we have defined the common conditions we introduce decision theory to examine monopoly behavior. Monopoly behavior serves as the ideal case which we use to compare the more likely cases of oligopoly. Oligopoly takes us from decision theory to game theory. Accordingly, we discuss the basics of games. We then use these basics to analyze four different competitive structures: Bertrand competition, Cournot competition, Stackelberg competition, and Bertrand differentiation. In each case, these discussions walk you through the process of choosing the optimal strategy. Thus one source of value from the appendix is illustrating tools to use for your own venture. The other source of value is intuition about what structural conditions will lead to each type of competition.

Conditions Common Across Settings

For purposes of comparing prices and profits across the market structures, let’s assume a specific aggregate demand curve that relates market price, p, to the combined output of all firms, q. Throughout we will assume that marginal cost, c, and fixed cost, F, are both $0. We will use the demand curve defined by Equation A.1.

Since firms behavior will be driven by a goal of maximizing profits, let’s remember that the basic profit equation for a firm i, expresses its profits, Π i, as the quantity it sells, qi, times its margin per unit sold, pi − ci.

Armed with the basic demand function and firm profit function, we will now examine how market structure affects profits. We begin with the very simple case of monopoly.

Decision Theory: Monopoly and Cartels

Monopoly. A monopoly market is one in which a single producer faces the entire demand curve. The monopolist may choose to produce at any quantity along the market demand curve, and that output decision will determine the good’s price. The monopolist’s goal, as with all firms, is to maximize profits. The firm does so by choosing a level of output. To determine what output the firm should choose, we substitute the formula for price from Equation A.1 into the general profit equation (A.2):

Since we defined marginal cost, c, and fixed cost, F, to be zero, and since firm i is the only one supplying the industry, the equation simplifies to:

To find the profit maximizing output, we need to take the derivative of profits with respect to quantity and set that equal to zero:

Thus the monopolist sets output at 60 units. If we apply that output level to Equation A.1 we see that market price = $60. We then insert the values for p and q into Equation A.2 to find that monopoly profits are (60 units × $60) = $3,600.

Cartel. A cartel is cooperation among a group of producers to maximize industry profits by restricting output. In essence a cartel is a group monopoly. The group as a whole faces the same decision as a monopolist. It attempts to maximize profits through choice of output. Since it operates a single entity with multiple members, the cartel chooses the monopoly level of output, which in our example is 60 units. The firms in the cartel then split the output, and each firm obtains monopoly price. If there are n firms with equal shares, the output of each firm in our example is qi = 60/n, and the profits of each firm are Πi = $3,600/n. Thus, if there are two firms, p = $60, qi =30 units, and Πi = $1,800.

Game Theory: Oligopoly

Under monopoly, price and output are perfectly circumscribed by the demand and cost curves. The profit maximization problem is therefore fairly straightforward. Monopoly (including cartels or joint monopoly) is the exception rather than the rule. Most industries are characterized as oligopolies. Here optimal pricing and product configuration decisions depend not only on the demand curve and production function but also on assumptions regarding the behavior of other firms. As we said previously, we will use game theory to guide our understanding of firm behavior under the various forms of oligopoly. Game theory is a tool to examine the decisions of firms in interactive games where outcomes depend not only on your decision but also on the decisions of other firms. There are four steps in analyzing any game.

1. Define the actions (strategies) of both firms. What is the decision the firm faces and what are the firms’ choices for that decision? In our context the firm will be choosing either an output level, q, or a price, p, for an industry with the demand curve in Equation A.1. The output levels and prices can be continuous.

2. Define payoffs for each firm for each scenario. What are the market shares and profits under each “strategy pair?” To obtain these you match each possible strategy for firm a, with each possible strategy for firm b, then calculate the market shares and profits that each firm would obtain.

3. Assess each firm’s best strategy for each strategy of its competitor. Examine all the possible outcomes for firm b, for a given strategy for firm a. Pick the best outcome. This is firm b’s best response to that strategy choice by firm a. Repeat this for all firm a strategies. This will define the set of firm b’s best responses. Once you have completed the best response exercise for firm b, find the firm a’s best responses for each of firm b’s strategies.

4. Determine if there are equilibrium strategies. A Nash equilibrium is a pair of strategies (a*, b*) such that each firm’s strategy is the optimal response taking the other firm’s strategy as given.[21] If a game has a Nash equilibrium, once firms reach it, they will have no incentive to change their strategies. The way to find a Nash equilibrium is to find the intersection between the firms’ best responses. We will be doing this for a number of market conditions.

A Nash equilibrium is like a physical equilibrium, in that it is a natural resting point for activity. One easily visualized example from physics is to imagine placing a ball inside the lip of a bowl. The ball will roll down one side of the bowl, then roll up the other side until it runs out of energy. It will then roll back toward the center and up the original side (but not to its original height) until it once again runs out of energy. The ball will continue in this fashion until it ultimately rests at the base of the bowl. The base of the bowl is its equilibrium state, its natural resting point. In our market setting the “ball” is price. It may fluctuate until firms understand the rules of behavior in the given market. Ultimately, if there is a Nash equilibrium, firms should find it, and once they do, prices and output levels should become stable (absent any outside forces).

We now examine some alternative market conditions that shape firm behavior. We will see how the equilibrium behaviors and outcomes for firms change over these conditions. For simplicity we treat competition between two firms (duopoly) rather than the general case n firms as we examine the various interpretations of oligopoly. The basic intuition from the duopoly holds as the number of firms increases.

Betrand Duopoly.[22] In Bertrand competition, firms produce identical products and can’t commit in advance to a level of output. Under these circumstances, the sales distribution of the product is determined exclusively by its price. If one firm has a lower price than the other firm, then it captures the entire market. If both firms price identically, then the market is split evenly. This type of game is characteristic of industries in which each firm has made substantial investments in capacity, and has relatively low marginal cost, for example, airlines serving identical markets with comparable schedules.

In a Bertrand game, the Nash equilibrium has both firms price at marginal cost: pa = pb = c and split the market. To demonstrate that this is the equilibrium, consider a situation in which firm a has price of $40, while firm b has a price of $41. All customers prefer to buy from firm a, thus firm a has profits of pq = p(120 − p) = $3,200, while firm b has zero profits. Thus b has an incentive to drop price to $39 leaving it with profits of $3,159, and with zero profits. This continues until neither firm has any incentive to lower price further: at p = c = 0.

Bertrand competition is therefore the set of rules and behaviors that characterize what is typically referred to as perfect competition. Perfect competition is a market condition in which no market participant can affect market price. Typically, people believe that to obtain perfect competition, a market needs a large number of competitors. Our example has shown that its main social benefit (price equal to marginal cost) can be obtained with only two firms, so long as they offer identical products. Empirical studies of firms in rural markets have demonstrated this basic result for five “industries”: doctors, dentists, druggists, plumbers, and tire dealers.[23] Once a second firm has entered the market there appears to be very little competitive effect by entry of additional firms. Firms want to avoid Bertrand competition. Accordingly, we examine the conditions and behaviors of other structures to see how they can accomplish this.

Cournot Duopoly.[24] A Cournot game is one in which firms can commit in advance to an output level. This would apply in settings where firms build manufacturing plants with fixed capacity (and it is costly to have excess capacity). The structure of a Cournot game assumes that firms move simultaneously to choose output (set capacity) and the sum of their output choices determines market price. Each firm recognizes its profits depend not only on its choice of output but also on that of the competitor. Thus it takes into account beliefs about rival output in determining its own output. What this means is that firm a considers what output levels firm b might choose as it makes its own output decision. To analyze its decision, firm a substitutes the sum of the two firms outputs for the market output q in Equation A.3:

This payoff function implies a reaction function, which is firm a’s best strategy against firm b, for the full range of output choices of firm b, qb. This reaction function is obtained by taking the derivative of Equation A.7 with respect to firm a’s choice of output, qa and setting that equal to zero:

We assume that firms a and b are identical. This means that firm b approaches its best response in an identical fashion to firm a. Thus, the two firms have the same payoff function and symmetric reaction functions. Accordingly, qb = (120 − qa)/2.

The Nash equilibrium is the pair of strategies at which each firm is responding optimally taking the other firm’s strategy as given. This occurs where the two reaction functions intersect. To find the intersection we solve the two reaction functions simultaneously, by substituting firm b’s reaction function for the value qb:

Thus, each firm chooses output, qa = qb = 40. This results in market price of $40 and profits for each firm of $1,600. These profits are lower than monopoly profits of $3,600 and profits for the two-firm cartel of $1,800; however, they are substantially higher than the zero profits of Bertrand competition.

The critical distinction between Bertrand and Cournot competitions is the Cournot assumption that firms can commit to output levels through investments in capacity. Thus we should find that firms earn positive profits even with identical products, if firms make substantial capacity investments. This appears to be the case in chemical plants.[25]

Stackelberg Duopoly.[26] In the Cournot game, we assumed that both firms move simultaneously in choosing industry output. This assumption of simultaneous moves can feel contrived. Often, firms observe one another and then make decisions. We might want to examine what happens in those settings. Fortunately, we have a framework for doing so. In the Stackelberg game, firm a chooses its output (or capacity) first, and firm b observes this decision before choosing its own capacity. To aid intuition in distinguishing between the two games, a Cournot game might be one in which two firms are racing to introduce identical products to market. In contrast, a Stackelberg game is one where a leader introduces a product, another follower firm then recognizes the value of the corresponding market, and enters with an identical product. The Stackelberg game allows us to examine the potential for first mover advantage.

The structure of the game is that firm a creates a market, and knows it will have a temporary monopoly, but it also recognizes that if the industry is attractive a second firm will enter. Accordingly, firm a considers the potential entrant’s strategy when it makes its capacity decisions. The way it treats firm b’ s behavior is to assume that firm b will choose the optimal strategy defined by the Cournot reaction function in Equation A.9. Here the reaction function is indeed a reaction function since firm b moves second and thus reacts to firm a’ s strategy. In the Cournot game, the reaction functions served more as anticipation functions. In the Stackelberg game, firm a incorporates firm b’ s reaction function into its anticipation function to find the optimal first mover strategy. What this means is that we substitute Equation A.10 for qb in Equation A.6, then take the derivative with respect to qa:

Thus qa = 60. Solving firm b’s best response to firm a’s output choice is obtained by substituting 60 for qa in Equation A.10:

The market price takes into account the combined output of both firms:

A few things are interesting here. The first observation is the tremendous advantage to moving first—firm a captures twice the output of firm b, and thus enjoys twice the profits. The second and possibly more interesting observation is that Stackelberg output is the same as monopoly output. Firm a’s optimal strategy under a monopoly is identical to its optimal preemptive strategy limiting the market of later entrants. Under this particular set of rules, there is no penalty for behaving like a monopolist. The only thing changing for firm a following entry by firm b is that profits drop from $60 under monopoly to $30 under Stackelberg duopoly.

Bertrand Differentiation. In all the games so far, the product is assumed to be undifferentiated and customers’ tastes are also assumed to be homogeneous. Here we introduce non-homogeneous (differentiated) products but keep the assumption of homogeneous customers. The simplest way to examine the impact of product differentiation is to modify the Bertrand game of price competition.

One way to model differentiation is through an assumption of customer loyalty. Think of two products that are essentially undifferentiated. Customers randomly choose which of the two products to try first, but once they have tried a product, they slightly prefer the known product to the unknown product (people tend to behave this way toward their utility suppliers since they don’t want to risk having their service interrupted). To capture customer loyalty, we modify the demand function, so that customers trade-off the price of the preferred product to that of the alternative product, that is, there is cross-price elasticity. Because we have customer loyalty, the coefficients on the prices differ:

We find each firm’s reaction function as we did for the Cournot game, except that here we are using pricing strategy rather than output strategy, so we maximize each firm’s profit function with respect to price:

The Nash equilibrium is the pair of strategies at which each firm is responding optimally taking the other firm’s strategy as given. This occurs where the two reaction functions intersect. Thus we solve the two reaction functions simultaneously:

Thus, each firm chooses price, p = $40. This results in output for each firm of 80 units and profits for each firm of $3,200—far better than the $0 profits of Bertrand competition without differentiation.

Summary. We could continue to gradually expand the complexity of these games. The next most logical step would be to introduce heterogeneous customers through a model of spatial competition.[27] However, most of the insights we wish to draw are already evident. The main conclusion we draw from consideration of pricing and product configuration under various industry structures, are that in most markets, output, price, and product configuration decisions are interdependent. Moreover, the equilibrium values for firm output, market price, and firm profits vary substantially as assumptions about the rules of competition change. These differences are summarized in Exhibit 7.1.

The main insights (also contained in main text of Chapter 7) are as follows:

1. Industries with undifferentiated products, where capacity can be expanded quickly and inexpensively (Bertrand competition) are likely to produce price competition and zero profits.

2. Having capacity constraints (Cournot competition) actually supports higher prices.

3. Product differentiation either real (Hotelling differentiation) or artificially constructed through switching costs (Bertrand differentiation) suppresses price competition.

4. Moving first in settings with either capacity constraints (Stackelberg competition) or product differentiation (Hotelling differentiation) can produce permanent advantage.

5. In some cases the monopoly choices or price, configuration, and output are also the best preemptive choices. In those cases there is no cost to behaving “strategically.”

These games are quite stylized and provide us with general insights. The next challenge is to apply the tools we have just illustrated as well as the insights to your venture. The analysis section of Chapter 7 does that for Epigraphs using real data on demand.

NOTES

1. See Klepper, S. (1996). Exit, entry, growth and innovation over the product life cycle. American Economic Review, 86, 562–583; Klepper, S. (1999). Firm survival and the evolution of oligopoly. Working Paper, Carnegie-Mellon University.

2. Porter, M. (1998). Competitive strategy: Techniques for analyzing industries and competitors. Boston: Free Press.

3. Buzzell, R. D., & Gale, B. T. (1987). The PIMS principles: Linking strategy to performance. Boston: Free Press.

4. Hou, K., & Robinson, D. T. (2006). Industry concentration and average stock returns. Journal of Finance, 61, 1927–1956.

5. Brandenburger, A. M., & Nalebuff, B. J. (1996). Co-opetition. New York: Doubleday.

6. Bertrand, J. (1883). Theorie Mathématique de la Richess Sociale. Journal des Savants, 499–511.

7. Ibid.

8. Cournot, A. (1838). Recherches sur les Principes mathematiques de la Théorie des Richesses. English edition. In Bacon, N. (Ed.). (1897). Researches into the mathematical principles of the theory of wealth. New York: Macmillan.

9. Lieberman capacity paper.

10. Von Stackelberg, H. (1934). Marktform und Gleichgewicht. Vienna, Austria: Julius Springer.

11. Grossman, J. (1996). Nowhere Men. Inc., June 1996, pp. 62–69.

12. Brandenburger & Nalebuff (1996).

13. Saxenian, A. (1996). Regional advantage: Culture and competition in Silicon Valley and Route 128. Cambridge, MA: Harvard University Press.

14. Knott, A., & Posen, H. (2005). Six forces? Analyzing Porter 1990 Innovation Competitions.

15. Schumpeter, J. (1942). Capitalism, socialism and democracy. New York: Harper.

16. Porter, M. (1990). Competitive advantage of nations. New York: Free Press.

17. Knott, A. M. (2003). Persistent heterogeneity and sustainable innovation. Strategic Management Journal, 24, 687–705; Knott, A. M., Wu, B., & Posen, H. (2005). Spillover asymmetry. Working paper.

18. Knott & Posen (2005).

19. This result comes from Porter’s and Saxenian’s work rather than the formal model.

20. Heslop, J. (Ed.). (1997). The American marketplace: demographics and spending patterns (3rd ed.). Ithaca, NY: New Strategist.

21. Nash, J. F. (1950). Equilibrium points in n-person games. Proceedings of the National Academy of Sciences, 36, 48–49.

22. Bertrand (1883).

23. Bresnahan, T., & Reiss, P. (1991). Entry and competition in concentrated markets. Journal of Political Economy, 99, 977–1009.

24. Cournot (1838).

25. Lieberman capacity paper.

26. Von Stackelberg (1934).

27. Hotelling, H. (1929). Stability in competition. Economic Journal, 39, 41–57.

CHAPTER 4 WORKSHEET

Industry Analysis

1. What industry best captures the proposed product/service? ___________

2. What is its NAICS code? ___________

3. What were the total industry revenues in the past year? ___________

4. What is the growth rate in industry revenues over the past few years? ___________%

5. How many firms compete in the industry? ___________

6. Identify the five largest firms:

7. Who buys the industry’s product/service:

a) Are the customers consumers or businesses?___________

b) If businesses (list the industries that purchase the product/service):

c) If consumers (how do sales vary over demographic segments that purchase the product/service):

8. Through what channels is the product sold to customers?

*If this channel is the only intermediary between the primary industry and the customer, then stage = 1; if product passes through one earlier intermediary, then = 2.

9. Identify the main industry associations and journals

10. What market research companies/analysts cover the industry?

11. Characterize the financials of firms in the industry:

The remaining information is obtained from industry articles:

12. Distribution of product price at final customer:

Minimum: ___________ Maximum: ___________ Mean: ___________ Std Dev: ___________ Median: ___________

13. What are the closest substitutes to your industry’s product/service:

14. Are there any complements to your industry’s product/service:

15. What are the main inputs to your industry’s product/service:

16. Given all the above, what do you see as the main entry barriers to the industry?

17. Identify any trends, insights gained from your research that is not captured above. List source for each.

CHAPTER 5

Perceptual Mapping

INTRODUCTION AND GOALS

Perceptual mapping is the second stage in the feasibility analysis of your new venture. Perceptual mapping is a tool to characterize the way customers view your product/service offering relative to competing or substitute products. The goal of the mapping exercise is to determine if the proposed product satisfies a clear but currently unmet need. Thus, while industry analysis assesses whether the industry is hospitable to entry generally, perceptual mapping determines whether your particular product offering is a viable entry wedge.

Perceptual maps are important in correcting two of the most common flaws venture capitalists see in business plans: “solutions in search of a problem”—identifying an interesting idea but never assessing whether anyone has need for it—and “viewing the world through a single pair of eyes”—relying on your own intuition. Perceptual mapping corrects these flaws by forcing the entrepreneur to understand as completely as possible the customers for the intended product or service: What products will customers compare with yours? What dimensions do they use to compare products? Where does your product or service rank along each dimension? By creating a map of customers’ perceptions, you can identify “position gaps” where there are customer needs or preferences but no product satisfying them. These position gaps represent entrepreneurial opportunity. The particular opportunity you choose becomes your product’s “core benefit proposition.” Thus, perceptual maps can identify opportunity or confirm that a proposed product satisfies a clear but currently unmet need.

The chapter actually introduces two tools: the perceptual map itself and focus groups—the technique used to gather the primary data from which the perceptual map is derived. Perceptual mapping thus begins our immersion into using primary data. Secondary data (as was used for industry analysis) are very important and should always be the starting point for investigation since the data are free. However, somebody else collects these data sets (usually for some general purposes), and thus, the data can’t answer questions specific to your venture. Secondary data will not tell you how potential customers view your particular product or service.

The chapter begins with a discussion of the principles underlying perceptual maps and focus groups. Next, it describes the processes for conducting focus groups and translating that data into perceptual maps. Finally, it discusses the application of these tools to Epigraphs and the insights gained from that exercise.

PRINCIPLES

Perceptual Maps

Perceptual mapping is a tool characterizing the competitive space—where a particular product lies relative to competing products or substitutes. The critical elements of a perceptual map are the dimensions—“What are they, and how many of them are there?”—and the location of competing products along those dimensions. While the issue of proximity between products is important, probably the greatest value of perceptual maps is defining the actual dimensions along which products are compared.

You could probably derive a perceptual map using secondary data and intuition. However, doing so poses the risks that your intuition is skewed or that the secondary data exclude the dimensions providing the greatest opportunity. In fact, entrepreneurship is often the discovery of a new dimension on which customers can evaluate a class of products. Fuel economy, for example, surfaced as a new dimension on which automobiles were compared during the fuel crisis in the late 1970s, and it is resurfacing with the recent oil crisis. Frequent flier programs were introduced by American Airlines in 1981 as a new dimension along which to compare airlines (originally just airlines that had them [American] vs. those who didn’t). Because secondary research is likely to be constrained by extant dimensions, we strongly recommend using primary research to generate perceptual maps. In particular, we recommend using focus groups.

Focus Groups

Focus groups are a qualitative research technique comprising in-depth interviews of a small group of individuals brought together in a single location.[1] Focus groups, like most qualitative research, are an exploratory technique. The goal is to explore customer opinion by listening with an open mind. The interview itself is an “unstructured-undisguised” research format, meaning that the purpose of the study is clear but that the responses are open-ended. This is in contrast to quantitative techniques, such as conjoint analysis, which we discuss in Chapter 6. In conjoint analysis and other quantitative techniques, the research format is structured and the goal generally is to confirm or refute hypotheses. While focus groups may confirm preconceptions, their real value, and the real fun, is in surfacing surprises.

Focus groups are an outgrowth of the group methods that became popular in the 1960s, such as the brainstorming[2] technique we saw in Chapter 3. The primary advantage of group methods over individual idea generation or opinion elicitation is the opportunity for snowballing—statements by one individual in the group trigger ideas in several others. In brainstorming, for example, there is an exponential increase in the number of ideas generated as a function of time. Furthermore, the increase in quantity produces an increase in quality—the last 50 ideas are generally better than the first 50 ideas.[3] These ideas might remain latent in a one-on-one interview where individuals are more likely to remain within a single train of thought. Similarly, focus groups provide greater breadth of ideas since they are coming from individuals with different perspectives.

In addition to focus group advantages in triggering ideas, there are advantages in having the triggered ideas expressed. In one-on-one interviews, often interviewees are concerned with maintaining a favorable image in the eyes of the interviewer. Thus, they may suppress ideas that could be viewed unfavorably. In a group situation, participants learn that their ideas are similar to those of peers and thus are more forthcoming with those ideas.

There is, however, an ongoing debate on the efficacy of focus groups versus a series of one-on-one interviews. In general, the number of ideas generated by each technique is a function of the number of interviews, but there are diminishing returns to each new interview. Griffin and Hauser estimate that the first seven interviews will elicit 60% of user needs, while the next seven interviews will only elicit another 20% of user needs (Exhibit 5.1).

EXHIBIT 5.1   Diminishing Returns to Interviews

Source: Griffin, A. J., & Hauser, J. R. (1993). The voice of the customer. Marketing Science, 12, 1–27.

The issue in comparing focus groups with one-on-one interviews is whether a 2-hour focus group with seven individuals is comparable with seven 1-hour one-on-one interviews. On the one hand, each individual in a focus group has only 15 minutes of airtime (1¾ hours/7). On the other hand, the focus group allows participants to think much of the time and speak only when their ideas reinforce or deviate from the group. It is likely that many ideas expressed in the first 30 minutes of one-on-one interviews are redundant across interviews. Focus groups avoid this redundancy. Additionally, the interviewer takes up more airtime in a one-on-one interview than does a moderator in a focus group. While one study[4] has compared the relative efficiency of focus groups versus one-on-one interviews and found that a 2-hour focus group is equivalent to two 1-hour interviews, this result is from a sample of one. My own experience, albeit invalidated, is that number of people interviewed, rather than number of hours, is the main factor driving the curve in Exhibit 5.1.

Core Benefit Proposition

The main output of the perceptual mapping exercise will be your definition of the opportunity in the marketplace. This opportunity will be defined by the unmet needs of the target market—locations in the perceptual map where there is demand, but for which there is no existing product or service. We call this unmet need the “core benefit proposition.” The core benefit proposition is a concise statement of the set of dimensions that you will offer to the customer in your new product/service.

PROCESS

Designing and Conducting Focus Groups[5]

Generally, focus groups consist of 8 to 12 recruited participants from a fairly homogeneous group. With less than 8 members, there is a greater chance that a single individual will tend to dominate the discussion; with more than 12 members, participants will have too little airtime and will tend to become bored. The reason you want a homogeneous group is to be able to distinguish the range of perspectives within a customer segment from fundamental differences across segments.

Participants are generally selected from a sample of a particular target segment and are typically paid a $50 to $200 honorarium. While the source list from which names are identified is the first screen, a “screening phone interview” ensures that participants match desired demographics and weeds out individuals with extensive focus group experience (who tend to be dysfunctional) and friends or relatives of other participants. See Exhibit 5.2 for a sample screening script.

The participants are brought together in a central location for 1½ to 2 hours. Sessions are typically videotaped for later analysis and often are conducted behind a one-way mirror so that other members of the venture team can observe the session. The moderator is the key to a successful session. While the moderator works from an outline, such as that in Exhibit 5.3, the real moderator skill is in eliciting a broad range of opinions from the participants. To do so, the moderator must create a permissive attitude yet keep discussion focused on the objective. The moderator must probe for the depth behind espoused views, “What do you mean by . . . ?” “Describe the feeling . . . .” The moderator must be flexible in allowing the discussion to go in unexpected directions and must secure the involvement of all participants, but in a nonthreatening way. Finally, since the real value of focus groups over one-on-one interviews is snowballing, which will elicit latent thoughts; the moderator must stimulate interaction among group members rather than conduct a series of concurrent interviews.

EXHIBIT 5.2   Epigraphs Screening Guide

Screener for Designers’ Focus Group

Hi my name is _____________ and I am calling from The Wharton School at the University of Pennsylvania. We are testing a new product concept with a group of interior designers who fit a specific profile, and we were wondering if you would be willing to participate in the test. It would require you to join us and approximately 8 other designers like yourself and to share your experiences with wall coverings such as paint and wallpaper. The session will be held at Wharton, last approximately 2 hours. We will compensate you with $100 for your time. Are you interested?

Check the line:

Yes ______

No ______

(If so, continue. If not, thank the person for his or her time.)

Great! As mentioned, we are looking for consumers who fit a particular profiles, so I must ask you some questions to see if you qualify.

1. Do you make wallcovering decisions for your clients?

Yes ________

No ________

(If so, continue. If not, thank the person for his or her time.)

Great! The focus group will be held at on in Steinberg-Dietrich Hall, which is accessible from either Spruce or Walnut between 36th and 37th streets in the middle of the University campus. There are several parking lots around the campus. The most convenient one is on Walnut and 38th.

May I please have your full name and address:

_______________________

_______________________

_______________________

I look forward to meeting you on the _______________________________

The session typically begins with broad open-ended inquiries such as asking the participants to describe how the product is used, describe the most recent purchase experience, enumerate likes and dislikes, or speculate about unmet needs. When using focus groups to develop a perceptual map, we also recommend use of a partially structured technique, such as “repertory grid.”[6] Repertory grid is a technique aimed at developing customers’ perceptual encoding schemes through discussion of similarities and differences among products/brands. The technique consists of printing the names of all pertinent products/brands on cards. The moderator selects three cards at random and asks the participants to think of ways in which any two of the cards are similar and the third is dissimilar. The process is repeated with new sets of three cards until no new dimensions are elicited. Participants are then asked to rank the remaining products/brands along all the dimensions.

EXHIBIT 5.3   Epigraphs Moderator’s Guide

MODERATOR’S GUIDE FOR FOCUS GROUP

Objectives

• Understand the attributes important to designers in selecting wallcovering for clients

• Understand the relative importance of these attributes

• Understand the level of satisfaction with current product offerings

• Assess the designer acceptance of the new product concept

• Test price point of product

Process

Brief Introductions. Name; brief story about last time-specified wallcovering, including what was specified, how it was selected, and how it was installed; approximate price (for materials and installation); and where in the client’s house/facility it was installed (write onto flip charts).

Discussion of Attributes. Based on stories, ask participants why they made their selections. (What was the need? What was important to them in making their purchase decisions? Why did they choose paint vs. wallpaper? Try to pull out as much information as possible unaided. When group seems to run out of ideas, go into brainstorming: dissatisfaction/satisfaction with their experience. Excursion . . . The client was satisfied when . . .).

Sort/List Attributes. Have each participant rank order the attributes with 100 points.

Gap Assessment. Brainstorm creative ideas to address gaps in current market: I wish . . .

Product Concept. Introduce product concept. First in words, then show prototype. Get initial reactions.

Channel/Price. Where would they learn about the product? How much do they think it should cost.

Appendix 5.1 is the actual transcript from the Epigraph’s focus group, which included the use of repertory grid. This transcript forms the raw data from which the perceptual map is developed.

Two cautions are worth mentioning at this point. First, in some settings, particularly dispersed commercial markets, focus groups may not be feasible. Second, even when subjects are local, it takes some time to recruit them. You may need to call 10 to 20 people to find one person able to participate at the appointed time.

Given the time constraints of a semester, you may need to consider the following alternatives to conducting your own focus group:

1. Hiring a professional facility. These are listed under Market Research in the phone directory. Alternatively, you can consult www.focusvision.com for a network of 140 independent facilities that support international video conferences.

2. Conducting the focus group online through a chat room. While you will lose the interpersonal dynamics, these are fairly easy to facilitate. You may want to take part in someone else’s before coordinating your own. To do so, consult the online focus groups at www.surveysite.com.

3. Finally, you can conduct a series of in-person or phone interviews. While you will lose snowballing, you may pick up more depth in each perspective.

Constructing Perceptual Maps

Exhibit 5.4 is a table of product attributes for small sedans. It compares models of small sedans along a number of dimensions identified in Consumer Reports. The dimensions we consider are fuel efficiency, reliability, depreciation, engine size, size of luggage compartment, and base price.[7] Note that these dimensions are actually physical attributes of the products rather than customer perceptions, and they ignore probably the most important dimension in automobile purchasing—styling. The reason that we exclude styling is that it is multidimensional. While we are fundamentally interested in perceptions and view physical attributes as mechanisms to shape those perceptions, these data lead to a nice exposition of perceptual mapping mechanics. In the Epigraphs example, we will deal directly with perceptions.

Exhibit 5.4 is loaded with useful information, but it does not readily facilitate comparison of models. A first step at a perceptual map then is a “snake plot”—a means to visually compare products across multiple dimensions. The simplest means to accomplish this is to merely select the entire table and have your spreadsheet program create a line plot. Because each attribute here is on a different scale, some differences would be more pronounced than others merely as an artifact of the scaling. To correct for this we recommend standardizing values. For each attribute, find the Range = (Max - Min). Then for each value of that attribute translate it into percentage of range ([Value - Min]/Range). In those cases with reverse scales, such as fuel efficiency and price, where a low value is best, invert the scale by subtracting the standardized value from one.

Exhibit 5.5 is a snake plot of the standardized values for each of the 10 models with complete data.[8] Exhibit 5.5 begins to illuminate the differences between models. The first observation is that no model dominates all others. For example, while the Civic is at the top of the reliability, depreciation, and base price scales, it rates poorly on engine size and fuel efficiency. This is not a surprise. If one model were clearly dominant on all dimensions (engine size, luggage compartment), it would either capture the entire market or other models would lower their price to make their offering more attractive. We will tackle this issue more directly in a moment when we discuss value maps. However, before introducing value maps, we want to consider the issue of dimensions.

Exhibit 5.5 is still quite complex. It is unlikely that customers keep track of all models on all these dimensions. Rather, the psychological literature suggests that individuals collapse attribute information into some salient dimensions. These dimensions can be derived statistically through factor analysis of customer rankings of products along several dimensions.[9] For this exercise, however, we will merely apply some intuition. If we exclude price (which makes sense, because it is instantly changed and because we will treat it in value maps), two dimensions emerge: a lifetime cost dimension (fuel efficiency, reliability, and depreciation) and a functionality/performance dimension. If we arbitrarily weight the three cost attributes equally (add them together and divide by three) and the two functionality dimensions equally (add them together and divide by two), we create the simplified perceptual map in Exhibit 5.6.

Models are increasing in quality as you move up and right in the perceptual map. If we have correctly captured the important dimensions and if customer utility has the normal concave shape in these two dimensions, then the Jetta should dominate the market. It has lower lifetime cost than all other models and greater functionality than all but one model. In contrast, the Prism and the Esteem are clearly of inferior quality. Irrespective of the shape of the consumer’s utility curve, there is always a product offering more (above or to the right) utility than the Prism and the Esteem.

It is possible, however, that even if the Prism and the Esteem offer inferior quality in an absolute sense, they offer superior value. We explore the issue of value next.

EXHIBIT 5.5   Snake Plot of Small Sedans

EXHIBIT 5.6   Perceptual Map of Small Sedans

Value Maps

Value pertains to the relationship between quality and price. While we recognize that a Rolls Royce is of superior quality when compared with the cars that most of us purchase, Rolls Royce does not dominate the automobile market. The price of a Rolls Royce far exceeds most household incomes, much less the budget for automobiles. Accordingly, automobiles are compared on the basis of value rather than absolute quality—which automobile provides me with the greatest benefit per dollar, given my budget for automobiles?

Value maps are a means to incorporate price into the product comparison. To translate a perceptual map into a value map, merely divide each dimension by price. Often, this conversion will lead to products arranging themselves along a single curve. Exhibit 5.7 converts the perceptual map in Exhibit 5.6 into a value map. Here, we see that while the Jetta offered the highest quality, because of its high price, it is now comparable to the other sedans. Value mapping does not substantially improve positioning of the Prism and the Esteem. (Remember, however, we fabricated the perceptual map using physical data rather than perceptual data, so we should be careful drawing conclusions.)

Identifying Opportunity

Often, perceptual maps will reveal a gap representing a new product opportunity. In our sedan example, most products lie along a curve trading functionality for lifetime cost. Volkswagen seemed to have recognized that there was an opportunity for a product with both high functionality and low lifetime cost. Because the Jetta filled an unmet need, Volkswagen was able to charge a higher price for the new sedan. Ultimately, as other firms imitate this strategy, we would expect the price of the Jetta to be more aligned with competing sedans.

EXHIBIT 5.7   Value Map of Small Sedans

Apart from the high function/low lifetime cost gap, this product space appears to be quite dense. Such density along existing dimensions suggests that further differentiation requires new dimensions—styling perhaps.

The Epigraphs example is more useful than the sedan example. It uses perceptions rather than physical attributes, and the “need gap” is more pronounced. We turn to that example next.

EPIGRAPHS

Recruiting Focus Group Participants

While personal frustration with wallpaper helped identify the product need, and thus might form the basis for a perceptual map, we wanted a more thorough understanding of the wallcovering market. Originally, we intended to interview two groups, an “expert” group of interior designers and a group of wallpaper consumers. Experts, even more so than lead users, have in-depth knowledge about a given product and its associated market. Interior designers, for example, have several clients and, thus, can represent a whole distribution of clients. Furthermore, because they design for a living, they have extensive experience with the industry’s products and must stay on top of all trends in products and consumer attitudes. Thus, their knowledge of the industry is very rich. The concern with relying exclusively on the opinions of experts, in general, and interior designers, in particular, is that they tend to work with high-end clients. Thus, the trends they perceive may never diffuse through the mass market.

Accordingly, we wanted to interview both experts and representative consumers. Ironically, it was more difficult to gather a group of consumers than professionals. Professionals were easily identified in the phone directory, whereas it was difficult to identify individuals matching desired demographic characteristics. Ultimately, we were able to secure a mailing list from a wallpaper retailer. However, we found that the next hurdle was consumer willingness and availability to participate. Interior design professionals seemed interested in the opportunity to meet with other professionals regarding a new product. In addition, professionals had some regard for Wharton. Furthermore, interview time at the end of the workday was convenient—in some sense merely extending the workday. In essence, the focus group fit within their definition of professional work. The consumers, in contrast, viewed the focus group as an inconvenience. Our response rate was less than 5%—making it unlikely we could field a group of adequate size with our mailing list of 150 names. Since we would later be surveying consumers for conjoint analysis and would gather perceptions at that time, we felt reasonably comfortable doing a single, expert-only focus group. (The screening guide for the recruiting calls was provided earlier as Exhibit 5.2.)

Conducting the Focus Group

The focus group comprised seven interior designers, a moderator, and myself. The participants were served refreshments while they waited for the entire group to arrive. The actual session began at 5:30 and ended promptly at 7:00. The moderator’s guide in Exhibit 5.3 served as the outline for the session. The session was videotaped for later analysis. The transcript for that tape is included as Appendix 5.1.

As mentioned previously, the real value of focus groups and other exploratory techniques over quantitative techniques is the depth of information and richness of detail. While the ultimate goal of the session was construction of the perceptual map, we began with a more general discussion of the industry, “What wallcovering products were used and why?” The group painted a slightly different picture of the industry than secondary data. For example, secondary data indicate growth of borders at the expense of sidewall sales. These designers uniformly felt borders were déclassé, “Not in vogue these days,” “I just did one for an eighty-five year old lady at a retirement home.” Since designers are lead users, this would portend a reversal in the trend toward borders.

Perceptual Map Dimensions. The group was successful in identifying a broad range of wallcovering products (broader than our own set) and identifying a set of dimensions along which they compared these products. This set came primarily from discussion of their engagement experiences rather than from direct questions about dimensions and product rankings. The complete list of dimensions and products is included as Exhibit 5.8. In addition to this unstructured approach, we conducted a repertory grid exercise, asking participants to identify ways in which two products were similar to each other but dissimilar to a third product. In this particular case, the repertory grid exercise was redundant with the broader discussion. This is an indication that the broader discussion was fairly exhaustive.

EXHIBIT 5.8   Wallcovering Products and Attributes (from focus group)

Key Attributes of Wallcoverings:

Key Attributes of New Product:

Aesthetics

Functionality

Budget

Durability/Ease of Maintenance

Ease of Installation

Speed/Availability of Product

Uniqueness

Flexibility/Customizability

Predictability/Consistency

Inexpensive

Accessorizes/ Offers accent to rooms (particularly children’s and powder rooms)

Whimsical

Customizable

Functional (enhances odd spaces like hallways, elevator lobbies)

Reaction to Epigraphs. The final exercise in the focus group was unveiling the new product. To prepare for the session, we had developed four prototypes of the Epigraphs product. Each prototype consisted of quotes mounted on 32 in. × 42 in. colored mat board. Quotes were taken from four different genres, produced in four colors, and in two typestyles. They were mounted on boards in the same color (tone on tone), complementary colors, or contrasting colors. Prototypes were displayed along one wall of the room, and the designers were asked for their reactions. Initially, the reactions were negative. The designers felt that the vinyl material was inconsistent with the high-end rooms they tried to create for their clients. They also felt that the product was similar to borders. (This impression was a by-product of the prototype execution—only one quote was mounted on each board. This points to the importance of prototype execution.)

Ultimately, the mood of the reaction shifted when the designers were asked where and how this product might be used. Here, they offered a number of suggestions:

“I could see doing it where you would do a big floral. I could see doing it in a powder room. It would be kind of fun”

“Media room or game room”

“I could possibly use it in a child’s room”

“As a panel at the end of a long corridor”

“Church or library”

“Elevator lobbies”

“I know from personal experience that going into office buildings where there is a waiting room, I will read anything”

“You mentioned elevator lobby, what about the elevator itself?”

Sources of New Product Information

Before ending the session, we asked the designers how they found out about new products. They identified several mechanisms, most of which were personal rather than through media: trade shows, trade representative (reps) calls and visits, and luncheons in showrooms. They also receive direct mail, and they review ads in design magazines.

Postsession Analysis

The real analysis took place after the session, from review of the video tape. In addition to reviewing the entire tape for emotion/timing, the tape was transcribed for content analysis. From that transcription, we derived a set of dimensions and a set of product rankings along those dimensions. This formed our preliminary perceptual map—the snake plot in Exhibit 5.9. The perceptual map confirms the need for a product with the durability, flexibility, and affordability of paint, but with the uniqueness of papers and faux finishes. This forms the core benefit proposition for Epigraphs.

EXHIBIT 5.9   Perceptual Map for Wallcovering

CONCLUSION

This chapter elicits customer perspectives using an exploratory process. Having finished this process for your venture, you should be able to answer the following questions: What is the customer’s experience when using your product? Did they see value in the product? What products do customers see as competing with yours? What are the key features that distinguish your product from others? It is impossible to overestimate the value of identifying who your customers are and how they perceive your product. After completing the worksheet in this chapter, you should have enough information to define your core benefit proposition and realistically evaluate your venture’s feasibility. In the next chapter, the final step in feasibility analysis, we use the information gathered here as the basis for characterizing and quantifying demand through conjoint analysis.

APPENDIX 5.1: Epigraphs Focus Group Transcript

Moderator: As I told all of you on the phone, the purpose of the group is to get some feedback from you guys on the current wallcovering industry, and not so much the industry, but what your experience as a designer is with wallcovering. We are defining wallcovering as anything you use to decorate a wall—whatever you put on a wall to sort of enhance its beauty or value for your clients. I’m not talking about wall sconces, those types of things. But I also do not want to use words like paint or wallpaper, because maybe there are other things that you use and we want to hear about those things as we get the group going.

The other thing that we want to do tonight is present a new wallcovering concept to you and get your reactions.

Anne Marie and I are on the research team for the person who has this idea, so we will be feeding back this information to this company. I am going to tell you that your answers will be anonymous, but we want to film you and we are going to ask if that is okay. We want to tape this so we have a record of what is going on.

While we are playing musical chairs, I want you to think about something as we do this. I am going to go around the room and ask each of you some questions about the types of wallcovering that you typically use with your clients and those things that you think about when you are selecting a wallcovering. Does that make sense for everybody? When you are ready, raise your pencil or finger.

Dina: I’ve specified all different kinds of wallcovering: zolotone paint, regular paint, vinyl wallcovering, paper, fabric, reed.

Moderator: What is vinyl wallcovering?

Number 7: It is durable.

Dina: Probably most widely specified in contract design, when using wallcovering more than paper more than fabric more than grass.

Moderator: What else do you use? You use paint. Anything else? The second part of the question . . . what are the things that you consider when selecting a wallcovering?

Dina: Selecting a wallcovering, first of all has to do with the space that it is being specified for, whether it is in a corridor or an executive area, and that will identify whether it is a vinyl or a more high-end finish like a silk wallcovering, or something like that.

Moderator: So it is the space itself, but it also seems that there is a durability aspect that you are getting at.

Dina: Definitely!

Moderator: Anything else that you consider?

Dina: Budget.

Moderator: Do you have a number per square foot that you use?

Dina: No, because it depends on the project and the installation, there’s a lot of facets that go into the decision-making process.

Moderator: You mean for the budget?

Dina: No, for all.

Moderator: What are some of those things?

Dina: Like what the client would accept, what the style of the interior is and

Moderator: So taste. . . .

Marco: Can I answer that?

Moderator: Oh, sure.

Dina: Yes, please!

Marco: Sometimes acoustic. I am working on a project right now, where there’s a room which is going to be used somewhat like a screening room. And so we’re doing fabric on the walls. Sometimes there are acoustic panels that you can put on the walls that are covered with fabric, so it is how the client using the room and to go back to vinyl . . . sometimes you have a client who is not really good at maintenance and really just wants something that is scrubbable or wipeable, so you would want to something with vinyl, not grass cloth because you can’t really take a damp cloth to it.

Moderator: Great! Maybe you can share with us, Nina, some of the wallcoverings that you’ve used.

Marco: Well I said fabric, paint, grass cloth, which is a type of wallpaper, vinyl wallcovering, custom screen-printed wallpaper.

Moderator: What do you find valuable in custom wallpaper?

Marco: You have more control over color or pattern.

Moderator: Great! Good. Anybody else?

7: Let me springboard off of something that was mentioned about acoustics . . . we are doing a media room right now, where we decided because of the sound that would travel through the rest of the house, that we would cover the walls in fabric. However, the client wanted silk, but this is the main traffic pattern to the pool, so we figured with kids coming in and out with suntan lotion that it would easily get damaged, so we decided to go with a polyester/cotton blend that looked like silk but definitely durability—how it is going to be maintained, how durable the fabric is, sometimes we deal with high-end Chinese papers, that need to be handled very delicately.

I know we just had one installation, an Osborne and Little paper, that required a lot of prework be done on the walls to make sure that it didn’t stretch or bubble up over the years.

Amy: Did you use paper or fabric?

7: Sometimes you have to use paper backing and the batting.

Amy: So they probably line the walls first before they put it in.

7: We do a lot of encostic—hand tinted encostic, which is a wax, so we call it Venetian plaster, but I don’t think that is really quite correct. It is great stuff. It really looks quite nice, but aesthetics is primarily our goal in the residential end of it, but definitely cost, some clients aren’t willing to spend a couple of hundred dollars a square foot. Some are. It depends on what their priorities are.

Moderator: Let’s talk about the aesthetics a little bit. That’s so hard to typify, because everyone has their own taste, but when you are working with clients, is there something that they are typically looking for or is there some issue with showing them all these different alternatives and meeting their needs or . . .

7: Well sometimes they will come right up to you with a picture they ripped out of a magazine and say “I want this look.” And then you are very narrow and focused about what they want. Other clients are completely open. We just had a couple of clients come up to us and say here is the layout, this is the apartment, let’s see what you can do. Which is sort of like a dream, but it is also difficult because then you have nothing to start with.

Moderator: Good. Oscar, what about you? What types of wallcovering do you use, or have you used?

Oscar: Anything and everything, basically. In the residential end, what I have noticed is that most likely the client is interested in something unique as opposed to a more typical situation. Most of the clients who are willing to invest in a wallcovering go for the watercolor painted paper or the silk fabric, or something that they aren’t going to find just anywhere. Gold leafing is something that we have found is quite unique in the market these days. In the paper form because you can apply easily not only on vertical surfaces but also on the horizontal surfaces and the ceilings without having to get involved in special trades to do such work, but it runs the gamut and is usually driven by cost—how much the client is wants to invest, and a function of the space, without any doubt. Other items that I have used more on the commercial end are coatings, zolatone, that is something that not only serves the purpose of giving you a different aesthetic but hides some of the imperfections in the wall, and it has some other ailments you have to deal with. Another element that I have encountered very often lately is paneling something like a marbleite product that is fiberboard backed product that is wood veneered or it could be painted surface or metallic surface. That has become a very flexible material that applied in modules. So it depends on the budget and a function of the space.

Moderator: That is good, and uniqueness—I thought that was interesting, and that gets back to I think what Nina said about certain customer controllability of material. Amy how about you?

Amy: I do residential, and depending on the flavor of the space and the house . . . lately we have been doing entire homes. We work with the clients, we make a presentation, we give them sort of a choice, and they are the ones who make the final selection. But most of the papers that I select I would say ARE paper. In a certain case, the client has four children, there is a process called fiber-seal or custom-seal. It doesn’t vinylize the product, but it protects it from fingerprints. It protects it, but doesn’t make it shiny, which I think adds at least a dollar a roll—no maybe more than that—not sure on the price.

Oscar: Usually by the yard.

Amy: But it is a process we do. If you want to do something for the bathroom, so it doesn’t get damaged by water, but initially when I pick out a paper, its keeping with the style of the house, with what the client already has, to coordinate with something that is off of it, so that’s how I make my selections, and then I make my presentation.

Moderator: Great! When you are making your presentations, or when you are selecting some of your samples, do you think about budget, customability, some of the things that other people are talking about?

Amy: Yes, I consider budget. Generally I don’t consider custom. That is sort of a last resort. There is enough, at least for what I do, there is enough out there. There are a zillion wallpapers. I also generally go for wallpapers that are on the unusual side. Then I go more decorative with fabrics. I like sort of background papers. I do a lot of stripes—tone on tone stripes. I do simple. I use Nina Campbell, Osborne, and Little. They are really beautiful, simple papers. Damasks, all the time. I don’t generally do anything. Sometimes in a powder room, I’ll do lots of flowers, but in general, I keep my papers toned down.

Moderator: Great! Hey David, how about you?

David: Well, I would like to explain to everyone a little bit about my business. I am more of a furnishings, I actually sell furnishings from wholesalers, and I am cutting out the furniture stores, and I am working more as a furnishings consultant. And I have dealt with wallpaper. For example, you guys may have heard of SJW Studios in Washington State. It is a wallpaper, high-end faux finish on paper—hand painted and silk. My clients are mainly high-end client, and they demand the top of line in style, but they don’t necessarily want to pay that price. It is $100 a yard, and a yard is very small, and I would rather—I’m not making any profits on wallpaper, and I am totally cutting out wallpaper, and I am putting it on the back burner as a last resort to use to finish off the room, because I’d rather see my profits being made on furniture. And I will pick out paint from my clients, and Ralph Lauren has textured paints. I also have, for example, a client that I was wanting to do some wallpaper and it was $100 a yard, and it came out to $4,000. That is $4,000 that I am making at 20 to 50% markup on my furniture, and I am not getting. I can’t buy the wallpaper from the factories. I have to buy the wallpaper from the design center here in town, and I am not going to buy the wallpaper and make $200 on the wallpaper job.

Moderator: What about that for other people? I think it’s an issue of profit margin. Are you able to make a decent margin on wallpaper, and is that something you consider?

Number 6: Definitely. We charge a 35% design commission on anything we that we select and specify.

David: I love wallpaper. I really do. However, I would rather see them purchase the entire room from me, and then maybe if they want to do a faux finish I’ve got a faux finisher doing a couple of jobs for half the price. In fact I took a $100 a yard sample from SGW Studios, to the faux finisher, and he totally—two examples—he’s totally copied.

Marco: Don’t tell them that (laughter)!

David: But I also called SGW studios, and asked them, “Can you sell me this wallpaper?” Why do I have to buy it from the design center? I have a tax number. I’m a business. However, they don’t want to sell to me. That’s fine, so I’ll take it to a faux finisher. And if a client really wants that wallpaper, I’ll have a faux finisher put it up. It comes down to the dollar in my case. I need to make money, and if I am not making money on wallpaper, I’m not pushing wallpaper.

Moderator: Good!

Oscar: I have the other end of the coin. Which is I don’t make any money on anything I specify. I am purely a specifier. I do what I do for the sake of design. I am consultant to my clients. I pass on all the discounts to my clients, because some of them have more power than I do to buy the product on discount—they have connections, they know the spreads of the dealers, so why go with the headache of the markup, so I deal strictly on consultation fees.

Moderator: So that is how you make your profit?

Oscar: That is how I make my profit. That is how I protect myself from the client telling me, “Oh, I was able to see the same wallpaper, the same wallcovering, the same wall treatment somewhere else and for half the price of what you are selling it to me.” So I deal strictly with consultation fees.

Moderator: Right. Great. Marco, we skipped you.

Marco: Somehow. Well, almost everything has been covered except I think other alternatives. Oscar “was it?” mentioned things being unique. Honestly I don’t always consider paper or vinyl first. In my firm I tend to specialize in the residential, and then even specialize in kitchens and bath, and those type areas, so I think of wall finishes in a different perspective, like tiling the whole wall, or maybe panel systems, but I tend to think of wood in general as a wall finish rather than just as a material.

Moderator: And why is that?

Marco: Just the kind of feeling or mode it conveys. Usually aesthetic overpowers the other factors, budget, especially in residential where you can get away with it more, I think than in the commercial work. And the unexpected, too. I think finding a surprise on the wall.

Moderator: Good, good. I think we heard that before with uniqueness. I want you guys to think of two things: a good experience you have had with some kind of wall covering, and a bad experience, and then let us know what made the good one good, and the bad one bad. It could be anything. I think David already started on that. There is some bad experience in terms of profit margin. . . . Are you guys ready? Does somebody have their stories?

Marco: I think so much has to do with installation. Like papers in the past—there have been problems. Actually, sometimes they will blame it on the paper manufacturer—the problem sometimes is that the paper manufacturer will blame it on the installer, and the installer will blame it on the manufacturer.

Several Voices: All say they have one now.

Moderator: Before we go on you guys, I need to know more about the problems. You said there are problems, can you typify those problems?

Marco: I remember once for a sea grass, grass cloth, it did start fraying.

David: I had that happen with my best friend.

Marco: You’ve had that experience?—Sorry.

Moderator: There are enough problems for everyone.

Marco: The installer said it was the paper—but the paper company said it was because of the way installed—it was the seams.

Moderator: Like how everything had to match up?

Marco: It was ugly.

Moderator: Is that also because of the room? The way the room is designed? Does the seaming problem have anything to do with the shape of the room?

7?: That is typical of grass cloth.

Marco: Well you want it to actually look like panels (simultaneous with comment above).

Moderator: Oh, okay.

Marco: That is one condition where you want to really see the line, but this was a situation where they said that it was how it was how they were butt together is what started the fraying.

Moderator: Good! Amy had a burning story, so let’s go to Amy.

Amy: The client from “you know where.” We put this beautiful Scalamandre paper up. It is kind of like a Chinese thing with lots of people and houses and flowers. We put the paper up. There were two strips of totally different color—the dye lots were off, so that meant they had to take the paper off. But it was an inconvenience to the client. They back-ordered the paper 6 weeks, so by the time this whole thing was said and done, it was 3 months later. You know we had to proof . . . You couldn’t tell until was actually up that the dye lots were different, and they were really different! They had to inspect it—Scalamandre had to send someone out to inspect it, then we had to send the bill from the paperhanger to Scalamandre. It was like a whole production.

Moderator: So there seem to be a couple of things in there: (1) there is a whole timing issue—that it held everybody up, so it is safe to say you would like to have this done as quickly as possible, but there is an issue of quality—everything you sell is of good quality.

Amy: If you looked at this wallpaper, and you rolled it out on the floor, and you looked at one roll and you looked at the other roll, you would’ve never known until it was actually on the wall.

Moderator: Wow!

Amy: So it was a nightmare. So they asked, “How are you going to know that it is not going to happen again? We are going to roll it out on the table and it is going to look perfect, and it is not, when it goes up, so what do you do? Keep your fingers crossed . . .

Moderator: Predictability is in there.

Marco: Consistency . . .

Moderator: Good.

Marco: That takes away from the unique sometimes.

Amy: Oh! I have another one!

Moderator: Go ahead, Amy.

Amy: The flooring finisher makes a gouge in the wallpaper. No stock. An entire hallway—20 double rolls.

Marco: Then you should call, Insto-finisher!

Laughter

Nina: I would say time is the big issue, which we have touched on. Because if it is coming from overseas and you have a client that is sort of chomping at the bit to have something installed, you are sort of a slave to when something is coming in, whereas if you did have a faux finish, you have more control over when it is going in, and the dialogue issue.

Moderator: Nobody has talked about borders. Does anybody do borders?

Oscar: Not in vogue these days.

Moderator: Borders are out?

Dina: My firm actually just started using borders, because we started doing health care and extended care facilities and so that is a big deal for them—they love borders!

Laughter

Amy: I just did one for an 85-year-old lady at a retirement home. It looks great!

Moderator: So it’s a generational thing, then.

Nina: I’ve seen some nice borders from Europe where it would be nice if we did it, but for some reason our clients . . .

David: You can go to Target and buy borders.

Marco: Once Martha Stewart Everyday started doing it.

Moderator: Then it was over. Do what Martha Stewart doesn’t do. Good. Anyone have a good story?

Marco: Well recently we had an Osborne and Little paper that the client was very hesitant to put up, and it was a wall and ceiling treatment, and actually it was finished a couple of weeks ago, and when I walked in, it totally altered the room. It was absolutely amazing, and she is absolutely in love with it.

Moderator: And what was it . . . it was just the pattern of the paper?

Marco: Well it was made to look like antique distressed plaster, but it had some ridiculous quarter drop repeat and it is this miniscule pattern, but it was a pattern, but it was made to look like it wasn’t a pattern, so it was . . . fortunately we had a well-seasoned and expert wallhanger do it, but it just really I still think it was amazing, and she was just delighted.

Moderator: Right. Let’s talk about that a little—the wallhanger, because that came up when Marco was talking.

Marco: It is VERY important. I mean we have had wallhangers that have botched jobs, and it is thousands of dollars which you lose out on.

Moderator: Is it a function of the wallpaper or the hanger?

Nina: Sometimes laziness.

Marco: Laziness . . . cutting the corners just right. Really taking that added time to make sure everything is pressed down, and very neat. The client in this job mentioned that it didn’t even seem like an inconvenience because he was so neat and cleaned up after himself as he went. I meant it really showed.

Moderator: What if there was a product that was incredibly easy to hang that you didn’t have to worry about. Do you think there is such a thing as that?

Marco: Vinyl wallcovering, but we don’t really use that.

Oscar: I think that substrate is a critical element when you are thinking of installing wallcovering. If the substrate is not perfectly finished or treated, no matter how wonderful the wallpaper is, it is still going to telegraph imperfections that are going to become very apparent.

Moderator: Okay, good. Any other stories?

David: I can only comment and say that it is very expensive as far as labor to have it installed, and again that is cost that I am losing. In fact one job a month ago, I missed out on $2,000 that went to a wallpaper hanger that could have been spent on services for me as far as furnishings, and I could easily have had some selected paint.

Moderator: Right. Okay. Now you guys have those three cards in front of you—one says paint, another says paper, another says fabric. I want you to cluster together two that sort of relate in some way to you, and keep the third one out. We are just going to go around quickly to see what comes out of that. We were going to put borders, but that is obviously a no-no, so . . .

Amy: You lost me—put two together.

Moderator: Put two together that relate to you in some way, whatever way.

Amy: Can you be more specific?

Moderator: I am trying to be as open-ended as possible because I don’t want to direct you to say a certain thing.

Dina: I put paper and fabric together because they are in my mind they are both goods that are produced by someone else offsite and then applied to the wall. And it seems to me paint is just a coating; it is not something that you unroll and hang up on the wall.

Moderator: Not many people talked about paint. It seems like paint is not a good thing these days.

Chorus of Disagreement

Dina: We use paint in probably 90% of our work.

Moderator: Oh, okay, because you guys haven’t really brought up paint very much.

Nina: Maybe because we thought this was about wallpaper.

Moderator: I’m sorry. I wanted to stay ambiguous. If you use paint, we need to know you use paint. So you think 90% of your work is paint?

Nodding

Moderator: And why do we use paint 90% of the time?

Dina: Because in contract, it is inexpensive.

Moderator: Inexpensive . . . Amy, why do you use paint?

Amy: Probably for budget reasons, I would use paint.

Moderator: Okay, David?

David: Same thing. I can give them the samples, they can go down to the local home depot, and paint it themselves, or pay someone to paint it.

Moderator: Great! Oscar, why do you use paint?

Oscar: Well it is cost, definitely. The other item behind paint is that you can apply different finishes to it. It’s not just paint, it can be flat, it can be eggshell, so you have a lot more flexibility.

Moderator: Flexibility, good.

Marco: Same reasons, and also it comes in any variety of colors, custom colors.

Moderator: Custom, good.

Marco: You can make decisions on site. You can test areas easier than you can with other wall finishings.

Moderator: Good.

Nina: I think too that if we were doing a whole home, you probably just wouldn’t want to do wallpaper in every single room because you want some sort of consistency throughout, and sometimes wallpaper is used as sort of a unique accent to make sort of a jewel-like space, and so sometimes it is used in specialized areas, not used widespread throughout the entire home.

Moderator: Okay, good. Go back to your clusterings. Dina went. Oscar went. No, Oscar told us about paint, sorry. What do your clusterings look like?

Oscar: Same.

Moderator: And why did you do it? Same reason?

Oscar: Same reason. The fact that Dina said, that it is applied versus coated. It just automatically differentiates two different types of applications.

Moderator: Is there something in your mind about a coating versus something that is applied. Do you have a preference? Would you go for something that’s applied or for something that is coated, or doesn’t it really matter?

GENERAL ANSWER: Depends on application.

Moderator: Okay, good.

Male: I have the same arrangement as they had. The one thing that I have down is that paper and fabric come in a given size, so you have to deal with a certain size factor, whereas as paint just covers a wall.

Moderator: So the wallpaper is not always manageable. . . . Okay, Marco?

Marco: Well, I did have it grouped the same. I feel like I should be unique . . .

Moderator: No, no!

Marco: For basically the same reasons. I think it is pretty cut and dried, unless you look at paint as a pigment, and then paint can go on paper or fabric.

Nina: You could say that paint and paper are the same in the sense that there might be less maintenance involved that with fabric—it is not as easy to clean if you get it dirty. The paint and paper you can do in such a way that it is easier to maintain for the client.

Moderator: Okay, good.

Amy: Okay, I’ll be different. I’ll put the paint and paper together. And the fabric by itself. Fabric comes first generally. Then it is a choice of paint or paper.

Moderator: Oh, so you always lead with the fabric in the room, so it is important that the paint or paper matches the fabric. So that is very interesting. Help me with the word for that. Everything seems to need to coordinate: the paint, the paper, and the fabric. So let’s say if there was a product that was out there that didn’t come in the same color scheme, it is of no use to you.

Amy: Correct.

Moderator: Okay, David, how about you?

David: I put fabric and paint.

Moderator: Okay, and why is that?

David: I always start with fabric and paint is very simple, you just throw it on the wall. And I throw away the paper, because if I do that, they can afford the fabric of upholstery pieces. You know it is an amazing difference if you take fabric—it is expensive. In an upholstery piece you are looking at a couple thousand dollars, and then a couple more thousand for wallpaper. There is nothing left over. So which would you rather have? Upholstery or wallpaper? I have some very cheap clients—they don’t want to part with their money.

Moderator Writes Traits on Board

Moderator: Am I am missing anything that you pulled out of the group in terms of any characteristics or attributes?

David: Installation.

Moderator: I put ease of use. Is that different than ease of use, do you think?

Oscar: Yes, because, for example, you want to separate two different traits versus paint versus paper or fabric.

Moderator: Anything else? I think some of the words were different, but I was trying to categorize them as we were going through. Do you think we are missing anything?

Moderator: Great. Now . . . what I want you to do is give us the top five attributes on the board for you when you are making a decision to buy wallcovering. Write those on the back of the card.

Delay While Group Is Writing

Moderator: For those of you who are done, I am going to give you 100 points, and you can divvy them up any way with the five attributes you have written down. This is a way to get at the weighting of what is more important for you. Let’s say durability is your number one choice, and it is number one by a lot relative to everything else, so you may give it 70 and then divvy up the rest of the points. So you have 100 points, and this isn’t scientific, so if they are all important, you can put 20–20–20–20–20, but if there’s something that really sticks out as more important to you.

?: The trick is that it comes to 100 when you are done.

Moderator: At the Wharton School, you know we have to throw something quantitative out.

Nina: I’m sorry, are we doing percentages or just points that add up to 100.

Moderator: Just points.

Marco: I have a little problem I think of function of space and acoustics as the same.

Moderator: No that is good. You can actually write that on your line.

Amy: Why do you say that? A function of space and acoustics?

Marco: Well it is almost like a function includes whether acoustics are relevant.

Oscar: Well if you are not counting not-coated wall covering in damp area.

Moderator: Okay, how are we doing? Pencils up when you are finished.

Moderator: One more thing. If I said to you guys, you’ve got millions of dollars, but you can’t spend it personally, you can do anything you want with it to create a wallcovering business, what would it be? And it doesn’t have to be . . . What characteristics would you address in putting this business together in terms of the product? Does that make sense?

?: Lots of options.

Moderator: Lots of options. Good.

?: Texture.

Moderator: Texture. What do you mean by texture?

?: Well I am always interested in something that has a texture or looks like it has a texture—that has a hand to it—something that has a luxuriant appearance or velvet on walls.

Moderator: Great! Oscar has a smile on his face.

Oscar: I’ll go back to uniqueness. If I am going to sell something, I better sell something that nobody else can do.

Moderator: Great!

Amy: Choices, but within those choices, say you have 10 choices, but within A only have 5 colors to choose from—don’t go crazy. Don’t make it.

Moderator: Too confusing . . .

Amy: Um hum.

Moderator: Wallpaper seems to be confusing—all these options.

Amy: Too may choices.

Moderator: Good. David?

David: I picked cost and style. Cost number one, and of course having the top of the line in style.

Moderator: Good.

Dina: Durability with flexibility.

Moderator: Good, and what do you mean by flexibility.

Dina: If you are able to change something in the field during installation.

Moderator: Help me understand that some more.

Dina: The process that I can equate to it really is application of a coating like zolatone, where you can change the size of the spots while they are spraying it on.

Moderator: Oh, so you have flexibility while you are actually doing the treatment.

Dina: Yeah, but I would want to have that still be a permanent coating, so I need both of those at the same time.

Moderator: Right. Okay, good. Oscar? Joshua?

Nina: I think I would go with either with style or uniqueness. I said before that I probably would stay away from lots of options and maybe go toward a specific niche that there is not a lot of, because I still think that specifically in wallpaper that there are tons of options. Sometimes there still seems to be not enough, yet maybe in a clean modern sophisticated sort of vein. There are tons of florals and printed patterns and stuff like that.

Moderator: We know Amy stays away from florals.

Marco: Except for bathrooms (simultaneously with moderator).

Moderator: Good. You guys talked a lot about options and uniqueness. Is there something behind that? Something you are thinking about? Why uniqueness? Is it just so you differentiate your product, or are your clients looking for something unique, or there is something out there that is not there that you are looking for?

Marco: We look at it at our firm that the client is spending so much money that they don’t want something that they could flip through Better Homes and Gardens and say, “Oh, look, there is my living room” something about a custom approach to things, like this is mine, this is unique, no one else has this, no one else will have this.

Moderator: Okay. Excellent ideas. Now is the unveiling. I am going to first read to you what this product concept is, and you guys think about it and we will get some reactions from you.

Moderator: This product is a wallcovering intended to be applied over paint. The original concept is quotes, but available in a palette of colors, and can be applied with any spacing, so it is easy to maneuver within spaces, and you can use any phrases or characters in the quotes that we are talking about. Does that make sense?

Nina: Are you asking us to fill in the blanks like MadLibs?

Laughter

Moderator: I’m not doing this very well.

Amy: Is this like lettering on the wall?

Moderator: Yes, thank you. Lettering on the wall.

Joshua and Marco: So, Graphics?

Moderator: Yes, graphics.

Joshua: So we are becoming graphic designers as well as interior designers.

Moderator: Well, yes.

Joshua: So we have the option of the font and the phrase.

Moderator: Yes, so you can basically customize the lettering, the quote, or you could even do a poem. If you have someone who is addicted to baseball scores, you could even put up baseball scores all over the wall.

Marco: What would be the advantage of using this system over having an artist paint it? My first thought if I wanted something graphic on the wall would be to hire an artist . . . or stencils.

Lots of Agreement

Moderator: Okay, what do other people think?

David: I think it is a wonderful idea. However as a designer, I would probably rather see something like that in Target where everyone can customize, maybe a kid’s room. I think it is a great idea. In fact, I know a furniture store that just opened that spent a lot of money on quotes and phrases out in West Chester, so as you tour the showroom, in each vignette, you see on the wall a nice quote or phrase that had to be hand done, and if there were something that someone could easily stencil up there . . . Is that what you are saying?

Moderator: Yeah, exactly! I didn’t get a reaction from you, Dina.

Dina: Can you say it again?

Moderator: Basically, it is something you apply over paint. It would come to you almost like wallpaper, but it would be the letters cut out in a clear material.

Dina: The only way I can see the application in contract design is to use it for company logos.

Marco: Like signage?

Dina: Yeah!

David: I can honestly say I would probably never use it.

Dina: Our clients NEVER ask for verbiage on the walls.

Moderator: Okay, what if we got back to the idea of faux finishing and stenciling that it would be considerably cheaper than doing that.

Marco: The other thing that comes to mind to me at least, and you mentioned this before, is border. I’ve done an application in a library where we had a Ralph Waldo Emerson quote. That is the only thing I could ever see using it for. I mean it is sort of reminiscent of a French textile that has sort of a script on it, but it is sort of nondescript.

Moderator: Script, but nondescript?

Joshua: It looks like the Declaration of Independence.

Marco: Right. I don’t know the name of it, but it is not meant to be read.

David: I think it would be a good catalog order piece—say Pottery Barn.

Amy: Oh, I think that is a good idea.

Moderator: Pottery Barn?

David: Pottery Barn, if that was in one of their catalogs, that would be great.

Nina: Ballard.

Lots of Agreement

David: Not as a designer, but as an average person. Yeah, I would order something like that.

More Agreement

Moderator: (unveiling the prototypes): This is to give you an idea of what it looks like.

Marco: Well, you can have that done at Kinko’s.

Laughter!

Marco: My gut reaction is when I used to be in visual merchandising, and we would use that kind of thing for retail all the time, with like a stick back and available in a million different finishes, and we would put it on walls or glass. That is what it kind of reminds me of.

Moderator: So you did it more for commercial?

David: I know where this could work well: in Staples or Office Max.

Moderator: You mean selling it or putting it up on the wall?

Nina: My immediate reaction was, we do a lot of restaurants too, I could see certain signage that happens at the very end, like men’s or women’s bathrooms or when we wanted to do it in different languages.

Marco: But signage and wall finishes are two different things.

Oscar: Galleries. How galleries change exhibits on a regular basis. That is what it reminds me of. Vinyl lettering that is done for gallery spaces.

Marco: Maybe if it were exquisitely done, like a silver or gold leaf I could see it as a panel at the end of a long corridor, but for an all over wall treatment, for me, it would give me a headache. It would be too much of a distraction.

David: Some businesses have mission statements . . .

Lots of Agreement

. . . and if I owned a business and I for example shop in Office Max or Home Depot, and I saw where this was available, I would say, “Well that’s cute.” I would pay probably 50 bucks to have my, and put it up myself. I can’t see as a designer EVER using this.

Nina: At the same time, I could see someone ordering it out of a catalog.

Lots of Agreement

Moderator: So, let’s sum this up, (1) I think everyone in this room agrees they probably wouldn’t use it.

Amy: I could possibly use it in a child’s room.

Moderator: Child’s room?

Amy: Yeah. If you had a wall or a border.

Lots of Talking at the Same Time

Amy: I just had three boys: one was 3, 6, and 7. We did a whole wall of tack board for them, so they could put their stuff up—their posters, their pictures, or whatever they wanted. They could do whatever they wanted and stick pins in it. So they might want to take a wall, and . . .

Moderator: Okay, would you do a whole wall?

Amy: No, I would just do part of it.

Moderator: Okay, part of the wall. Would it be a border?

Amy: No. I also see the bathroom thing going.

Moderator: Oscar?

Oscar: Beside that application, it would be as a border, perhaps in the library, in church.

Moderator: But it doesn’t seem like anyone would cover the whole wall.

Marco: Now that I was thinking about it, where you would do a big floral, something like a powder room. I could see doing it in a powder room.

Amy: Yeah, definitely.

Marco: It would be kind of fun.

Moderator: So we see it in children’s rooms. Let’s just talk residential for a minute, because we also had some good commercial uses. Childs room, powder room.

Marco: Media room or game room?

Moderator: Media room or game room?

Joshua: A room that you are not going to spend a lot of time in.

Moderator: Sort of a more whimsical feel. Okay, does everyone agree that we don’t see quotes all over the wall. Oscar said, “border.” Amy said, “part of a wall.”

Amy: Well maybe one wall, just one wall or part of one wall.

Moderator: Okay, and would you put one quote or one poem, or does it depend on the space.

Amy: It depends on the space. Are there characters that go with this, like elves and mice?

Moderator: We can probably get you elves and mice. Right now we have the letters, we don’t know about the characters. Somebody said a hallway.

Joshua: As like a panel at the end of a long corridor. If you had something that didn’t have a door at the end of a blank wall, I could see doing that.

Moderator: The other thing I heard earlier, people like maybe a gold leaf.

Marco: It depends on how it is applied to, and how durable it is. We talked about that too. We don’t really know anything about it. Is this like vinyl letters where a little kid can sit there and start there and start picking at the corner and peel it all off?

Nina: And also how easy is it to install? You want to have it straight.

Marco: And how easy is it to remove? You don’t want someone to paint over it and have that impression forever.

Moderator: Sure.

Amy: Oh, yeah. Removal is important.

Nina: Who would install it?

Moderator: It would probably be your paper hanger or whomever.

Marco: You specify the quote and it comes in a sheet. Is that what you are saying?

Moderator: Yeah, yeah.

David: I can honestly tell you, if this has to be applied by a professional, no one would ever buy it, unless they could put it up themselves. I would never pay anyone to hang it on my wall. Is that what you are saying?

Moderator: Because I am talking to designers, I would say paper hanger, but it is actually to be very easy to put up. And any consumer, including myself, could do it.

Marco: You mentioned it would be a clear coat applied over paint, so basically you could do whatever background you wanted.

Moderator: Actually I was wrong because I hadn’t really seen it. There is no clear. The letters come right off.

Marco: So it is just like vinyl lettering if it peels right off. So what is the advantage of this over going to Kinko’s?

Moderator: We’ll do your whole quote.

Laughter!

Marco: Because we will write out the whole Declaration of Independence.

Lots of Simultaneous Comments.

Nina: You have to have more sophisticated finishes.

Moderator: Okay, to make it unique from going to Kinko’s.

We heard some commercial uses: restaurants!

Nina: Any time we do a restaurant there is always some last minute signage.

Moderator: Like all employees have to wash their hands before leaving.

Marco: That just happened actually!

Laughter!

I had to have something done that was nicer than you find anywhere, ’cause there’s not anything that nice that you can find that says that. Not everyone wants mens and womens, we have done Latin.

Oscar: However, there has to be code in those circumstances.

Moderator: Okay, good. Whatever commercial uses can we think of?

Joshua: Retail.

Moderator: Retail, okay. Oscar said “church.”

Nina: We’ve done lettering in elevator lobbies.

Dina: That would be nice if it was flexible enough in removal and redoing it.

Agreement

Marco: I know from personal experience that going into office buildings where there is a waiting room, I will read anything. You mentioned elevator lobby, what about the elevator itself? Just something to look at, to do, but I wouldn’t do it someplace where you had to look at it for a long time.

David: I see this as being 90% commercial and 10% residential.

Moderator: What do others feel about that?

Joshua: If I were to use words or phrases in a residential application it would have to look so knock out, spectacular—you were talking about that Emerson quote—I would only see an artist . . . it would have to be so special, and I don’t see that as looking special.

Moderator: Okay. What if this were sold in Target or Home Depot, would you guys use it?

David: I would recommend it to someone.

Moderator: You would recommend it, you would tell them to go get it.

David: Sure!

Oscar: But then they would have their own focus group.

Moderator: I know, I’m just testing.

David: I know if I were doing a family room, this would be great in a family room or a kids room, and I would say, “Oh, by the way, after you do the room package, go down to Home Depot and do a phrase” and then explain a little bit about it as being a cute idea, and that’s it.

Dina: It’s something the consumer can do.

David: To be honest with you, I don’t really want to waste a lot of time on something like that.

Nina: My first thought too is how open would an installer be to putting it up, because it is a lot more than just matching a pattern. It seems that if you are installing each letter you have to make sure that the letters are level and evenly spaced.

Agreement

Moderator: So it looks difficult to install.

Nina: I don’t know if it comes letter by letter or if it is installed by sheet. If somebody is ordering custom phrases, it needs to come on sheets so it is easier to install.

Moderator: Let’s pretend that we really like the idea, and we are going to put it up in Amy’s children’s rooms.

Amy: Bathroom. I’ll do the bathroom.

Moderator: How big would you have this lettering?

Dina: It depends on where it is. If it is in a larger space, and it were up high, it would need to be larger than if it were in a powder room.

Marco: Yeah! If it is in a powder room do it much smaller scale.

Moderator: So you would like the flexibility to be able to adjust the size?

Agreement

Moderator: Okay, great. Does everyone feel that way pretty much?

Marco: I wouldn’t even consider it unless it was totally flexible.

Moderator: Okay. What if there were different types of poems, the romantic poem package, and someone had selected the top ten romantic poems of western civilization, and you could buy this package and put them all over your powder room. Amy doesn’t like that idea.

Laughter

Dina: I think that would be nice to help me specify it, but I do not think that would make me want to buy it.

David: As a retailer, I could never see stocking something like that. Maybe ordering, yes.

Moderator: Yeah, you wouldn’t stock it, you would order it. You would call me up and say, Kyle, order me the romantic package.

David: Then that is great.

Laughter

Amy: How long is it going to take?

Moderator: And that is the beauty of this. This could be brought to you in a week.

Marco: Again, Kinko’s can do this in about a day, so what is the advantage of this?

Joshua: If it were gold leaf you might consider it, but again it’s like you mentioned, but if were an idea to consider, I would definitely go to a painter or an artisan. I don’t think I would do something like that.

Moderator: How much would you pay for this?

David: Oh, wow.

Dina: I keep equating it with vinyl lettering, so . . .

Agreement

Marco: It doesn’t look any better than vinyl lettering to me.

David: It looks like $20 wholesale phrase.

Marco: Even the gold one looks like gold vinyl.

David: I am sure it didn’t cost $20. It probably cost $1.

Moderator: Well, I don’t know how much it cost, but . . .

How would you want to buy it? Would you want to buy it by the word.

David: By the poem.

Moderator: By the poem.

Amy: By the word. I would say by the word.

Moderator: By the word, because you would want the flexibility I would think.

David: Well if there was a poem, it would be easy to say “that’s a cute poem” rather than trying to think of one, maybe a favorite.

Nina: That goes back to the package thing. I could honestly see this as being sold in a catalog.

David: Definitely. Pottery Barn.

Nina: It is the kind of thing where people are flipping through and for some reason a particular poem touches someone, but maybe it’s not for everyone, but I could see people ordering it, because it is already sort of done for them.

Oscar: However, although I see this as being packaged, I think you have too many variables to deal: size, spacing, size of wall, location, background, material. A person trying to make a selection on this is going to have to consider so many things, by the time they are ready to order they are going to have to reconsider are they making the right decision.

Nina: That’s why I see it as being like a pillow that people somebody buys with like a needlepoint poem on it, or a . . .

Moderator: So you wouldn’t give the consumer all these choices, you would say, “here’s the poem” or “here’s the phrase” “take it or leave it.”

David: Choices in color. The number one color you would probably get orders for is black, because white you can’t read very well.

Oscar: But you may not want to read.

Lots of Simultaneous Comments

David: Any time I have ever seen these types of things it’s been done in black, and I can also see gold and silver leaf, and maybe one or two other colors, and that’s all the options I think that you would really need.

Marco: I think that if you were marketing this directly to designers, I would have a lot of choices, but when you are dealing with clients and the consumer at large, a limited number of choices I think is better because . . .

David: Less confusion!

Marco: Right. For us it’s like it would be easy for us to have a client come over and peruse our fabric samples and pick out whatever colors you like, but we are never going to do that because we narrow it down for them.

Nina: You know what it sort of reminds me of—T-shirts. There are some people who love to buy T-shirts that have quotes on them, and I can see certain people will go through a catalog.

David: I have to tell you that none of my clients would ever spend more than 3 minutes looking through a catalog that is a $20 item. I am not going to waste my 20 and 30 minutes on a $20 item, when I can channel that for maybe a $3,000 sofa or something like that. I don’t want to be bothered with the little stuff, and that I consider very little.

Moderator: How do others feel about that? This is kind of like a minor piece.

Marco: It doesn’t have to be a minor piece. If that clear, subtle behind you . . .

David: As far as flipping through a catalog.

Marco: It goes back to who you market to. Are you marketing to designers, or are you marketing to the general public.

Nina: I think most designers also look to accessorize. It goes beyond finishes and furniture too. If you are really working on an entire room or house, and you are trying to also tap into what your client’s personal tastes are, working with the kid’s room, you might want to do something really whimsical on the wall. You might not always be focusing in on a sofa. You want to personalize things.

David: Well I prioritize things, and a $20 item on the wall is last on the list.

Joshua: But if you are charging hourly, it doesn’t matter.

Agreement

David: If I left the house, and was charging them $100 an hour to show them little things to go on the wall that cost $20, they would be complaining I was wasting their time.

Marco: This tone on tone is an interesting idea. It is like a subtle effect for a hallway or something that you don’t see right away, but maybe later when you are walking with a candle you may pick it up . . . or maybe something whimsical.

Dina: I just happened to think of the Paramount in New York, and you would use that kind of thing.

Joshua: That’s the most sophisticated idea of all.

Joshua: It is subtle, but I don’t really think there is a market for it. I think it is a very specific job-oriented product.

David: It is definitely more retail oriented.

Amy: Possibly on a children’s wing in a hospital.

Oscar: Borders?

Laughter

Oscar: Borders is the only application I can see. It will be easy to install, just strip after strip. I have trouble seeing everything lined up. How does it come? You may have to have skilled labor to line up all these things. It is a different skill altogether.

Moderator: Okay.

Nina: And also, I don’t think any of us here would say we would use it on every single job.

Agreement

Nina: I mean it would be once in.

Oscar: If I were to use letters in something like this in a space, I would do it two ways: with dimensions; second with sophisticated light fixture with acetate, and project onto the wall and that way I could change it every so often, and that is something much more unique.

Moderator: What if a client of yours says they want a poem on the wall, would you do this, or would you go to a faux finisher.

Marco: I would go to a faux finisher. With the kind of clients I have, if I were to propose something like this, they would laugh.

Moderator: One last comment. When a new product comes out on the design market, how do you guys usually find out about it?

Joshua: A luncheon

Nina: Or a trade show

Oscar: Magazines

Nina: Reps

Joshua: Calls

Marco: Right now there are a lot of new things coming out it seems.

David: Mail is another.

Marco: But I think a trade show or a luncheon at a showroom is nice because you really get to see everything. I know Coach just came out with their line of furnishings.

David: I can’t imagine going to a luncheon for this.

Agreement

David: This is not Coach or some big line.

Oscar: No, but it could be tied in to a multiple line rep, that brings in several products, and you tie in the product with that face. I think this product to make it really identifiable would have to have a person behind it. We rely on reps.

Moderator: That is how you would buy it is through a rep.

Oscar: You would become aware of it through a rep.

Marco: Well if it was of designer quality . . . if we were talking about the high-end finishes and options.

Moderator: So that seems to be coming up over and over again. You don’t feel it is designer quality? Not in this state

Dina: It feels more like in corporate—like a signage package.

Moderator: Okay, well it is 7:00. Thank you very much for your time. I know you guys have a lot to do, so it was nice of you to do this.

NOTES

1. For discussions of focus groups in the context of marketing research, see Urban, G. L., & Hauser, J. R. (1993). Design and marketing of new products. New York: Prentice-Hall; Churchill, G. A., & Churchill Jr., G. A. (1999). Marketing research method foundations (7th ed.). Orlando, FL: Harcourt College. For more general discussions of focus group technique, see Calder, B. J. (1977). Focus groups and the nature of qualitative marketing research. Journal of Marketing Research, 14, 353–364; Templeton, J. F. (1994). The focus group: A strategic guide to organizing, conducting and analyzing the focus group interview. New York: McGraw-Hill.

2. For discussion of brainstorming, see Osborn, A. F. (1963). Applied imagination. New York: Scribner.

3. Ibid.

4. Silver, J., & Thompson J. (1991). “Understanding customer needs: A systematic approach to the ‘voice of the customer.’” Master’s Thesis, Sloan School of Management, MIT Cambridge.

5. See Templeton for greater discussion of each of these design issues and samples for each stage. Note also that professional focus group firms will perform all of these functions for a fee. A typical fee includes $500 facility fee, $100 per participant recruiting fee, $1,000 moderator fee. This is in addition to the costs you would incur conducting the focus group yourself for honoraria and materials (videotape and food).

6. For original development of repertory grid, see Kelly, G. A. (1955). Psychology of personal constructs. New York: Norton.

7. While Consumer Reports also forms an overall rating, we are more interested in the multidimensionality of automobiles. Data for this section come from Consumer Reports, November 1999, several articles.

8. The normalized scale would ordinarily have models at 0 and 1 values for each attribute. The reason this does not happen for some attributes in the figure is that the normalization is done for the full set of models and the figure only includes those for which all data are available.

9. For discussions of factor analysis, see Harman, H. H. (1976). Modern factor analysis. Chicago: University of Chicago Press. For discussions of factor analysis in the context of Marketing Research, see Urban & Hauser (1993) or Churchill & Churchill (1999).

CHAPTER 5 WORKSHEET

Perceptual Mapping

1. Identifying buyers (from secondary data)

a) Are your customers consumers or businesses? __________

b) If businesses (list the industries that purchase your product/service):

c) If consumers:

2. What mailing lists (or other sources) can you use to locate people/firms in your industry?

3. Are you conducting interviews or focus groups to gather data?________________

Why?

4. Characterize the people you interviewed:

5. What raw dimensions were elicited in the interviews:

6. What competing/substitute products were elicited?

7. Summarize the rankings of each product on each dimension

8. Create Snake Diagram of above table:

Legend for Products

9. Interesting comments from interviews/focus groups

10. Where is there opportunity in perceptual map?

11. What physical attributes of the product can you create to capture the perceptual dimensions elicited from the focus group/interviews:

CHAPTER 6

Characterizing Demand

INTRODUCTION AND GOALS

Conjoint analysis is the centerpiece of the venture design process. Its use marks the transition from feasibility analysis to venture design. The previous chapter helped us reveal the perceptual dimensions that customers use to distinguish one product from another. In this chapter, we convert those perceptual dimensions’ perception into physical attributes of the product. We then gather primary survey data and apply conjoint analysis to characterize demand for each of those attributes. From these demand curves, we can choose the optimal product configuration and price under any assumption about market structure. The goals of this chapter, then, are to close feasibility analysis by defining whether the unmet need identified in the perceptual map has sufficient demand at a profitable price and to begin venture design by gathering the information needed to define the optimal price and configuration.

Conjoint analysis is important for two reasons. At the most simple level, carefully gathered survey data are the foundation for a reliable estimate of product demand. Since almost all venture decisions rely on the demand forecast, moving forward without a good estimate of demand is similar to beginning a trek without knowing your destination, yet trying to make decisions about what equipment and supplies to bring. The real power of conjoint analysis, however, lies not in knowing the extent of demand but in knowing the nuances of the demand—how much of one attribute are customers willing to give up to get more of another? What price will they pay for more of a given attribute? This information allows you to pinpoint the most lucrative market segments with the most profitable product.

The chapter proceeds as follows. First, we discuss the principles underlying conjoint analysis. Then, we walk through each of the steps in the analysis: identifying attributes and attribute levels; designing a survey that elicits customer preferences for different configurations of attributes; and using the survey data to derive demand curves for each attribute as well as for the product as a whole. In addition to gathering data for the conjoint analysis, the survey gathers ancillary data about customer characteristics to inform decisions beyond price and product configuration. In particular, the survey data will help determine if the target market you envision exists and if that market has segments whose tastes for the product differ. Additionally, the survey implicitly tests the effectiveness of the preliminary core benefit proposition and corresponding ad copy and can help uncover the media habits of that target. Finally, the survey gathers qualitative assessments of the product that augment insights from the focus group and confirm them on a wider scale.

PRINCIPLES

Conjoint analysis is a technique that allows a researcher to decompose an individual’s judgment into its underlying structure.[1] The foundational premise that necessitates conjoint analysis is that individuals don’t fully understand their own preferences. Thus, self-reports of those preferences are unreliable.

This self-reporting problem manifests itself in mismatches between the set of attributes that individuals claim are important in their decisions and the actual attributes that are evident in their ultimate decisions. In a really nice illustration of this mismatch, one study asked venture capitalists what criteria they use to determine which business plans to fund.[2] They did this by presenting venture capitalists with a portfolio of 25 real proposals. The venture capitalists in the study were asked to select the ventures they would fund and then to identify for each decision, what criteria drove their decision. The study compared these reported criteria with statistical analysis of the implicit criteria distinguishing funded versus unfunded projects. The comparison revealed that while the venture capitalists reported that the management team was the most important factor in their decisions, the decisions themselves indicated that industry structure was the most important factor.

While conjoint analysis can be applied to any complex decision, we are interested in it here for characterizing customer preferences and product demand. In a marketing context, the problem of mismatches is one between stated preferences and ultimate purchases. Say, for example, that I believe (and tell a realtor) that what I am looking for in a house is a fireplace, a grand stairway, a new kitchen, and a garage. The realtor shows me several houses with those characteristics and finds that none of the houses appeal to me. Ultimately, he expands the search to include several houses and finds that what really draws me to a house is an imposing exterior. The realtor would have saved a great deal of time (both mine and his) if I hadn’t misled him. The problem is that the misleading is unintentional—I am actually specifying what I truly believe matters to me.

The cost of fallacious understanding of customer decision structures in the house problem is fairly trivial. Ultimately, the realtor solves the problem by expanding the search to include more houses. It is likely that people want to look at several houses even if they fall in love with the first one to convince themselves that they have made the best choice. The problem is far more severe in the case of mass markets. Here, firms make product design decisions based on market surveys. If customers innocently, yet incorrectly, report that they care about x when they really make their decisions based on y, then the cost to the company is the entire product development, product launch, and the amount of production that occurs until the problem is discovered. With long distribution channels, it could take several months of production before the problem is even discovered.

A better way to solve the product design problem is for the firm to do something comparable with what the realtor does. Rather than ask customers what matters to them, ask them to evaluate a whole series of products (houses), all of which are feasible configurations of the ultimate product. This is essentially what conjoint analysis does. Each “product” is characterized by a product description or a real physical prototype comprising a specific bundle of attributes. Statistical analysis allows the researcher to decompose the ratings of the set of products into customer utilities for each of the attributes. This decomposition can be done for each individual, aggregated for the market as a whole, or aggregated for any segment of the market. In fact, the analysis allows the researcher to determine if the market is naturally segmented or if it is homogeneous.

In essence, conjoint analysis creates utility curves for each individual and each product attribute. These utility curves are then aggregated to create the demand curves for any group of individuals, combination of attributes, or both. These demand curves, in turn, can be combined with internal cost data (marginal cost curves) to find the optimal product configuration. This is exactly what we plan to do. We will execute conjoint analysis in this chapter to find attribute demand curves. In Chapter 7, we will combine these demand curves with cost data to derive optimal price and product configuration under a variety of market structures.

Before beginning the analytical process discussion, you may want to see an actual conjoint survey. A number of examples can be found by a Web search for “conjoint analysis demo.” In addition, the Epigraphs survey can be viewed at www.questionpro.com/akira/TakeSurvey?id=223385.

ANALYTICAL PROCESS

The conjoint analysis procedure involves a number of steps: (1) identifying the various physical attributes of the product/service together with “levels” for each of these attributes, (2) creating potential product configuration descriptions that combine each level of an attribute with each level of every other attribute,[3] (3) designing and administering a survey that probes customer preferences for each potential product configuration, (4) analyzing the survey data to create demand curves for each attribute, and (5) combining that information analytically to choose optimal product configurations and prices for each segment. We discuss Steps 1 through 4 in this chapter, and leave Step 5 for the next chapter.

Attribute Matrix

One of the outputs of the focus group in Chapter 5 is a set of dimensions characterizing the consumer’s choice map—what dimensions they use to compare competing products. In the case of automobiles, these may be fuel efficiency, acceleration, comfort, etc. In the case of cellular phone service, these may be the size of the network, the clarity of calls, and customer service. The dimensions revealed by the focus group will be perceptual dimensions—intangible aspects of products that buyers use to discriminate one product from another. While we want to satisfy these perceptual dimensions, we accomplish this by manipulating something physical. The first challenge in product design, then, is converting the perceptual dimensions elicited in focus groups into physical attributes of the product that can be specified and costed. Exhibit 6.1 presents the translation of perceptual dimensions into physical attributes for Epigraphs. Examples of the important perceptual dimensions are durability, uniqueness, and ease of installation. There are a number of physical means to make a wallcovering more durable: It could be coated with polymers to make it washable or the actual paper could be made thicker so that it didn’t tear when being applied. Vinyl is both washable and unlikely to tear. Conjoint analysis characterizes the extent to which these physical attributes satisfy customer desires along intangible dimensions.

EXHIBIT 6.1   Converting Perceptual Dimensions Into Physical Attributes (Epigraphs)

Perceptual Dimensions:

Corresponding Physical Attributes:

Budget

Price of materials, hours of labor

Durability/Ease of Maintenance

Vinyl material

Ease of Installation

Package with tools & instruction video

Versatility

Choice of colors, choice of genres

Uniqueness

Custom colors, custom genres

Lag Time

Retailer inventory policy

Predictability/Consistency

Inherent in product

Once the attributes have been identified, the next step is choosing “levels” for each attribute—how much of the attribute should you offer. The levels for any given attribute are inherently either discrete or continuous. Returning to the automobile example, transmission is generally a discrete choice: either automatic or manual, whereas fuel efficiency is continuous (any value from 8 miles per gallon [mpg] for the Ferrari 550 to 68 mpg for the Honda Insight[4]). When attributes are inherently discrete, the choice of levels is simple—merely include each of the discrete options. When attributes are inherently continuous, you will want to offer three levels. Three levels is the minimum required to define a curve, but the refinement gained by having more than three levels generally does not justify the added complexity of the survey task. Moreover, when you offer more than three levels, it draws more attention to an attribute, which tends to make it appear more important than it really is.[5] The exception to this guideline of using three levels pertains to key dimensions along which customer tastes are differentiated. In those cases, each point along the curve corresponds to a different customer segment. The way to recognize products where customers have differentiated tastes is that they exhibit substantial variety for a given price and quality. Examples of differentiated products where you can choose from an almost infinite variety at a given price are cereals, clothing styles, music CDs. Differentiated taste attributes are distinct from “shared scale” attributes such as acceleration, where more acceleration is always better.

The choice of which three levels to offer for continuous attributes is governed by the desire to capture the “optimal” level with the range of the levels. Thus, if current automobiles offer fuel efficiency of 15 to 45 mpg, you might want to offer 10, 30, and 50 mpg (go slightly beyond the existing performance range). Don’t forget that one of the most important continuous attributes is price.

This process of choosing levels for each attribute will yield a table like that in Exhibit 6.2, where attributes are represented by columns and levels for each attribute are represented by rows. The total product configurations (each level of one attribute combined with each level of the other attribute) implied by Exhibit 6.2 is 162. We obtain this by multiplying 3 fuel efficiencies × 3 transmissions × 3 accelerations × 2 brakes × 3 prices. Asking subjects to evaluate all 162 products would be an enormous task. Fortunately, we only need to present them with a small subset of these combinations. We then use statistics to infer what results will be for the remaining combinations.

You can imagine that the reliability of the conjoint responses is an inverse function of the survey complexity. Studies show that when subjects face too much complexity, they tend to focus on a few attributes and ignore the rest.[6] To ensure reliable results, you should only include in your matrix those attributes (1) that you control, meaning you can actually choose to include or exclude them in your product design and (2) that incur a cost. It is probably easiest to explain this by discussing what attributes to exclude:

1. Exclude any attribute that is expected as part of the industry standard. In the case of automobiles, this set is infinite, but one example is driver-side airbags. Since you know that you have to include airbags, there is no reason to estimate their value. Sometimes, these attributes are referred to as “Table Stakes.” They are the ante you need merely to enter the game.

2. Exclude attributes where the design decision can be made without a demand curve. One way to identify these attributes is that their marginal cost is typically zero. Color is a good example. It doesn’t cost any more to paint all cars blue than to paint all cars black. If you can only offer one color, you merely ask what color respondents prefer and choose the most popular. If you can offer multiple colors, ask for color rankings and then attempt to offer those colors that span the most “first choices.”

Conversely, some attributes not typically considered part of the product, should be treated as such. Location and distribution channel, for example, aren’t typically considered part of the product, but they have a profound impact on demand. This demand impact is distinct from the “access” effects of how many people use a given distribution channel. The example of Neiman-Marcus helps distinguish between the two effects. Neiman-Marcus has low access—there are only 34 stores and the mean customer income is above $75,000, so very few customers actually shop at Neiman-Marcus. However, if you sell a product through Neiman-Marcus, people will be willing to pay more for it than if you sell the same product at Wal-Mart because Neiman-Marcus imbues the product with prestige. Another extremely important attribute not typically considered part of the product design is brand. If you are introducing a new product into an arena with existing brands, you need to understand how much pull those brands actually have relative to a new brand. Create a “brand” attribute and include two existing brands plus whatever brand you plan to use for your product.

Web-Based Conjoint Surveys

Until very recently (including the previous edition of Venture Design), the implementation details for designing and analyzing conjoint surveys were so tedious that only the truly enthusiastic entrepreneur would tackle them. Fortunately, that is no longer the case. Turnkey Web-based application service providers (ASP) have made conjoint analysis accessible both financially and computationally to most entrepreneurs and now account for 40% to 50% of conjoint studies.[7]

The advantages of Web-based surveys over paper-and-pencil versions can be divided into two categories: things you can see and things you can’t. The advantages you can see include immediate response (avoiding lags both directions when using mail); flexibility—if you discover that subjects are misinterpreting something, you can change it for all subsequent subjects; reliability—data are collected electronically, thereby avoiding the time and errors associated with coding; vividness—full color interactive surveys may induce higher response rates; and simplicity—online page configurations makes surveys appear shorter and easier to complete.

While the advantages you can see are substantial, those you can’t see are possibly even more important. These include the automatic conversion of attributes and levels into the conjoint questions, the conversion of gathered data into a format suitable for analysis, the actual analysis of the data, and a simulator which allows you to examine the impact of competition from other products.

The enormous administration advantages of online surveys alone are sufficient to advocate the Web-based ASPs. However, there is also evidence that Web-based surveys have greater predictive validity than paper-and-pencil surveys. What this means is that predictions from online surveys better match actual purchases.[8] This greater predictive validity may arise because the interactive nature of Web surveys stimulates greater attention and involvement. Alternatively, it may arise because people now purchase online, and therefore, the online survey choice task better mimics a real purchase process than does a paper-and-pencil survey.

The only remaining caveat for Web surveys is the issue of sample bias. By definition, responses are only collected from people who have access to the Internet. As of 2007, 34% of households still do not have Internet access.[9] Since Internet access is correlated with income, a Web-based survey will systematically underrepresent low-income segments of the market. This is the modern day equivalent of using the phone book to sample voters prior to the Dewey-Truman election (and having high confidence that Dewey would win). Of course, if you are distributing your product or service exclusively over the Internet, this bias is irrelevant. Similarly, if you are targeting affluent segments, its impact may be minimal. You may be surprised that we recommend a Web-based survey even if you are surveying low-income segments. However, rather than having subjects use the Web themselves, you can create a print version and have subjects complete it with paper and pencil. Once you collect the paper surveys, you can have someone on the venture team complete a Web survey for each paper version. While this approach foregoes the “advantages you can see,” it preserves those you can’t.

Designing the Survey

Survey design involves six elements: (1) specifying/obtaining the sample, (2) designing the cover letter or contact script, (3) creating the “ad copy,” (4) writing the instructions, (5) creating the product configuration questions, and (6) writing the ancillary questions regarding demographics (to assess segmenting), distribution channel (if not part of the product configuration), and media exposure. We treat each of these in turn.

Sample. Sample choice is an art as much as a science. The problem with almost any sampling technique is that it introduces sample bias. Thus, the best sample is one in which the attendant bias is least likely to affect you. Most samples will be based on mailing lists. While you can contact potential subjects by mail or phone, a more logical means to contact them for a Web-based survey is by e-mail. Lists of opt-in e-mail addresses can be purchased from a number of online vendors. PostmasterDirect.com, for example, maintains 30 million opt-in e-mail addresses for consumers that you can purchase. Similarly, lead411.com sells e-mail addresses for 200,000 executives at 50,000 companies. For both consumer lists and executive lists, most firms will allow you to target your list by consumer demographics or firm characteristics.

Remember that you will want at least 30 respondents from each market segment to obtain reliable results. Thus, if you think men’s preferences for your product will differ from women’s, and you want to sell to both groups, you will want to obtain 30 surveys from each group. Furthermore, not everyone who receives the e-mail will respond. In fact, typically less than 10% of solicited consumers will complete the survey and even fewer executives (3%)[10] are likely to complete the survey. Accordingly, if you want reliable results, you should plan to send e-mails to at least 300 people or 1,000 executives to obtain 30 completed surveys.

The Cover Letter. One of the main mechanisms for improving the response rate to a survey is the initial contact letter/e-mail. The goal of the cover letter or e-mail is to capture the attention of the potential respondents and to provide them with a compelling reason to participate in the study. Think of the cover letter as an advertisement for your study. People are most interested in participating in a study if they feel it is important or interesting and if they believe that their participation is highly valued. Techniques commonly recommended to achieve these goals areas follows:

• Preliminary contact (so respondents anticipate the survey)

• Monetary (or other) inducements

• Follow-up contact (since the response rate increases from 10% for a single contact to 24% for five contacts)

• Survey sponsorship by a reputable institution (adds credibility)

• Personalization (using the subject’s name in the greeting and possibly the body)

• Confidentiality/anonymity of responses (to increase the likelihood of obtaining sensitive information)

For the Epigraphs survey, we followed all these suggestions other than the preliminary and follow-up contacts. Our initial contact was a personalized (using mail merge) and hand-signed letter on Wharton letterhead. We included a contest for those who returned responses quickly. This approach yielded a 25% response rate. Exhibit 6.3 is the cover letter for the Epigraphs survey.[11]

The Ad Copy. Obtaining reliable answers to the conjoint questions depend on your ability to convey the product’s core benefit proposition clearly yet concisely. This is the job of the “ad copy.” What we mean by ad copy is the product description at the beginning of the survey that introduces your subjects to the product for the first time. The survey ad copy works in similar fashion to an online or print advertisement that introduces customers to new products—visually and through written description. As much as possible, you want the survey to mimic the process of a customer being exposed to an ad and then making a purchase decision. Accordingly, all the guidelines for creating advertising copy apply here.[12] You may even want to hire an advertising firm to create the ad copy now then use it again later for actual print and online ads. The main difference between customers viewing the ad in the survey versus in the media is that you are guaranteed attention. In the print media, your ad competes with the other 1,500 communications consumers see each day. To get a good intuitive sense of what constitutes good copy for your product read print ads for similar products in magazines matched to your target demographics. Exhibit 6.4 is the ad copy from the Epigraphs survey.

Survey Instructions. Once you have captivated your subjects with the ad copy, you want to instruct them on answering the survey. The main goal of the instructions is to ensure that all subjects are interpreting the survey questions correctly and in exactly the same manner. The instructions should restate the projects goals, explain the survey format, clarify all assumptions that subjects should make, and describe each of the attributes and their levels. Exhibit 6.5 is the set of instructions for the Epigraph survey.

EXHIBIT 6.3   Epigraphs Cover Letter

Date

«Title» «First_name» «Last_name»

«Address»

«City», «State» «Zip»

Dear «Title» «Last_name»,

I am leading a research team at The Wharton School to help a new firm design and market its first product for the home decorating market. We would like to ask for your help. In order to do so, we will ask you to read the enclosed “advertisement.” This ad is in very rough form, but imagine that it would appear in more professional form in a home decorating magazine some time in the future.

Once you have read the ad, we would like you to complete the attached survey, which asks your opinions about the new product. Your opinions will help in creating the final design for the product and will also help determine where and how it should be sold.

Since it is a new firm, there is not much of a budget (we are offering our services for free). However, we are able to offer a very small token ($1.00) of thanks. In addition, all people who respond by November 15 may enter a contest to win $100. Since we are only sending the survey to 150 people, and not all of them will respond, there is a decent chance of actually winning. Details on the contest are at the end of the survey.

If you are willing to help us, please return the survey in the enclosed envelope by November 12, and keep the $1.00 as a token of our thanks. If you are unable to help us, we ask that you return the $1.00 in the enclosed envelope, so that we can find another opinion to replace yours.

We sincerely appreciate your help!

Sincerely

Anne Marie Knott

Product Configuration Questions. Designing the product configuration questions involves three decisions: (1) the question format—how the purchase decisions are presented (selfexplicated, adaptive conjoint, choice comparisons, and full ratings profiles), (2) the number of tasks (questions), and (3) the number of choices (products) per task. The objective in making each of these decisions is reliability—ensuring that inferences drawn from the survey data reflect the purchase decisions that will ultimately be made in the real world. Reliability has two components. The first is behavioral reliability: Choices in the survey match the choices subjects would make in the real world. The second is statistical reliability: The inferences drawn from the limited data for each subject match inferences you would obtain if you could ask an infinite set of questions.

EXHIBIT 6.4   Epigraphs Ad Copy

Rough Version of the Advertisement

Epigraphs is a new product that can be applied to painted walls to create a custom look. Epigraphs have the look of stencils, but with less repetition, and far less work. Single lines of epigraphs can be used as an accent, or several lines can be used in lieu of wallpaper to create a whimsical room.

Epigraphs come in strips of self-stick graphics ready for installation. The product is applied dry, so it has none of the mess of stencils, borders or wallpaper, nor any of the rush to apply the product before it dries. Further, because there is space between words, Epigraphs do not have the alignment and abutment problems of wallpaper. This leads to two advantages over wallpaper: 1) Epigraphs tolerate minor installation problems that wallpaper won’t, and 2) there is no need to buy 20% extra Epigraphs to compensate for matching problems, and waste around doors and windows. Experience indicates that an entire 10’ × 15’ room (400 square feet of wall) can be installed in less than 8 hours.

Epigraphs come in 7 standard colors (including gold, silver, hunter, burgundy, sapphire, black, and white), and 5 standard themes (including literacy, humorous, inspirational, sports, and movies). For each of the standard colors, Epigraphs has identified coordinating paints for three different looks: tone-on-tone (a very subtle look), complementary (a subdued look), and contrasting. These combinations create 105 different patterns. While this is a good deal of variety, there is also an option for you to create your own unique look with custom colors and graphics.

Background for questions that follow

We would like you to evaluate alternative versions of the product described in the “advertisement.”

As you consider the product keep in mind the following assumptions:

a) Assume that the product is packaged in 50-foot sets. Each set will cover 50 square feet of wall space. This is comparable to a double roll of wallpaper. (A good size 10’×15’ room has 400 square feet of wallspace.)

b) Assume that the product is packaged with fully illustrated instructions, and that it can be installed by a “do-it-yourselfer” with more effort than paint, but less effort than wallpaper.

c) Assume that the only special tool needed to install the product is a squeegee that comes packaged with the product. The only other tools you will require are a ruler and a level.

d) Assume that when you purchase the product, we will provide suggestions for coordinating paint. These suggestions will include two or three “looks” (tone-on-tone, complements, and contrasts) that you can choose from. For each look, we will identify a specific manufacture’s paint name and color number.

e) Assume that for standard options, your purchase will be available immediately, and for custom options, the product will be shipped in 4–6 weeks

Potential product features

There are four basic features of the product that the firm is trying to pin down. We need your help deciding which versions of these features to offer. We describe each of these to help you make your decisions.

COLORS:

Standard colors: the basic product will come in a variety of 7 standard colors, including gold, silver, hunter, burgundy, sapphire, black, and white

Custom colors: for a premium, the product can be made in a variety of 100 colors

QUOTE THEMES:

Standard themes: the basic product will come in a variety of 5 standard themes, including literary, humorous, inspirational, sports, and movies.

Custom themes: for a premium, you can specify a custom set of quotes/graphics that you would like to have produced. We would provide you with information on how many words you would need given your space requirements.

WHERE PRODUCT IS SOLD:

Paint/wallpaper chain (such as Sherwin-Williams or Wallpapers to Go)

Home superstore (such as Home Depot)

Internet

PRICE PER 50-FOOT SET:

$35.00

$60.00

$100.00

Product choice questions

You will now be presented with 12 questions that describe three potential versions of the product. For each question, please pick the version of the product you prefer most.

Data on the overall reliability of conjoint studies are extremely difficult to obtain. In general, firms are very protective of both their primary research data and their sales data, and we need both to validate the methodology. We do, however, have two reasons to believe that conjoint results are reliable. The first is the dramatic growth in the use of conjoint studies. Current estimates are that 40% of all online research is conjoint analysis. This estimate seems plausible given the fact that a Google search on “conjoint demo” yields 92,800 hits. Presumably firms wouldn’t use conjoint more than once if results were unreliable.

The main evidence that results are reliable, however, comes from two careful studies. The first study examines statistical reliability through a Monte Carlo simulation of 30 synthetic individuals evaluating a product with 8 attributes and 31 levels. This study found that with as few as 160 “level observations” the correlation between actual preferences and inferred preferences was 97.8%. This was true even with response error as high as 12.5% of the range of values (±0.5 on a 9-point scale).[13] The second study examined behavioral reliability comparing conjoint results with actual purchases.[14] The study involved 600 subjects in five grocery stores, where each subject evaluated one of three product categories then made purchases in the store. The primary purpose of the study was to examine price elasticity (the sensitivity of demand to changes in price), so the conjoint attributes were brand, price, and a “decoy” attribute that was irrelevant to the analysis. The study found 97.3% correlation between the market shares predicted by conjoint analysis and the actual shares of products purchased in the store that day.

As we design the product configuration questions, we want to preserve these levels of reliability. We now discuss each of the major survey design issues: question format, number of choices (products) per task, and number of tasks (questions). In each discussion, the emphasis is on obtaining results that reliably predict purchase behavior.

Question Format. The first design issue is the format for asking each of the product configuration questions. There are two basic options: ratings-based conjoint and choice-based conjoint (CBC).[15] The choice of which format to use should be guided by the decision process subjects face for your product category.

Ratings-based conjoint presents subjects with a series of questions, where each question corresponds to a single product configuration. The respondent is asked to rate the configuration on either an attractiveness scale or a purchase likelihood scale. The defining aspect of this question format is that the respondent is asked to evaluate each configuration in isolation—that is, ignoring other possible configurations. One issue with this approach is that the standard of comparison is implicit. This poses two problems. The first is that the standard may change over the course of the survey as subjects learn more about alternatives. The second is that we as researchers don’t ever know what implicit standard the subject is using. This is fine if products in this category are evaluated in isolation rather than by comparison with other alternatives. Examples of such product categories are clothes, music, books. People are deciding whether they want something enough to purchase it versus deciding they like it more than a competing product.

The most common conjoint format is CBC. With this format, subjects are presented with a series of questions (tasks), where each task offers two or more product configurations. The subject is asked which configuration they prefer. CBC questions are generally easier to answer than ratings-based conjoint. It is easier, for example, to identify which of two or three versions you like best than it is to identify how likely you are to purchase a particular version. There is some concern that CBC forces subjects to focus on a few salient attributes while ignoring others. This is only problematic, however, if during real purchases, customers really weight all attributes equally, which seems doubtful. CBC is the preferred format for product categories where customers do indeed choose between competing alternatives. This seems to cover the vast majority of consumer products and services.

Number of Choices per Task. If your product category favors a CBC format, the second survey design issue is how many alternatives to offer per question. (If you choose ratings-based conjoint, there is only one alternative per question). Again, the goals for this decision are estimation efficiency and predictive reliability. Fortunately, there is research to guide this decision. The research is based on a Monte-Carlo study of a product consisting of four attributes, each of which had three possible levels.[16] The study compared the estimation efficiency of two-, three-, and four-choice designs, holding constant at 36, the number of configurations presented with subjects. In other words, the two-choice format had 18 questions, the three-choice format had 12 questions, and the four-choice format had 9 questions. Results from that study indicate that the three-choice format had the greatest estimation efficiency. It offered a 47% improvement over a two-choice baseline, while a four-choice design offered only a 25% improvement over the baseline. Given these results, and given that the workload of 12 three-choice questions seems preferable to the workload of 18 two-choice questions, we recommend three-choice designs.

Number of Tasks. Once you have chosen a question format and determined the number of choices per task, the next decision is how many questions (tasks) to present. The reliability trade-off here is between statistical significance (favoring more questions) and fatigue effects (favoring fewer questions). Fortunately again, research can guide us. Another Monte Carlo study examined the choices of 30 simulated individuals to a conjoint survey for a product with 8 attributes and 31 levels.[17] The researchers wanted to determine how closely the statistical inferences from the survey matched the individuals’ true preferences under conditions of rounding error and response error. The results indicate that six observations per level (40 paired comparisons of two attributes at a time) ensured 98% correlation between inferred preferences and actual preferences. This was true with up to 10% response error, where subjects made mistakes in reporting the strength of their preferences. In the case of Epigraphs, the “six observations per level” rule of thumb suggests we only need five tasks, where each task compares three product configurations (10 levels × 6 observations per level)/(3 configurations per task × 4 attributes per configuration) = 5 tasks. When the number of tasks obtained by the rule of thumb method is less than 12, we still recommend asking 12 questions. This follows from the number of choices study above that showed that for the same number of level observations, 12 tasks yielded greater statistical efficiency than either 9 or 18 tasks.

The Demand Question. One concern with CBC questions is that the results are expressed as relative attractiveness or utility. Ideally, results would be expressed in absolute terms such as unit demand: How much of the product will customers buy if it has a given set of features? There are two ways to estimate demand from utilities. Which method to use depends on how far your product departs from existing products. If your product shares many features with existing products, then you include attributes and levels that capture the existing product in addition to the attributes and levels needed to test the proposed product. Using this method, you merely find the estimated utility for the existing product using conjoint then compare the conjoint utility estimate with actual sales for the product. This provides a demand-to-utility scale factor that can be applied to the utility estimates for all other configurations.

The existing product approach offers the most reliable demand estimates because it is rooted in real sales data. In some cases, however, the proposed product is such a radical departure from the past that no combination of conjoint attributes will capture an existing product. In those instances, you will want to include a demand question for the “worst configuration” of your product. The worst configuration combines the most barren levels of each of the attributes. The particular version of the demand question to ask depends on your product type. For durable goods that consumers purchase infrequently, the best means for asking demand is likelihood of purchase: “How likely (on a scale of 1 to 5) it is that you will purchase this product in the next 6 months?” For repeat goods, such as shampoo, consumers would be asked how frequently they would purchase this product within the next 6 months or how many they would purchase in that period.

One thing to remember when asking purchase intentions is that subjects tend to be optimistic. A separate but related problem is that subjects who take the survey actually become more likely to purchase the product. What we really want to predict is demand for all customers, not just those who took the survey. Accordingly, we need to subtract out the demand that is stimulated by the survey itself and compare latent intentions with real purchases. One study has done both these things for groceries (consumables), automobiles, and computers (durable goods with different price/income ratios).[18] Exhibit 6.6 indicates fairly close agreement between latent intentions and actual near-term purchases for consumables and lower-priced durable goods but shows substantial optimism for expensive durable goods (autos). For example, 75% of the subjects reporting that they would return to the grocery store did so within 4 months. Similarly, 67% of the subjects reporting that they would buy computers within the next 7 to 12 months actually purchased one within 6 months. Note that several of those who didn’t expect to purchase a computer actually did so. These results stress the importance of specifying a time frame for purchase when you ask your demand question. In contrast to the grocery and computer results, note that only 25% of the subjects reporting that they would purchase a new automobile within the next 6 months actually did so.

Once you have purchase intentions for the “worst configuration,” and correct them for optimism, you proceed in the same manner as for existing products. Find the estimated utility for the worst configuration using conjoint, then compare the conjoint utility estimate with the corrected purchase intentions (demand). As before, this provides a demand-to-utility scale factor that can be applied to the utility estimates for all other configurations.

EXHIBIT 6.6   Rescaling Survey Responses for Optimism

Source: Chandon, P., Morwitz, V., and Reinartz, W. (2005). Do intentions really predict behavior? Self-generated validity effects in survey research. Journal of Marketing, 69(2), 1–14.

Ancillary Questions. The final component of the survey is the ancillary questions. There are two types of ancillary questions: demographic questions and product insight questions. The most important ancillary questions are demographics. Demographics allow you to interpret variance in demand for your product or its attributes. Substantial demand variance is an indication that your market is segmented. Demographic questions allow you to characterize the segments and determine whom to target with what product configuration. In designing an urban shuttle service, for example, you might find that there is large variance in the number of stops subjects are willing to tolerate. If you have demographic data, you may find that women prefer more stops (under the assumption that more stops means more passengers and greater safety in number) whereas men prefer fewer stops (indicating little concern with safety, but a premium on convenience). With such a result, you could choose to offer two services or serve the more lucrative segment. Without such data, you would be forced to design a compromise service unlikely to be attractive to either group. A moderate number of stops, for example, is neither safe nor convenient.

Another important set of ancillary questions deals with attributes excluded from the product configuration questions for reasons discussed earlier. For example, if you are deciding how many and which colors to offer, here you would ask respondents to rank a set of colors. Similarly if distribution channel is not one of the attributes, you would now ask where respondents are likely to look for (or last searched for/purchased) products in your category. You would identify candidate channels and ask them to rank or choose between them. You might also include an “other ________” choice to surface channels you had not considered. Finally, an equivalent question to the distribution channel question asks respondents what media vehicles they use most frequently. The answers may merely confirm what you know from secondary data, but in combination with the demographic data, they may allow you to better target your advertising.

Survey Logistics

Once you have designed the survey, you need to post it online. There are a number of survey ASPs, but the best we have found is questionpro.com. The site has an interactive guide illustrating each step and also has extensive help links: www.questionpro.com/conjoint/choice-based-conjoint.html.

After the survey is posted, but before you release it to the main subject pool, you want to pretest it with two or three representative customers. The goal of pretesting is to ensure that people unfamiliar with the product comprehend it. You further want to ensure that subjects understand the survey instructions and will respond to each question in the way you intend. After subjects take the survey, interview them and ask about each of these things. Also ask if there was anything about the product or survey they found confusing.

When you are satisfied that any pretest problems have been corrected, you can “release” the survey. To do so, merely send the cover e-mail with a link to the survey URL to each subject on the e-mail list. While you can send e-mails from most survey sites, you will want to send them from an e-mail program with mail merge capability. This allows you to personalize the e-mail to increase the response rate as we discussed under the cover letter.

You should expect to receive some responses immediately. Review these early responses right away as a final check of the survey’s integrity. (The nice thing about Web surveys is that you can change them if you find an error. You must, however, keep track of which responses were received prior to the correction.) You will receive the bulk of your responses within the first 2 to 3 days. Beyond that time, you should assume that people who haven’t responded have either decided not to participate or have saved the e-mail intending to respond later. After about 1 week send a reminder e-mail. This will nudge those who intend to respond and possibly encourage a few others to participate.

Analyzing Data

The conjoint survey ASPs allow you to review results in almost an infinite number of ways. The first thing that you should view and save are the raw data. The raw data are merely the spreadsheet that captures each question as a column and each subject as a row. This allows you to review the entire record for each subject and is useful to check the quality of each completed survey. Most software also allows you to view question summaries. These are typically displayed as bar charts showing the distribution of answers to a given question. Exhibit 6.7 provides summaries for the ancillary questions in the Epigraphs survey.

EXHIBIT 6.7   Summaries of Ancillary Data

The two most important analytical tools for evaluating alternative product configurations, however, are the “utilities” summaries and the market share simulator. The aggregate utility summary for each attribute defines how much additional benefit the average subject obtains as you increase the level of an attribute. Exhibit 6.8 presents the utility summary for Epigraphs.

Probably the best means to view utility data, however, is to create utility curves. To do this, you merely plot utility versus level separately for each attribute using a spreadsheet graphing function. Exhibit 6.9 shows the utility curves for each of the Epigraphs attributes.

Utility curves provide nice intuition about the importance of attributes and levels, but utilities are unitless, so on their own they can’t support product configuration decisions. To facilitate these decisions, you need to convert utilities into either demand or “willingness to pay” (WTP). We describe the conversion from utility to demand first, then describe the conversion from utility to WTP.

Utility to Demand Conversion. Unit demand is the number of units sold over a given period of time (typically a year). There are two means to convert utility to demand. We briefly described each of these methods when we discussed the demand question. The first and most reliable conversion uses sales and utility for an existing product. For such a product, identify the conjoint utility for each of its attribute levels, including the utility of the brand. Add these together. The sum is the total utility for the product. The unit sales for that product (obtained as part of the industry analysis in Chapter 4) provide the demand associated with that utility. The two figures form a demand-to-utility scale factor ([unit sales for the existing product]/[sum of the utilities for all its attributes]) that can be applied to the utility for any other configuration or attribute to convert it to demand.

EXHIBIT 6.9   Utility Curve for Internet and Chain Distribution

Sample utility to demand conversion (existing product): Suppose you have a new toothpaste that turns from green to white when your teeth are clean. You conduct a conjoint study and obtain the utility for your brand, for turning white, and for several attributes already in the market. Crest gel with fluoride and whitener had sales of 25 million tubes. The conjoint utilities you obtain for Crest, gel, fluoride, and whitener are, respectively, 0.20, 0.05, 0.10, and 0.15. The total utility for the version of Crest which sold 25 million tubes is therefore 0.50. The conversion scale factor is obtained by dividing sales by utility: 25 million/0.50 or 50 million/1. Thus, each unit of utility is expected to generate demand of 50 million tubes of toothpaste.

The conjoint utility for your brand is 0, the utility for turning white is 0.10. Your product’s total utility is therefore 0.10. To estimate demand for your product, apply the scale factor (50:1) to the product’s utility (0.10). The expected demand for your new toothpaste is 5 million tubes (50 million × 0.10).

The conversion using existing products offers the most reliable demand estimates because it is rooted in actual purchase behavior. For new to the world products, where there is no existing product to use as the basis of comparison, you need to combine utility data with answers to your demand question for the “worst configuration.” Demand for each configuration is the reported demand adjusted for optimism (Exhibit 6.6). Utility for each configuration is computed as above, by adding the utilities for the relevant attribute levels. The scale factor is demand/utility for the worst configuration.

Sample utility to demand conversion (new consumable product): Suppose, the average purchase intention from conjoint is four units in a 6-month period. Suppose also that industry analysis in Chapter 4 indicates that your target market has 1 million customers. The purchase intention for consumables optimism in Exhibit 6.6 indicates that actual purchases are only 75% of intended purchases. Applying the optimism adjustment (0.75) to the number of units (4) and the market size yields a demand estimate of 4 × 0.75 × 1 million = 3 million units. If the conjoint utilities for the attributes sum to 0.30, then the scale factor is 3,000,000/.3 = 10 million/1.

If your product’s total utility is 0.40, the expected demand for your new toothpaste is 4,000,000 (10 million × 0.40).

The demand conversion tells you how many units you can expect to sell of any given configuration. So one way to make profit-maximizing configuration choices is to compute demand for all product configurations and then compare total revenues with aggregate cost for each configuration. The problem with this approach is that the number of potential configurations is generally quite large. Remember the number of possible configurations for the auto example in Exhibit 6.2 was 162. A simpler approach is to look at each attribute separately. To do that you need to convert demand for an attribute level into a price that customers are willing to pay for that attribute level. We do that conversion next.

Willingness to pay, as the name suggests, tells you how much more customers are willing to pay for the next higher level of an attribute. You need this information in combination with attribute cost information to determine (1) if it is profitable to offer the attribute at all and (2) at what level the attribute is most profitable.

To estimate WTP for an attribute you first find the utilities for the baseline configuration by adding the utilities for all attribute levels in that configuration. In the Epigraphs example, the utility for a baseline configuration of standard colors, standard themes, and Internet distribution with a price of $100 is found by adding 0.003 (standard colors), 0.004 (standard themes), 0.020 (Internet), and 0.005 ($100). This yields total utility of 0.032. We compute the utilities for the other two prices by replacing their respective utilities for 0.005. The three points define the baseline utility curve in Exhibit 6.9.

A change in the product configuration (by adding and deleting an attribute) shifts the utility curve up or down by the amount of the attribute’s utility. For example, changing the distribution channel from the Internet to chains shifts the utility curve up by 0.493. This shift represents the utility for chains, 0.513, minus the utility for the Internet, 0.020.

To estimate the WTP of chains graphically using Exhibit 6.9, choose a given level of utility, draw a horizontal line through that utility, then find the corresponding prices for both the base configuration and the new configuration. The difference in price is the WTP of that attribute (at that utility level). Take for example, a utility of 1.00. The price for the base configuration (Internet) at that utility level is $47.50. The price for distribution through chains at that utility is $60 (obtained by moving to the right along that level of utility to the “chains curve, then dropping down to the corresponding price on the X- axis). Thus, the WTP for chains at that utility is $12.50. Note that for higher levels of utility, the marginal value of attributes is lower.[19]

EPIGRAPHS ANALYSIS

We have already presented a good deal of the Epigraphs data and analysis as part of our process description. The aggregate utilities are shown in Exhibit 6.8 and the ancillary data are presented in Exhibit 6.7. There are a few additional things that we can do. The first is to convert utility to demand and review the basic conclusions. The second is to conduct segment analysis.

Demand Conversion. The demand question in the survey was phrased as follows:

If a product with standard colors and standard themes were available through a chain, such as Sherwin-Williams, at a price of $35, how many rolls (50 square feet each) would you purchase within the next 6 months?

The mean response to this question was 5.03 rolls. If we adjust that estimate for optimism (0.75 for consumables), the estimated demand for that configuration is 4.03 rolls. The full distribution of responses across the number of rolls is presented in Exhibit 6.10. The corresponding utility for this configuration is obtained by summing the utilities for each of the attribute-levels: 0.003 (standard colors), 0.004 (standard themes), 0.513 (chain), 0.487 ($35). This sum is 1.00. Comparing demand of 4.03 with a utility of 1.00 yields a conversion factor of 4.03 rolls per unit of utility. We can apply this conversion factor to the utility curves in Exhibit 6.9 to obtain the demand curve in Exhibit 6.11.

EXHIBIT 6.10   Distribution of Demand

EXHIBIT 6.11   Demand Curve for Internet and Chain Distribution

Preliminary Demand Forecast. Without optimizing the product configuration (which we do in Chapter 7), we can formulate a preliminary demand forecast. To do so, we take the demand estimate for the baseline (4.03 rolls), then apply the adjusted estimate to the market size obtained in Chapter 4 (15 million households purchase household textiles each year). The resulting forecast for the baseline configuration is, therefore, 60 million rolls sold in year 1.

This forecast assumes that the sample is representative of the target market and that respondents have responded truthfully (subject to optimism bias). This estimate is an average over those who like the product and would need eight or more rolls and those who dislike the product and would not purchase any rolls. Moreover, these results are for a baseline configuration. In addition to developing a preliminary top-level forecast of demand, we can also draw some inferences about the attributes.

Price. The first observation is that the market is price sensitive. Exhibit 6.8 indicates that price is the most important attribute—explaining 72% of the variance in demand. The demand curve and corresponding demand equations reinforce this. At low-end prices, each $1.00 increase in price decreases demand by 0.04 rolls.

Distribution Channel. The second most important “attribute” is the distribution channel. It explains 21% of the variance in demand. We offered three distribution channels: paint/wallpaper chains, home superstores, and the Internet. The aggregate utilities indicate that the preferred channel is paint/wallpaper chains, with a utility of 0.513. This channel is, however, almost interchangeable with superstores. Their utility is 0.507. The Internet, however, has a significant negative impact on demand. The utility for the Internet is 0.020. Given the scale factor, this implies a 1.96 roll decrease in demand for any given price. This probably reflects the fact that people prefer to see real samples of their wallcovering before purchasing.

Product Configuration. There appears to be no demand for custom colors or themes. In fact, utility decreases slightly going from standard to custom versions of each. This is consistent with comments in the focus group that the product needs to be simple. As it is, customers have an implicit choice among 35 configurations (7 colors × 5 themes). Choice from among more alternatives requires considerable work on their part.

Segment Analysis

So far, our analysis has been for the entire group of subjects as a whole, with the implicit assumption that they are identical. At this point, we examine whether demand differs across customer groups. We do this through the “grouping/segmentation analysis” function in the survey software.

Income. The first segment results pertain to income. Exhibit 6.12 indicates that demand peaks at incomes of $75,000 to $100,000. This is consistent with the focus group results. The designers in the focus group tended to respond negatively to use of the product for their clients, but said that they could envision its attraction to the mass market.

Married. The most significant segmentation result pertains to marital status. It more than doubles demand. Average demand for unmarried households is 1.41 rolls. In contrast average demand for married households is 3.58 rolls.

Children. Demand further increases in households with children by 0.9 rolls. This is an interesting result, since it runs counter to the trends in American Marketplace (Exhibit 5.5). Associating this quantitative result with comments from the focus group provides some insight. Children pose problems for many wallcoverings—fingerprints, tearing, etc. The Epigraphs product is less susceptible to these problems and, thus, may be tapping latent demand for wallcovering. Demand for existing wallcovering may be suppressed by its characteristic fragility. An alternative explanation is that this product is somehow matched to children (suitable for children’s rooms). We can test these two hypotheses by reviewing the summary of open-ended responses in Exhibit 6.13. These data indicate that a child’s room is in fact the third most popular room for the product—suggesting support for the latter explanation.

EXHIBIT 6.12   Sample Segmentation Analysis: Demand Versus Income

Gender. Demand is 1.43 rolls higher for females than males. This is consistent with conventional wisdom suggesting that women do most of the home design (they comprise 85% of subscribers to “shelter” magazines).

Thus, the target market for Epigraphs does not appear to be segmented. Rather, it appears to match the mass market for home decorating that we found from industry analysis. Accordingly, we can take advantage of cumulative industry wisdom regarding access to the wallcovering target market—both distribution channels and media vehicles.

Having generated the demand curves from primary data, we move in the next chapter to combining them with cost data to analyze optimal price and product configuration. Note that there is a good deal of data from the survey that we have not discussed as part of the analysis. These data are captured in charts of ancillary data (Exhibit 6.7) and the summary of open-ended responses (Exhibit 6.13). While not germane here, these data become important in subsequent analyses.

CONCLUSION

This chapter gathers primary survey data and applies conjoint analysis to characterize demand for the new venture. Conjoint analysis allows customers to compare products comprising different combinations of attributes. Keys to this process include defining attributes, determining the attributes’ levels, limiting the set of possible product configurations so as not to overwhelm the consumer with choices, and deriving a demand curve for the product configurations and the individual attributes. This requires significant effort. Yet this market research can save entrepreneurs significant amounts of time and money by carefully developing a product that consumers will want and be happy to pay for. The next chapter continues by analyzing this chapter’s demand data to develop the venture’s competitive strategy (price and product configuration).

NOTES

1. Green, P., & Rao, V. R. (1971). Conjoint measurement for quantifying judgmental data. Journal of Marketing Research, 8, 355–363.

2. Shepherd, D. A., & Zacharakis, A. (1997). Conjoint analysis: A window of opportunity for entrepreneurship research. In J. A. Katz (Ed.), Advances in entrepreneurship, firm emergence, and growth (pp. 203–248). Greenwich, CT: JAI Press.

3. Note that the survey only captures a subset (fractional factorial design) of the total possible combinations. Statistical analysis allows us to reconstruct the responses we would have gotten with the complete set (full factorial design).

4. Values obtained from www.fueleconomy.gov

5. Citation for overstating attributes with multiple levels.

6. Huber, J. (2004). Conjoint analysis: How we got here are where we are (an update). Sawtooth Software Research Paper Series.

7. Sethuraman, R., Kerin, R., & Cron, W. (2005). A field study comparing online and offline data collection methods for identifying product attribute preferences using conjoint analysis. Journal of Business Research, 58, 602–610.

8. Sethuraman et al., op cit.

9. Source: emarketer, May 2006.

10. This was our response rate for an online survey of the construction industry solicited by personalized letters on Wharton letterhead.

11. Don’t merely copy this letter and change the names as several students did. The contest—coming up with a quote, was specifically linked to the product in the Epigraphs. It makes less sense for other products. Have fun with the letter and the incentive/contests—if you have fun, you will likely create something that interests the readers and makes them more likely to respond.

12. See, for example, www.adcopywriting.com/Tutorials_List.htm

13. Johnson, R. (1987). Accuracy of utility estimation in ACA. Sawtooth Software Research Paper Series.

14. Orme, B., & Huft, M. (1999). Predicting actual sales with CBC: How capturing heterogeneity improves results. Sawtooth Software Research Paper Series.

15. A third alternative, self-explicated models ask subjects to provide the relative value of levels within each attribute. Since this violates the premise behind conjoint—that customers don’t understand their valuations, we ignore this alternative.

16. Sandor, Z., & Wedel, M. (2002). Profile construction in experimental choice designs for mixed logit models. Marketing Science, 21(4), 455–475.

17. Johnson (1987).

18. Chandon, P., Morwitz, V., & Reinartz, W. (2005). Do intentions really predict behavior? Self-generated validity effects in survey research. Journal of Marketing, 69(2), 1–14.

19. You can also estimate the WTP of an attribute analytically for any given price. You first need to create the utility equation for the attribute as we did for chains. Next, insert the utility on the left-hand side of the equation, solve for price, and compare that price with the corresponding price in the base configuration. Inserting a utility of 1.20 in the equation for chains yields a price of $42.33. Comparing this with the price of $35 at the same utility for the baseline, indicates a WTP of $7.33 for chains. Given this willingness to pay for chains, a preliminary conclusion would be that chains are a better means of distribution if the wholesale margin is less than $7.33.

CHAPTER 6 WORKSHEET

Conjoint Analysis

1. Matching dimensions to attributes:

What physical attributes of the product can you create to capture the perceptual dimensions elicited from the focus group/interviews:

(a) Some of the attributes above may be “table stakes”—meaning you would offer these attributes no matter what. Some of these attributes don’t require demand data for decision making. In the table above, designate whether attributes are “table stakes” or “demand independent.”

(b) Develop the attribute matrix using the remaining attributes. For each important physical attribute, identify “levels” at which the attribute could be offered. For continuous scale attributes (e.g., price) choose three levels that bound the likely optimum.

Create the template question.

Create ancillary questions:

For those attributes that were demand independent in Question 2

For demographic information to help identify market segments

For media habits, to help identify advertising channels

Anything else that is important to understanding the customer

What mailing lists can you use to locate people/firms in your industry?

Which of the above sources will you use and why?

What is the URL for your survey?

Please attach copy of cover letter/e-mail.

PART III

Designing the Venture

CHAPTER 7

Competitive Strategy

INTRODUCTION AND GOALS

This is the first chapter where we make strategic decisions regarding the venture design. Until now, we have been characterizing the industry, the competitive space, and the customers to determine if there is a viable venture. Henceforth, we assume the venture is viable and will focus on how to optimize it. Competitive strategy (price and product configuration decisions) is the first step in that process.

The goal of this chapter is to use the demand curves derived from conjoint analysis to develop a competitive strategy. What we mean by competitive strategy is the choice of price and product configuration that maximizes venture profits. We examine the price and configuration choices jointly over a range of industry conditions. We then determine which choices will best shape the industry conditions. We also determine how to position the venture optimally within those conditions. The basic assumption underlying the analysis is that a new venture will have some market power. Accordingly, you can take advantage of that power to maximize current profits or to limit entry and, thereby, maximize lifetime profits.

Very few firms actually do conjoint analysis and, therefore, lack the information to optimize the product configuration and price. Thus, it is clearly possible to begin a venture without doing so. This is a mistake. Sales may fail to materialize because of a mismatch between the bundle of attributes you offer and the bundle of attributes that the customers prefer. Accordingly, you may attract entry by a competitor who learns from your mistakes to offer a product better matched to customer preferences. This is the classic phenomenon of first movers as market losers.[1] A strong entry with the “optimal product” not only generates short-term profits (to fuel growth) but also constrains the opportunities for later entrants, thereby maximizing lifetime profits.

The principles underlying competitive strategy are the game theoretic principles discussed in Chapter 4. Whereas in that chapter, all the games employed a generic demand curve to demonstrate the impact of structural differences, here, we discuss how to analyze games using the specific demand curve derived from conjoint analysis and the specific structure of our industry.

This process of evaluating the best competitive strategy used to be extraordinarily complex and analytically intensive. Fortunately, the new conjoint application service providers (ASPs) that we used in the last chapter to collect and analyze demand data greatly simplify the analysis. The ASPs have “market simulators” that allow you to specify any possible product configuration from your attribute set and to determine how much market share that configuration captures in head-to-head competition with any other product configuration from the set. You can simulate any market with up to 10 products. This comparison allows you to determine how well any potential configuration does under various levels and forms of competition. With some additional analysis, you can also determine how many competitors are likely to enter and with what product configuration. We conclude by comparing the profits under each industry condition to make a decision about whether to use market power to extract current profits or to shape future industry conditions.

PRINCIPLES

The industry analysis in Chapter 4 provided a rich understanding of the links between industry structure and firm behavior. The principles section (and the companion appendix on game theory) walked you through a series of general games of competitive strategy. We rely on these principles again to design your competitive strategy. The challenge in this chapter is to identify which structure pertains to your venture and, accordingly, which behaviors are likely to emerge. From these two things, you can choose your optimal strategy taking those behaviors into account. We provide tools for making that choice next and illustrate their use for Epigraphs.

ANALYTICAL PROCESS

Ideally, you will determine that your product has the potential for durable monopoly. In all likelihood, however, if your market appears lucrative, you will attract entry. While you will form your real response strategy if and when a firm enters, the goal at this stage is to determine whether there is anything you can do now to affect the strategies of potential entrants. In particular, are there strategies that will dissuade entry or strategies that will cause entrants to choose inferior market positions. We start, however, by examining the monopoly strategy since it offers the highest profits (and thus establishes a baseline). It serves as more than a baseline however. If you are creating a new market, you may enjoy at least a temporary monopoly.

Determining Monopoly Price and Product Configuration

The Demand Curve. The first step in the analysis of price and product configuration under any of the industry structures is to transform the three price points from conjoint demand into a curve. Note that the demand “curve” for Epigraphs in Exhibit 6.11 is actually two straight lines (one between $35 and $60, and one between $60 and $100). You can find a better fit through these points using regression analysis (regressing conjoint demand on price for the three prices). Typically, the best fit for demand data is either a quadratic: q = ap^2 + bp + c, or a power curve: q = cpb.[2] To see which form better fits the data, choose the one with the higher R^2.

Epigraphs has two basic demand curves, one for distribution through chains and one for distribution over the Internet. A quadratic regression of demand on price and price-squared, yields the following equations:

We also tested a power curve by regressing ln(demand) on ln(price). However, this model had lower R^2, so we restrict attention to the quadratic. The quadratic curves for both chains and the Internet are shown in Exhibit 7.1.

EXHIBIT 7.1   Epigraphs Fitted Demand Curve

Cost Function. We will discuss cost in greater detail in Chapters 11 through 13. Here, however, we use a preliminary estimate of unit cost obtained through conversations with an expert in the sign-making industry. As noted in Chapter 3, the use of sign-making technology was the “solution” component of the venture inspiration. The preliminary estimate assumes that we produce the product in-house using “sign-making” equipment and materials. This configuration yields a unit cost per roll of $10.73 (materials and labor). Because there is a glut of used sign-making equipment, we can obtain all necessary equipment for approximately $10,000. Since this amount can be expensed rather than capitalized, we assume that recurring fixed costs are $0.

Monopoly Price. To obtain the optimal price for a monopolist under the baseline configuration of chain distribution, with standard genres and colors, we maximize profits. The most straightforward means to do this is to form the profit equation, take the first derivative, and set it equal to zero[3]. If your calculus is rusty, you can merely create a spreadsheet of prices and associated profits and then visually examine where profits are greatest. In either case, you need the profit equation. The general form is as follows:

where Π is profits, q is the quantity sold, p is the unit price, c is the unit cost, and F is the fixed cost.

Because q is actually a function of p, and because demand is characterized for retail price rather than wholesale price, we need to expand the basic equation for Epigraphs. We express q as a function of pretail: q = q (pretail). One thing we need to account for is the difference between retail price (that defines the demand curve) and wholesale price (that defines revenues). The two are related through the channel markup. We therefore express pwholesale as a function of pretail and the channel markup, m: pwholesale = (pretail)/(1 + m). We then make the substitutions for q and pwholesale as follows:

where q(pretail) is the quantity sold as a function of retail price, pretail is the retail price, and m is channel markup over wholesale price.

We substitute Equation 1 for q(pretail), then insert Epigraph’s values for m, c, and F. The value for m comes from the industry analysis in Chapter 4, where we learned that retail markup is 40% over wholesale. The values for c and F are $10.73 and $0, respectively, as mentioned on the previous page. The resulting profit equation is as follows:

To find the profit-maximizing price, we take the derivative of profits with respect to price and set it equal to 0:

This yields two solutions, the one for which d^2Π/dp^2 is negative (indicating a maximum rather than a minimum) is as follows:

This price yields the following demand:

and corresponding profits (gross margin) per person:

We obtain the same optimal price without calculus by creating a spreadsheet of profits versus price using Equation 7.6. This spreadsheet and the corresponding graph are given in Exhibit 7.2. What the exhibit adds to the calculus is the observation that profits through chain distribution are relatively inelastic at prices above $35. This is not the case for sales through the Internet. There, profits decline rapidly at prices above the optimal price.

Optimal Product Configuration. The prior analysis treats optimal price for the baseline configuration. To determine whether the baseline configuration is, in fact, the optimal product configuration, we find the optimal price for each configuration and then compare profits across those configurations. To find the optimal price, we change the intercept in Equation 7.5 to incorporate the coefficient for the configuration change (as we did going from Equation 7.1 to Equation 7.2 for distribution channel). We then repeat the steps captured in Equations 6 through 10. Exhibit 7.3 is a summary of optimal price and corresponding demand and profits for each single dimension change to the baseline.

Since price and distribution channel were the only significant attributes in Epigraphs conjoint analysis, the configuration decision is primarily one of distribution channel. However, the channel decision involves additional considerations such as access, awareness, and opportunities for personal selling. We treat these in detail in Chapter 6.

In the absence of detailed channel analysis, the optimal product configuration appears to be sales of standard genres and colors through the Internet at a price of $38.06. This results in profits of $71.88 per person in the target market. The Internet generates higher profits despite lower price because it is a zero-stage channel. Thus, wholesale price equals retail price. The revenue to the firm for each roll sold is the optimal retail price of $38.06. In contrast, the revenue to the firm for each roll sold through chains is $36.82 (the wholesale price corresponding to a retail price of $51.55 given a 40% markup).

Custom genres and custom colors yield lower profits than do standard genres and colors. This stems from the fact that they are more costly to produce, yet are no more attractive to customers, than are the standard genres and colors. This is consistent with the focus group comment that too many options overwhelm customers.

**Note all values of q and Pπ are expressed per person in the target market.

Marginal Value of Attributes. A more straightforward approach to choosing the optimal product configuration looks at attributes one at a time rather than at whole bundles. What we want for each attribute is an estimate of its marginal value to compare with its marginal cost. We would then include all attributes for which marginal value is greater than marginal cost.

To estimate the marginal value for each attribute, we need the demand curve for the product with the base features (preferably expressed as an equation) and the set of demand coefficients for each attribute.

In the case of Epigraphs, the basic demand curve is Equation 1:

This is the “basic” demand curve because it is for the default product configuration. (We could use the Internet demand curve, but then we would need to take precautions when we look at the signs of coefficients.)

A change in the product configuration (by adding and deleting an attribute) shifts the demand curve up or down by the amount of the attribute’s coefficient. For example, adding custom themes (coefficient of 0.11) changes the intercept in Equation 7.11 from 8.612 to 8.722.

We have two strategies with respect to product attributes. We can preserve price for the default product configuration (throw in the attribute for free) and enjoy higher demand. Alternatively, we can preserve demand and charge a higher price. These options are shown graphically in the Exhibit 7.4 for a notional attribute with a coefficient of 2.00. Assume that the optimal price for the basic configuration is $35.00. The corresponding demand is 4 units. By introducing the new attribute, I have a choice of preserving the $35.00 and enjoying demand of 6 units (moving vertically to the new demand curve). Alternatively, I can preserve demand and charge a price of $65.00 (moving horizontally to the new demand curve).

EXHIBIT 7.4   Demand Curve Shift From Addition of Attribute

The analytical process for both approaches begins with the new demand curve. For Epigraphs, the new demand curve for each attribute is merely the equation above plus the coefficient for the attribute. So, for example, the demand curve for custom colors is:

If I want to preserve the price of the basic configuration, I merely substitute $35.00 for p in Equation 2 and solve for q. This yields demand of 3.82 units. If instead, I want to preserve demand for the basic configuration (4.03 units), then I merely substitute 4.03 for q and solve for the new price. This is slightly more complex since it involves solving a quadratic, but the new price is $32.96.

Finally, the best approach to making the decision of whether to include an attribute is to compare its marginal value with its marginal cost. The marginal value is the price premium over the basic configuration. In our example for custom colors, the price of the basic configuration is $35.00. The demand preserving price for the product with custom colors is $32.96. Thus, the marginal value of custom colors is -$2.04, so we would never offer them.

Exhibit 7.5 summarizes the marginal value analysis for each of the Epigraphs attributes. Column 2 is the attribute coefficient from conjoint regression. Column 3 is the new intercept (constant) in the demand equation (obtained by adding the coefficient to the intercept in equation 1). Column 4 is the demand at the base price (obtained by solving for q in the equation with the new intercept). Column 5 is just an aid to solving the quadratic for new price (obtained by subtracting basic configuration demand of 4.03 from the intercept in Column 4). Column 6 is the demand-preserving price (obtained by solving the new demand equation for p). Column 7 is the marginal value of the attribute (obtained by subtracting base price of $35.00 from the price in Column 6).

The two attributes that seem to add value are superstores and custom themes (though remember these weren’t significant). If the marginal cost of selling through superstores (relative to chains) is less than $1.62, it is probably worthwhile to do so. Similarly, if the marginal cost to offer custom themes (relative to standard themes) is less than $1.11, Epigraphs should do so.

Ancillary Data. A final piece of the optimal product configuration considers which standard colors and genres to offer. While we could offer all 5 genres in all 7 colors, this involves inventorying 35 (5 × 7) versions of the product. This implies considerable inventory costs and higher obsolescence write-offs at the end of the product life. To help make a decision about the optimal versions of the product to offer, we consult the ancillary data on genre and color preferences. Exhibit 7.6 is the raw data on color and genre preferences. Respondents were asked to identify the colors and genres in which they were most interested. This resulted in multiple votes by several of the respondents, which we rank equally. In retrospect, we would have been better off asking for their ranking of colors and genres. We reorganized the data from Exhibit 7.6 to show unique versus shared preferences for each genre and each color. This reorganization is shown in Exhibit 7.7a for genres and Exhibit 7.7b for colors.

To determine the appropriate number of genres and colors to carry, we need to organize the genres and colors in decreasing marginal value. We make the assumption that anyone who voted for a genre (even if that respondent cast multiple votes) would buy it if it were the only genre available. Exhibit 7.7a indicates that the genre with the greatest value is literary quotes. As a sole genre, it captures 52% of the market, while inspirational quotes, the next most popular genre captures 48% of the market. Thus, if we were to choose only one genre, it would be literary quotes.

If we choose to offer two genres, we imagine that inspirational quotes would be the second choice. However, it is possible that people who like inspirational quotes are merely a subset of those who like literary quotes. Reading down the literary column and across the inspirational row of Exhibit 7.7a indicates that half of the respondents choosing inspirational quotes also chose literary quotes (their intersection). Thus, the value-added of the inspirational genre is only 24% of the market (0.48 total inspirational genre - 0.24 shared literary/inspirational).

We systematically consider the value-added of each genre by examining its market capture minus the intersection of its capture with that of all prior genres. Exhibit 7.7a indicates that the pair of genres with the highest market capture is indeed literary quotes and inspirational quotes with 76% of the market. If we look at the market for the remaining genres and exclude intersections with literary and inspirational quotes, then the next most valuable are humor and sports. Either would add 9% to increase the capture to 85% of the market. Exhibit 7.8a shows the market capture for the optimal combination of genres as the number of genres is increased. We determine the optimal number of genres by comparing the value-added of each new genre with the marginal cost of offering an additional genre.

EXHIBIT 7.8   Value-Added of Colors and Genres. (a) Value-added of genres (in rank order): Genre 1 is literary, Genre 2 is inspirational, Genres 3 and 4 are humor or sports, Genre 5 is movies. (b) Value-added of colors (in rank order): Color 1 is hunter, Color 2 is black, Color 3 is silver. All other colors are redundant.

Equivalent analysis of colors is given in Exhibits 7.7b and 7.8b. Complete coverage of the market is achieved with three colors: hunter captures 55%, black adds 30%, silver adds 9%. All remaining colors are redundant with the first three in that anyone who expressed interest in the remaining colors also expressed interest in one of the first three. Since there is no up-front fixed cost associated with offering each color, the relevant cost in determining optimal number of color choices is the additional inventory and obsolescence cost for each color. Thus, it is easier to offer color options than genre options.[4] In the absence of cost data on cutting new genre dies and holding inventory for the entire distribution system, there appears to be little value in offering more than two genres and two colors (four color-genre combinations).

Determining Price and Product Configuration Under Competition

While establishing monopoly price and product configuration uses decision theoretic principles (optimization logic), examining the same decisions under competition requires game theory. Since we want you to be familiar with the formal theory, we will go through it. However, one very valuable aspect of the conjoint ASP software is the “market simulator.” The simulator uses the data gathered from surveys to analyze how the market would split if products with different configurations were offered in the market at the same time. Thus, you can examine competition without game theory. The value of game theory is that it helps you focus on which of the seemingly infinite combinations to focus on. Remember, even for a simple product like Epigraphs, there are 36 possible product/price configurations. If each of these were paired with only one other competitor with the same options, it would require 1,296 simulations.

There are four steps in assessing price and product configuration under competition. These are the same steps used in solving any game and were discussed in greater detail in Appendix 4.1.

• Defining the actions and reactions of both firms

• Defining payoffs for each firm for each path of the game—characterizing the impact of “strategy pairs” on both firms’ market shares and profits

• Assessing each firm’s best strategy given the payoff structure—Is there an equilibrium strategy?

Actions. While the complete action space is infinite, the likely action space confronting an entrant is comparable with that you considered in the monopoly setting. The set of actions between you and a later entrant is thus the same. What differs is the relative attractiveness of each action. The set of actions for Epigraphs include distribution channels, the product attributes, and their prices. If there are n such options, there are n^2 paths in the game (I can match each of your n actions with any of the n actions). Fortunately, some of these paths are clearly inferior, and so we can ignore them. The first step then is to create the list of actions. In the case of Epigraphs, the set of actions are (distribution channels) × (genre-color combinations) × (price). Because this quickly becomes quite complex, we treat each dimension of strategy in sequence.

A. Distribution

We assume that Epigraphs has an exclusive distribution contract with a chain. This implies both that the chain carries only Epigraphs product and that Epigraphs is not available in any other retail outlet. With such a contract, the entrant must choose an alternate distribution channel. Assume it chooses the next most attractive channel. What is really nice in constructing this game is that you know from your own research which action is next most attractive to your rival because it is also the alternative next most attractive to you. In this case, the next most attractive option is a home superstore.

When we analyzed distribution channel for the monopoly strategy, the demand we obtained was for all people in the market who would purchase the product at that price if it were available through chains. Thus, even if people preferred superstores, they might purchase the product from chains.

What changes with entry is that now people who prefer superstores can actually buy the product there. The question becomes, How many people will prefer this new alternative? This is not the same question as finding the demand using the superstore equation from Exhibit 7.4 (that would tell us monopoly demand).

Fortunately, the conjoint ASPs offer a routine for estimating market shares of competing product configurations, the “Market segmentation simulator.” The simulator asks you to define up to 10 product “profiles” you wish to compare, where each profile is a product configuration consisting of one level of each attribute. Note that these profiles must be circumscribed by the attributes and levels included in your conjoint survey.[5] Once the profiles are entered, the simulator will report back the market share for each profile. It does this by assessing the utilities for each individual in the survey for each attribute of the profile and then assigning the individuals to the profile, offering them the highest utility.

Exhibit 7.9 shows the output for a simulation that compares two versions of the baseline configuration (standard colors, standard themes, sold for $35). The first version is sold through chains (Profile 1). The second is sold over the Internet (Profile 2). The exhibit indicates that Profile 1 obtains 54% share, while Profile 2 obtains 46% share. The simulator also tabulates the utilities for each respondent for each profile, so you can see which respondent chose each profile. While this is not particularly helpful for the product configuration decision itself, it may later be helpful for advertising. The demographics of the respondents choosing each profile may differ sufficiently that you can target advertising.

B. Product configuration

The next choice facing the entrant is the range of product offerings. Here, we frame the choice as a simple one of matching Epigraphs product line or differentiating. Remember, the available product configurations were 5 genres × 7 colors, with options for custom quotes and colors. Epigraphs chose two genres in rank order of customer preference. The third genre is unlikely to have sufficient demand to justify the fixed cost of new dies. Epigraphs chose two colors, also in rank order, where the third color is unlikely to have sufficient demand to warrant the switching costs between production batches, scale economies in material purchases, and additional obsolescence costs. Thus, if the entrant chooses a differentiation strategy, it will be left with less popular genres and colors.

If we had asked the color and genre questions as part of conjoint, we could use the market segment simulator to evaluate this choice. Instead, we examine firms’ strategies through a game. In the normal form of a game, the columns of the matrix depict your (the first mover) strategies. The rows of the matrix depict the entrant’s strategies. Each cell defines the payoff to you and to the entrant for the combination of your strategy (column) and the entrant strategy (row). Note that the matrix characterizes a two-stage game: You create the market with a given strategy; another firm observes your strategy and then enters the market with its own strategy.[6] We could make the game more complex. We could allow the first mover to respond to the entrant with a revised strategy. The basic methodology is the same, but far more complex. We leave that exercise to the reader. Exhibit 7.10 is the normal form of the genre-color component of the Epigraphs game.

Defining Payoffs. To determine the market splitting shown in the cells, we need to assess how each consumer would behave given the choice among both firms’ product offerings. The demand curve we generated earlier tells us how much demand will exist for a new product configuration given the existing set of products. It does not tell us the relative demand of one configuration when multiple configurations coexist. We can, however, derive this from the ancillary data summarized in Exhibit 7.7. When a color or genre is unique to one firm, we give it that share of the market; when colors or genres are shared, firms split those colors or genres. The payoff for each firm is thus the sum of all unique and common colors and genres. Note that the shares are of the potential market—by not offering the full complement of colors and genres, firms exclude portions of the market.

Assessing Equilibrium Strategies. Exhibit 7.10 assumes that both firms introduce the product at monopoly price. The logic is that both firms have “local monopolies” in their respective channels.[7] Under this assumption, there is a Nash equilibrium. Remember from Appendix 4.1 that a Nash equilibrium is a pair of strategies that represents each firm’s optimal strategy, given the optimal strategy of the rival. In this game, the Nash equilibrium is for both firms to choose the monopoly product configuration. Thus, the optimal strategy for the entrant is to match Epigraph’s product strategy. To illustrate this, assume that Epigraphs enters with one color and one genre (Column 1). The market share for the entrant, if it matches Epigraph’s strategy, is 14.3%. If, instead, it offers a different color and genre, its market share is only 13.5%; thus, the entrant is better-off matching.

Similarly, if Epigraphs offers two colors and genres (Column 2), the maximum share for the entrant is obtained by matching (32.3%). The matching strategy is optimal because Epigraphs chooses the most popular colors, leaving the less popular colors. While in essence Epigraphs cedes the entrant a monopoly to other colors/genres, these monopolies are less attractive than splitting Epigraph’s monopoly. This is true whether Epigraphs enters with only one genre-color combinations (1 × 1) or four genre-color combinations (2 × 2). For example, the second best 2 × 2 strategy for the entrant results in a 15.3% share of the potential market. Matching Epigraphs products and colors yields a 32.3% share of the potential market.

Price. Typically, a matching strategy would yield price competition driving industry profits to zero. Here, however, we assume differentiated distribution: Epigraphs through chains and the entrant through superstores. With differentiated distribution, firms’ incentives to reduce price are suppressed because it is not possible to directly compare products. In essence, each firm has a local monopoly and splits monopoly profits (like a cartel).

To test the assumption, we turn again to the market segmentation simulator. Here, we keep the profiles the same as those used to assess distribution channel: Profile 1 (Epigraphs) is standard colors, standard themes, and chain distribution, Profile 2 (entrant) is standard colors, standard themes, and superstore distribution. We then simulate what happens when firms adjust prices. The results from these simulations are captured in Exhibit 7.11. As we would expect, a lower price will cause customers who prefer one distribution channel to change to the alternative channel. Examining the top plot for Epigraphs’ price of $35, we see that for rival prices between $35 and $60, each dollar increase in rival price increases Epigraphs’ share 1.37 percentage points.

Opportunities for Preemption. Given that the entrant’s best strategy is matching the leader, Epigraphs has little opportunity to preempt rivals through its choice of colors and genres. Thus, choice of colors and genres should conform to the monopoly configurations.

EXHIBIT 7.11   Impact of Pricing on Epigraph’s Market Share (both firms offer standard colors and themes)

One other consideration is whether Epigraphs should attempt to deter rivals by choosing an alternative configuration and price.[8] Formal analysis would require details of the upfront costs and inventory costs associated with the range of genre-color options. However, it is doubtful that pricing below monopoly levels is warranted in this case. Wallcovering is a durable good, and 60% of a new product line’s sales occur within the first year. Thus, the incentive for a follower firm to enter with any strategy is decreasing over time. There is little need for Epigraphs to fuel this process by lowering its price. This is particularly true since Epigraphs would be expending near-term profits on a large sales base to preserve future profits on a small and decreasing sales base.

Summary

Ignoring later analysis that will introduce additional considerations to the choice of distribution channel and may modify the firm cost structure, it appears that the optimal strategy for Epigraphs is as follows.

Introduce a product line consisting of four color-genre options (hunter and black) × (literary and inspirational). These products should be sold over the Internet at a price of $50.00 per set. This strategy should produce average sales of $87.86 per person in the target market. The corresponding profits are $69.00 per person in the target market.

This strategy appears to be the best strategy not only for a monopolist but also in anticipation of later entry. Epigraphs would cede distribution in superstores to entrants, with the anticipation that the entrant would match Epigraphs product line. This would reduce the rate of subsequent sales of Epigraphs products by 47.1%. However, since 60% of product line sales occur in the first year, and the entrant will take time to respond, the net impact on life cycle sales is minimal.

CONCLUSION

This chapter treated the first of the strategic decisions facing the venture. This is the competitive strategy of what product configuration and price to introduce in the market. What makes this decision strategic is the fact that your choice affects the product configuration and price choices of later entrants and, potentially, their decision of whether to enter at all.

We relied on Chapter 4 for the general principles of game theory and strategic behavior. In the Analysis section, we showed how to extend game theory beyond principles to real mechanics using data obtained from conjoint analysis. We generated the actual payoff matrix for Epigraphs and a potential entrant and used that payoff matrix to find the Nash equilibrium—the Epigraphs strategy that generates the highest profits for it assuming that the entrant is maximizing its profits.

While the price, demand, and profits from this strategy will be fed into the financials in Chapter 13, the most important conclusions from this chapter are (1) the insight that Epigraphs’ choices constrain those of the potential entrant and (2) the monopoly strategy is also the best preemptive strategy. Thus, there is no cost to behaving strategically in this scenario.

One “configuration” choice we examined for Epigraphs in this chapter was the distribution channel. We derived demand curves for both Internet distribution and chain distribution. Since expected profits for the two channels are comparable, the final distribution decision hinges on other factors. In the next chapter, we discuss these other factors and present alternative methods for making the distribution decision.

NOTES

1. For example, see Teece, D. J. (1986). Profiting from technological innovation: Implications for integration, collaboration, licensing and public policy. Research Policy, 15, 285–305.

2. Many calculators will do this regression for you. You merely enter the three data points (where each data point is the set of demand and price), and the calculator will come back with the equation that best fits those points, along with the R2 that assesses the fit. Unfortunately, Excel only does linear regression, so you need to manually create exponential variables in the case of the quadratic. In the quadratic regression, your dependent variable is the demand, one of your independent variable is price, and the other is a new variable that you create by squaring price. For the power curve, you take logs of both the dependent variable (demand) and the independent variable (price): Ln(q) = ln(intercept) + ln(p).

3. Remember to check second order conditions.

4. Each new genre requires a new set of dies/templates used to cut the quotes from the material.

5. This is something you might want to take into account when you design the survey. Even if YOU never want to offer an attribute, if someone else does, or if you think someone else might, it could be worthwhile to include the attribute in the survey to assess its drawing power.

6. This structure of play is similar to Stackelberg except that Stackelberg assumes homogeneous products across firms.

7. For the firms to have local monopolies, the price minus consumer surplus must be greater than half the transportation cost between the chain and the superstore.

8. See Chapter 8 in Tirole, J. (1988). The theory of industrial organization. Cambridge: MIT Press, for a nice tutorial on entry models.

CHAPTER 8

The Distribution Channel Decision

INTRODUCTION AND GOALS

The distribution channel is the second strategic decision in the venture design. The channel is the means by which your product or service is made available to the end customer. The decision has implications for both reach (the number of customers who have access to your product) and effectiveness (the likelihood that customers will purchase your product, given it is accessible to them). The goal for the channel decision (as with all the strategic decisions) is maximizing firm profits. In this case, the maximization problem trades reach and effectiveness against the cost of distribution.

The decision is important because it is one of the two means available to the firm to control realized demand (the other being advertising). Chapters 6 and 7 defined the potential demand for the product. This potential demand assumes that all customers in the market are aware of the product and have access to it. While it is reasonable to assume that we want all customers to be immediately aware of the product and have unlimited access to it, this is probably unwise. We may want demand to unfold slowly over time to minimize the repercussions of early mistakes and possibly to exploit the potential of intertemporal price discrimination (charging a high price early and capturing all the people willing to pay that price, then dropping the price to capture the next tier of customers).

This chapter begins by reviewing the principles underlying the distribution channel decision, both the vertical contracting literature in economics and the marketing literature. Next, we introduce tools to assess distribution channels: breakeven analysis and channel contribution. Finally, we apply these analyses to Epigraphs and draw conclusions about the appropriate distribution channel.

PRINCIPLES

Vertical Contracting

The vertical contracting literature[1] treats the channel decision as a principal-agent problem, where the manufacturer (or other upstream party) is the principal and the dealer (downstream party) is the agent. While the literature is primarily concerned with designing the optimal contract between the principal and the agent, rather than choice of agent or channel (which we consider here), the theory is useful for framing the channel decision.

The basic structure of the theory has the manufacturer designing a contract in which the agent simultaneously maximizes manufacturer revenues and his or her own payments. Such contracts where the dealers’ incentives are aligned with those of the manufacturer minimize monitoring costs.

Since the dealer network likely exists, and likely follows fairly standard contracts, the vertical contracting literature is less useful in contract design than it is in merely illuminating the issues that confront you in making the channel decision. These issues are dealer attributes and behaviors that increase demand, and dealer attributes that minimize cost.

Dealer Attributes Affecting Demand. To the extent that the dealer has reputational advantages that imbue your product with higher quality, the dealer may be able to shift the demand curve for your product. This may be the case, for example, if Hammacher-Schlemmer carries your product. Since the Hammacher-Schlemmer Institute tests several manufacturers’ versions of each product it sells, carrying your product is an endorsement of its quality. To the extent that customers ordinarily would be uncertain about the quality of your product, Hammacher-Schlemmer may be able to increase the number of people willing to buy your product at any given price.

We already saw evidence of the potential for the distribution channel to shift demand for Epigraphs. The demand curve for chains was above that for the Internet. While we didn’t probe why the demand curve for chains was higher, there are likely reputation effects as well as experience effects. The reputation of the chain provides confidence to the buyer that if they are unhappy with the product they will have recourse. The experience effect is that customers can view samples of the product first hand to get a sense of the product’s size and texture.

This leads nicely to the second dealer attribute affecting demand, reach. While Hammacher-Schlemmer may shift the demand curve, you may not realize any greater demand through it than through other more conventional dealers because of the limited reach of its catalog. If Hammacher-Schlemmer mails its catalog to 1 million households, you can never sell your product to more than 1 million households if the catalog is your exclusive outlet. In essence, while the catalog may shift the demand curve, generating greater demand at any given price for customers within its reach, it truncates total demand by not providing access to all those with a willingness to buy the product at the higher price.

Dealer Attributes Affecting Cost. In addition to the demand implications of the channel decision are the cost implications. The wholesale price to Hammacher-Schlemmer may be lower than that to other channels. Since Hammacher-Schlemmer knows it has the ability to increase demand relative to other dealers, it may require a contract that allows it to capture much of the benefit of the demand increase. It may “charge higher cost” to sell each unit by requiring a lower wholesale price.

The example so far has been primarily a passive channel. Hammacher-Schlemmer “sells” by distributing its catalog. The issues addressed above become more pronounced with industrial products requiring personal selling. There, the opportunity to increase demand is active selling by an agent. Here incentives become tremendously important not only through increasing overall selling activity by the agent but also through relative emphasis on your product versus the other products the dealer represents. (In the case of a direct sales force, the emphasis is on the former rather than the latter.)

Marketing Literature

The vertical contracting literature does a fine job of laying out the theory underpinning the distribution channel decision. However, as a start-up venture, the challenge will be choosing from a set of existing channels and associated contracts rather than designing an entirely new contract. The marketing literature helps us translate the profit maximization structure of the vertical contracting literature into a set of guidelines that help inform the channel decision. While the cost implications and reach implications translate directly, the demand implications are treated through the lens of “channel length.”

Channel length refers to the number of intermediaries between the manufacturer and the final customer. In the case of a direct sales force to the end customer, the length is zero; in the case of the GAP, which manufactures its own goods, and sells them through its own stores, the length is also zero. In the case of toys, a small manufacturer works through independent sales representatives, who market to retailers, who in turn sell to consumers. There the channel length is two.

In general, the trade-off between channels of different lengths is one of high fixed cost and high effectiveness, limited reach (short channel length) and low fixed cost, reduced effectiveness and greater reach (long channel length). One of the exciting promises of Internet retailing is combining the advantages of short and long channels at relatively low cost. To the extent that your product does not require personal selling, the Internet provides unlimited reach to the 60 million U.S. households who purchase online (see Exhibit 8.1). In addition, the channel provides in-depth product information at close to zero unit transaction cost, in an environment where your product may not be competing with others.

A number of factors influence the feasibility of short versus long channels: (a) customer characteristics such as geographic dispersion, frequency of purchase, and need for information; (b) product characteristics such as product weight, perishability, unit value, degree of standardization, and need for maintenance/service; and (c) company strategy such as delivery policies, financial resources, and scope of product mix. Exhibit 8.2 summarizes the factors that tend to move distribution toward short or long length channels.

Relating the Marketing Principles to the Vertical Contracting Principles. Short channels tend to shift the demand curve—they enhance the product through superior delivery, service, and information. On the flip side, they tend to truncate demand due to their limited reach. In contrast, long channels provide more complete reach. We tend to see short channels in small markets and ones for which the product’s value is high relative to customer income. We tend to see long channels for mass markets of lower priced goods.

EXHIBIT 8.1   Distribution of Internet Purchasing

Source: Data from www.internetretailer.com/article.asp?id=20372.

EXHIBIT 8.2   Characteristics Driving Distribution Toward Long or Short Channels

CHANNEL LENGTH

Short

Long

Customer Characteristics

*Concentrated Market

**Dispersed market

*Well–informed

*Frequent purchase

Product Characteristics

**Perishable

*Custom product

*High unit value

**Requires maintenance/service

*Standard product

**Low unit value

Company Characteristics

**Rapid delivery policy

**Single product

**Financial constraints

*Wide product mix

*Enables use of channel.

**Precludes use of alternative channel.

Two distribution innovations attempt to combine the advantages of long and short channels. Franchising creates a network of short channels, thereby combining increased demand with greater reach. While this is typically a high-fixed-cost strategy, franchising overcomes the financial constraints by having the local owner/managers finance their own outlets. Similarly, as mentioned previously, Internet retailing provides unlimited reach, with in-depth product information at low cost.

All the above considerations flow nicely into an economic analysis that allows us to choose the channel that maximizes firm profits. We will illustrate that in a moment, but before doing so, we need to mention three other characteristics of channels that are probably best treated outside the analysis. (Note that with adequate information, these too could probably be folded into economic analysis.)

The first issue if flexibility. In general, it is quite costly to change distribution channels. Distributors or representatives often require long-term contracts with high degrees of exclusivity. Thus, if you begin with long channels, then realize your product requires shorter channels, you may not be able to implement them for a considerable period. Additionally, there may be switching costs—some retailers may not be willing to deal with you if you have already established other channels. Neiman Marcus, for example, is unlikely to carry your product if it was first introduced at Wal-Mart. Beyond the issue of switching, some channels provide a greater flexibility in that they tolerate parallel channels. This is probably the exception. Many outlets not only require exclusivity in the channel but also restrict selling in other channels. Retailers, for example, are generally intolerant of direct sales by the manufacturer.

To the extent you may ultimately want direct channels (zero level), you should take that into account when choosing current channels and when structuring their contracts.

A final consideration is reverse information flow. We have seen that shorter channels facilitate greater information flow to the customer. The reverse is also true. Shorter channels facilitate greater information flow to you from the customer. Even if your product allows you to use longer channels, you may want to consider short channels if customer information is important. Short channels permit you to learn what customers think about your product and how they use the product. Timely receipt of such information may lead to superior innovation capability. Similarly, short channels allow you to track changes in demand more quickly and more accurately. Such tracking helps preclude the possibility that customers will shift to competitor’s products during stock outs or that you will be left with obsolete inventory.

Analytical Process

While the task of designing a distribution channel from scratch would be overwhelming, the task is made considerably more tractable by the prevalence of existing channels. The starting point for the channel analysis is the industry analysis conducted in Chapter 4. To complete that analysis, you needed to identify all the industry players, including the distribution channels. For each channel, and possibly for each firm in that channel (if firms are not perfect substitutes), you need to gather the information called for in the worksheet provided in this chapter. This includes the demand information from Chapter 7 (optimal price and units demanded at that price) and the industry information from Chapter 4 (channel reach, the number of outlets, the required inventory per outlet, channel markup, the accounts payable period, and training cost per outlet).

For channels with multiple levels (through dealers to retailers, for example), you need to examine each level separately, then combine the levels to draw conclusions for the entire channel. Thus, for a two-level channel, the distributor may charge a 30% markup over manufacturer price, and retailer may charge a retail price that represents a 40% markup over wholesale price. You would combine these to determine manufacturer’s price as a function of retail price. With the markups just mentioned, the manufacturer’s price would be 55% of retail price (= retail price/(1.3 × 1.4)).

There are two approaches to analyzing these data once they have been compiled. One approach is merely to compute a single profit number for each channel, then compare channels. The second is to do a breakeven analysis of each channel, then assess the likelihood of achieving breaking even volume. We advocate doing both. We begin with breakeven analysis.

Breakeven

Breakeven analysis compares fixed costs with unit margin, to determine the number of units that must be sold to “breakeven” or cover fixed costs. While this results in a single number, generally breakeven analysis is depicted as a plot of net income versus number of units sold (as shown in Exhibit 8.3). To do the analysis then, you merely sum the fixed costs, compute the unit margins, and divide fixed costs by unit margins to determine breakeven volume. The breakeven volume occurs when this equation equals zero when the plot crosses the X-axis.

Below breakeven volume, the channel is a net cost to the firm. Above that volume, the channel contributes to firm profits. As a simple example, assume the firm has a product with two channel options: (a) selling direct and (b) selling through a wholesaler and then retailer. Assume that a direct sales force with comparable reach to the retail channel incurs fixed costs of $100,000 per year and that the commission is 10% on a unit price of $500. Thus, each sale generates $450 in unit revenue. Furthermore, goods are paid for via credit card, so the cash cycle and attendant carrying costs are zero (possibly even negative—suggesting the potential to earn interest on the float). Assume that the retail channel consists of 100 outlets and that each outlet requires one display unit and two units in inventory (shared between wholesaler and retailer). Thus, 300 units are required to fill the channel. Assume further that the wholesaler markup is 30% and the retailer markup is 40%. This yields unit revenues to the manufacturer equal to 55% of retail price ($500 × 0.55 = $275).

There are two approaches to the breakeven here: One is the lifetime breakeven approach, in which we consider the actual manufacturing cost of the 300 units in inventory; the other is the annual breakeven approach, in which we consider only the carrying cost of the 300 units. Since the 300 units will ultimately be sold, the annual approach is generally more appropriate (though the lifetime approach is important for start-up cash flow analysis). Assume also that the manufacturing cost (mfr) is $150/unit. Finally, assume that the cost of capital is 20% and that the cash cycle for units sold through the wholesale channel is 90 days (meaning on average, you finance inventory for 90 days before you receive payment, whereas for direct sales, the cash cycle is 2 days).

EXHIBIT 8.3   Sample Comparison of Channels Showing Breakeven Volumes as Well as Cross-Over Volume

Sales force breakeven = $100,000 fixed cost = 333.5 units,

$450 revenue − $150 mfr cost − 0.20(2/365) × $150 carrying cost

Retail breakeven = (300 units) (0.20 × $150 carrying) = 76.7 units.

($500 retail price /(1.3 × 1.4)) − (150 + (0.20(90/365) × $150 carrying))

We depict this graphically in Exhibit 8.3. The exhibit plots the net contribution for each distribution channel as a function of unit sales. Note that while retail breaks even more quickly, its slope is shallower. Thus, at some volume, sales through the direct channel are more lucrative. We can solve for this “channel indifference” volume—the volume beyond which one channel is strictly preferred to the other:

(Unit margin)ax − Fixed costa = (Unit margin)bx − Fixed costb,

$299.83x − $100,000 = $117.63x − $9,000,

x = 499.5 units.

Thus, if the firm anticipates selling more than 500 units per year, it prefers to sell through direct channels. The issue then is how likely are sales of 500 units.

Total Contribution per Channel

While breakeven analysis is a simple means to determine the relative advantage of channels, the data gathered from conjoint allow you to take a more comprehensive approach. This second approach to analyzing channels combines demand considerations with cost considerations. Since direct sales is a shorter channel, we would expect it to produce greater sales, holding reach and price constant. Thus, not only is direct sales a more lucrative channel above 500 units, but because it is an information intensive channel, it is more likely to reach sales of 500 units than is a retail channel with the same reach.

The total contribution approach to the channel decision requires the demand data derived from conjoint analysis. Assume that conjoint analysis indicates sales through direct channels produces 20% probability of purchase, while sales at retail produces 7% probability of purchase. Assume further that the reach of direct sales is 50,000 consumers per year. Direct sales has lower reach because it requires a personal contact (thus reach is the number of people in the sales force times the number of people they come in contact with per year), then the expected contribution for direct sales is

(0.20)(50,000)($299.83) − $100,000 = $2,898,300.

The reach for retail channels is much higher. It is the number of retail outlets times the number of unique customers at each outlet per year. Assume for this example that the retail reach is 500,000 (25 outlets, each with 20,000 unique customers per year). For retail, the expected contribution is

(0.07)(500,000)($117.33) − $9,000 = $4,097,550.

This analysis suggests that the venture should choose the retail channel. Although there is higher demand for each person reached via direct sales (0.20 vs. 0.07), and although the margins are higher for direct sales ($299.83 vs. $117.33), retail reaches 10 times greater customers and has lower fixed costs.

Other Considerations

One final consideration for distribution channel pertains to life cycle issues. Remember from studies of diffusion that different types of customers buy products at different points in the product life cycle. Accordingly selling methods and media vary throughout the product life cycle. Early users tend to make independent decisions based on mass media. Later users tend to imitate early users.

Second and relatedly, it is easier to degrade reputation, than to enhance it. These life cycle considerations suggest two things for distribution channel decisions:

1. There may be a natural flow from short, information-intensive channels with truncated reach to lead users in early stages. Once lead users have adopted the product, and have begun to fuel imitation, then the firm can move distribution to longer channels with greater reach. We saw this with personal computers (PCs). Early PCs were sold as kits through the mail to technologists. Now that people understand how and when to use PCs, they can be sold through discount department stores such as Wal-Mart.

2. There may be a natural flow from high margin, high reputation channels with truncated reach in early stages to mass market discount retailers in later stages. We saw this for the TV Guide game.[2] Early sales were to exclusive retailers such as Neiman-Marcus. In the next stage, sales were through department stores, such as Sears. In the final stage, sales were through discounters such Toys-R-Us and Wal-Mart. This provided an opportunity for price discrimination. Early sales at the more exclusive retailers were at a retail price of $25.00. Ultimately, the game sold in Kmart for $16.97.

Accordingly, distribution channels play a secondary role of promotion-/advertising-stimulating demand. This is in addition to their primary role of providing access to the product. We now apply these tools to the Epigraphs case.

EPIGRAPHS

Data on markups and inventory requirements for the wallcovering retail channels are shown in Exhibit 8.4. These data were obtained from one of the manufacturers. The three main channels are independent retailers, chains, and superstores.

Industry analysis had indicated that there were approximately 15,000 independent retailers served by 100 distributors with an estimated reach of 15 million consumers. Because there are 40% markups both at the distributor and at the retailer, the unit revenue is 0.51 × retail price (= price/(1.4)2).

There are fewer chains—Sherwin-Williams, the largest chain has 2,200 outlets. There are even fewer superstores—Home Depot, the largest superstore has approximately 750 outlets. Despite the fewer numbers of chains and superstores, their reach is equivalent to the independents. Sherwin-Williams has approximately 2,200 stores, with 1,500 transactions per quarter. This number exceeds the number of wallcovering transactions per month; thus, it appears that distribution through Sherwin-Williams provides 100% availability to the target market.

EXHIBIT 8.4   Wallcovering Flows Through the Distribution Channels

Because manufacturers sell directly to the chains and superstores, without distributors, there is a single markup of 40%. The unit revenues through this channel are therefore 0.71 × retail price. At this point, we add the Internet channel, which has no intermediaries, and therefore no markup. The Internet reach is higher than that for the bricks and mortar retailers. The current estimate for Internet purchase penetration is 60 million households.[3]

We combined these contribution numbers with considerations for inventory and other fixed costs to derive the breakeven volume for each channel. These are given in Exhibit 8.5. Breakeven analysis indicates that the most lucrative channel is direct sales through the Internet. The three channels have breakeven volumes that differ by an order of magnitude given as follows: Breakeven volume for the Internet is 626 units; for sales through chains or superstores, breakeven volume is 6,556 units; for sales through distributors to independents, breakeven volume is 50,038 units.

While the Internet appears at this point to be the most attractive channel, there are two other issues: the demand issue—Will the Internet attract sales, since the customer can’t “feel” the product, and if so, at what volume? The other issue is the life cycle issue: Is there value in initiating sales through a channel that packages design consulting with the wallcovering sales? This is the advantage of independent retailers over the other channels.

Note: *Assumes use of only one firm (the largest) in each channel: chains=Sherwin-Williams, superstore=Home Depot.

To answer these questions, we turn to the results from conjoint analysis. Exhibit 7.2 indicated that the optimal price for distribution through chains was $50. This yields demand of 2.72 rolls and contribution of $67.94 per person in the target market. The Internet has a lower sales forecast (2.45 rolls at its optimal price of $40), but this is still very healthy demand. The chain/superstore demand advantage is not sufficient to compensate for the order of magnitude difference in breakeven sales between chains and the Internet.

The final issue in comparing the distribution channels is the reach. So far we know the breakeven volume for each channel and the average demand for each person through each channel. The total demand for each channel applies the average contribution per person with the total people reached. For chains, this is $67.94 × 2,200 outlets × 1,500 customers. For the Internet this is $98 × 0.60 (share of households who purchase online) × 15 million households in market for wallpaper.

Epigraphs Summary

We combine all the above information in Exhibit 8.5 and show the breakeven plot in Exhibit 8.6. The table indicates that the breakeven approach draws the same conclusion as the contribution approach. The preferred channel from the breakeven analysis is the Internet. The Internet channel breaks even at 3,659 rolls, while chains breakeven at 29,935 rolls. This is true because the fixed costs of the Internet channel are quite low. The preferred channel from the contribution analysis is also the Internet. The expected contribution from chains is $222 million, while that from the Internet is $882 million. Thus, the Internet not only has higher margins but also has higher demand.

EXHIBIT 8.6   Breakeven and Indifference Volumes for Epigraphs Channels

Breakeven analysis is the preferred approach if you want to minimize financial risk. Total contribution is the preferred approach if you want to maximize profits. Accordingly, our quantitative analysis indicates that we should distribute Epigraphs through the Internet. Qualitative analysis reaches a different conclusion. Chains have the potential to shift the demand curve, because they create awareness (people who hadn’t seen Epigraphs advertising may see the product when they look for wallpaper), and chains also provide experience with the product. Customers can see the real size and texture in context.

CONCLUSION

This chapter examined the second strategic decision of the new venture—the choice of distribution channel. The distribution channel has a major impact on the venture’s ability to realize the potential demand forecasted by conjoint analysis. The distribution channel determines reach—the number of customers who actually have access to the product.

To analyze the decision we took data from Chapter 4 regarding the structure of existing distribution channels and data from Chapter 7 estimating demand within each channel. We introduced two quantitative techniques to compare channels: breakeven analysis and total channel contribution. We augmented quantitative analysis with qualitative considerations of channel attractiveness. In particular, we evaluated the channels’ ability to shift demand, their reversibility, and their potential for customer feedback. We applied these tools to Epigraphs.

NOTES

1. For a summary, see Katz, M. L. (1989). Vertical contractual relations. In R. Schmalensee & R. Willig (Eds.), Handbook of industrial organization (Vol. 1), pp. 27–38.

2. Mossi, J., & Stevenson, H. (1985). “R&R,” Harvard Business School Case 9–386–019.

3. Forrester Research, November 2006.

CHAPTER 8 WORKSHEET

Channel Comparison

Plot Channel Indifference

Using an Excel spreadsheet, create sample volume levels in Column 1. Choose a channel for Column 2. In Column 2, insert function: = Total unit margin × volume in Column 1 – Total fixed cost. Assign a column for each of the remaining channels. In each of the remaining columns, insert the same function, but apply the new “Unit margin” and new “Fixed cost.”

Set Column 1 (volume) as the X-axis and plot the remaining columns (channels) against it.

CHAPTER 9

Advertising Decisions

INTRODUCTION AND GOALS

The advertising program is the third strategic decision in the venture design. Its goal is to stimulate purchase through a paid program of communication that makes your target market aware and fully informed about the product. The advertising program is the second means (distribution channel being the first) by which firms transform potential demand into realized demand. To realize demand, customers must be aware of the product and its benefits, and must have access to it. Advertising controls awareness, while distribution channel controls availability.

The advertising program is important because it solves a common misperception among entrepreneurs—particularly those with a new innovation that, “If you build a better mousetrap, the world will beat a path to your door.” In essence, these entrepreneurs believe the product will sell itself. This just isn’t plausible—customers need to know there is a new mousetrap, and they need to know what makes it more effective than their existing mousetrap.

We are unable to provide enough guidance in a single chapter to develop a complete advertising campaign. In fact, we advocate use of an agency. Our goal rather is to define the principles underlying adoption of new products. We then translate these principles into tools for specifying campaign goals, linking them to demand implications, outlining a budget likely to accomplish those goals, and providing you with enough information to make you a sophisticated buyer of advertising. We end the chapter by specifying the advertising budget and vehicles for Epigraphs.

PRINCIPLES

There are two levels of analysis in research on advertising design and effectiveness. At the micro level, we are interested in the effort necessary to induce a single customer to purchase the product or service. The theoretical underpinnings at this level are from behavioral psychology. At the macro level of analysis, we are interested in the impact that social structure will have (and how we can take advantage of it) on the rate at which product adoption will move through the population. Here, the theoretical underpinnings come from many fields, but are subsumed under the heading “Diffusion of Innovation.”[1]

Micro Level

There are two basic frameworks of interest to advertising from behavioral psychology: response hierarchy models[2] and studies of communication format effectiveness.[3]

Response Hierarchy Models. Response hierarchy models propose that buyers pass through cognitive, affective, and behavioral stages toward purchasing a product. In the AIDA model for example, buyers pass through Awareness, Interest, Desire, and Action.

In the awareness stage, the goal is merely to gain attention for your product amidst the 1,500 commercial messages people are exposed to each day. Repeating simple messages is probably the most effective means to accomplishing this. In the interest stage, customers move from knowing the product exists to wanting to know more about how the product meets their needs (holding interest). In the desire stage, customers know enough about the product to recognize it to be superior to alternatives—the goal is to arouse desire. In the action stage, advertising moves customers with desire toward actual purchase (obtain action). Other versions of the basic model propose that there are substages within these stages. We are less interested in establishing the exact number of stages than we are in surfacing the idea that there is a progression through stages.

The joint contribution of these models is

1. the insight that even an effective campaign will have delayed impact, since customers are not immediately moved to action;

2. the implication that it may be necessary to create different ads for each of the stages; and

3. accordingly, products in different parts of their life cycle may require different types of campaigns. For entirely new products, a good portion of advertising is devoted merely to generating awareness. In the mature stage, customers are likely aware and may only need to be reminded of the product.

Knowledge of these models forces firms to be specific about the response sought from the buyers.

Format Effectiveness. Once you have established a response goal, the next issue is how to accomplish it. Here, behavioral psychology contributes frameworks that define types of appeals and their effectiveness in achieving desired responses. Rational appeals are ones that attempt to educate the customer about the specific benefits of the product: its quality, features, value, and performance. These types of appeals are essential for industrial customers and for big-ticket consumer purchases. The presumption here is that customers are gathering information and carefully comparing alternatives—thus, they want advertising to support their data gathering and analysis. The recent raft of pharmaceuticals ads in the mass media are rational appeals that attempt to educate consumers about the benefits and side effects of ethical drugs—thus making consumers, rather than doctors, the source of primary demand. Emotional appeals attempt to stir up negative or positive emotion to stimulate purchase. Automobile ads are typically emotional appeals that try to capture how you will feel driving the car. Similarly DeBeers ads for diamonds are emotional appeals that try to capture wives’ reactions to a gift of diamonds. Moral appeals, used primarily for social causes and nonprofit contribution campaigns, attempt to stimulate the audience’s sense of right and wrong to induce action. One example of moral appeals are “The More You Know” ads on NBC featuring stars who convey messages such as spend more time with your children.

Structure considers issues of conclusion drawing, argument dimensionality, and order of argument presentation. Conclusion drawing pertains to whether the message should explicitly draw a conclusion or whether it is better to let the audience do so. Generally, letting the audience do so is more effective,[4] but if there is a chance that they will draw the wrong conclusion, you may want the ad to do so for them. Argument dimensionality is the issue of whether to present one-sided or two-sided arguments. Two-sided arguments project greater credibility, and provide an opportunity for you to preempt any arguments that the customer might naturally raise. Accordingly, two-sided arguments may be more compelling. The risk in presenting opposing arguments is that you may introduce shortcomings that the customer would not have considered otherwise. Some of the pharmaceutical ads, for example, seem to raise more concerns over the side effects than interest in the product. The final structure issue order of presentation considers whether to present the strongest arguments first (to gain attention) or last (to reach a climax toward action).

Macro Level

While the microlevel studies (behavioral psychology) help us understand the behavioral mechanisms involved in stimulating purchase at the individual level, macro studies (diffusion of innovation) help us understand how individual behavior will aggregate to the population level and unfold over time. The contribution of greatest interest here is the notion that different portions of the population are moved to action by different mechanisms.[5]

In particular, if individuals are arranged in the order in which they adopt an innovation relative to the time it was introduced, they form a normal distribution as shown in Exhibit 9.1. “Adopter categories” correspond to the deviations from mean adoption time. Individuals who adopt innovations earlier than 2 standard deviations before mean adoption (μ - 2σ) are termed innovators (2.5% of the population); those who adopt earlier than 1 standard deviation are termed early adopters (13.5%); those who adopt before the mean are early majority (34%); those who adopt up to 1 standard deviation after the mean are late majority (34%), and the remaining population is termed laggards.

There are a number of characteristics that tend to discriminate between these groups. Innovators tend to have six times the mass media exposure of laggards; have more education; communicate with nonlocal sources to a much higher degree; and have greater wealth (necessary to afford both the volume and higher price of new innovations). While innovators are the earliest adopters, the real opinion leaders fueling the critical mass—the point at which the diffusion process is self-sustaining—are the early adopters. Innovators are often considered to be outliers—both behaviorally and socially. Their willingness to try anything leads others to discount their opinions, and their limited connections with local social networks minimize the interpersonal interaction fueling diffusion.

EXHIBIT 9.1   Adopter Categories

Source: Rogers, E. M. (1995). Diffusion of innovation. New York: Free Press.

In contrast, early adopters are perceived to use greater discretion in adopting new products, and are more integrated in the local social system. Thus, their opinions are both valued and accessible. Early adopters are the role models for the remainder of the population. Their example and word of mouth stimulates action by others.

These early use and personal influence mechanisms carry the greatest weight when the product is expensive and purchased infrequently. Here buyers will consult trusted sources that they know to have superior information. Personal influence is also critical in products with substantial social character—those that convey status or taste. Here customers will tend to imitate those whose tastes they admire. The implication is that early appeals in mass media should target opinion leaders rather than the population at large. Once early campaigns have stimulated purchase by innovators and early adopters, later campaigns can take advantage of these opinion leaders to stimulate imitative adoption in the remaining population.

Note that publicity (unpaid ads incorporated in news and magazine articles) is particularly effective as early-stage communication. Publicity follows similar principles to advertising, but conveys greater credibility, because information about the product is implicitly endorsed by the given vehicle (publisher or station). In addition to the endorsement advantage, another significant advantage of publicity is that it is free. Gaining publicity requires your product to be newsworthy. The firm 180s, who invented “behind the head” ear warmers in 1995, relies exclusively on publicity to gain awareness for their products—they spend no money on advertising. They are able to garner publicity because they generate a continual stream of innovative products. Each patent serves as a “news event.” While we don’t treat publicity in this book, we highly recommend a public relations campaign as a companion to (or substitute for) the advertising campaign. A good ad agency ought to provide these services as part of the total communications package.

The second contribution of diffusion literature is quantitative tools to forecast the rate and extent of adoptions. We will discuss these models in greater detail in Chapter 10, Demand Forecasting; however, we discuss the Bass diffusion model here because of its specific link to advertising. The Bass diffusion model[6] marked the beginning of marketing contributions to the diffusion literature. The intent of the model was to forecast the diffusion of new consumer products as a function of advertising policy.

The model is particularly interesting because of its comprehensive consideration of diffusion phenomena. In particular, the model decomposes diffusion into mass media influence (p), as well as interpersonal influence (q). Studies that have empirically examined diffusion using the Bass model have found that the coefficient for interpersonal influence is 12 times that for mass media influence.[7] While this would tend to suggest the futility of advertising, mass media influence precedes and initiates interpersonal influence (as shown in Exhibit 9.2). Thus, advertising is crucial.

A variant of the Bass model tailored to sales and advertising expenditures[8] models sales, S, as a function of advertising expenditure, A, an advertising response constant, r, saturation level of sales, M, and a decay constant, λ.

where S is sales in period t, A is advertising expenditure in period t, r is sales response consant (dS / dt at time 0), M is saturation level of sales, and λ is sales decay constant (fraction sales lost when A = 0).

The basic intuition of the model is that advertising costs grow exponentially with sales: This obtains quantitatively because as the sales base grows, so too does the cost to maintain those sales (λ. This occurs in practice for the same reason, but also because the laggards are intrinsically those individuals who are either hard to reach or for whom the product holds little utility.

We demonstrate use of the model via example. Assume conjoint analysis indicates that potential sales are $10 million sales. Assume also that sales response, r, in Year 0 is 5 (each dollar of advertising produced $5 of sales), sales in Year 3 are $4 million, and sales decay, λ, is 10% in the absence of advertising. Given this information, we can forecast Year 4 sales as a function of advertising expenditures:

Thus, I need to spend $133,000 in advertising merely to maintain current sales (400,000/3). Furthermore, each additional sale costs 65% more than the first sale (5A/3A). This is pretty dismal. However, the most frustrating problem as a new venture is that while we know M ($10 million) from conjoint, we don’t know r or λ.

EXHIBIT 9.2   Pattern of Innovation Diffusion

Source: Rogers, E. M. (1995). Diffusion of innovation. New York: Free Press.

This leads nicely to the applied discussion of how to develop the advertising program. Before doing so, we would like to reiterate the conclusions we draw from the foundation literature:

1. A single advertising message does not fit all individuals.

2. A single message does not fit all stages of the AIDA process even for a single individual.

Thus, at any given time, you may need to send separate messages to separate audiences. Exhibit 9.3 is an effort to convey the idea that during most periods you will be appealing simultaneously to different groups with different messages. While the exhibit is discrete for purposes of clarity, the distribution of adopters is actually continuous. Thus, so is the distribution of needed messages.

The implications from the exhibit are that messages and media will vary over the product life cycle. The introduction stage calls for rational, information-intensive advertising in fairly exclusive vehicles (high income/education demographics) matched to the product characteristics. Such advertising stimulates awareness, interest, desire, and action for innovators in the product category. As innovators begin purchasing the product, campaigns expand into broader media with messages that may relax information intensity. These campaigns may feature testimonials by early adopters.

Fortunately, technology and deregulation trends have fostered the growth of highly targeted advertising vehicles in magazines, radio, and cable television. These media are not only more efficient than mass media (in that you can send separate messages to separate audiences), but they are also less expensive on an absolute basis, because the audiences of each vehicle are smaller than those for mass media. Thus, you aren’t wasting money advertising to customers who aren’t in the target market.

DEVELOPING THE ADVERTISING PROGRAM

The key elements of the advertising program are identifying the target audience, determining the communication objectives, designing the message, selecting the advertising channels, and establishing the budget. We discuss each of these in turn.

Identifying the Target Audience

The broadest definition of the target audience is the set of customers who are potentially interested in your product/service at some price. This is the audience that you sampled to develop the perceptual map (focus group) as well as the demand curve (conjoint analysis).

This broad specification is refined passively by information obtained via the survey (segments of the target that have no interest in your product). The target is also refined actively, when you make pricing, product configuration, and distribution decisions that exclude further segments of the target.

It may help clarify the distinctions by way of example. Imagine that one has developed a noise cancellation system that replaces an automobile muffler. The advantages of this product are that (1) it is more effective than the muffler in reducing engine noise; (2) it reduces the cost to operate the automobile, because the muffler consumes fuel; and (3) it reduces pollution (again because it does not consume fuel). Assume that one is only interested in the aftermarket for the system (since one has struck separate arrangements with each of the automobile manufacturers for new automobiles). The broadest definition of the target market is all U.S. registered automobiles: roughly 130 million vehicles.

Conjoint analysis reveals that people are not interested in purchasing the system for automobiles older than 5 years. Although consumer breakeven for the system (dollars saved in fuel consumption vs. nominal cost of the system and installation) is estimated at 12,000 miles, consumers appear unwilling to make sunken investments in cars that they don’t plan on driving much longer. Thus, the passive refinement of the target market yields an estimate of 45 million vehicles (shrinking over time, as existing cars age further, and new cars come factory-equipped with the system). Finally, active refinement of the target market, based on choice of optimal price, excludes 50% of the prior market—leaving a potential market of 22 million vehicles. Fortunately, the conjoint analysis provides demographic characterization of (1) people likely to have cars 0 to 5 years old (vs. older or newer cars) and (2) people willing to pay at least the optimal price. Thus, we know not only how large the target market is, but more important, we have insight on who it is.

Determining Communication Objectives

The communication objectives pertain to the desired advertising outcome. While ultimately the objective is to move the entire potential market to purchase, this objective is not reached immediately. The communication objectives specifically address the cascading in Exhibit 9.3, where separate messages are sent to distinct adopter categories, and where each adopter category is moved at different points in time through the response hierarchy. For example, in the first time period in Exhibit 9.3, the communication objective is merely to make innovators aware of the product. In the second period, there are two objectives: generating product interest among innovators and creating awareness among early adopters. Within these qualitative objectives are quantitative objectives regarding how many innovators and early adopters to reach.

Designing the Message

As mentioned previously, the actual message design is outside the scope of the book. We strongly recommend the use of an advertising agency for message design and copy execution. In general (at least in the past), the services of advertising agencies were included in the cost of the advertising through the commission paid to them by the advertising vehicles. Thus, these services are “free” to the advertiser and are certain to be of higher quality than ads you can produce yourself. Having said that, there will be differences across agencies, and therefore you will want to be an educated customer of their services.[9] Thus, we will touch on message basics. We also recommend the book Guerilla Marketing[10] for a good hands-on guide to some of these design issues.

The message itself has four elements: content (what to say), structure (how to say it logically), format (how to say it symbolically—the actual copy), and source (who should say it). We will discuss content and structure briefly, but ignore format and source, since they are in the details of the message design.

The most important component of the message content is the core benefit proposition that emerges from the focus group and is refined by conjoint analysis. In addition, content pertains to the type of appeal: rational, emotional, moral. We discussed these types of appeals previously. Rational appeals convey the message that the product will produce the claimed benefits; emotional appeals attempt to stir up emotion to motivate purchase; and moral appeals (a variant of emotional appeals) stir up a sense of civic responsibility to induce a desired action. Knowledge of your product and the response it engenders in the audience (obtained from focus group and qualitative comments in the survey) will help you determine which of these appeals is best suited to your product for each of the audience segments.

Selecting Advertising Media and Vehicles

In our discussion of diffusion models, we drew the distinction between mass media channels and personal channels of communication. Personal communication refers to advocates (sales people), experts (independent persons with expertise), and social channels (word of mouth). Personal communication as an “advertising” medium is most effective for the population at large, when the product is expensive, risky, or purchased infrequently (where there is high information seeking), or when the product has significant social character—when it implies status or taste.

Mass media channels are those typically associated with advertising. These include print (newspapers, magazines), broadcast (radio, TV), display (billboards, signs), and more recently the Internet. There is no “best medium.” Each medium has characteristics that make it attractive for some products and less attractive for others. Exhibit 9.4 is an effort to summarize these qualitative differences, as well as cost and reach differences.

All cost, audience data from Burnett, L. (1993). Worldwide Advertising and Media Factbook. Chicago: Triumph Books; Qualitative comparisons from Kotler, P. (1999). Marketing Management: Analysis, Planning, Implementation, and Control. Englewood cliffs, NJ: Prentice Hall,

Mass media are critical in reaching innovators and early adopters, since this is their main source of information on new products. These opinion leaders can then stimulate communication to the later adopters. While it is easiest for advertisers to control mass media channels to reach early adopters, there are things a firm can do to stimulate personal channels to reach later adopters. They can create opinion leaders by supplying certain people with the product on attractive terms. It is quite common for manufacturers of sporting goods to sponsor athletes so that they will endorse the product. In fact, many athletes make more money from endorsements than they do from actual play. Tiger Woods, in 2006, for example, made $11.9 million from golf purses, but earned approximately $87 million from endorsements.[11]

Within each mass medium there are thousands of specific advertising vehicles. For example, there are more than 3,000 consumer magazines and 7,000 trade magazines. The goal in choosing a specific vehicle is to find the most cost-effective way to deliver the desired exposures to the target audience. Cost effectiveness is a function of the reach of a given vehicle (number of persons exposed to the medium during a given period), the frequency (the number of times a given person is exposed to the medium during the same period), and the impact (the value of an exposure for that product in that medium). While reach and frequency are characteristics of the vehicle itself, impact is a function of the match between the product and the vehicle. Exhibit 9.4 includes a comparison of several representative publications to provide a sense of how cost varies with vehicle characteristics.

Media choice to achieve the highest impact is based on audience quality, characteristics of the advertising vehicle, product characteristics, the message, and cost.

With respect to the audience quality, the issue is exposure value (the portion of the audience that is in the target market). Since advertising pricing is based on audience size (cost per thousand—CPM), the amount you pay per person in the target audience is a function of the alignment between your target and the vehicles audience. Modern Maturity, for example, is a cost-effective means to reach a large portion of the U.S. population. It has paid circulation of 22 million readers and a 1/3 page ad has a CPM of $9.50 (vs. a range of $7.00 to $400). If you are selling Medicare supplements, this is probably a great place to advertise, but if you are selling birth control, you have wasted $90,000. There are a number of good means to identify vehicles that are aligned with the target market. From secondary research, Simmons Marketing Research Bureau[12] and MediaMark[13] cross-match product categories and media habits. In your primary research, we recommend asking focus group interviewees as well as survey respondents their media habits, as well as their sources for information on new products.

The main characteristics of the advertising vehicle that affect advertising impact are attention probability and editorial quality. Attention probability is the likelihood that the audience will pay attention to your ad versus the 1,500 other communications they see each day. Editorial quality affects how they will interpret the ad, given that they have paid attention to it. Radio spots during rush hour have high attention probability because the drivers are captive. While drivers could channel surf to avoid ads, doing so increases the stress of rush hour driving. If the radio spot airs on the Kevin and Bean show on KROQ in Los Angeles, and better yet, Kevin and Bean produce the ad, and it pertains to new music, then the ad not only is attended to, but is interpreted as being credible by the show’s audience.

With respect to product characteristics, the issues are how to best convey information about the product. If the product requires demonstration, you will need to use visual media—most likely television. If the product requires explanation, you may need print media, so that audience can take time to read through all the details.

Characteristics of the message also constrain choice of vehicle, most notably through timing. If, for example, you are advertising a 1-day sale, the most effective vehicles are dailies (ones with daily frequency), such as newspaper or television.

Establishing the Advertising Budget

There are two basic approaches to establishing an advertising budget: rules of thumb and goal oriented.

Generally, rules of thumb establish advertising budgets on a percentage of sales (advertising intensity) basis. While such an approach seems backward in that it ignores opportunity, and nonsensical for startups with zero sales, rules-of-thumb approaches are supported by reasonable logic. Generally, industries are characterized by fairly consistent advertising intensities across firms. These intensities reflect collective wisdom on the amount of advertising required to sustain a given level of sales. Accordingly, advertising intensities provide focal points that lead to stable advertising equilibria in an industry. Many industries are best characterized as zero-sum games, in which any sales increase one achieves comes at a competitors’ expense. In such settings, increases in advertising, aimed at increasing market share, can lead to advertising wars that are harmful to the industry in that they increase total spending without increasing sales.[14] Even in cases where the increased spending results in higher share, generally the cost to increase market share equals the net present value of the increased profits associated with the increased share.[15] Thus, rules of thumb are not a bad way to go. Even if you use a goal-oriented approach, you should compare your resultant advertising intensity with those in the industry (available in industry ratio studies).[16] The approach we advocate here is a goal-oriented approach. Here we take the objectives defined in Step 2, determine the advertising needed to accomplish those goals, and estimate the costs to conduct that advertising.

Remember that our goal for the noise cancellation system was 22 million units from the target audience of 45 million car owners with automobiles that are 0 to 5 years old. The first issue is choosing a cost-effective advertising vehicle that reaches these 22 million people. Car and Driver, while offering a good editorial match with the product only reaches 1 million people. For the moment, however, assume that there is such a magazine and that the CPM for a 1/3 page ad is $45.00 (about average).

Trial, for those likely to respond, is induced by three “attention episodes.”[17] The first episode creates awareness, the second stimulates response, and the third either causes the audience to engage or withdraw. Not all exposures produce attention episodes. To compensate for failure to gain attention and/or forgetting between episodes, you may need three or more exposures to gain one attention episode. Accordingly, a good budgeting estimate is that you will need 9 exposures per member of the target audience to induce purchase.

Thus, the total budget would be

Audience size/1,000 × (CPM) × 9 exposures.

In our noise cancellation system example, this would be

22,000,000/1,000 × $45.00 × 9 = $8.9 million.

It is likely that the true cost would be much higher, because it is unlikely that there is an advertising vehicle perfectly matched to the target audience (or a set of vehicles combined that perfectly matches the target audience without overlap). In practice, you would need to identify the specific vehicles before establishing the budget.

VEHICLES THAT COMBINE ADVERTISING WITH DISTRIBUTION

The $8.9 million advertising estimate highlights one of the big challenges for new ventures—the enormous cost to create awareness. By now you realize that advertising can be quite expensive—in many cases prohibitive for new ventures. This creates a chicken-and-egg problem. Distributors and retailers are often unwilling to carry a new product (particularly from a firm that only offers a single product) without demonstrated demand, but without advertising there is no way to stimulate demand. Fortunately, there are a set of vehicles that are ideal for new product ventures in that they simultaneously advertise the product and offer it for sale. They are not optimal in the long run because they have limited reach, but they are useful in the short run because they create awareness and demonstrate demand (while generating revenues). Once your product has generated a track record with these vehicle/channels, you can parlay that to gain acceptance in more traditional channels with greater reach. The two principle vehicle/channels are catalogs and television shopping shows (such as QVC and Home Shopping Network).

Catalogs

Catalogs are “magazines” of product offerings that are mailed to subscriber lists at regular intervals throughout the year (SkyMall is also a catalog, but is distributed to airline seats rather than mailed to subscribers). Catalogs are like retailers in that they have buyers who search for new products and make decisions about which to offer; they are like ad agencies in that they have to create photos and “copy” for each product they offer; they are like magazines in that they do layouts, then produce and distribute copies; and finally they are like distributors (fulfillment houses) in that they take, package, and ship orders as well as collect payments.

Catalogs vary in the quality and type of products they carry and correspondingly with the size and demographics of their subscriber base. Not surprisingly, they also vary in their fees and markups. Thus, catalog choice is very similar to the choice of distribution channel (trading demand and reach against cost of selling). The distinction here is that reach and awareness coincide since they are both accomplished through the catalog, whereas conventionally the distribution channel determines reach, while advertising determines awareness.

It is worth pointing out that selling through catalogs tends to be expensive, thus as mentioned previously you may introduce your product in catalogs, then shift to a more conventional channel once you have created awareness and demonstrated demand. As an example, Early Winters, now Sahalie, charges a “placement fee” of $5,000 to carry a product and has a markup of 60 to 70 points (meaning the catalog keeps 60% to 70% of the retail price). This is a higher markup than the combined markups for distributor and retailer for wallcovering. Both the distributor and retailer charge 40% markups, which correspond to a combined markup of 51 points (1/(1.4)2).

Getting a catalog to carry your product is similar to getting a retailer to carry your product, though there are additional constraints imposed by the medium: (1) The customer can’t experience the product (they make their decision based on print media) and (2) the product must be shipped. Thus, it helps if your product is new, simple, unique, durable, lightweight, and photographs well. Fortunately, there are as many catalogs as there are magazines, so there are numerous opportunities. Additionally, there are “catalog representatives” who help you identify the best catalog for your product and help you gain acceptance by that catalog.

Television Shopping Shows

Television shopping shows originated with the Home Shopping Network (HSN), which began cable broadcasts in 1977. The two primary shopping channels are HSN and QVC. Both broadcasts live 24 hours a day, 364 days a year. Their ability to generate viewers and revenues is a function of the number and novelty of the products they offer. As an example, QVC offers 1,600 products per week, of those, 250 are brand new. While each channel is available in most U.S. households with cable television (87 to 89 million homes), a better sense of their reach is the customer base. In 2005, QVC sales were $6.5 billion to 10 million customers. In the same period, sales for HSN were $3 billion.

Moreover, customers are segmented by the actual “programs.” Thus, your product will not reach 10 million viewers. Instead, it will reach a targeted audience that has interest in similar products. As an example, one of the most popular shows is “Joan Rivers’s jewelry.”

The shopping networks are similar to other distribution channels in that there is competition to gain access to the channel. An interesting article on becoming a QVC vendor is, “Getting Ready for Prime Time” (Inc. magazine, November 2003). In addition, QVC offers advice for gaining acceptance: www.qvcproductsearch.com. However, once you have access your product gains 5 to 10 minutes of television advertising with an estimated audience of 500,000. If you had to purchase slots in daytime television, they would cost $20,000. As with catalogs, once you gain awareness and demonstrate demand through the shopping networks, you can parlay them for access to more conventional channels with broader reach.

Infomercials (Direct Response Television)

A final avenue for joint advertising/distribution is infomercials (more formally referred to as direct response television—DRTV). While infomercials are similar in many regards to the shopping shows, we only mention them in passing because of their expense. There is an entire industry devoted to infomercials. It consists of writers, production companies, media buyers, fulfillment houses, and “all-in-one firms” that do everything. There are several books and Web sites to guide new ventures in creating an infomercial (see, e.g., www.direct-response-television.com).

In general, the goal of an infomercial is to break even: generate enough margins from infomercial sales to cover the production and airing costs. In this way, the venture creates awareness at zero net cost and then uses demonstrated sales to gain entry into conventional distribution channels. Thereafter, the product can sport the ever-popular “as seen on TV” logo on its packaging and promotional materials. The problem with infomercials is that costs run about $150,000 plus royalties for a 30-minute segment, and about $40,000 for a 2-minute segment (for both production and media). Thus, the same cash flow constraints that preclude advertising also seem to preclude infomercials.

EPIGRAPHS ADVERTISING PLAN

Identifying the Target Audience

We identified the broadest target market for wallcovering as the 67 million owner-occupied households. American Marketplace reports peak household textile use among households as married couples, age 45 to 54, with annual incomes in excess of $70,000. Our market survey confirms these basic trends for Epigraphs demand. However, we find that demand peaks at incomes of $100,000 to $150,000.

Determining Communication Objectives

Ultimately, our objective is to induce purchase in the entire market. Before discussing more specific objectives, it is worth commenting on some idiosyncrasies of the wallcovering market. First, sales are “skewed left.” An average wallpaper pattern sells 7 million single rolls over a 3-year life. Sixty percent of the rolls are sold within the first year, as shown in Exhibit 9.5 (same as Exhibit 4.7). Second, ratio studies of the industry indicate that advertising intensity is less than 1%. Thus, a wallpaper manufacturer with first year sales forecast of $75 million at wholesale ($105 million retail) only spends $750,000 on advertising. The low level of advertising, as well as the fact that sales peak early (antithetical to the slow diffusion associated with the AIDA process), tend to suggest that advertising is a relatively unimportant component in the communication process. It appears rather that 20% to 25% of homeowners decide to purchase wallcovering each year irrespective of advertising, and then shop among patterns. In fact, our survey data (Exhibit 9.6) indicates that store displays are the second most prominent source of ideas (magazines being first).

An additional issue, raised in the focus groups is that consumers seek uniqueness in their décor. To the extent that customers repeatedly see a wallcovering in advertisements, they may reject it as something that is no longer unique. The skewed 3-year life cycle corroborates the importance of uniqueness—a wallcovering’s greatest sales occur when it is new and unique, and then diminish as it becomes more common.

The implications for advertising in this context are first that ads at most play an attention/interest role. The final stages of the AIDA process occur at the retailer, where the consumer makes on-site comparisons of wallcovering alternatives. Second, and more important, any advertising beyond that point may truncate sales by overexposing the product and eliminating its novelty. Thus, wallcovering by nature rather than strategic choice is a low advertising-intensive industry.

EXHIBIT 9.5   Profile of Wallcovering Sales Over Time

If we examine the wallcovering life cycle (Exhibit 9.5) once again, we see that demand peaks in Quarter 3. We recommend advertising to create awareness only until the product reaches critical mass in that quarter and rely on interpersonal influence (including the retailer) thereafter. We can revisit this tentative decision at the critical mass point.

Designing the Message

While we will leave the structure, format, and source decisions of message design to an ad agency, we need to supply the content. The content of the message is the core benefit proposition that emerged in the focus group and was confirmed by conjoint results. The proposition is a whimsical wallcovering with the versatility and uniqueness of custom finishes (faux, stenciling), with greater durability, and easier installation than wallpaper.

One interesting observation with respect to the message is that we have already pretested a preliminary message in the product literature sheet that we distributed with the conjoint survey. The relatively high potential demand suggests that in general we have compelling ad copy. However, a review of the qualitative comments about the product suggests that we created a misperception regarding the quotes. People seemed to believe that they would be reading a single quote over and over rather than 50 ft of different quotes. Thus, the product literature sheet is a valuable opportunity to examine both the core benefit proposition and the effectiveness of the ad copy in communicating that proposition.

Source: Mediamark Research: Household and Personal, Appliances, Etc., Spring 1995.

Selecting the Advertising Media and Vehicles

MediaMark[18] identified the main demographics and media habits tied to remodeling. These are listed in Exhibit 9.6. While the Audit Bureau of Circulations (www.accessabc.com) maintains data on circulations and audience demographics for these vehicles, only circulation data are available to nonmembers. The next best reference is SRDS.[19] SRDS provides rate information for every advertising vehicle (organized in volumes by medium, and then within medium by genre). Thus, we can compare rates but not audience demographics. To get demographics, we requested media kits from the vehicles we felt (from personal experience) would be most attractive. Exhibit 9.7 is a brief overview of the major “home service and home” vehicles identified by SRDS.

Media kits provide information on circulation, detailed audience demographics, audience media habits and spending habits, editorial content, advertising rates, and any advertising format requirements. Media kits for print media usually include copies of the publication, so that you can get a firsthand sense of the editorial content and tone.

Exhibit 9.8 summarizes circulation, demographic, and rate information for the media kits we received. In general, the demographics are comparable across the vehicles: The audience is predominately female, 40 to 45 years old, median household income of $50,000 to $60,000, and 80% home ownership. Apart from advertising reach and cost, which we discuss in a moment, the main feature discriminating these vehicles is “percentage medium devoted to home furnishings.” Here HGTV (broadcast media), and House Beautiful (print media) dominate Living and Better Homes & Gardens. This distinction is evident in comparing samples of the print media—Living primarily focuses on crafts/entertaining and Better Homes & Gardens deals broadly with house, family life, and gardening in addition to home furnishings. Thus, House Beautiful and HGTV are a better match to the product—the audience is more conditioned to respond to home furnishings advertisements.

Source: SRDS Consumer Magazine Advertising Source, January 1999.

Note: Home service and home (selected magazines).

* For HGTV this is cost per half-hour show.

One of the interesting features of media kits is that they are “advertising to advertisers.” Thus, the vehicles conduct their own audience studies in an effort to distinguish themselves from other similar vehicles. House Beautiful, for example, did a set of interesting studies that compared spending generated by their magazine with that of competing magazines. In addition, they created a perceptual map (Exhibit 9.9) of the competitors (which we applaud). The perceptual map brought clarity to intuitions we had about the distinctions between the editorial focus of the various “shelter” magazines. The map confirmed that the magazine offering the best match for Epigraphs was Home, which is unfortunate since its audience is only 1 million households. We next consider reach and advertising cost as part of the advertising budget.

EXHIBIT 9.9   Perceptual Map of Home Decorating Magazines Done by House Beautiful

Establishing the Advertising Budget

Our goal is to reach the 15 million home owners who purchase wallcovering in a given year. Because we don’t want to destroy product uniqueness through overexposure, we only want to achieve awareness/interest through advertising—thus, only one or two attention episodes per target member. Assuming failure to gain attention in some episodes, but no forgetting-between episodes, we estimate two exposures per attention episode. Thus, total exposures per target is (1 to 2) × 2 = 2 to 4.

A third page color ad in House Beautiful costs $37,405 and reaches an audience of 880,206. This yields a CPM of $42.69. This is the highest CPM of all the vehicles. It is three times the CPM of Better Homes & Gardens, and twice that of Living. In contrast, a 30-second spot on HGTV is only $1,500 and reaches an audience of 1,140,000. Thus, you could purchase 24 spots on HGTV and reach a larger audience with more exposures. Additionally, HGTV offers the opportunity for more focused targeting than House Beautiful—each show has a particular topic. Thus, Epigraphs ads could be aired during shows having to do with wallcoverings, or do-it-yourself projects, rather than gardening.

HGTV appears to be the most cost-effective means to reach the target. While each show has only 1.1 million viewers, the total subscribers to the channel is 55 million. Thus, there is the possibility of reaching the entire target. If so, the total advertising budget would be

10 million target market/1.1 million viewers per show = 9 shows.

9 shows × $1,500 per show × 3 exposures on each show = $40,500.

One caveat is that our primary research indicates that magazines outrank television by a factor of 2:1 as a source of decorating ideas. Thus, we plan to augment HGTV advertising with print advertising in three issues of Home:

3 issues × $27,000 per 1/3 page color ad = $81,000.

Summary

The tentative advertising program for Epigraphs is to place 27 spots on HGTV. This comprises 3 spots each across nine different weekly shows in an effort to reach all 10 million people in the target market. In addition, we will place three 1/3 page color advertisements in Home Magazine.

The timing of this advertising is shown in Exhibit 9.10. The advertising will be concentrated in the first 3 months following introduction. The televisions spots will occur at a rate of roughly three per week. The print ads will be placed in each of the first 3 months. This is a tentative program. Response to first-month advertising will provide an indication how best to manage the remaining 2 months.

The cost of the program is $40,500 for HGTV and $81,000 for Home Magazine, for a total of $121,500. As a test of reasonableness of this budget, we examine advertising intensity. Combining advertising expenditures of $121,500 with forecasted first-year sales of $29.9 million at wholesale yields an advertising intensity of 0.4%. This is slightly below the industry average.

CONCLUSION

This chapter examined the third strategic decision of the new venture—the advertising program. The product configuration, advertising, and distribution decisions jointly determine how much of the potential demand from conjoint analysis is actually realized. All three strategic decisions assess the marginal value of appealing to less attractive portions of the target market.

In the case of the price and product configuration decisions, less attractive was defined as portions of the market with lower values for the product; in the distribution decision less attractive meant harder to access physically; and in the advertising decision less attractive meant harder to access through media. Thus, the product and pricing decisions exclude customers with low reservation prices and obscure preferences; the distribution decision excludes customers who are hard to reach and the advertising decision excludes customers with obscure media habits.

To analyze the advertising decision, we combined audience data from various vehicles with ancillary data from the conjoint survey. We chose vehicles that cover the target market cost effectively. While we didn’t provide details sufficient to design an advertising campaign, we did provide enough background to make the entrepreneur a sophisticated advertising customer.

In the next chapter, we combine all the strategic decisions to develop a dynamic forecast for venture sales.

NOTES

1. Rogers, E. M. (1995). Diffusion of innovations. New York: Free Press.

2. Strong, E. K. (1925). The psychology of selling. New York: McGraw-Hill.

3. Hovland, C. I., Lumsdaine, A. A., & Sheffield, F. D. (1948). Experiments on mass communication. Princeton, NJ: Princeton University Press.

3. Hovlad, C. I., & Mandell, W. (1952). An experimental comparison of conclusion-drawing by the communication and by the audience. Journal of Abnormal and Social Psychology, 47, 581–588.

5. Rogers (op cit), Durstmann and Borda [AU: Please provide details.] (1962).

6. Bass, F. (1969). A new product growth model for consumer durables. Management Science, 15(5), 215–227.

7. Sultan, F., Farley, J., & Lehmann, D. (1990). A meta-analysis of applications of diffusion models. Journal of Marketing Research, 2, 70–77.

8. Vidale, M. L., & Wolfe, H. B. (1957). An operations-research study of sales response to advertising. Operations Research, June, 370–381.

9. The best means to select an agency is to collect ads that appeal to you and contact the advertiser to see what agency they use. The agencies used by major advertisers are identified in AdWeek and Advertising Age.

10. Levinson, J., & Godin, S. (1994). The guerilla marketing handbook. New York: Houghton-Mifflin.

11. www.golfdigest.com/features/index.ssf?/features/gd200702top50.html

12. Simmons Marketing Research Bureau.

13. MediaMark.

14. Schmalensee, R. (1972). The economics of advertising. Amsterdam, The Netherlands: North-Holland.

15. Rumelt, R. P., & Wensley, R. (1981). In search of the market share effect. Academy of Management Proceedings.

16. See, for example, Robert Morris Associates. (1923–present). RMA annual statement studies. Philadelphia: Author; Dun & Bradstreet, Inc. (several years). Dun & Bradstreet’s key business ratios. New York: Author.

17. Krugman, H. (1972). Why three exposures may be enough. Journal of Advertising Research, 12, 11–14.

18. Krugman (op cit).

19. Standard Rate and Data Service (SRDS).

CHAPTER 9 WORKSHEET

Advertising Decision

1. Identifying the target audience

Since Chapter 2 you have been working with a definition of who the target audience is. In Chapter 2, the definition is broad—all possible individuals /households /firms with potential need for your product/service. As we progressed through focus groups and conjoint analysis, we found that some portions of the market are not worth pursuing (less heavy use, too costly too reach, willingness to pay is below optimal price).

2. Determining communication objectives

(a) What is the average advertising/promotion intensity in your industry ($ad/$sales)?

_______________ A good source for this is LNA/Media Watch (Lippincott reference desk). They have advertising expenditures for each firm, by product line.

(b) What is the relative emphasis you need to place on awareness, interest, desire, and action? Take into account the maturity of the industry.

3. Designing the message

What is your core benefit proposition? What is the unmet need that surfaced in focus groups that you will be able to satisfy?

4. Selecting the advertising media and vehicles

If you have not already done so, and your product/service is consumer based, you should consult Mediamark Research (a hard copy is at the reference desk in Lippincott). Mediamark Research characterizes consumers by a seemingly infinite number of buying behaviors and matches that to demographics, psychographics, and media habits. Summarize this for your product/service using Exhibit 9.6 as a guide.

If your product/service serves a commercial market, then psychographics are not useful, but you will need to characterize firms by their size, and will need to identify the major journals, trade shows, and associations in the industry. You will also need to know what percentage of firms in the industry participates in each of these.

Once you have identified candidate advertising vehicles, you need to characterize them by demographics, reach, and cost (see Exhibit 9.8). These cost and reach data are available from SRDS for both consumer and trade magazines (Lippincott reference desk).

Do an equivalent characterization for any nonmedia promotion you are considering, for example,

Trade shows (identify each and define cost and attendance)

Direct mail (identify mailing list and cost to obtain)

5. Establishing the advertising budget

The advertising budget is merely the sum of the number of exposures times the cost per exposure for all advertising/promotion that you are implementing. As a rule of thumb, three attention episodes are generally required to achieve purchase. Note that in crowded media, it may take three exposures to achieve an attention episode.

When planning your media, take into account redundancies between vehicles. For example, the audience of a CBS show at 10:00 p.m. on Wednesday has no overlap with an ABC show at 10:00 p.m. on Wednesday. Thus, if you advertise on both shows, you have doubled the audience, but not the exposures. In contrast, if you advertise on Law and Order and in Time, and if 60% of people who watch Law and Order read Time, then your total audience is less than their sum, but you gain more exposures per person in the audience.

As a check, compare your total advertising expenditures with your sales forecast, to determine your advertising intensity.

How does this compare with the industry?

CHAPTER 10

Dynamic Demand Forecast

INTRODUCTION AND GOALS

Demand forecasting is the linchpin of the entire business plan, yet rarely are forecasts accurate. Venture capitalists indicate that 60% of plans overstate demand by 60%, while 40% of plans overstate demand by 90%. All decisions in the design of the venture are contingent on the demand forecast—even those that ultimately affect demand. The channel decision, for example, is based on the likelihood of exceeding breakeven demand, yet the channel itself determines product availability, which in turn affects realized demand. The goal of demand forecasting is reliable estimates of future revenues to support well-informed decisions regarding resource levels.

Reliable forecasting is important because erroneous demand forecasts in and of themselves could lead to failure. Optimistic forecasts generate requirements for high levels of physical, human, and financial resources. The associated carrying costs for the excess resources could strangle an otherwise viable venture. Similarly, pessimistic forecasts may result in insufficient capacity to meet demand. Inability to meet demand will cause customers to go elsewhere, perhaps permanently. This was the case when the Titleist Pro VI was first introduced. Demand exceeded supply, so retailers were forced to recommend competitors’ balls.

Because the demand forecast is so critical, we tackle it from two different analytical approaches. The first technique recognizes the controllable elements of demand. It is a bottom-up approach that combines the potential demand from conjoint analysis with sales formation decisions: the distribution channel decision in Chapter 8 and advertising decision in Chapter 9. The second technique assumes that much of demand is inherent in the product. It is a top-down approach that uses adoption data for comparable prior products (historical analogy). After reviewing these two approaches, the chapter applies the techniques to Epigraphs to generate a 3-year demand forecast.

PRINCIPLES

The first approach for demand forecasting is conjoint analysis combined with models of sales formation. This approach focuses on the controllable aspects of demand. It combines primary data regarding the potential demand with venture decisions affecting how much of that potential is realized. The second approach is historical analogy. Here, we examine the diffusion of similar past products to estimate the likely diffusion of our own product. The conjoint approach is “bottom-up”–building an aggregate forecast combining purchase intentions at the individual level with decisions at the firm level. In contrast, historical analogy is a “top-down” approach beginning with diffusion patterns at the population level for prior products. From the various diffusion patterns, we assess which innovation is most similar to ours and use its diffusion path as the basis for estimating our own sales diffusion.

Unless the product is completely new to the world, we recommend using conjoint analysis as the primary forecast, while using historical analogy as a validation tool. If, however, the product is “new to the world,” then individuals may have no sense of why they would want it and how they would use it. In those instances, stated purchase intentions, such as those gathered in conjoint, are highly speculative. Examples of “new-to-the-world” products are copiers and personal computers. Until people experience these products, they may not anticipate any use for them. As an illustration, the initial forecasted demand for copiers was four units worldwide. For these “new-to-the-world” products we recommend using historical analogy as the primary forecasting tool.

Bottom-Up Forecasting: Conjoint Analysis/Sales Formation Models

The bottom-up approach takes the perspective that almost every element of demand is controlled by the venture design with the possible exception of the target market. Exhibit 10.1 captures this notion. The outer circle in the exhibit represents the target market identified by industry analysis in Chapter 4. This is the maximum level of demand that could possibly be achieved. Not all this market can be served profitably, however. In particular, four critical venture decisions determine which portions of the potential market to exclude in order to maximize profits. Each of these decisions truncates potential demand to define realized demand.

The first truncation occurs with the product configuration decision (Chapter 7). The product configuration decision determines which set of features is most profitable. This decision, therefore, excludes some features that might draw a broader base of customers.

The second truncation occurs with the pricing decision (Chapter 7). Because the decision sets marginal revenue equal to marginal cost, it excludes some people who might be willing to purchase the product at a lower price.

The third truncation occurs with the distribution channel decision (Chapter 8). This decision determines which portions of the target market have access to your product. Your decision will typically exclude people too costly to reach physically. If, for example, you distribute exclusively through a particular retailer, you will not reach customers who live outside a 5- to 10-mile radius of all that retailer’s stores.

The fourth truncation occurs with the advertising decision (Chapter 9). That decision determines which portions of the target market become aware of your product through mass media. Therefore, the decision excludes people who don’t use the particular advertising vehicles you select. This decision is the least constraining in that the advertising decision only controls who becomes aware of your product through mass media. People may become aware of your product through store displays and word of mouth.

EXHIBIT 10.1   Potential Versus Realized Demand

The four decisions taken together nest the realized demand within the potential demand. Thus, in Exhibit 10.1, we see that the realized demand is only a small central portion of potential demand. This nesting produces a “point estimate” of the potential demand for the product. By point estimate, we mean a single value for the ultimate number of product adoptions (saturation point) rather than a growth path to the saturation point.

Obviously, not all sales to the “realized demand” group materialize on the first day you offer the product. Sales unfold over time. You need to understand these demand dynamics to make resource decisions. To forecast the dynamics, we apply sales formation models to the conjoint point estimate. For a sense of how sales formation models modify the point estimate, remember that responses to conjoint surveys assume full awareness and availability of the product. This is true because the survey itself makes the customer aware of the product and has the customer assume it is widely available. Sales formation models convert the point estimate of demand to a dynamic sales forecast, by simply applying firm advertising and channel decisions that control awareness and availability.

In other words, while potential demand, the inherent attractiveness of the new product/service relative to the alternatives, is something outside the control of the firm, sales formation, the actual capture of the potential demand over time, is controlled by the firm.[1] Strategic decisions by the firm determine the product’s availability and awareness. Availability is set through the channel decision; awareness is set through the advertising decision. Realized sales, S, in any period, t, is merely the sum over all individuals, i, in the target market of size, n, of their respective awareness, aw, availability, av, and purchase intention (obtained by conjoint analysis), bc, where bc is expressed as demand per person, av is expressed as traffic (customers per given time interval) in the chosen distribution channel, and aw is expressed as percentage of people in the target market viewing the given advertising vehicle (audience/n): [2]

St = awtavtbct.

While in principle we could do this analysis for each individual in the target market, in practice we will assume that the mean responses in the survey reflect a representative individual. We, therefore, focus attention on the “reach” of our advertising and distribution across all individuals. (Note: To the extent there are market segments that we target differently, the aggregation should be done within segments.)

The sales formation process can be illustrated nicely from the R&R case[3] for the introduction of the TV Guide game. With regard to availability, avt, R&R planned to introduce the TV Guide game through exclusive retailers for the first 3 weeks, expanding to department stores in Week 4, and finally to discounters in Week 8. Assume that the exclusive retailers have weekly traffic of 3.2 million, that the department stores have weekly traffic of 4.8 million, and that the discounters also have weekly traffic of 4.8 million. We add the traffic of all outlets in which the product was available, to establish the product availability at any given time, av, in the first row of Exhibit 10.2.

We follow similar analysis for advertising reach, awt. We begin by looking at the reach of the planned advertising vehicles. R&R planned to place five ads in TV Guide, one per week over 5 weeks. At the time of the case, TV Guide had an audience of 17 million out of 87 million total U.S. households (19.5%). Assume that the first ad only achieves attention in one third of the TV Guide audience, and that each of the next two exposures adds another third. The resulting advertising reach, aw, is given in the second line of Exhibit 10.2. Remember that customers need repeated exposures to advertising to create awareness (the rule of thumb is three attention episodes).[4]

Finally, we treat the stated purchase intentions obtained from conjoint, bcit. Ordinarily, this is a single number for a homogeneous target market. Remember that the optimization procedure in Chapter 7 using the conjoint data leads to a single price. However, in the case of R&R, the company decreased the price of the TV Guide game over time. This is a form of price discrimination—early adopters at exclusive retailers pay one price, majority adopters at department stores pay a lower price, and laggards at discount stores pay the lowest price. Since R&R did not conduct conjoint analysis, we do not know the explicit demand curve for the TV Guide game. Assume, however, that at $25, customers are 2% likely to buy the game, at $20, they are 3% likely to buy the game, and at $15, they are 4% likely to buy the game. The respective purchase intentions, bc, for the prevailing price in each period are given in Row 3.

To find weekly sales in each period, multiply avt × awt × bct. These weekly sales estimates are given in Row 5. To find cumulative sales, add sales for the current week to sales from all prior weeks (Row 6). This is your demand forecast. Row 5 captures current adoptions, while Row 6 captures cumulative adoptions.

Notes:

Availability: R&R introduced the product first in high-end retailers, then in department stores, and finally in discounters.

Awareness: We focus on the TV Guide ads, because we do not have details on the cooperative ads placed by retailers. There were five ads in total.

Purchase intention: Purchase intention is a function of price (this is characterized by the demand curve). The price of the TV Guide game dropped over time, primarily because of the pricing policies of the stores in which it was sold. Dropping the price increases the number of people willing to purchase it. Thus, there are two effects increasing demand when moving from Bloomingdales to Wal-Mart—one is greater availability (more people shop in Wal-Mart stores than in Bloomingdales stores). The other effect is the price effect. More people will buy the game at $16.97 than will buy it at $25.00 (regardless of whether it is in Bloomingdales or Wal-Mart).

As you can see from the discussion of bottom-up forecasting, venture decisions control realized demand by excluding some people from the target market. However, two of the decisions also control the pace at which the demand unfolds. The channel and advertising decisions determine how quickly you create access and awareness for the new product. A third decision, price, can also control both the level and the pace of demand.

Historical Analogy

While the bottom-up approach to demand forecasting focuses on the controllable aspects of demand, the top-down approach assumes that adoption propensities are inherent in the product. The top-down approach exploits the fact that new product adoptions (first purchase) by customers follow a predictable pattern. Accordingly, we can predict demand for a new product by making use of patterns for prior analogous products. We call this approach to forecasting historical analogy.

The predictable pattern that new product adoptions follow is a logistic (S-shape) growth curve. This pattern for cumulative adoptions is depicted in the top panel of Exhibit 10.3. The derivative pattern for new adoptions in the current period is depicted in the bottom panel. The basic formula characterizing the logistic curve is the growth rate in cumulative adoptions:

g(t) = a − bX(t),

where x(t) is new adoptions during period t, X(t) is cumulative adoptions through time t, a is the diffusion rate, b is the crowding effect, and g(t) is the growth rate = x(t)/X(t).

EXHIBIT 10.3   Characteristic Diffusion Curve: (a) Cumulative Adoptions and (b) Corresponding Current Period Adoptions

Note: Figure 10.3b is obtained by taking the derivative of the function in Figure 10.3a.

The maximum value for X(t) is the saturation point, Xs. The saturation point is interpreted as the total number of customers who ever adopt the product. It corresponds to the potential demand in the bottom-up approach for a given price and product configuration. By definition, growth ceases when a product reaches this point, so we can solve for the saturation level of adoption by setting g(t) = 0 in the equation above. This reveals the following relationship between the saturation level, the diffusion rate, and the crowding effect:

Xs = a/b

Knowing this formula helps us in two ways. First, it allows us to forecast the saturation point and all intermediate adoption points once we have a few periods of adoption data. Second, it allows us to characterize the diffusion and crowding rates for comparison to other historical products.

To demonstrate this forward forecasting from prior adoptions, we use the example of XM satellite radio subscriptions. Exhibit 10.4 shows the growth of XM subscriptions from launch through March 31, 2007. Growth is shown both graphically and as a spreadsheet. To forecast future growth in subscriptions using the logistic curve, begin by regressing the growth rate, g(t), on cumulative adoptions, X(t). A regression on those 21 data points indicates that a = 0.642 and b = 0.090. Using the formula above for the saturation level, Xs, suggests that XM subscriptions will peak at 7.1 million (= 0.642/0.090).

This forward forecasting is only possible once sales for the new product have begun, so it is of limited help in the venture design stages. However, the logistic curve mechanics behind the forward forecasting are useful for another type of forecasting: historical analogy. The basic idea behind historical analogy is that you identify prior products similar to your product; obtain their diffusion rates, crowding rates, and saturation levels; and then use these rates to forecast your own product diffusion.

Exhibit 10.5 shows actual adoption rates (as percentage of total firms or households) versus time since introduction for five product innovations: color TV, ultrasound, mammography, air conditioners, and clothes dryers. On average, product adoptions peak in the eighth year following introduction, at a rate of 7.5% households per year, but there is substantial variance across products.[5] Recognize that Exhibit 10.5 shows current period adoptions rather than cumulative adoptions. Current period adoption is the derivative of cumulative adoption.

The variance across products in Exhibit 10.5 is captured by two parameters: the rate of adoption, a (some products diffuse more rapidly than others), and the extent of adoption, or saturation level, Xs. Products with high rates of adoption (color TV) peak before year 8. Those with high levels of adoption (ultrasound), peak above 7.5% of households/population. Exhibit 10.6 shows Xs for some widely adopted products. Note that there is no requirement that rate and level be correlated. The art of historical analogy is choosing prior products whose values for Xs and are likely to be similar to the new product.

Appropriate choice of analogous products requires some understanding of the factors affecting diffusion. We turn again to the diffusion literature. In Chapter 9, we used the diffusion literature to learn about the relative effectiveness of mass media versus interpersonal channels in various stages of the product life cycle. This informs “what to do when” to facilitate adoption. Here, we are interested in the contributions of the diffusion literature for understanding “inherent adoption propensities” of new products.

EXHIBIT 10.5   Sample Adoption Rates for New Products

EXHIBIT 10.6   Adoption Levels for Some Recent, Widely Adopted Innovations

Mobile phones

2001: 122 million

2002: 160 million

2003: 205 million

2005: 253 million

Internet

68.5 million homes

Cable TV

88.3 million homes

March 2000 households = 104 million, population = 272 million.

Five inherent attributes of products affect 49% to 87% of the variance in the rate of their adoption, a: [6]

• Relative advantage of the new product over the product it supercedes

• Compatibility of the new product with the values, experience, and needs of users

• Complexity or the perceived difficulty to understand and use the product

• Trialability or the extent to which the product can be tested prior to purchase

• Observability or the ability of potential adopters to observe the products benefits

We can compute a for each of the consumer products in Exhibit 10.5 and add three more recent innovations to get a rank ordering of products according to their rate of adoption in their early years (Exhibit 10.7). The products diffusing most rapidly are color television and Nintendo. Color televisions had obvious relative advantage over black and white TVs but benefited greatly from the fact that consumers had experience with black and white. This ensured compatibility of color TV with existing experience. Similarly, since color television operation was identical to black and white, uncertainty/complexity were removed. Trialability and observability were facilitated by store displays.

Nintendo is a little harder to explain—while Atari superseded it, Atari’s introduction led Nintendo by only a year or so. Thus, the diffusion of Nintendo is taken to be diffusion of consumer video games as a product class. Comparing video games with television makes some sense, since the games used the displays of home televisions. Trialability and observability were comparable to TV, in that games could be tried in all outlets in which they were sold. In addition, home games were comparable to arcade games (facilitating compatibility and reducing complexity). The real relative advantage of Nintendo is probably with respect to arcade games. Home games are far more convenient and accessible and have lower lifetime cost (since games at arcades cost 50 cents or more per play).

The product with the slowest diffusion is the personal computer (PC). Here the slowness is explained through complexity and relative advantage. Early PCs were only accessible to techies, who could build their own systems from parts. Even after user-friendly turn-key systems, such as the Apple, and packaged software were available, few households could perceive a use for PCs that would justify their price. This suggests that one final element affecting the rate of adoption is affordability. One means to characterize this for consumer goods is the ratio between product price and household income.

It is worth noting that understanding these five attributes not only helps you forecast adoption, but it can actually help you facilitate adoption. This was the strategy of Thomas Edison in his efforts to commercialize electricity.[7] Electricity had several advantages over gas. It was cheaper, cleaner, brighter, and had the potential to supply power in addition to heat and light. However, rather than introduce electricity in all its glory, Edison chose to mimic gas. He retrofitted existing gas lamps with electric fixtures and wiring; his first bulbs were 13 watts (comparable to one gas jet) rather than the 25- to 40-watt bulbs that had been demonstrated; he incorporated under the gas statutes so that electric lines ran underground rather than overhead (like telegraph); and he charged for electricity using a meter, even though it was much simpler to imbed electricity costs in the cost of lightbulbs, and even though it took several years to have working meters. Thus, Edison manipulated the compatibility and complexity dimensions of his innovation to increase its adoption rates.

We now understand some of the factors driving b and Xs. This understanding will help us identify analogous products whose diffusion parameters should match that of a new product. To actually form a forecast using historical analogy, we need one additional piece of information: What product(s) is the new product superceding. We need this to get a handle on relative advantage, compatibility, and complexity. Thus, historical analogy is not just comparing a new product with an analogous product. It is comparing a “new product-displaced product” pair to an analogous “new product-displaced product” pair. To make the process of historical analogy forecasting clear, we again take the case of satellite radio.

Satellite radio is intended as a substitute for broadcast (AM/FM) radio. Thus, satellite-broadcast is the appropriate “new product-displaced product” pair. Note that satellite radio also substitutes for other things as well. It replaces Muzak in retail/service settings, and it replaces recorded music in places where broadcast is unavailable. These applications are small relative to broadcast, however.

Now that we have identified the pair, we want to evaluate the new product with respect to the six attributes affecting adoption rates: relative advantage, compatibility, complexity, trialability, observability, and affordability.

Relative Advantage. The main advantages of satellite radio over broadcast are the absence of commercials and program variety. Broadcast radio averages 15 to 17 minutes of commercials per hour, with even higher rates during commuting hours. In contrast, each of the satellite providers offers more than 50 commercial-free channels. The mean number of broadcast formats in radio markets is 11.6. This ranges from a low of 7.8 formats in small markets to a high of 16.4 in the largest markets.[8] In contrast, each of the satellite offers more than 100 channels. While it is true that no one needs 100 channels, the value of variety is not the opportunity to listen to all of them. Rather, with 100 channels it is possible that you can get very close to your listening preference. Other advantages include broader geographic coverage (important for travel outside major metropolitan areas, e.g., trucks and boats), better sound quality, and digital display of current programming.

Compatibility. Apart from installing the antenna and receiver and learning which of the 100 stations are most interesting, use of satellite radio is identical to using AM/FM. In fact, the stand-alone satellite receivers are dual function—offering both AM/FM and satellite. Furthermore, these receivers are made by the same manufacturers who make the AM/FM receivers. Thus, satellite radio is very compatible with existing experience.

Complexity. Since satellite was designed to be compatible with AM/FM, there is no added complexity other than antenna installation.

Trialability. There is no means to rent a satellite receiver prior to purchase, but XM engineered a clever trial opportunity by negotiated arrangements with auto manufacturers and auto rental companies to install XM in the high-end models.

Observability. Customers can observe satellite radio in retailers, in select rental cars and ultimately in the cars and homes of prior adopters.

Affordability. Satellite radio is more expensive than AM/FM in that it has a subscription fee ($12.95 per month), while AM/FM is free. However, the fee is small in absolute sense. The least-expensive cell phone plans, cable subscriptions, and broadband subscriptions are $30, $40, and $30 per month, respectively.

Now that we have identified the new product-displaced product pair and have analyzed the new product along the six attributes affecting adoption, the next challenge is the top-down forecast in identifying an analogous prior new product-displaced product pair. The innovation pair that typically comes to mind is cable TV-broadcast TV. For almost all attributes, satellite radio mimics cable TV. The initial advantages of cable over broadcast were variety and commercial-free programming. Cable was highly compatible with broadcast. While there was a new decoder box, it was controlled in much the same way as broadcast television. Cable was less trialable than satellite radio because there was no rental car equivalent, but set tops could be rented, thus there was less up-front investment. Observability was similar. Affordability was similar in that cable and satellite radio were both instances of charging for services that historically had been free.

One distinction between cable TV and satellite radio is that subscription fees were rare at the time of cable introduction, whereas today people have cable, Internet, TiVo, and cell phone subscriptions. Accordingly, we might expect the saturation level of satellite radio to be comparable with cable, but we might expect the adoption rate to be higher due to the prevalence of subscription services. Exhibit 10.8 shows the diffusion path for cable television. A regression similar to that for XM indicates a value for a (for 5-year growth rather than quarterly growth) of 1.088 and a value for b of 0.0130. These rates correspond to a cable saturation level, Xs, of 83.75% of households.

The final consideration for the forecast is the appropriate base for the penetration rates. In the case of cell phones, the appropriate base is individuals, since people carry their own phone; for cable the base is households, since one subscription covers all television sets in the household. For satellite radio, it could be either of these, but since the dominant place for radio listening is automobiles, a more appropriate base might be the private motor vehicle registrations, which is approximately 208 million.

Putting all these together suggests that a plausible top-down forecast for satellite radio is 174 million subscriptions (= 0.8375 × 208 million vehicles).

This leaves one remaining challenge: how to reconcile the saturation point of 7.1 million obtained from the bottom-up forecast with the saturation point of 174 million from the top-down forecast. One possible reconciliation is that current adoptions are coming principally from new cars with factory-equipped satellite radio. If this is the case, then we haven’t yet observed representative adoptions. An alternative explanation is that there are more substitutes for satellite radio than there were for cable television. These include MP3 players and Internet radio.

EXHIBIT 10.8   Diffusion of Cable Television (excludes satellite television)

Source: Data from mediafamily.org.

Commercial Adoption

Up until this point we have been speaking largely about consumer products. Accordingly, the factors affecting diffusion are fairly subjective. Things become somewhat more predictable when we turn to commercial adoption.

One study has done this in the context of industrial products,[9] examining the diffusion of 12 innovations throughout four industries (Exhibit 10.9). The study modeled the diffusion rate (b in the equation above) of a given innovation, in a given industry, as a function of the profitability impact of that innovation to the target industry, Pij, the cost of adopting the innovation in that industry, Sij, and a set of dummies for each industry. This simple model explained 90% to 98% of the variance in the diffusion rate, bij.

bij = 0.530Pij − 0.027Sij + industry dummies,

where P is the average payback period to justify investments divided by the average payout period for investment in the innovation and S is the average investment in the innovation divided by firm assets.

Source: Mansfield, E. (1968). The economics of technological change. New York: W. W. Norton.

The quantitative factors explaining industrial diffusion correspond roughly to the qualitative factors discussed previously for consumer products. Profitability captures relative advantage, the cost of adopting the innovation is comparable to the complexity of the innovation (or psychic cost), and industry dummies are characteristics of the market segments (such as wealth) that help explain differences in diffusion. Of these variables, most of the action is in profitability or relative advantage. This makes sense—rational firms considering innovations examine first the extent to which the innovation will affect their unit margins. They then compare the improvement in margins with the fixed cost of implementing the innovation to assess the breakeven point.

This range of estimates for b and Xs, and their subjective assessments provide guidelines for estimating the rate of diffusion of new-to-the world products. Often historical analogy is much simpler. In industries marked by regular innovation, there are likely secondary data on the distribution of sales volume over product lives, as well the profile of sales over the life. For example, in wall coverings, lifetime sales for the average product line are 7 million rolls (minimum and maximum are 2 million and 200 million, respectively). The modal (or most likely) product life is 3 years (with a maximum of 10 years). Finally, sales are highly skewed toward the early stages of the product’s life cycle. Typically, 60% of product sales occur within the first 12 months of introduction.

This diffusion pattern is different from the logistic curve. It is skewed left (heavy sales early) (as we saw in Exhibit 9.5). To forecast sales of a new wallcovering, take advantage of the historic sales pattern to form a monthly sales profile. This dynamic profile can be applied to point estimate from conjoint.

Industry data can help identify other temporal patterns in demand. One important pattern is seasonality. Many business services experience slower sales in the summer; many retail sales peak in December. These patterns are largely outside the control of the new venture. Others that may be within your control have to do with response to events. Catalog sales follow a predictable pattern of sales following each mailing.[10] Similarly, advertising, promotions, and trade shows will cause sales spikes. Secondary data will help you understand sales patterns arising from both controllable and uncontrollable events in your industry.

EPIGRAPHS DEMAND FORECAST

We will use the wallcovering specific diffusion curve in Exhibit 9.5 as the historical analogy on which to build the top-down Epigraphs forecast. The primary role of the top-down forecast is to test the plausibility of the bottom-up forecast—does the bottom-up forecast fall within the observed range for past wallcoverings? To develop the bottom-up forecast for Epigraphs, we combine data gathered over several chapters:

• A point estimate of potential demand given awareness and availability in the target market (from conjoint analysis, Chapters 6 and 7)

• An estimate of target market size (from industry studies of the annual market for wallcovering, Chapter 4)

• A distribution channel with known reach (from the channel decision in Chapter 8)

• An advertising policy driving awareness (from the advertising decisions in Chapter 9)

• An historical analogy for demand distribution over the life cycle of a given wallcovering (Chapter 4)

Historical Analogy

We have already discussed information from historical analogy in the previous section. The analogy of past wallcovering sales patterns provides the skewed shape of the distribution curve (Exhibit 9.5), as well as the distribution of lifetime sales over the population of wallpaper patterns. This distribution indicates that the average wallpaper sells 7 million rolls, but there is substantial variance across wallcoverings. Minimum lifetime sales is around 2 million rolls; the maximum is approximately 200 million rolls.

In addition, from industry analysis we estimate that the target market for all wallcovering is 10,000,000 households per year. We obtain this estimate by comparing annual wallcovering sales at retail of $2 billion, with average dollar value per transaction of $200. Thus, the number of transactions is 10,000,000 (or 2,500,000 per quarter). This market size is given in Row 3 of the Epigraphs demand forecast (Exhibit 10.10).

Point Estimate of Total Demand

The initial point estimate for total demand from conjoint was the intercept value of 4.03 rolls per customer. This estimate can only be achieved if (1) everyone in the target market is aware of the product, (2) they all have access to it, (3) all colors and genres are available, and (4) we price the product at $35.00. The goal of the last several chapters was to determine how much of this potential demand is actually profitable. We found that we were better off by raising the price, restricting the range of colors and genres, and limiting distribution and advertising.

While we made a tentative decision to distribute through chains, we continue to examine both Internet and chain distribution. The optimal price differs between the two channels. There are two opposing factors that affect demand through chains relative to demand through the Internet. The first factor is distributor markups—unit revenues to the manufacturer from chain sales are less than retail price; for Internet sales, unit revenues equal retail price. The second factor is observability—customers are able to see the actual installed product in chain displays—this provides greater assurance of the installation outcome than an image over the Internet.

For distribution over the Internet, the optimal price to the nearest $5.00 is $40.00. This corresponds to demand of 2.45 rolls per person (both optimal price and corresponding demand come from Chapter 7). For distribution through chains, the optimal price to the nearest $5.00 is $50.00. This corresponds to demand of 2.72 rolls per person.

In addition to truncating demand by choice of distribution channel and price, we also truncated demand by choice of two colors and two genres. Our analysis in Chapter 7 indicates that those restrictions cause us to forego another 35.4% (100-64.6%) of potential demand. Thus, the point estimate for Internet distribution becomes 1.58 rolls per person (2.45 × 0.646) and the point estimate for chain distribution becomes 1.76 rolls per person (Rows 1 and 2 in Exhibit 10.10).

These point estimates assume uniform sales over the 3-year period. To generate dynamic sales forecasts, we need to incorporate the industry lifetime sales profile, with awareness and availability estimates arising from our advertising and distribution channel decisions. The sales profile is a temporal pattern outside our control. The advertising and distribution decisions generate a temporal pattern of awareness and availability that is within our control.

Lifetime Sales Profile

If we assume that these point estimates accurately capture first-year sales, then we can apply the rule of thumb that 60% of lifetime sales are in the first year to generate the lifetime sales estimate. Row 4 of Exhibit 10.5 generates the entire pattern of sales over the 3-year product life from Exhibit 9.5.

Awareness

Our preliminary plans for advertising are the same for Internet and chain distribution. Ultimately, we assume that the Internet will require more advertising in that it has no counterpart to the store displays that provide supplemental “free” advertising. We adopt the advertising plan from Chapter 9, which provides advertising on HGTV and Home magazine in the first 3 months of product introduction. This produces the three exposures generally needed to stimulate sales. After that period, we will terminate advertising, so that the product does not become overexposed.

HGTV has an audience of 1,100,000, and Home magazine has an audience of 1,000,000. For simplicity, and because neither HGTV nor Home has data on overlap, we assume that the two audiences are distinct. Thus, the advertising program should create awareness in 2.1 million households. We assume that this audience is a complete subset of the market for wallcovering—that neither vehicle is “wasting” advertising outside the market. Both these assumptions may be optimistic, but because we are ignoring the free advertising associated with Internet and store displays, we feel the assumptions are warranted.

Our estimates of awareness are captured in Row 5 of Exhibit 10.10. In all periods after the first quarter, we assume awareness of 21% of the target households (2.1 million audience/10 million households purchasing wallcovering annually). In the first period, we assume awareness is half the ultimate value, as the ad exposures accumulate.

Availability

Internet. The Internet truncates reach, in that only 60% of U.S. households made purchases over the Internet in 2006 (total Internet penetration was 69.6% of households, growing at about 2%). The corresponding Internet reach is captured in Row 6 of Exhibit 10.10. Note that it is likely all households who purchase wallcovering have Internet access since both home ownership and Internet access require some affluence, but we take a conservative stance. Internet reach is captured.

Chains. We assume that the product will be distributed through Sherwin-Williams. The chain has approximately 2,200 stores, with 1,500 transactions per quarter. This number exceeds the number of wallcovering transactions per month, and the markets are assumed to be identical; thus, we conclude that distribution through Sherwin-Williams provides 100% availability to the target market (Row 7 of Exhibit 10.10).

Sales Projections

We obtain quarterly sales projections by merely multiplying per person demand, bij, awareness, awij, availability, avij, market size, and lifetime sales profile within each of the distribution channels. This leads to the quarterly unit sales in Rows 8 and 9 of Exhibit 10.10 and the cumulative sales in Rows 12 and 13. Total sales peak in Quarter 3. For Internet distribution, this corresponds to 405,000 rolls, for distribution through chains the peak is at 739,000 rolls. Cumulative Internet sales over the 3-year life are 1.89 million rolls; cumulative sales for chains are 3.46 million rolls.

We can assess the plausibility of this estimate by comparing it with the historical wallcovering sales. Our estimates in either channel are well below the mode of 7 million rolls over a pattern life. Furthermore, our first-year sales represent only 2% to 4% of annual wallcovering sales. Both comparisons tend to suggest that our estimates are reasonable.

Note that we would ordinarily form optimistic and pessimistic versions of these forecasts using the variance in the conjoint demand estimates as the basis for variance in the summary forecasts. Our regression results exhibited very little variance. The standard error on the demand estimate was 0.29 versus a mean of 4.01 (variance = 7.5% of the mean). Optimistic and pessimistic forecasts that provide a 67% chance of capturing the true estimate of total chain demand are 3.20 million rolls and 3.72 million rolls, respectively.

Exhibit 10.10 also provides revenue forecasts. These are formed by multiplying the optimal price in each channel by the sales in that channel (Rows 10 and 11 provide quarterly revenues; Rows 14 and 15 provide cumulative revenues). These will form the basis of our financial forecasts in Chapter 13.

Summary

We continue to validate the conclusion to distribute Epigraphs through chains—creating total revenues four times that through the Internet. Moreover, we find that our sales estimates appear to be conservative relative to industry standards.

CONCLUSION

In this chapter, we combined secondary data from Chapter 4 with primary data and strategic decisions from Chapters 5, 6, 7, and 8 to define the dynamic demand forecast for the venture. While Chapter 6 defines a point estimate for potential demand that is outside our control, the decision in Chapters 7 through 9 determine how much of that potential to capture and when. The price and product configuration decisions in Chapter 7 define how much of the potential demand to exclude by virtue of low willingness to pay and/or obscure tastes. When we apply these decisions to potential demand, we still have point estimates.

Chapters 8 and 9 introduce dynamics. The distribution decision determines how many buyers in each period will have access to the product. The advertising decision determines how many buyers in each period will be aware of our product. Since these decisions are within the control of the venture, there is some opportunity to shape demand.

In addition to dynamic factors within the venture’s control, some temporal patterns, such as seasonality, are inherent characteristics of the industry and thus outside the venture’s control. We discussed some of these patterns and their impact on demand.

This primary approach to the dynamic forecast is a bottom-up approach. However, as a test of reasonableness, you should also look for historical analogies. The analogies define levels and rates of product diffusion based on the new product’s attractiveness relative to the product it replaces.

The dynamic forecast defines the scale of the venture. This scale is a critical input to all subsequent decisions. In the next chapter, we consider the final strategic decision—organizational scope.

NOTES

1. One caveat here—some products, such as Furbys and Pokemons are driven by a social process (as discussed in Chapter 7). For these products, purchase intentions will be understated because the survey is conducted in isolation of the social effects.

2. If the product is a durable good, like a refrigerator, that is purchased by consumers only once, then S is interpreted as cumulative sales up through that period. If, however, the product or service is a repeat good, like shampoo, that is purchased on a regular basis, then S is interpreted as sales during the period.

3. Mossi, J., & Stevenson, H. (1985). R&R. Harvard Business School Case 9–386–019.

4. Krugman, H. (1972). Why three exposures may be enough. Journal of Advertising Research, 12, 11–14.

5. Lenk, P., & Rao, A. (1990). New models from old: Forecasting product adoption by hierarchical Bayes procedures. Marketing Science, 9(1), 42–53.

6. Rogers, E. M. (1995). Diffusion of innovations. New York: Free Press.

7. Hargadon, A. (2003). How breakthroughs happen: The surprising truth about how companies innovate. Cambridge, MA: Harvard Business School Press.

8. Berry, S. & Waldfogel, J. (2001). Do mergers increase product variety? Evidence from radio broadcasting. The Quarterly Journal of Economics, 116(3), 1009–1025.

9. Mansfield, E. (1968). The economics of technological change. New York: W. W. Norton.

10. See Werssowetz, R., Kent, R., & Stevenson, H. (1985). Ruth M. Owades. HBS Case 9–383–051 for a typical catalog response pattern.

CHAPTER 10 WORKSHEET

Dynamic Demand Forecast

You will create demand forecasts two ways: Bottom-up from the conjoint data and the product configuration, advertising, and distribution channel decisions.

Bottom-Up

1. How many individuals, households, or firms are in the target market?_____
Show in all cells of Row 2 of the worksheet (from Chapter 4).

2. Show the demand curve from conjoint analysis, what is the optimal price?_____
(from Chapter 7)

3. What is the point estimate for demand from conjoint analysis, given your choice of price and product configuration (should be expressed as units per person in the target)?_____
Remember to adjust for respondent optimism.
Show in all cells of Row 1 of the worksheet (from Chapter 7).

4. What is the reach of your distribution channel over time?_____% of target.
Show in Row 3 of the worksheet (from Chapter 8).

5. What is the reach of your advertising policy over time?_____% of target.
Show in Row 4 of the worksheet (from Chapter 9).

6. Find calendarized unit demand by multiplying rows 1, 2, 3, and 4. Show in Row 5.

7. Find calendarized revenues by multiplying Row 5 by unit price. Show in Row 6.

8. Find cumulative unit demand by summing current and all prior demand in Row 5. Show in Row 7.

9. Find cumulative revenues by summing current and all prior revenues in Row 6. Show in Row 8.

Historical Analogy

10. What products/services are similar to that in your venture?

11. For each analogous product, define the total sales and the rate of sales growth.

12. Is your demand forecast from the bottom-up approach within the range of the analogous products?

CHAPTER 11

Scope of Operations

INTRODUCTION AND GOALS

One of the most important strategic decisions that a firm makes is that of its operational scope—which activities should the firm execute internally versus outsource to other firms. This is the last of the strategic decisions we make in the venture design. What makes the scope decision strategically important are the facts that it is largely irreversible and that it affects the long-term viability of the firm.

On one extreme of operational scope are highly vertically integrated firms such as General Motors (GM). GM designs and manufactures not only the automobile but also most of its components and then distributes the finished goods through its own dealers. At the other end of the spectrum are “virtual firms” such as Compaq Computer. Compaq outsources its design and manufacturing and distributes its products through independent retailers. Since both firms are highly successful, it is not true that one form dominates the other. In general, most firms are hybrids of the two forms—outsourcing some activities and internalizing others.

Our goal in this chapter is to develop a framework for determining which activities to outsource and which to execute internally to ensure the long-term viability of the firm. The objective in making the decision is to provide reliable provision of high-quality goods and services at the lowest cost, while building/preserving the capabilities that lead to sustained competitive advantage.

The chapter first reviews the principles underlying the decision—transaction cost economics and the resource-based view of strategy. Next, we present an analytical process for making the scope decision, and then we apply that process to Epigraphs.

PRINCIPLES

The principles underlying this chapter on the scope of the firm are closely related to those in Chapter 8 pertaining to the distribution decision. Both chapters deal with the level of vertical integration of the firm. Chapter 8 deals with forward integration into market activities, while this chapter deals with backward integration into various stages of supply. Accordingly, we might expect the theoretical foundations to be identical.

While both issues draw from the literature on vertical contracting, there is a subtle difference that justifies separate treatment. In particular, the central concern in the forward contracting literature is the principal-agent problem of designing contracts (or choosing channels) where the incentives of the agents in the channel are aligned with those of the firm. In contrast, the central concern in the backward contracting literature is the holdup problem—that suppliers will control critical resources and accordingly will extract the rents from those resources at the expense of the firm.

This literature has a decidedly defensive posture, focusing on mechanisms that prevent or minimize supplier holdup. We argue that even if there is no problem of supplier holdup, there may be reasons to internalize a given activity. Thus, we augment the transaction cost perspective in the vertical contracting literature with other perspectives from the management literature.

Transaction Cost Economics

Transaction cost economics tries to explain when economic activity will be organized in hierarchies (firms) rather than markets. The basic assumption in the literature is that markets provide powerful incentives for price to be driven toward marginal cost and even for marginal cost to fall over time through learning and scale economies. Thus, the “anomaly” that the literature tries to explain is the existence of firms—nonmarket activity.

The answer to the firm anomaly is that some transactions are more costly to conduct across markets. This occurs (a) when there are firm-specific assets (to be defined momentarily), (b) when it is difficult to observe or measure quality of an output, (c) when there are coordination problems, and (d) when there are externalities. We will discuss each of these and their implication for firm scope.

Firm-specific assets are costly assets (both physical and human) that are significantly more valuable in the provision of a particular good or service than they are in their next best use. Assets can become specific in any of three ways. Site specificity pertains to physical assets that are colocated with a particular customer. This is the case if a supplier of engines to Toyota chooses to locate its plant next door to Toyota to minimize transportation costs. If it later chooses to supply engines to Nissan, the net cost (engine plus shipping) to Nissan for each engine is much higher than the net cost to Toyota for the same engine. If there are other comparable firms located more centrally, then Nissan will prefer the centrally located firms.

Physical asset specificity pertains to physical assets that are tailored to a given producer. This is the case, for example, if a supplier creates molds for the production of a new toy. Once the molds are created, they are of no use to any other producer. Finally, human asset specificity pertains to employee training or on-the-job learning of skills that are valuable only to a given firm. This might be the case with workers on an assembly line, who have no technical training, but who have through years of experience become adept at their particular task (unique to the firm and sometimes even to a specific product).

When a supplier’s assets are likely to become specific to a particular buyer, there are two (seemingly offsetting) holdup problems. The first problem is that once the supplier has made the investments, their specificity causes those investments to become sunk. Accordingly, the supplier will become powerless in price negotiations with the buyer and will ultimately be willing to drop price to marginal cost (never recouping the investment from the specific asset) (buyer holdup of supplier). Knowing this, a rational supplier would be unwilling to make such investments. This market failure forces “buyer” firms to integrate into the supply of the input requiring the specific investments.

A symmetric problem to buyer holdup is to the supplier holdup that occurs when a firm is the sole source of supply for a given input. This allows the supplier to charge a price equal to the input’s marginal product, leaving little opportunity for producer profit. Oddly, once a supplier has made investments in specific assets, it becomes the sole source of supply for the good/service from that asset. Thus, one would expect that buyer and seller have comparable holdup power and could reach an equitable solution. However, both asset specificity (buyer holdup) and lack of competition in the supply chain (seller holdup) tend to produce backward vertical integration by the producer.

The other circumstances under which transaction costs may be high and we, therefore, expect activity to be organized in firms rather than markets include the following:

• When it is difficult or costly to assess the quality of an input. This is the case, for example, with Dairy Queen. Dairy Queen, the franchisor, requires individual outlets to purchase ice cream mix directly from headquarters to prevent outlet owners from purchasing poor quality mix at lower cost. Neither Dairy Queen nor outlet owners have the capability to continuously monitor the quality of other suppliers’ mixes. Since the quality of the final product critically depends on the mix, the best solution is to control the mix quality by producing it internally.

• When there is high interdependence among activities requiring coordination. This is the case in the early stages of new devices. Go Corporation, the first developer of a tablet computer had to develop both hardware and software simultaneously because the capabilities of each were evolving over time.

• When two or more goods are complements—one good is only valuable if the owner has (or has access to) a complementary good. This is the case, for example, with Switch Manufacturing.[1] The firm developed a quick-release binding for snowboards, but the binding required the redesign of boots (typically manufactured by different firms). Thus, Switch faced the choice of developing its own line of boots, or forming alliances with existing boot manufacturers. Initially, it developed its own boots, but ultimately the firm was acquired by Vans, a leading boot manufacturer.

The transaction cost perspective is an efficiency perspective—where is it most efficient for a given economic activity to be organized? Thus, we might expect that all firms in an industry would behave identically. Since all firms face comparable input requirements, they should reach similar conclusions about which activities to execute internally versus which to outsource. This is not the case. Several industries—auto manufacturers and personal computers, for example, all have firms that appear to outsource all activity (virtual firms), while others appear to be fully integrated. We demonstrated this earlier for autos (GM is highly integrated, while Chrysler is largely a virtual firm) and personal computers (PCs) (Apple is highly integrated, while Compaq is virtual). Thus, transaction cost economics is not sufficient in explaining firm scope. It appears instead that firm scope decisions are intrinsically linked to firm strategies for competitive advantage.

Interestingly, a number of economic trends have eased many of the factors that previously pushed firms in the direction of vertical integration. In particular, the integration of the global economy has led to more competitive markets, minimizing the likelihood of sole suppliers. In addition, flexible production technology has enabled “mass customization”—the ability to produce products to order with a speed comparable to mass production. McDonald’s, for example, is now rolling out “made-to-order” technology that actually reduces the average order time and cost relative to its “made-to-stock” process. Flexible production technology reduces the prevalence of specific physical assets. Finally, information technology, such as Electronic Data Interchange (EDI), has facilitated highly coordinated activities between buyers and sellers.[2]

Strategic Perspective

While the transaction cost perspective is geared toward the cost implications of firm scope decisions, the strategic (competitive advantage) perspective is geared toward the demand implications of firm scope decisions. The goal of the strategic perspective is to develop and protect capabilities deemed important to maintaining the firm’s basis for differentiation.

If the venture is founded on a proprietary concept that is not patentable (or patented but easy to invent around), then the guiding principle in scope decisions is to internalize activities that would otherwise cause the proprietary information to be divulged. This is particularly true if the supplier is capable of integrating forward into your activity. A salient example here was Go Corporation’s decision to team with Microsoft to develop companion software for its tablet computer. Although both firms had signed nondisclosure, noncompete agreements, once Microsoft fully understood Go’s operating system, it severed the alliance and began developing a competing operating system.[3] While this was not the only source of Go’s $100 million failure, it was certainly a significant factor.

In addition to a defensive posture of internalizing activities to prevent disclosure is an offensive posture of internalizing activities to further develop capabilities that are linked to the firm’s core benefit proposition. The underlying principle here is that while rivals are attempting to imitate your initial offering, you will be developing capability to improve your offering. This applies both to cost advantage strategies as well as differentiation strategies.

E-Steel, for example, was an early pioneer in business-to-business (b2b) commerce serving as an Internet broker of steel products. Its core benefit proposition was that in bypassing conventional brokers it created a more efficient market such that buyers paid lower prices, while sellers received higher prices. This is inherently a cost advantage strategy—buyers and sellers preferred E-Steel to brokers, because it was a lower cost means to exchange steel products.

The concern with the basic venture concept was that it is easily imitated. In fact, another firm founded about the same time, Vertical Net, created b2b intermediaries in a whole range of markets. Thus, Vertical Net had scale economies that made it likely that it would enter all lucrative b2b exchanges, including steel. While E-steel would have liked its early entry (with existing contracts and reputation advantages) to form a barrier to entry, the fact that E-Steel was able to penetrate the steel market so rapidly itself was evidence that reputation was either easy to achieve or unimportant in that setting. Moreover, Vertical Net could transfer its reputation from other markets to the steel market. Since Vertical Net could transfer both reputation and technology, it could be a formidable player in a matter of days should it choose to enter. While loyalty may be important in consumer markets because tastes often dominate budget considerations, business customers are focused on the bottom line and thus are prone to disloyalty.

The issue then is that E-Steel’s core benefit proposition required it to continually reduce its cost so as to maintain advantage over likely rivals. Whereas Go’s scope decisions should have internalized activities that required divulging proprietary knowledge, E-Steel’s scope decisions should internalize activities that allow it to reduce its operating cost over time.

Similar logic applies when a venture’s core benefit proposition is differentiation rather than lower cost. C-Pen, a product introduced by C-Technologies, is a pen-sized scanner that allows users to digitally record “highlighted” text. While the product may be patent-protected, the long-term survival of the firm will require product innovation. In fact, several firms have already introduced competing products. Thus, C-Technologies will want to internalize activities that enhance its ability to do product innovation. These activities may include customer service—so that the firm learns about the reliability of existing components and learns about additional capabilities that customers would like to have.

Complementarity Considerations

A final consideration for the scope decisions is activity complementarities. Complementary activities is a concept that is similar to that of complementary products introduced in Chapter 4. When two activities are complements, the payoff to performing one activity increases when the firm also performs the second activity. In these circumstances, both activities should be performed by the same firm, regardless of whether they are performed internally or externally. These complementary activities can be thought of as modules. Two factors influence the modularity of activities. The first factor pertains to the intrinsic properties of the activities; the second factor pertains to the maturity of the product/process design.

Two activities, A and B are intrinsically coupled if the output of A is required for B, but the quality of the output of A is not observable, except as it is manifest in the output of B.[4]

Activities A and B are also intrinsically linked if they share a common knowledge base such that learning from activity A enhances learning from activity B, and vice versa. This is the case for production and product development. Intimate knowledge of the production process enhances the likelihood that product development will lead to designs that can be efficiently produced. This was one of the contributions of “lean production” in the Japanese auto industry. When development and production were coupled, both production cost and product development time were reduced.

Even if activities aren’t intrinsically coupled, they may be functionally coupled if (a) a firm produces custom rather than standard products/services or (b) if technology is in the ferment stage such that interfaces between component technologies have not been standardized. In these instances, new ventures will need to internalize more activities than they would like.

Empirical Evidence

A number of empirical studies have examined when firms outsource a given activity versus execute it internally. The general observations from these studies are summarized in Exhibit 11.1. The exhibit demonstrates that both efficiency factors and strategic factors affect the scope decision.

A particularly nice study is summarized in Exhibit 11.2. In this study, Ulrich and Ellison examined the scope decisions of firms in the Mountain Bike industry. They took into account efficiency considerations, strategic considerations, and complementarities. They attempted to predict firm scope (design = circle, production = square) as a function of the design strategy (whether the firm used a unique suspension), the materials strategy, the materials processing capability, and the scale of the firm (less than 50,000 bikes is below minimum efficient scale). These factors accurately predicted the scope decision in 20 of 23 firms.

Outsource Bias

Before getting into the nuts and bolts of the scope decision process, it is useful to establish a default decision—which direction the decision will go in the absence of a compelling reason to do otherwise. While it is not essential to do so, it does ease the decision process.

The issue then is whether the default should be internalizing or outsourcing. In the case of a start-up venture with severe resource constraints, both financial and managerial, we advocate outsourcing as the default decision for the provision of each activity in the value chain. This bias offers four advantages: First, it minimizes operational risk of the venture by reducing the managerial task not only technically but also administratively. By the technical task, we mean the diversity of activities over which management must maintain expertise and oversight. By the administrative task, we mean the human resources tasks of recruiting, training, counseling, and replacing employees who execute the activities.

The second advantage of the outsourcing bias is that it minimizes the financial risk of the venture. Because the firm makes minimal investments in physical and human assets, it requires less funding (and has lower overhead and financial carrying costs). The lower fixed costs translate into a lower breakeven volume. The combined effect of low operational risk and low financial risk is superadditive in increasing the odds of venture success. As an illustration of the value of minimizing operational and thereby financial risk, two thirds of the 1999 Inc. 500 firms were started with less than $50,000 in capital. Only 21% required more than $100,000.[5]

The third advantage of the outsourcing bias is that outsourcing is a rapid response decision. Once the decision to internalize has been reached, the firm still needs to wait for delivery, installation and integration of physical assets, and recruiting and training of human assets. Since there is attendant uncertainty of the outcomes of both processes, the firm needs to allow additional time for the system (both human and physical capital) to perform reliability checks. In contrast, suppliers should be fully operational with demonstrated performance on comparable activities. They should only need time to accommodate the aspects of the process that are idiosyncratic to your venture.

Fourth, the outsourcing decision is more easily reversed than an internalization decision. Once a firm has made investments in both human and physical assets for a particular activity, it becomes difficult to displace them. In contrast, the outsourcing decision is largely reversible (an exception is long-term contracts, which start to approach vertical integration). Experience with your suppliers, the quality of their outputs, and the impact of that quality on your final product/service will refine your understanding of which activities are critical or strategic. Once you have this information, you can make more informed choices about which activities to internalize.

EXHIBIT 11.2   Organization Scope Versus Activity Characteristics for Bicycle Manufacturers

Source: Ulrich, K., & Ellison, D. (2005). Beyond make-buy: Internalization and integration of design and production. Production and Operations Management 14(3), 315–330.

Finally, outsourcing offers the highest potential for internal growth:[6] (1) fewer things have to be rescaled or replicated and, accordingly, (2) less financing is required. This is captured succinctly in the well-known tenet of corporate finance that the maximum internally sustainable growth rate is equal to the firm’s return on invested capital. Thus, all else equal lower invested capital for a given level of output supports higher output growth.

Dynamics of Firm Scope

The discussion of outsourcing bias suggests that there are venture-specific dynamics of firm scope. There are also industry-specific dynamics of firm scope that are driven by industry maturity. In emerging industries, there is limited opportunity to outsource activities, since support industries have not yet developed. Generally, support industries will not emerge until the primary industry has demonstrated viability and adequate scale to justify creation of the support industries. Thus, for example, the e-tailing pioneers such as CDNow had to create search software, purchase transaction software, customer tracking software, and the fulfillment interface. Later Internet retailers not only could purchase each of these components, but they could purchase whole suites that integrated all the components, or more convenient still, they could merely customize a storefront provided by an Internet service provider. These Internet service providers register the domain name, host the site, and process the credit cards.

Thus, the outsourcing options available to a firm are a function of industry maturity. In the early stages of an industry, firms must internalize most transactions. In the growth stage, as support industries emerge, many firms outsource a large fraction of their activities to quickly meet the needs of the growing market and to focus on those activities at which they excel. Exhibit 11.3 shows this for the PC industry.

Ultimately, as the industry matures, and competition begins to weed out inferior competitors, firms may internalize more activities to enhance their bases for competitive advantage. In bikes, for example, Shimano’s innovation of index shifting in 1995 integrated four key bicycle components (the shifter, derailleur, freewheel, and chain). This required all four components be produced within the firm. This changed the structure of the industry and in the process increased Shimano’s market share from approximately 20% to more than 60% in road bikes, with an even more dramatic improvement in mountain bikes (Exhibit 11.4).

This evolution of outsource activity as a function of industry development is depicted in Exhibit 11.5. It is interesting to note that this evolution is not ensured. Route 128 in Boston and Silicon Valley in California were largely engaged in similar industries. While Route 128 is primarily associated with minicomputers, and Silicon Valley is associated with personal computers, both regions were highly involved in most stages of electronics innovation since World War II. An interesting distinction between the two regions, often cited as the reason Silicon Valley has ultimately been more successful, is the fact that Route 128 comprises large vertically integrated electronics firms, while Silicon Valley is primarily single function and virtual firms.[7]

EXHIBIT 11.3   Evolution of Firm Scope in the PC Industry

Source: Carliss Baldwin’s unpublished presentation “Architectural innovation and dynamic capabilities.”

A Note on Strategic Alliances

One very popular trend for both established firms and new ventures is alliance formation. Strategic alliances can take on many forms: technology alliances are formed to jointly develop new technologies; marketing alliances allow a new venture to tap into the distribution channels of established firms; while allowing the established firm to fill out its product line; and sourcing alliances allow representatives from the buyer organization to reside within the supplier organization for more effective development and incorporation of the supplied parts.

The concern with strategic alliances is that rather than combining the benefits of markets and hierarchies, they actually tend to combine the detriments. Alliance partners forego the high power incentives and efficiency of outsourcing through the market, and also lose the protection of proprietary knowledge afforded by internalization. In addition, alliances require as much, if not more, oversight and communication as internalization. Those resources strain an established firm, much more so a new venture.

In one personal experience, I had a customer for an R&D program who required full disclosure of our work to a “consultant” firm hired to evaluate it. This evaluation included an assessment of our technical proposal for the follow-on contract. Ultimately, our follow-on contract was for one-half the work we had proposed. When I asked what happened to the other work, I learned it was going to the “consultant” firm. If you aren’t managing the alliance strategically, it is likely your partner is. Thus, you may be “raising your rivals” and thereby compromising future advantage.

EXHIBIT 11.4   Evolution of Firm Scope in the Bicycle Industry

Source: Sebastian Fixsonfixson@mit.edu.

EXHIBIT 11.5   Evolution of Firm Scope in the Emerging Industry

The literature is riddled with other horror stories. For some really nice stories of alliances forced on a new venture by its investors, read the accounts of Go Corporation.[8] In one case (an alliance with Microsoft), the problem was loss of proprietary knowledge, in another case (an alliance with State Farm), it was inordinate effort dealing with a reluctant buyer, who ultimately never succumbed.

This is not to say that strategic alliances are to be avoided completely. It is to say strategic alliances should not be entered casually. New ventures can form valuable alliances when those ventures have well-defined objectives and a comprehensive strategy for exploiting the alliance. One very successful example of a new venture that exploited strategic alliances with powerful established firms is Millennium Pharmaceuticals.[9] Millennium had proprietary biotechnology that was attractive to the large pharmaceuticals firms. In a series of alliances, Millennium was able to successively enter more stages of the value chain, such that within its 7-year life, it was in sight of being a fully integrated pharmaceutical firm.

The recommendation then is that you consider strategic alliances only if there are problems with your outsourcing (no reliable firm is willing to supply you) and internalization options (your venture lacks capability), and only if you have the resources and foresight to manage the alliance strategically.

ANALYTICAL PROCESS

Having identified the venture’s core benefit proposition in Chapter 5, and having established the default decision above as outsourcing all activities, we proceed with the process for determining when activities should be internalized. The process begins by characterizing the venture’s value chain. From there we develop a profile of the relative efficiency and relative advantage from internalizing each activity. This allows us to rank activities by their long-term value added. The firm then internalizes activities with the greatest value added up to the point at which the firm’s scope becomes too large for the current management. Other activities that add value can be internalized at some point in the future (remembering that it is easier to integrate activities in the future than it is to sever them).

Value Chain

The first step in the scope decision is to characterize the venture’s value chain. The value chain is the sequence of activities that convert a firm’s inputs into outputs. Exhibit 11.4 is a generic, top-level value chain for a manufacturing firm. The primary activities (those performed for each unit of output) are inbound logistics (purchasing, inventory holding, and materials handling), production, outbound logistics (warehousing and distribution), sales and marketing, and customer service.

In addition to the primary activities is a set of support activities. These include finance, accounting, information systems, legal services, research, design and development, and human resources. Support activities occur on a continual or as-needed basis, related to the scale, but not the pace of primary activities. A simple means of distinguishing between the classes of activities is to partition them into tasks that enter into costs of goods sold (primary activities) versus everything else (support activities).

Exhibit 11.6 characterizes activity at too high a level to aid in decision making, but it is helpful in triggering a complete, more detailed value chain for specific ventures. We have translated the high level depiction into a detailed value chain for Epigraphs in Exhibit 11.7. Here, we have distinguished a third type of activity—development. While primary and support activities are recurring, development activities occur only once (or once per product development). The goal in characterizing the value chain (fleshing out Exhibit 11.7 for your venture) is to be as thorough as possible. This framework not only supports the scope decision but also provides the template for specifying resource requirements in the next chapter.

Scope Worksheet

Once the value chain has been fully characterized, we gather details on each activity. We assess the structure of the supply industry, the cost to execute the activity both internally and through outsourcing, the current level of firm competence in executing the activity, the degree of strategic value, and the extent of complementarities between activities. This “Scope Worksheet” has been completed for Epigraphs in Exhibit 11.8. Information on the structure of the supply industry comes from the analysis in Chapter 4; information on costs is from bids from potential suppliers.

EXHIBIT 11.6   Generic Value Chain for a Manufacturing Firm

Source: Reprinted with the permission of The Free Press, A Division of Simon & Schuster Adult Publisher Group, from Competitive advantage: Creating and sustaining superior performance by Michael E. Porter. Copyright ©1985, 1988 by Michael E. Porter. All rights reserved.

EXHIBIT 11.7   Epigraphs Value Chain

The worksheet can be used in a number of ways to draw conclusions about which activities to internalize. One approach is to compute the breakeven volume and cross-over volume for each activity (or each module), just as we did for distribution channel analysis in Chapter 8. At this point, given our outsource bias, that analysis may be overkill. Instead, one of the columns that captures the spirit of breakeven analysis, but not the details, is minimum efficient scale. Minimum efficient scale (MES), as the name implies, is the scale of operations below which it makes little sense to internalize an activity. Think of MES as a flag for us to revisit the scope decision when we reach that scale in the future.

We advocate following simple decision rules, like those in Ulrich and Ellison for mapping the activity characteristics into a scope decision. These decision rules are summarized in Exhibit 11.9. If the activity is strategic, then internalize it unless the supply industry is competitive, or your venture has limited competence. If the activity is nonstrategic, then outsource it unless (a) the supply industry is noncompetitive, (b) there is substantial threat of forward integration by the supplier, and (c) your outsourcing would require you to divulge proprietary information to the supplier.

Notes:

a. This is particularly important if there is proprietary knowledge/technology that is not protected by patent.

b. Assumes 12% cost of capital and 30 days material inventory.

c. Assumes 15 minutes labor at $ 10.00 (may be costless with EDI).

EPIGRAPHS

Epigraphs is somewhat unique in that it is a transient venture—one product with a 3-year life span, with no plans to develop new products beyond that. Thus, the venture has an even more pronounced outsourcing bias than other new ventures. Having said that, the scope decisions suggest it is not a virtual firm.

We have already developed and discussed Epigraphs value chain (Exhibit 11.7) and the activity worksheet (Exhibit 11.8) in the previous section on analytical process. We now apply the decision rules in Exhibit 11.9 to the Epigraphs activity worksheet in Exhibit 11.8 to make internalization/outsourcing decisions for each module. We examined modules rather than activities to keep interconnected activities together regardless of whether the activities were to be outsourced or internalized. This mapping process led us to the following scope decisions:

Design Module (Design of the Product and Packaging): Internalize. Two things argue in favor of internalization. First, this module is of strategic importance—it is the most fundamental element of the venture. Second, much of this task has already been done in generating the prototype for the focus group, and analyzing the refinements from conjoint data. The only work remaining is to determine the sources of materials and select the quotes. (If we were to outsource the relevant supply industry is product designers, which is competitive.)

Customer Interface Module (Order Taking, Dealer Support, Customer Service): Internalize. This module is also of strategic importance because we plan to use a single distribution channel. Thus, maintaining a good relationship with the channel is critical. In addition, tight links with the channel and the order database provide rapid feedback on any issues end users have with the product.

Manufacturing Module (Material Purchase and Inventory, Manufacture Rolls): Outsource. While product quality is of strategic importance, two factors argue in favor of outsourcing. First, the two potential supply industries: sign makers and die cutters are both competitive. Second, the venture has no expertise or facility with which to begin manufacturing, and investments in expertise and facilities make little sense for a venture with a 3-year life.

Fulfillment Module (Package and Inventory Rolls, Fulfill Orders): Outsource. Fulfillment is the tail end of the relationship with the channel; thus, it is potentially important. However, this module, like the manufacturing module, requires investments in facilities and equipment that seem unwarranted given the venture’s short life. Moreover, fulfillment is a competitive industry.

Miscellaneous Support Activities (Advertising, Human Resources, Legal, Accounting): Outsource. These services are all in competitive supply, and the venture has inadequate scale to justify bringing any of them in house. By definition, none of them is of strategic importance.

Thus, the Epigraphs venture becomes similar in scope to R&R (TV Guide game). While Epigraphs tends toward a virtual configuration, the firm maintains competence and control over design activities as well as dealer/customer interface. The strategic value of the dealer/customer interface is that it provides data on product demand and quality to facilitate rapid reconfiguration of manufacturing and the product mix. (It may also provide insights for future venture ideas.)

CONCLUSION

In this chapter, we examined the last of the strategic decisions—that of firm scope. The two extremes of firm scope are complete vertical integration on one end and a virtual firm (complete outsourcing) on the other. We discussed issues that would drive the venture toward one direction versus the other.

We outlined a process for decomposing firm activities and assessing the decision separately, and within modules, for each activity.

This is the final step in venture design. We’ve designed both the product and the firm. In the remaining chapters, we outline the resources that are required to execute that venture design. The first step is to identify the necessary human and physical resources. We do that in the next chapter.

NOTES

1. Caggiano, C. (1996). Kings of the Hill. Inc. August, 46–53.

2. These observations were drawn by Brickley, J. A., Smith, C. W., & Zimmerman, J. L. (2000). Managerial economics and organization architecture. New York: McGraw-Hill.

3. Kaplan, J. (2000). Startup: A Silicon Valley adventure. New York: Penguin Books.

4. King, A. (1999). Retrieving and transferring embodied data: Implications for the management of interdependence within organizations. Management Science, 45(7), 918–935.

5. The Inc. 500 represent the most successful (fastest growing) privately held new ventures. To qualify for the 1999 Inc. 500, a company had to have sales of at least $200,000 in base year 1994. The fastest growing firm had 20332% (377% AGR) growth from 1994 to 1998, while firm 500 had growth of 595% (156% AGR) over the same period.

6. Baldwin, C., & Clark, K. (2006). Architectural innovation and dynamic competition: The smaller “footprint” strategy. HBS Working Paper.

7. For a detailed comparison of the two regions, see Saxenian, A. (1996). Regional advantage: Culture and competition in Silicon Valley and Route 128. Cambridge, MA: Harvard University Press.

8. Kaplan (op cit).

9. Thomke, S., & Nimgade, A. (2000). Millennium Pharmaceuticals, Inc. (A). HBS Case 9–600–038.

CHAPTER 11 WORKSHEET

Organizational Scope

Our goal in this chapter is to determine which activities to outsource and which to execute internally to ensure the long-term viability of the venture. To make that decision, you need to characterize the venture’s value chain, and you need to analyze each activity.

1. Characterize the venture’s value chain. Distinguish between primary activities, support activities, and development activities. Show interdependencies between activities, where they exist (use Exhibit 11.7 as an example).

2. Complete the scope worksheet (use Exhibit 11.8 as an example).

3. Make the scope decision for each activity based on the information in the worksheet and the principles in the chapter (enter decision in last column of table above).

Note:

a. This is particularly important if there is proprietary knowledge/technology that is not protected by patent.

PART IV

Determining Requirements

CHAPTER 12

Resource Requirements and Capacity Planning

INTRODUCTION AND GOALS

Until this point, we have been making major strategic decisions for the venture: whom to target, with what product, at what price, through what distribution channel and advertising program, and with what internal operations. Now we move from strategic decisions to operational implementation—given the decisions we have made, what resources are required to execute those decisions. In this chapter, we consider physical and human resource requirements. In the next chapter, we translate the physical and human resources requirements into financial requirements.

The goal in this chapter and the next is to provide adequate resources to satisfy the forecasted demand. In Chapter 10, we emphasized that an accurate demand forecast is the linchpin of the business plan. We said that an optimistic forecast will lead to overinvestment in human and physical capital resources, and that the carrying costs of those investments could strangle an otherwise healthy venture. Similarly, a pessimistic forecast can lead to underinvestment in resources. Such underinvestment will render the firm unable to satisfy demand, and may lead to permanent losses in potential market share as customers go elsewhere. In this chapter, we specify the internal resources that are commensurate with demand, so that we avoid both underinvestment and overinvestment.

The chapter presents three new tools: the operating cycle, the bill of capacity, and the master production schedule. We combine these tools with the demand forecast developed in Chapter 10 and the scope decision in Chapter 11 to develop the human and physical resource requirements for the venture. We apply this approach to the Epigraphs example.

PRINCIPLES

Whereas in the previous chapters our principles have been more or less theoretical, in this chapter the principles are decidedly operational. The chapter first translates the demand forecast into the resource requirements (labor hours, machine hours, and floor space). These resource requirements are then used to make venture capacity decisions: How many people to employ and how much equipment to secure (either lease or buy).

The important distinction between requirements and capacity is that while requirements can be expressed in divisible units, actual investments in capacity are lumpy. A firm can’t, for example, add 0.5 machines. While it can, in principle, add human resources in partial units (through the use of part-time labor), a practice of doing so to solve the lumpiness problem will lead to a larger (and less committed) workforce than the corresponding full-time force.

These problems of adding capacity are particularly acute for new ventures. A 10% increase in demand for a large manufacturer with 20 workstations translates into the fairly straight-forward addition of two workstations. A 10% increase in demand for a new venture operating at capacity with one workstation implies a dilemma between overtime on the existing workstation (and, therefore, overtime labor and higher equipment maintenance costs) and committing to the second workstation (despite the fact that it will likely operate below breakeven volume).

The goal of capacity planning is to recognize at what point it is optimal to add units of capacity. This is a long-term planning approach to adjusting capacity. It is also possible to adjust capacity in the short term. However, short-term adjustments are costly, because they generally involve the use of overtime labor (with wage premiums). They are also disruptive. Not only are new employees not immediately functional, but worse, their training requires valuable labor hours from more experienced employees who are already working beyond capacity. It is for these reasons that short-run marginal cost curves are upward sloping, even though most industries exhibit scale economies. Thus, a secondary goal in defining resource requirements is to minimize the need for short-term adjustments in capacity.

ANALYTICAL PROCESS

This chapter is closely related to the last chapter on firm scope. Both chapters require knowledge of the value chain and of the technology associated with each stage of the value chain. Whereas in the last chapter, this knowledge was at the rather high level of activities, here we work at the more detailed level of task execution. We actually specify over time the types of equipment and labor required to produce forecasted demand.

To establish the resource requirements for the venture’s internal operations, we need to define or characterize four things:

1. The relevant unit of output

2. The operating cycle

3. The “bill of capacity”

4. The demand forecast or master production schedule

Output Units

While defining the unit of output is trivial in many industries, in some, it is less obvious. We therefore take a moment to review standard industry definitions. The goal in defining the unit of output is to capture the limiting resource. In the case of auto production, the obvious output measure is the number of vehicles. In the case of airlines, the limiting resources are the number of seats in each aircraft and the number of trips that each aircraft can make. Thus, the standard output measure in the industry is seat-miles. Both these measures (vehicles and seat-miles) obscure the fact that there is a good deal of variation in the types of vehicles (Toyota produces the Corolla as well as the Lexus), and the types of flights (short hops vs. long hauls). This variation becomes important in detailed operations planning, but we leave those details to more general operations texts.

Operating Cycle

The operating cycle is the schedule of activities that convert the venture’s inputs into delivery of its outputs. In the case of a multiproduct or multiservice firm, there will be a set of operating cycles. In McDonald’s, for example, there are separate cycles for hamburgers, French fries, and shakes. Even in the case of a single-product firm, there may be two operating cycles: the external cycle of processing orders and the internal cycle of producing the goods to fulfill the orders. Relatedly, direct mail catalogs have separate cycles for “catalog” production and order processing.

The objective in characterizing the operating cycle is to “calendarize” the utilization of assets. This is necessary because peak demand in November may not correspond to peak labor in November if, for example, the operating cycle is 2 months.

The value chain developed in Chapter 11 is a good starting point for characterizing the operating cycle. To convert the value chain to an operating cycle, we focus on the primary activities. For each activity, we specify its duration. Since the value chain implies the ordered sequence of activities, we can also characterize each activity in terms of its start time and completion time relative to the start of the entire cycle. This is done for Epigraphs in Exhibit 12.1. The exhibit makes an assumption that there are no queues in any of the product processes. Under this assumption, the elapsed time from receipt of order to delivery to the shipping dock is 2 hours and 5 minutes. Whether the item ships on the day of order, receipt is a function of the time of day it is received relative to shipper pickup times.

Bill of Capacity

While the operating cycle characterizes the sequence of activities that convert inputs to a given unit of output, the “bill of capacity” specifies the total standard time of each piece of equipment, and each type of labor required to produce that unit of output.[1] Standard time is the number of equipment or labor minutes (or hours) required to execute a task. These standards can be developed from micro detail of the motions involved in executing each task using universal standards. In general, however, standards are historical firm-specific averages of the time required to perform tasks.

EXHIBIT 12.1   Epigraphs Operating Cycle

A particularly charming example of an effort to simultaneously design a plant layout and develop time standards for firm activities comes from the early history of McDonald’s:

The McDonald brothers showed similar inventiveness when they designed the kitchen for the new building. It was more than twice the size of the one in San Bernardino, and the brothers wanted to be certain that its design accommodated their well-defined production system. They had a brainstorm. They drew the outline of the new kitchen on their home tennis court, and after closing one night at Fourteenth and E, they invited the night crew over to go through all the hamburger assembly motions. As the crew members moved around the court making imaginary hamburgers, shakes and fries, the brothers followed them, marking in red chalk exactly where all the kitchen equipment should be placed. By 3:00 A.M., the tennis court markup was completed; and for a fraction of the cost of conventional design work, the brothers had a detailed kitchen layout.[2]

As the McDonald’s story illustrates, developing the bill of capacity requires fairly detailed knowledge of the operational processes. Since we are designing new ventures, this problem is particularly difficult. We won’t yet have our own historical standards. Possibly, the best source of operational knowledge for new ventures is equipment suppliers. Because suppliers sell the equipment to firms who use it in their operations, they must understand those operations in sufficient detail to argue that their equipment offers efficiency advantages over that of other vendors.

In cases where there is no equipment, and thus no equipment suppliers, you may be able to get the information from firms within your own industry. Though this seems counterintuitive, there are instances when you don’t compete directly with other firms in the industry. This is the case, for example, in fragmented industries such as restaurants and auto repair, where each firm serves a local market. Such industries are more easily recognized by the presence of franchises. If you plan to operate in a single region, you may be able to get someone in a distant region to share information with you (possibly for a fee). This was the approach followed by Tables to Teapots. The founders of the venture discovered a store very similar to the one they hoped to start and convinced the owners to mentor them in exchange for $1,500 and an agreement not to compete within 50 miles.[3] Relatedly, if you are in a diversified industry, such as trade journal publishing, where firms serve highly targeted market segments, you may be able to get information from firms who serve a segment unrelated to the one you plan to serve.

Exhibit 12.2 provides the bill of capacity (and materials) for Epigraphs production process. A separate bill of capacity is necessary for order processing.

The estimates for the production process came from a potential subcontractor. The bill indicates that each roll of wallcovering requires 0.08 hours of graphics computer time, 0.83 hours of cutter time, and 0.14 hours of slitter time. The corresponding labor requirements are 0.08 hours of computer operation and 0.83 hours of weeding/taping. We have incorporated costs for each of the equipment, labor, and material requirements to form the fully burdened unit cost for a produced roll of $12.37. Note that this bill of capacity is specific to a particular configuration of technology.

Demand Forecast/Master Production Schedule (MPS)

A master production schedule (MPS) is the anticipated build schedule for manufacturing end products. It is a statement of production, rather than a demand forecast. The MPS and the demand forecast are the same, however, if the venture plans to produce to demand. Alternatively, the venture could produce to inventory (to smooth work, for example). In those cases, the MPS and the demand forecast will be different. As a first step, you will want to look at unsmoothed demand.

For Epigraphs, the demand forecast pertains to sales at the distribution channel. Assuming setbacks for shipping and stocking at the chains of 1 month, the MPS for Epigraphs is merely the demand forecast shifted by 1 month. This is shown in Exhibit 12.3. The Exhibit indicates that production peaks in Quarter 3 at 294,000 rolls. This peaking reflects the industry sales profile over a pattern life.

The low early sales help the venture ramp-up production. The low sales after Quarter 6 suggest a strategy of level production in Quarters 2 through 6, followed by shutdown thereafter. You wouldn’t want to smooth production over all 12 quarters. Doing so, would leave customers with unmet demand, thus alienating them and inviting entry. For now, we will ignore the smoothing issue and continue with the assumption of producing to demand to help illuminate the next two stages of analysis.

Calendarized Resource Requirements

The bill of capacity is combined with the master production schedule to specify the requirements for each type of equipment and each type of labor. The resource requirements are merely the hours required for each unit of production times the planned units in the master production schedule in each quarter. These are shown for Epigraphs in Exhibit 12.4.

Exhibit 12.4 indicates that the equipment resources required to produce the level demand of 294,000 rolls are: 23,520 hours of graphics computer time, 244,902 hours of cutter time, 41,160 hours of slitter time, and 244,902 hours of table time per quarter. The corresponding human resources are 23,520 hours of computer operators and 244,902 hours of a weeder/taper. Finally, peak quarterly production consumes 32,340 rolls of vinyl and 4,116 rolls of transfer tape. Next, we translate these hourly requirements into capacity requirements—numbers of equipment to purchase or lease and number of employees to hire.

Associated Capacity Requirements

The calendarized resource requirements in Exhibit 12.4 are expressed in hours. To convert these resource requirements into capacity plans, we translate the hours into full-time equivalent. We make an assumption that all resources are used for a single shift only. Thus, over 3 months, each employee or piece of equipment is productive for 504 hours (40 hours per week times 13 weeks—less 2 days holiday per quarter).

The peak in Quarter 3 establishes the necessary capacity of all resources. These are elucidated in Exhibit 12.5. The most significant requirements—those driving the venture scale are for plotters (equipment) and weeders (labor). Single shift operations dictate a requirement for 486 plotters, 486 tables, and 486 weeders (as well as other equipment and labor).

While we could ease the equipment requirement by operating double shift, this would not ease the labor requirement. One advantage of single shift operation is that servicing can take place in the second shift, where it does not disrupt production. In a double shift operation, we would need to add machine service downtime to the hourly equipment requirements. Thus, if a machine requires 10 hour servicing for every 200 hours of operation, we would need to rescale the hours above by 1.05 (210/200)—thus 244,902 hours of cutter time becomes 257,147 hours. Another advantage of single shift operation is that only one management team is required. A thorough examination of the shift decision would require that these advantages of the single shift be weighed against the cost savings from cutting the equipment resources in half and cutting the physical plant size accordingly.

EXHIBIT 12.5   Capacity Requirements for Epigraphs

Resource

Maximum Hours*

Required Capacity**

Graphics Computer

Machine

Labor

23,520

23,520

47

47

Cutter/Plotter

Machine

Labor

244,902

486

Slitter

Machine

Labor

41,160

82

Weeding/Taping

Table

Labor

244,902

244,902

486

486

*From Exhibit 12.4, Quarter 3.

**Assumes 504 hours per quarter (13 weeks × 40 hours - 2 holidays).

EPIGRAPHS

Details for Epigraphs resource requirements analysis have been outlined above in the process section, thus we won’t duplicate them here. We do, however, want to comment on a venture design implication that arises from this analysis. In particular, the capacity requirements in Exhibit 12.5 define a very large-scale operation—in fact 20 times the size of an average sign shop. Such scale is infeasible for a new operation without prior production expertise. Even if the managerial challenges could be solved, the financial investment is significant—the 486 plotters are approximately $3.1 million. Moreover, the physical space necessary to accommodate the plotters and the weeding tables is approximately 200,000 sq ft. Even in an industrial location, this implies monthly rent of $200,000 (with a likely requirement for a long-term lease). Given the short expected life of the venture, these investments seem unwarranted. Thus, the resource requirements analysis supports the decision reached in the Chapter 11 on scope—that Epigraphs should outsource production.

CONCLUSION

In this chapter, we translated all the prior venture decisions into a set of physical and human resource requirements to implement the venture. To do this, we had to define a unit of output, generate an operating cycle, create an MPS, and specify the bill of materials to produce the unit output. We then applied the bill of materials to the MPS to quantify the equipment and employment necessary to satisfy demand.

In the next chapter, we combine these calendarized resource costs with firm revenues to generate the pro forma financial statements. We then analyze those statements to determine the financial requirements as well as the firm’s valuation.

NOTES

1. This term is similar to the “bill of materials,” which is an ordered list of all materials necessary for the production of a single unit. We ignore materials requirements in this text.

2. Love, J. F. (1986). McDonald’s: Behind the arches. New York: Bantam Books, p. 21.

3. McLaughlin, S. (1998). Hands on: Mentor for hire. Inc. Dec 1, 1998.

CHAPTER 12 WORKSHEET

Resource Requirements

Our goal in this chapter is to specify the resource and capacity requirements of the venture. To make that decision, you need to characterize the venture’s operating cycle, the bill of capacity for internal activities, the master schedule (may be the same as the top-level demand forecast), the calendarized resource requirements, and the capacity requirements.

1. Characterize the operating cycle for the venture. This is like the value chain for the primary activities in the last chapter, but it adds information about the time it takes to execute the activities (see Exhibit 12.1 for an example).

2. Create the bill of capacity (set of equipment and labor hours required to execute one cycle of the primary activities) (see Exhibit 12.2).

3. Characterize the master “production” schedule (see Exhibit 12.3). This may be the same as the demand forecast if there are no lags in the operating cycle.

4. Combine the information from the “bill of capacity” on the requirements for each unit, with the output levels in the master production schedule, to create a calendar of resource requirements (see Exhibit 12.4).

5. Determine the capacity requirements for the venture by examining the maximum hours of each piece of equipment and type labor in each period. Divide the required hours by the usable hours. For example, in a single shift, there are approximately 168 hours per month for each piece of equipment and each employee (see Exhibit 12.5).

Resource

Required Capacity

Activity 1

Material

Machine

Labor

Activity 2

Material

Machine

Labor

Activity 3

Material

Machine

Labor

Activity 4

CHAPTER 13

Valuation and Financial Requirements

INTRODUCTION AND GOALS

Having designed the venture and defined its human and physical resource requirements, we can now do the final analysis for the venture—financial analysis. The goals of financial analysis are threefold. First, we need to characterize the profit potential of the firm through its valuation. Second, we need to determine the funding required to implement the venture design, and third, we need to determine if there is anything we can change in the operational design to improve profits or minimize financial risk.

These three elements are linked. The financial requirements define how much outside investment is required, the valuation determines how much equity is available in exchange for investment, and the risk analysis helps establish the required rate of return for investments. Together, these three elements define how much equity in the venture must be given up to gain the necessary funds to ensure the venture’s success.

The chapter begins by reviewing the principles of financial analysis and valuation. Next, we present the steps in the analytical process: developing financial statements, performing diagnostics on the operational design using those statements, defining the financial requirement, performing the valuation, and determining the foregone equity necessary to obtain the financing. We apply all these tools to the Epigraphs example.

PRINCIPLES

The two basic principles that we deal with in this chapter are operating economics and valuation. Operating economics are the translation of your operational practices into their financial impact, both the demands for outside financing and the financial risk of that financing. Valuation is the process of assigning a price tag to your business—What is the value of your venture as an ongoing concern? The two constructs are linked in that the operating economics define how much outside financing the venture requires, while valuation defines the equity price of those outside funds.

The basic building blocks for the operating economics and the valuation are the same. The primary inputs are the demand forecast from Chapter 11 and the operating cycle and resource requirements from Chapter 12. From these, we develop intermediate inputs: the pro forma financial statements (income statement, balance sheet, and cash flow statement) and the cash conversion cycle.

The perspective we take in this chapter is that the venture has not yet raised any funds, either from outsiders or from the founders themselves. Thus, we define the total funding requirement. Accordingly, we ignore financial structure issues (amount of debt vs. amount of equity) as well as their impact on subsequent valuation. The financial structure of the firm contributes an additional component of risk to the venture. Operating economics define the business risk of variability of operating income. Financial structure contributes to overall risk through its impact on net income.

Operating Economics

The operating economics characterize the economic efficiency of the venture—to what extent is the operational design of the venture driving the requirement for outside financing. We use two tools to assess operating economics: ratio analysis and the cash conversion cycle. Ratio analysis is a comparative tool to assess your venture’s operating economics relative to those of other ventures. In some sense, the use of ratio analysis at the “paper stage” of the venture seems premature, since the real value of the analysis is as a diagnostic tool. However, it is useful at this stage in testing the reasonableness of the operations design and in setting operating targets. The cash conversion cycle is an absolute tool for assessing the impact of the operations design on the venture’s cash requirements.

Cash Conversion Cycle. The cash conversion cycle is a financial interpretation of the operating cycle developed in Chapter 12. The cash conversion cycle measures the length of time that the venture needs to fund the costs of production. Functionally, it is the length of time between incurring the expenses associated with production and receiving payment for the goods or services produced. This is depicted graphically in Exhibit 13.1. The cycle is triggered by the receipt of raw materials, but the cycle actually begins when the firm makes payment for those materials. The length of time between receipt and payment is defined by the accounts payable (AP) policy. Once materials are received, they are inventoried as either raw materials, work-in-process, or finished goods. The length of time in each stage is a function of the venture’s inventory and delivery policies. At some point goods are sold, and at some later point payment is received for those goods. The length of time between sale and actual payment is a function of the venture’s accounts receivable (AR) policy. The total time that the venture funds the unit of output is computed as the number of days between payment for final goods and payment for the corresponding raw materials.

Let’s look at the cash conversion cycles of two very different ventures, a manufacturer and an Internet retailer. Let’s assume that the manufacturer purchases raw materials monthly. If so, the average length of time in raw materials inventory is 15 days. If it makes four different products, and each of them is produced 1 week of the month, then on average, goods are inventoried as work-in-process for another 15 days. Assuming further that the venture produces to stock and that on average goods are stored as finished product for another 15 days, the total inventory cycle is 45 days.

EXHIBIT 13.1   The Cash Conversion Cycle

We make two additional assumptions. The first very credible assumption is that as a new venture, suppliers require payment on receipt, thus the AP period is 0 days. The second assumption is that the venture is a commercial firm whose buyers expect an industry norm of 45-day-payment period (invoices are collected throughout the month, billed at the end of the month, and due 30 days later).

Thus, the cash conversion cycle for the manufacturer is the average days in inventory (45), plus the AR days (45), minus the AP days (0). In this example then, the venture funds materials for 90 days (3 months). The corresponding working capital requirement is the cost of materials times the daily demand forecast times the cash conversion cycle (in days). If I forecast demand of 10,000 units per month, and the cost of materials for those units is $100, with a cash conversion cycle of 3 months, then I require working capital of $3,000,000 ($100 × 10,000 units/month × 3months). The associated carrying cost for that working capital might be $30,000 per month (with debt financing at 12%).

Let’s now look at a contrasting example of an Internet retailer who takes title to the goods it sells, but not possession. This would be the case if distributors shipped from their inventory to the end customer, but billed the retailer. Let’s assume that the retailer has favorable payment terms with the distributors because the retailer never takes possession (30 days), and that payment from customers is by credit card, so that the venture receives payment within 2 days of the order. There is no inventory, so the cash conversion cycle is merely the AR days (2) minus the AP days (30). Thus, the cash conversion cycle is actually a negative 28 days. Here, rather than having to fund production, the venture actually makes money on float. In particular, if we assume parity with the above example, 10,000 transactions per month at $150 (unit revenues rather than the $100 cost of goods), yields a cash balance of $1,500,000, on which the venture might earn $3,750 per month (3%).

Thus, despite comparable revenues and cost of goods sold (COGS), the Internet retailer will have $405,000 higher net income ($33,750 monthly) than the commercial manufacturer (Exhibit 13.2). If both firms look to the equity markets to fund their development costs, the manufacturer will have a lower valuation due to lower net income and, thus, will have to give up more equity to obtain the same funds. However, it is even worse off because it needs greater funds. The implication is that operations policies (inventory) and payment policies (AR and AP) have a significant impact not only on the funding requirements for the venture but also on its financial risk and its valuation.

Ratio Analysis. Ratio analysis is a diagnostic tool to examine the performance of the venture relative to comparable firms and to track changes in its own performance over time. Ratios are used internally to make operational decisions; they are used externally to gauge the quality of the venture as an investment. In general, ratio analysis is used to examine realized performance relative to a goal. Here however, we merely have a venture design and the corresponding pro forma statements, so the analysis will test the quality and reasonableness of the design. There are basically four categories of ratios used to evaluate a firm: liquidity ratios, leverage ratios, efficiency ratios, and profit ratios. Liquidity ratios assess the ability of the venture to meet short-term financial obligations. Leverage ratios characterize the financial stability of the venture. Efficiency ratios assess the ability of the venture to make effective use of its assets. Profitability ratios measure the overall performance of the venture. Since liquidity ratios and leverage ratios pertain to the financial structure of the venture, and we will not be discussing financial structure, we will treat them only superficially. We deal primarily with the performance (efficiency and profitability) ratios.

EXHIBIT 13.2   Comparing Working Capital Requirement: Firms With Comparable Output and Price/COGS but Different Cash Cycles

Commercial Goods Manufacturer

Internet Retailer

Annual Output (units)

COGS/unit

Inventory Days

Raw materials

WIP

Finished Goods

Accounts Payable (AP) Days

Accounts Receivable (AR) Days

Cash Conversion Cycle

Inv + AR - AP

120,000

$100

15

15

15

0

45

90

120,000

$100

30

2

-28

Working Capital Requirement

Output Over CCC * COGS

3,000,000

–1,500,000

Exhibit 13.3 summarizes the standard ratios, their calculation, and typical values. For the most part, efficiency ratios are measures of the constructs we discussed for the cash conversion cycle. “Average collection period” is the measure of AR days in the cash cycle. It is computed using AR turnover. A collection period of 45 days corresponds to an AR turnover of 8, meaning that AR are turned over 8 times per year (365/45 = 8). Similarly, “Average purchase credit period” is the measure of AP days in the cash cycle. It is computed using AP turnover. Finally, “Average inventory holding period” is the measure of days of inventory in the cash cycle. It is computed using inventory turnover. The main distinction between the AP and inventory turnover ratios versus the AR turnover ratio is that the numerator for AR turnover is revenues, while for AP and inventory the numerator is COGS. As we implied in the cash cycle discussion, the goals are to minimize the inventory holding and collections periods while increasing the purchase credit period. These collectively reduce the need for working capital.

The one efficiency measure not captured by the cash cycle is asset turnover. Whereas the cash cycle measures focus attention on working capital, asset turnover takes into account the effective use of all assets, including physical capital. Asset turnover is improved when firms reduce the cycle time on machines (the time to produce one unit of output), when their maintenance policy minimizes down times, or when they operate multiple shifts. Three really nice examples of firms that are driven to continually improve operational efficiency are Lincoln Electric,[1] Wal-Mart,[2] and McDonald’s.[3]

The profitability ratios are measures of the venture’s investment quality. Return on sales (ROS) varies substantially with industry and, thus, is best examined relative to other firms in a given industry. A more useful measure, in large part because it transcends industry, is return on equity (ROE). This allows investments in a firm to be compared with investments in other financial instruments (these comparisons however, must take into account the higher risk and lower liquidity of privately held firms). You may remember from Chapter 11 that ROE has special significance beyond a metric for comparing investments. In particular, it also serves as the venture’s maximum internally sustainable growth rate, since growth of sales requires growth in assets:

a. Earnings before interest and tax.

b. Cost of goods sold.

c. Important to designate whether the assets are characterized by book value or market value (market value preferred).

Valuation

The market value of your venture will ultimately be determined by equity investors, as their investment divided by their equity share. However, you need to do your own valuation so that you can assess the implicit valuations of potential investors.

The foundation for venture valuation is securities valuation, but there are special adjustments for privately held firms. There are three basic approaches to valuation: asset valuations, cash flow valuations, and market valuations. We discuss each of these in turn.

Asset-Based Valuations. Asset-based valuations define the firm’s value as the value of its assets minus its debt. There are three basic approaches to asset-based valuations: book value, replacement value, and liquidation value. Generally, these approaches are used for purposes other than seeking equity financing, since they disregard the firm’s potential to generate income. Book values are based on the historical costs of assets’ less accumulated depreciation. They are primarily of interest for loans against assets. Replacement values take into account the fact that current market prices for the firm’s assets may differ from book value. Replacement valuations are important for securing adequate insurance and for entrepreneurs/firms contemplating entry into new industries or markets. To the extent Greenfield startups (purchase of new assets) in your industry or market are more expensive than the book value of assets, then there is opportunity for existing owners to sell their ventures to the new entrants profitably. Liquidation values pertain to the net proceeds from selling all the firm’s assets in a quick sale and are, thus, only relevant at the point of dissolution.

Cash Flow Valuations. Cash flow valuation is the fundamental technique for valuing financial assets generally and public companies in particular. The present value of a firm is the sum of its future cash flows (CF) discounted by the cost of capital, r:

Since the venture generates a pro forma cash flow statement, cash flow valuations are fairly straightforward. The real challenge is in choosing the appropriate discount rate. We will assume that you are being funded by a venture capitalist and that the exit strategy is an initial public offering (IPO). In this case, the terminal value is your earnings in the terminal year (typically year 5) times the price-to-earnings (P/E) ratio of comparable public firms in your industry. If there are no comparable firms, then you compute terminal value as the cash flows in the terminal year divided by r - g (the Gordon growth model). The challenge of course is determining values for the discount rate, r, and the growth rate, g. (Note that the P/E ratios are merely shorthand for the Gordon growth model.)

Adjustments to Discount Rate for Private Firms. We mentioned previously that private firms are valued differently than public firms. In particular, there are four adjustments to the discount rate that potentially come into play. The first is an illiquidity premium. Because equity in private firms is not traded in competitive markets, investors’ shares are less marketable. Accordingly, they expect a premium for the illiquidity of their investments. Historically, this premium is an additional 40% over the discount rate of publicly held firms in the industry.[4] This premium creates the arbitrage opportunity (buying private-selling public) that fueled the leveraged buyout (LBO) trend in the 1980s.[5]

NPVprivate × 1.4 = NPVpublic,

where NPV denotes net present value,

Since the cash flows are the same:

rprivate = 1.4 × rpublic.

The second adjustment is the key person discount. The key person discount typically arises in small businesses where the founder controls relationships with customers and suppliers and has historically made all the major decisions. Think of Bill Gates in the early days of Microsoft. In these instances, there is a significant risk that business will decline even if a replacement manager is found. In fact, a study by Lerch found that even in public firms the value of securities fell 30% after the unexpected death of the owner.[6]

NPVkey person = 0.70 ×NPVno key person

The third adjustment is the minority discount/control premium. The minority discount applies when there is an individual or group of individuals controlling more than 50% of the voting rights of the venture. In these instances, the minority shareholders equity stakes are discounted by approximately 25% relative to ventures in which there are no majority blocks.[7] The control premium is not quite as straightforward, since it varies with the extent of the majority. The control premium is found by taking the market value of the venture, subtracting the market value of the minority shares (adjusted for the minority discount), and dividing the remaining market value by the majority equity stake and the unadjusted discount rate (see, for example, Exhibit 13.4).

EXHIBIT 13.4   Determining the Control Premium

• Control Premium: Market value-(value of minority shares)

• Example:

Firm is worth 10 million

2 shareholders: 70% and 30%

The minority shares are worth 0.3*0.75*10 = 2.25 million

Majority shares are worth 10–2.25 = 7.75 million

Control Premium in this case is 7.75/7.00 = 10.7%

Finally, there are size premia, reflecting the higher failure rates for small ventures. The size premium for firms valued at less than $150,000 is roughly 4.0%; for firms valued at less than $600,000, the premium is roughly 2.1%; and for firms valued at less than 2,500,000, the premium is roughly 1.3%. Note that these size premia are added to the discount rate, whereas the other adjustments were multiplied by the discount rate.

If all four adjustments apply: a minority shareholder in a private firm valued at less than $150,000, with a key person, in an industry with an average discount rate of 15%, then the effective discount rate that the minority shareholder must achieve is

(15%) × (1.4 illiquidity) × (1.3 key person) × (1.25 minority) + 4% = 38%.

Discount Rates for Earlier Periods. The discussion above pertains to discount rates for the venture’s terminal value. The underlying assumption is that the firm is being acquired or going public at that point. For earlier stage ventures with greater risk, investors will seek much higher returns. Exhibit 13.5 summarizes the sources and implicit rates of financing typically associated with each stage of the venture.

Note that none of the adjustments just discussed is as precisely defined as I have depicted it. The main point of the foregoing discussion is to make you aware of the set of adjustments, the rationale behind them, and the likely values they may take.

Multiples Valuations. The final approach to valuation, and probably the one most commonly used by business brokers is multiples valuations. While multiples of earnings is the equivalent of P/E ratios and, therefore, fundamentally a discounted cash flow (DCF) approach, it is common in many industries to use multiples of revenues. While we do not advocate this approach to arrive at a valuation for your venture, you will need to be familiar with the revenue multiples in your industry. This is particularly true if you are an acquisition candidate or if you are creating your venture through acquisition of existing firms. One particularly notable example of venture creation through acquisition is the serial entrepreneur, Wayne Huizenga, who created several successful public firms through roll-up of existing private firms in a given industry.[8]

The primary multiple approach used by business brokers is the “multiple of discretionary earnings.” Discretionary earnings is defined by the International Business Brokers Association as earnings prior to income taxes, nonoperating income and expense, nonrecurring income and expense, depreciation and amortization, interest income or expense, and owner’s compensation. The important distinction between discretionary earnings and EBITDA (earnings before interest, taxes, depreciation, and amortization) is the exclusion of owner’s compensation expense. The reason that discretionary earnings exclude owner’s compensation is that owners have substantial discretion over whether to take income as wages or profits. Because they pay social security tax on the wage component, but not on the profit component, they may actually prefer to understate the market wage for their services. Thus, discretionary earnings are a more reliable measure of a venture’s earnings potential than is EBITDA. Having said that, discretionary earnings overstate “earnings” since they don’t account for managerial wages. Accordingly, we would expect the multiples of these private firms to be below the P/E ratios for comparable public firms even after we make the adjustments discussed above.

Exhibit 13.5 Sources and Rates of Financing Versus Venture Stage Exhibit 13.6 is a table of typical multiples in several industries from Bizcomps.[9] These multiples are from sales where the transaction price excluded inventory. Note that these multiples are far below standard P/E ratios because owners should not have to pay the NPV of the wage component of their earnings. Perhaps more interesting than the multiples themselves is the manner in which they are derived by business appraisers.

A less common, but occasionally used approach to multiples valuation is “gross revenue multiples.” The underlying logic of this approach is that the revenue stream is the valuable asset and that it defines the true profit potential of the firm rather than current earnings. Revenue multiples are most likely to be used in either of the two extremes: when income data are unreliable or erratic or in homogeneous industries, where the cost structure is standard and, thus, income is highly predictable from revenues (stable ROS). The homogenous industry example captures the valuation strategy for roll-ups. Here, the buyer will replace existing operational practices with its own practices once the firm is under its umbrella. Thus, it cares only about the revenue potential of the target.

Source: Reprinted from West Handbook of Business Valuation 1991 rds@businessbookpress.com, Wiley, 201-748-6008 or mail (Permissions Dept., John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774) copies of the figures (and your adapted versions if applicable) with this request.

Financial Requirement

The next step in your financial analysis is determining how much financing your venture requires. The financial requirement for the venture is simply the most negative cash balance the venture expects in its future. This is obtained from the bottom line of the cash flow statement (the cash balance). Read the cash balance left to right. The point at which it is most negative is your financial requirement. The most negative cash balance occurs at the breakeven point. Prior to that point, losses add to the negative balance, whereas after the breakeven point, profits help to erode it. The basic requirement is determined from the cash flow statement for the nominal (most likely) demand forecast.

You also need to know the impact of your optimistic demand forecast and pessimistic demand forecast on the funding requirement. It is not necessarily true that pessimistic demand presents the worst case for funding requirements. Often optimistic demand creates more pressure on financing. This is particularly true if the cash conversion cycle is long, driving the need for greater working capital. Thus, you have to examine the most negative cash balance for both scenarios, determine which is greater, and compare that to the nominal requirement to specify a “contingency requirement.” You will ask for the nominal amount but make provisions up front for the contingency amount.

Forgone Equity

The final step in your financial analysis is determining how much equity you need to forgo to obtain the necessary financing. To do this, simply divide the funding requirement by the valuation. For example, if you determine that the venture needs $1,000,000 and your valuation for a particular investor class is $5,000,000, then you must give up a 20% equity stake to obtain the necessary financing ($1,000,000/$5,000,000 = 0.20).

It is now useful to introduce two terms common in venture financing. These are “pre-money valuation” and “post-money valuation.” The valuation you calculated previously is called the “post-money valuation” because it reflects the venture’s valuation if it obtains the necessary financing. The “pre-money valuation” is merely the post-money valuation minus the investment. For the example here, the post-money valuation is $5,000,000. The pre-money valuation is $5,000,000 minus the $1,000,000 investment, which equals $4,000,000.

ANALYTICAL PROCESS

Financial Statements

The analytical process begins with pro forma financial statements. The main statement of interest is the cash flow statement, but it is generally easiest to create the income statement first and use it to derive the cash flow statement. While the balance sheet won’t be particularly interesting until you know the structure of financing, it is valuable in characterizing the potential for debt financing. Inventories, AR, property, plant, and equipment are all assets you can borrow against.

One issue with regard to financial statements is timing. How far into the future do you need to forecast the financials (time horizon), and how frequently within that period do you need to characterize the financials (reporting interval)? The answers to both questions depend on what the statements will be used for. With respect to the time horizon question, venture capitalists typically envision exit after 5 years, so you will need to forecast cash flows that far into the future to be able to form a valuation. Thus, you will need a 5-year summary of cash flows. In principle, since valuation analysis is driving the requirement, you should only need the cash flow statement. In practice, you typically see a 5-year summary of all three statements.

With respect to the second question of reporting interval, again the answer depends on what the statements will be used for. Here, the driving requirement is accurately specifying the funding requirement. Typically, the most negative cash balance is going to occur within the first 2 years, so you will need monthly cash flow summaries over that period. Otherwise, the true requirement will be “smoothed” over the year in which it occurs, and the requirement will be understated. For example, if the most negative cash balance, -$1,500,000, occurs in July of year 2, but cash flow statements are year-end summaries, then the cash balances in December of years 1 and 2 are by definition less negative than $1,500,000.

For planning purposes, you may need monthly summaries of the income statement over the same period. Note that if your negative cash balance continues to increase beyond 2 years, you will want to continue with monthly summaries until the breakeven point. Similarly, if you reach breakeven in year 1, then you only need the monthly summaries of the first year.

The third issue with respect to the financial statements pertains to the scenarios: nominal case, pessimistic case, and optimistic case. Again, since these scenarios are created to assess the financial requirement, you will need cash flow statements for each scenario for the monthly summaries.

The nominal case for your financial statements is defined by the conjoint analysis demand coefficients for the chosen product configuration and price. This is the potential demand that you derived in Chapter 7. The realized demand that we developed in Chapter 10 combined that potential demand with your decisions about advertising and distribution channel.

Remember from Chapter 10 that in addition to the nominal forecast, we also generated optimistic and pessimistic demand forecasts based on the standard errors from conjoint analysis. These demand forecasts are the bases for the optimistic and pessimistic versions of each of the financial statements. In total then, you will need the following financial statements.

Cash Flow Statement

Monthly summaries for the first 24 months (or until breakeven)—nominal case

Monthly summaries for the first 24 months (or until breakeven)—pessimistic case

Monthly summaries for the first 24 months (or until breakeven)—optimistic case

Annual summary for the first 5 years

Income Statement

Monthly summaries for the first 24 months (or until breakeven)—nominal case

Monthly summaries for the first 24 months (or until breakeven)—pessimistic case

Monthly summaries for the first 24 months (or until breakeven)—optimistic case

Annual summary for the first 5 years

Balance Sheet

Annual summary for the first 5 years

Exhibits 13.7 through 13.15 are the pro forma financial statements for Epigraphs. Exhibit 13.7 is the income statement for the nominal case, Exhibit 13.8 is the cash flow statement for the nominal case, and Exhibit 13.9 is the balance sheet for the nominal case. Exhibits 13.10 through 13.12 are the corresponding statements for the optimistic case. Exhibits 13.13 through 13.15 are the corresponding statements for the pessimistic case.

The optimistic scenario was created by adding the normalized standard error to the nominal forecast. The normalized standard error is merely the standard error of a coefficient divided by the value of the coefficient itself. Remember from Chapter 10 that the normalized standard error for Epigraphs was 0.072. To create the optimistic forecast, we merely multiply demand in each period of the nominal forecast by 1.072.

The pessimistic scenario is simply the mirror image of the optimistic scenario—we subtract the normalized standard error from the demand forecast. Thus, we multiply the nominal demand forecast by 0.928 (= 1 - 0.072).

Diagostics

Cash Conversion Cycle. The cash conversion cycle is derived from the operating cycle in Chapter 12. Under the final plan of outsourcing production and distributing through a chain, we make the following assumptions: The purchase credit period for AP and finished goods inventory is 30 days, while the average collection period for AR is 45 days. Thus, the cash conversion cycle is 30 days (inventory) + 45 days (AR) – 30 days (AP) = 45 days. This is a rather long conversion cycle and, thus, will drive a significant requirement for initial working capital.

Financial Ratio

We apply the formulas in Exhibit 13.1 to Epigraphs income statement and balance sheet to characterize Epigraphs performance and assess the plausibility of its assumptions. Since ratio analysis is really a comparative technique, we compare Epigraph’s ratios to industry averages. To do this, we gathered the ratio summary for SIC code 5231 (note that this is the SIC code for paint, glass, and wallpaper retailers). We might want to do another analysis using SIC code 2671 (for wallpaper manufacturers). We present ratios from Risk Management Association (formerly Robert Morris Associates) in Exhibit 13.16.[10]

* Assumes unit cost of $12.37 (from Exhibit 10.2).

** Assumes two workstations.

*Assume AR days = 45.

**Assume inventory days = 60.

***Assume AP days = 30.

****Purchase of dyes.

*5-year straight line.

* Assumes unit cost of $12.37 (from Exhibit 10-2).

** Assumes two workstations.

* Assumes AR days = 45.

** Assumes inventory days = 60.

*** Assumes AP days = 30.

**** Purchase of dyes.

* 5-year straight line.

* Assumes unit cost of $12.37 (from Exhibit 10.2).

** Assumes two workstations.

* Assumes AR days =45.

** Assumes inventory=60.

*** Assumes AP days=30.

**** Purchase of dyes.

* 5-year straight line.

The average collection period for Epigraphs is 45 days. This corresponds to an AR turnover of 8. Comparing this number to the industry ratios indicates that Epigraphs is comparable with larger retailers. Smaller retailers have better (higher) AR turns due to cash and credit card sales, whereas larger retailers are more likely to have commercial sales involving purchase credit. Since Epigraphs will be selling exclusively to a single commercial customer, the assumption of a 45-day collection period seems plausible.

The average purchase credit period for Epigraphs is 30 days. This corresponds to AP turnover of 12. This is consistent with medium-sized firms in the industry and actually conservative relative to smaller or larger firms. Thus, the assumption of a 30-day purchase credit period also seems plausible.

Finished goods inventory is estimated at 30 days. (Since production is outsourced, there are no materials and work-in-process inventories.) This corresponds to an inventory turnover of 12. This assumption appears to be somewhat optimistic. Medium and large retailers turn inventory only about five times per year. The argument in favor of higher turns for Epigraphs is that it will only have one product and will control its production through real-time tracking of retailer sales. Thus, it should be able to avoid producing inventory that becomes obsolete.

Epigraph’s ROS in year 1 is 40%. This is obtained by adding the net income from all four quarters, $12,140, and dividing by the sum of sales for all four quarters, $29,464. This is substantially higher than the retailer norm of 1% to 3.5%. The higher returns stem from monopoly pricing in a new product class.

Financial Requirement

Basic Requirement. The most negative cash balance for Epigraphs occurs at the end of month 3. The cash flow statement indicates that Epigraphs will need $181,800 of external financing. The requirement in month 3 is driven by up-front costs (production of dyes, development of customer interface software, and advertising) as well as working capital to fund AR over the 45-day AR cycle.

By the end of the second quarter, this deficit disappears and is replaced by a cash surplus of $786,700.

Contingency Requirement. To assess the potential requirement for contingency funds, we examine the cash flow statements for the optimistic and pessimistic cases. We look first to see which scenario poses the greatest funding requirement and, then, compare that requirement to the nominal case.

There is very little difference between the cases. All three cases exhibit their most negative cash balance in month 3. The optimistic case exhibits a most negative cash balance of $188,200. The pessimistic case exhibits a most negative cash balance of $175,000. The differences in cases are largely due to differences in AR levels; thus, the higher sales in the optimistic case drive the higher cash requirement.

The contingency requirement for Epigraphs is the difference between the greatest funding requirement and the nominal funding requirement. In this case, it is $188,200 in the optimistic forecast minus $181,800 (nominal forecast) or $6,400. The reason that the contingency requirement is so low is that the standard errors from conjoint analysis were low. In most instances, the contingency requirement would be much larger. Here, because the contingency amount is trivial, it probably makes sense to merely ask for the entire amount (basic requirement plus contingency requirement) up front.

Valuation

The only relevant valuation for Epigraphs is a cash flow valuation since the extent of physical assets is trivial ($135,000) and below the amount of funding sought. Similarly, multiples valuation primarily pertains to firms for which there is a terminal value. We anticipate that the product’s life cycle will be exhausted in 3 years. The only intangible assets of value at that point will be the brand name and the relationships with both the manufacturer and Sherwin-Williams. If these were to be of value to anyone, it would likely be existing wallpaper manufacturers. We assume that wallpaper manufacturers already have comparable brand name and relationships and, therefore, would not be interested in those of Epigraphs.

Cash flow valuation is merely the present value of the cash stream discounted at the appropriate rate. To determine a discount rate for Epigraphs, we begin with the implicit discount rate for Sherwin-Williams. Sherwin-Williams trades at a P/E ratio of 14, and its earnings have been growing at 9.9%. The corresponding discount rate is therefore

1/(P/E) + g,

1/14 + 9.9 = 17.04%.

Thus, the implicit discount rate for a comparable publicly traded firm is 17.04%. We need to adjust this rate to account for the fact that Epigraphs is a private firm, with a key person, who is also a majority shareholder. Thus, we need to apply an illiquidity premium (factor of 1.4), a key-person discount (factor of 1.3), and a minority discount (factor of 1.25). We assume that the valuation will exceed $2.5 million; thus, no size premium is warranted. The resulting discount rate is therefore

17.04 × 1.4 × 1.3 × 1.25 = 38.77%.

Exhibit 13.17 is a spreadsheet that applies this discount rate to Epigraph’s cash flows for the nominal scenario. The resulting valuation over the 3-year venture life is $33,360,000. This is the “post-money” valuation. This is what the venture is worth if it obtains the necessary financing.

Equity Stake Corresponding to Financial Requirement

If Epigraphs seeks outside equity financing for the financial requirement of $188,200 (basic requirement plus contingency), it should only have to give up 0.56% of the venture. This share is obtained by dividing the funding requirement of $188,200 by the valuation, $33,360,000. Combining the post-money valuation of $33,360,000 with the $188,200 investment yields a pre-money valuation of $33,179,800 ($33,360,000 - $188,200).

1. Earnings before interest and tax.

2. Cost of goods sold.

3. Important to designate whether the assets are characterized by book value or market value (market value preferred).

In practice, an equity investor will always discount your numbers, so you will likely have to forego more equity. Similarly, equity investors typically want substantial equity stake. A stake of less than 1% is unlikely to appeal to them. Thus, you may want to consider debt financing. While Epigraphs has limited opportunity for asset-based lending, a very viable alternative is personal debt. In fact, any debt for new ventures will require a personal signature (even if you form a corporation) because of the high risk of dissolution; thus, all new venture debt is personal debt. The opportunity for personal debt is more substantial than you may realize. As an example, when the founders of Trilogy Development Group were unable to secure venture capital funds for development of their configurator (enterprise software that links the supply chain with the selling chain), they funded the venture by pyramiding credit card debt (obtaining new cards to make monthly payments on older cards). Between the four of them, they were able to secure $500,000 in credit card debt!

CONCLUSION

In this chapter, we translated the physical and human asset requirements into the financial requirement for the venture: How much money is required to execute the venture you’ve designed?

To answer this question, we first developed pro forma financial statements using the demand forecast from Chapter 11 and the corresponding resource requirements from Chapter 12. We created three statements: the income statement, the cash flow statement, and the balance sheet. We did this for each of the three scenarios: a nominal case, an optimistic case, and a pessimistic case.

From the cash flow statements, we found the most negative cash balance in each of the three scenarios to define the funding requirement. We used the cash flow statement again to develop the venture’s valuation. By combining the funding requirement and the valuation, we defined the share of equity that you must forego to obtain the necessary financing.

You and investors will undoubtedly differ on the valuation, the funding requirement and, thus, the equity stake. The analysis here provides you with a foundation for assessing alternative forecasts. Even if you reject the alternative forecasts, you may still want to forego a larger equity stake to obtain the backing of a particular investor. It may be wise to do so. As will be discussed in Chapter 14, some investors make it more likely to achieve a given level of demand, a given measure of professionalism or an IPO. Thus, the higher discount rate they require is justified by the higher returns they generate. The advantage you now have with the spreadsheet simulation and the corresponding financial analysis is that you can compare various investors. Investors who add more value will increase your cash flows (including the terminal value) but may also charge higher costs of capital. By comparing the NPV of various investors, you can determine when the higher costs of capital are warranted.

At this stage, we have completely designed the venture and identified the resources necessary to execute that design. In the final chapter, we assemble all the analysis from the preceding chapters to create a comprehensive depiction of your venture—the business plan.

NOTES

1. Norman, B., & Norman, F. (1983). Lincoln electric. HBS case 9–376–028.

2. Bradley, S. P., Ghemawat, P., & Foley, S. (1996). Wal-Mart Stores, Inc. HBS case 9–794–024.

3. See Love, J. F. (1986). McDonald’s: Behind the arches. New York: Bantam Books.

4. Ibbotson & Associates. (1993). Stocks, bonds, bills and inflation, 1993 yearbook. Chicago: Ibbotson.

5. Wells, E. (2002, February 1). Rolled up and rolled over. Fortune Small Business, February.

6. Lerch, M. (1992). Discount for key man loss: A quantitative analysis. Business Valuation Review, December, 183–194.

7. Lerch, M. (1991). Quantitative measures of minority interest discounts. Business Valuation Review, March, 7–13.

8. The first of these was Waste Management, the most famous is Blockbuster, and the most recent is AutoNation.

For a really nice account of his strategy, see DeGeorge, G. (1996). The making of a blockbuster. New York: Wiley.

9. West, T. L. (1997). The 1997 business reference guide. Concord, MA: Business Brokerage Press, p. 323.

10. Alternative sources of industry ratios are Schonfield and Associates, “IRS ratio studies” and The Almanac of Business and Industry Financial Ratios.

PART V

Putting It All Together

CHAPTER 14

A Business Plan for Venture Capital

INTRODUCTION AND GOALS

The business plan is the final step in the venture design—it ties together all the analyses and decisions from the prior chapters in a single document. The business plan basically serves two purposes for the venture—as a planning tool for the founders and as a sales document for potential investors and resource providers. This leads many people to conclude that there should be two separate documents—one that provides substance (the planning tool) and another that provides flash (the sales document). We argue, however, that given the criteria of venture capitalists (VCs), the well-conceived planning tool is also the best sales document.

To make this argument, we first review the decision criteria of VCs in an effort to characterize what makes a good sales tool. We then review the elements of an effective planning tool. Of course, the entire book has been the planning tool—the business plan is merely the documentation of the process. Finally, we discuss how the elements from each of the chapters are incorporated into the business plan to make the document most effective.

VENTURE CAPITALISTS AND THEIR CRITERIA

One of the primary outside audiences for the business plan is potential investors, the most sophisticated of whom are VCs. Thus, the best means for understanding how to make plans compelling sales documents is to review the criteria VCs use for their investment decisions. Before doing so, however, it is worthwhile to discuss venture capital (VC) more generally.

The Venture Capital Industry

You may remember from Chapter 1 that the goal of the book was to design ventures that enjoyed the success probabilities of VCs rather than those of independent entrepreneurs. We never really discussed however what VC actually is. We do that now.

VC is long-term (3 to 7 years) equity capital invested in new or rapidly expanding enterprises. A VC firm is typically a limited partnership comprising a set of general partners (those working directly for the VC firm) who raise a “fund” from an informal network of investors (the limited partners). These limited partners typically come from pension funds, insurance companies, endowment funds, corporations, or private wealth. The fund is actually a set of commitments to invest in ventures as opportunities arise, rather than a pool of money sitting in a bank account. Thus, we distinguish between VC commitments (the amount of money a VC fund has raised) and VC investments (the amount of money it has invested in new ventures).

VC is a fairly recent and largely U.S. phenomenon. The total amount of U.S. investment is three times that for the next 21 countries combined.[1] The “original” VC fund is considered to be American Research and Development, a publicly traded firm founded in 1946 by a group of MIT and HBS professors. The real growth in the industry however occurred with The Employee Retirement Income Security Act of 1974 (ERISA). ERISA established the “prudent man” rule, which protected pension fund managers from liability claims so long as their investment decisions reflected the “care, skill, prudence, and diligence” that a prudent person would use in making his or her own investments. This protection encouraged the inclusion of riskier investments in pension fund portfolios, so that now roughly 50% of VC commitments come from pension funds. Exhibit 14.1 captures trends in VC commitments as well as investments. The exhibit demonstrates relatively slow growth throughout the 1980s, a dramatic rise during the 1990s, and the 2001 crash of the dot-com bubble. As of 2005, however, VC commitments and investments have recovered to their 1998 levels.

Venture Funding in Context

Given the attention paid to VC-backed firms, it may be surprising to learn that VC represents a very small portion of total venture financing. Exhibit 14.2 demonstrates the share of new venture investments associated with the nine most prevalent sources of funds. The figure indicates that the dominant source of venture funds is asset based lenders at 46.9%, followed by angels at 27.3%, and receivables factoring at 22.4%. VC is a very distant fourth at 1.4%. Since this represents funding for all firms, and since VC restricts investments to high growth firms, we might rather know the prevalence of VC among high growth firms. To do so, we examine funding sources for the Inc. 500—the fastest growing privately held firms in the United States. Even here we see that only 5% of these high-growth firms received VC. Thus, VC backing is not a prerequisite for success.

Who are the 5%? Given the relatively short life of venture funds, VCs pay considerable attention to exit strategies of proposed ventures. On average, venture companies are divested after 4 years. The ultimate divesture outcome is an initial public offering (IPO). A successful IPO typically generates a 59.5% annual return; whereas an acquisition generates one-fourth that (15.4%).[2] For VC-backed firms founded between 1989 and 1993, VCs were able to take 25% of them public by 2001, another 19% were acquired, 32% were terminated, while 19% remained in the portfolio.[3] Since an IPO is the ultimate goal, VCs favor ventures with good IPO prospects. Accordingly, VC is concentrated in a few sectors, as shown in Exhibit 14.3. The figure indicates that the industry receiving the greatest number of investments is software, while the industry receiving the largest amount of investment is biotechnology. There are 14 other industries receiving a measurable share of VC. Almost all of them have a science or technology component. This suggests that VC is most likely in settings requiring sizable investments in R&D, equipment, or technology. This is as much because VCs want “scalable” ventures as it is because entrepreneurs avoid VC if they can find suitable investment from other sources. VCs also tend to specialize by region (Exhibit 14.4) and stage of development (Exhibit 14.5).

EXHIBIT 14.1   Trends in Venture Capital

EXHIBIT 14.2   Shares of Venture Funding by Source

Why avoid venture capital, and what are the alternatives? The chief reasons entrepreneurs give for avoiding venture capital are that (1) they forgo too much equity and (2) they give up too much control. The forgone equity is due to the high returns sought by VCs. These returns range from an annual rate of 50% for later stage investments to 90% for seed financing. The forgone control stems from VC interest in ensuring the success of their portfolio (we discuss typical control measures in the following section). The joint consequence of VC goals for high returns and entrepreneurs’ goals for maintaining equity and control is that VC is a relatively uncommon source of venture funding. Exhibit 14.6 is an effort to put VC in context with other sources of funding. Exhibit 14.2 did this with respect to prevalence, while this exhibit does so with respect to timing. The dominant source of financing (68%) is asset-based lending, including factoring of accounts receivable. The advantage of this source is that it is the least costly (typically prime + 2%). The disadvantage is that it is typically feasible only at later stages in the venture. The second most prevalent source of funding (27%) is angel investors. Angels are typically former entrepreneurs with excess cash who enjoy the process of mentoring new ventures. Angel investments are attractive in that they are available at early stages for reasonable rates of return, though the typical amounts ($100,000) are too small for heavy investments in R&D and equipment. Angels usually form networks in local communities and are best accessed through personal contacts, though a Google search on “angel investors” provides a wealth of Web sites devoted to matching entrepreneurs to angel investors.

EXHIBIT 14.3   VC Investment by Industry

EXHIBIT 14.4   VC Investment by Region

The case for VC backing. Even if you have less expensive sources of financing there are instances when VC backing may be useful. This stems from the fact that VCs add value to their investee firms. Since VC returns are based on the success of their portfolio, the best success being IPO, they manage portfolio firms to increase the likelihood of IPO. In fact, many of the measures VCs take are precisely the measures entrepreneurs view as lost control. Among the things VCs do to add value are (1) forging relationships between portfolio firms and potential buyers and suppliers; (2) reducing the time to market;[4] (3) professionalizing the firm by instituting human resource policies and stock option plans, recruiting personnel, hiring a sales/marketing vice president, and replacing the CEO;[5] (4) putting in place better corporate governance such as conservative earnings management, independent boards, outside audit and compensation committees, and shareholder rights agreements;[6] (5) monitoring performance via monthly onsite visits;[7] and (6) staging investments to key milestones to keep the venture on a tight leash.[8] All these things seem to enhance the likelihood of successful exit. As gross evidence of this, the rate of IPO for VC-backed firms founded between 1989 and 1993 was 25%, while the corresponding rate for acquisitions was 19%. Only 32% of these firms had been terminated by 2001.[9] The 32% failure rate of VC-backed ventures after 10 years is less than half the failure rate for independent start-ups (where 50.4% fail by year 4 and 60.5% fail by year 6).[10] Of course, performance varies across VC firms just as it does across firms in all other industries. So even within the same sector, region, and stage of development, there are more prominent VCs. Exhibit 14.7 identifies the 20 most powerful VCs in Silicon Valley, which itself is the most powerful region for VC.

EXHIBIT 14.5   VC Investment by Venture Stage

Venture Capital Criteria

Even if you don’t need or want VC, you do want to understand the criteria VCs use to evaluate ventures because they have tremendous incentives to get the selection process right. Their compensation as well as their ability to raise further funds depends on their investment returns. We take advantage of three formal studies of VCs and some additional anecdotal comments from entrepreneurs and VCs to understand the criteria underpinning their decisions.

The first study[11] gathered responses from 102 (of 150) members of the National Venture Capital Association regarding the importance of 27 criteria used for investment decisions. The results from the survey are summarized in Exhibit 14.8. The main conclusion the authors drew was that the most important investment criteria pertained to the entrepreneurial team. In particular, VCs wanted evidence that the entrepreneurial team was capable of sustained effort, was able to evaluate and react to risk, was thoroughly familiar with the market, and had a demonstrated track record. The interesting puzzle for entrepreneurs is how to convey this information in a business plan. We argue that a business plan developed from the intensive venture design process in this book will automatically convey much of this. It will certainly demonstrate knowledge of the market and ability to assess risk. We think too that the substantial work behind the plan will be indicative of sustained effort.

The second study is the one already discussed in Chapter 6.[12] Remember that the study was used to motivate the use of conjoint analysis. The study asked 66 VCs to evaluate 25 actual ventures that the researchers characterized along 8 dimensions. The VCs were asked to make investment decisions for each of the ventures and for each decision to specify the criteria underlying it. The researchers conducted conjoint analysis on the investment decisions using the eight dimensions. They then compared the conjoint criteria to the self-reported decision criteria. The results of that comparison are presented in Exhibit 14.9. The results for the stated criteria are consistent with those from the survey study. The most important stated criterion is the entrepreneurial team. However, the results from conjoint indicate that VCs actually rely more heavily on market structure—the level of competition and the extent of competitive advantage. While the team is important, one means of evaluating the team is by examining its decisions about which market to target (Chapter 4), the understanding of that market (Chapters 4, 5, and 6), and the plan for gaining advantage within that market (Chapter 7).

EXHIBIT 14.7   Twenty Most Influential Silicon Valley Venture Capitalists

Source: Castilla, E. J. (2003). Networks of venture capital firms in Silicon Valley. International Journal of Technology Management, 25, 113–135. © by Inderscience Publishers.

Note: Influence based on percentage of other Silicon Valley firms with which it shares at least one investee company.

The final study evaluates investment memoranda compiled by 10 VC firms for 58 funded investments.[13] Because all these ventures were funded, the study can’t draw distinctions between funded versus unfunded ventures. What the study is able to do however is evaluate the impact of criteria used to evaluate the venture on subsequent performance. The authors find that of 14 criteria captured in the investment memoranda only three were significant in explaining pre-money valuation (the stipulated value of the firm prior to VC funding), or likelihood of an IPO. Strong competition actually led to higher pre-money valuation and higher likelihood of IPO. Firms with moderate to strong competition were six times as likely to have gone public as those with weak competition. This suggests that a vigorous market is more important than strong positioning within a docile market. A strong management team increases the likelihood of IPO by a factor of 3 relative to neutral or weak management teams. This fits with the prior studies about the importance of management. The final criterion pertains to strategy or business model risk—things such as scalability, firm focus, and ability to nail down key partnerships. These risks were present in 50% of the funded ventures. Firms with such risks were half as likely to go public.

EXHIBIT 14.8   Results From Survey Study

Mean

SD

The Entrepreneur’s Personality

Capable of sustained intense effort

3.60

0.57

Able to evaluate and react well to risk

3.34

0.73

Articulate in discussing venture

3.11

0.71

Attends to detail

2.82

0.67

Has a personality compatible to mine

2.09

0.81

The Entrepreneur’s Experience

Thoroughly familiar with the market targeted by venture

3.58

0.57

Demonstrated leadership ability in past

3.41

0.67

Has a track record relevant to venture

3.24

0.69

Referred to me by a trustworthy source

2.03

0.62

Already familiar with the entrepreneur’s reputation

1.83

0.71

Characteristics of the Product or Service

The product is proprietary or can otherwise be protected

3.11

0.71

The product enjoys demonstrated market acceptance

2.45

0.74

The product has a functioning prototype

2.38

0.90

The product may be described as “high tech”

2.03

0.96

Characteristics of the Market

The target market enjoys a significant growth rate

3.34

0.64

The venture will stimulate an existing market

2.43

0.76

The venture is in an industry with which I am familiar

2.36

0.78

Little threat of competition during the first 3 years

2.33

0.72

The venture will create a new market

1.82

0.83

Financial Considerations

I require a return at least 10 times my investment in 10 years

3.42

0.79

I require an investment that can be made liquid

3.17

0.89

I require a return at least 10 times my investment in 5 years

2.34

0.81

I will not be expected to make subsequent investments

1.34

0.52

I will not participate in later round of investment

1.20

0.45

Responses are to the question, “How important is this criterion to your investment decision?” 1 = irrelevant, 2 = desirable, 3 = important, 4 = essential.

EXHIBIT 14.9   Results From Survey Study

Actual Decision Policy Rank

Stated Decision Policy Rank

Entrepreneurial Team

Market familiarity

Leadership

Start-ups

5

7

8

4

1

8

Product

Proprietary

6

5

Market

Size

Growth

Competitors

Strength

3

4

1

2

3

2

7

6

Other indications of VCs’ decision criteria emerge from comments from individual entrepreneurs and VCs. These comments are delineated in Exhibit 14.10.

Taken together, the three studies as well as the anecdotal comments indicate that the best investment sales tool is a business plan for an early venture in a rapidly growing market written by a team with sufficient technical and managerial expertise in the market to be able to define and execute an offering likely to achieve market leadership.

The best sales tool is thus a business plan that conveys sophisticated understanding of the market, the technology underlying the products/services in those markets, a marketing plan that optimizes demand, and an operations plan that ensures efficient exploitation of the demand. Thus the best sales tool is a business plan that documents a well-conceived venture design. In that sense the best sales tool is the manifestation of a good planning tool.

EXHIBIT 14.10   Informal Comments From Entrepreneurs and Venture Capitalists Regarding Investment Decision Criteria

Primus Venture Partner Criteria[14]

Competent management with deep experience in the industry or market
Venture potential to become a market leader, indicated by:

A distinctive, proprietary product

Unique services with strong appeal

Opportunity to harvest in 3 to 5 years

One million to 5 million dollar investment

John Doerr of Kleiner-Perkins[15]

Technical excellence

Outstanding management

Large, rapidly growing market

Team sense of urgency

First or second to market

Peter Ligeti of Keystone Capital

Recognizable customers, strategic partners, board members

Elisa Parsons of Parts River

Well-defined need

Typical Complaints Venture Capitalists Have With Entrepreneurs/Business Plans

Well-defined solution to a problem that is either undefined or nonexistent

Don’t place sufficient emphasis on in-depth market analysis

Rely primarily on intuition to estimate market potential

Are biased (ignore negative information) when interpreting market information

Underestimate what is required to market products

More than 90% overestimate market by 40%; more than 60% overestimate market by 60%

PLANNING TOOL

The venture design process is the real planning tool. The business plan is merely a snapshot of the venture design at a particular point in time. At this point, you have a reasonably complete venture design.[16] In all likelihood, your original concept of the venture has changed in response to analytical results. In Epigraphs, for example, the original distribution plan that emerged from industry analysis was to use the internet to circumvent entry barriers. However, during the demand forecasting exercise we realized that Internet distribution substantially truncated demand, while increasing the need for advertising. Similarly, we originally envisioned in-house production using Gerber technology. However, when we went through the resource requirements exercise, we learned that we would have to establish 486 workstations—a substantial investment in technology for a venture with a limited 3-year life.

Thus we now have a sense that any venture design is a living organism. The advantage you have over virtually all other entrepreneurs is that your experimentation and evolution have taken place on paper. The most obvious advantage of paper experimentation is that it is costless.[17] If Epigraph’s experimentation had taken place in practice, we would have incurred sunk costs for Gerber technology and advertising geared toward Web traffic. Additionally, we may have permanently lost market share and access to the chains as established competitors viewed our product, imitated it, and distributed it through their existing channels.

More important, we avoided confusing the customer by changing the product and distribution channel after product launch. Perhaps most important, we avoided the inertial tendency to stick with inferior strategies simply because they have already been implemented. In the case of new ventures, nimbleness is an asset. You are most nimble on paper, but you run the risk of “experimenting in a vacuum”—creating a perfect venture for a customer group that doesn’t exist. Here, however, our experimentation has involved real contact with the customer—in person during interviews and focus groups, and remotely (via mail or the Internet) during the survey.

Simulation

Continuing with the theme of experimentation and nimbleness, possibly the most valuable output of the venture design approach in this book is that you have now created an entire venture simulation. The set of spreadsheets from Chapters 6 through 13 and their linkages comprise the simulation. The design at any given point in time is merely the most recent numbers in the set of spreadsheets. The business plan is the text that interprets those numbers. Thus, if you choose to change any element of the product design or venture design, you can test its impact on the bottom line by changing the corresponding entry in the spreadsheet. This experimentation can now be done in a matter of minutes rather than weeks.

Say, for example, competition enters your market with a product design that you considered in your conjoint survey. You can now go back to see how many people prefer your product to theirs, and as a result, the profit impact of their entry. You can also test whether any revision to your product or venture design will provide higher profits in this new environment.

There generally is very little time to think strategically once you start the venture. Most entrepreneurs complain of having trouble merely behaving tactically. Having the simulation in place allows entrepreneurs to test changes in strategy in less time than it takes to examine changes in tactics. That is, the opportunity to experiment on paper continues even after the venture is initiated.

GENERAL GUIDELINES ON BUSINESS PLAN CONTENT

Since you have a venture design, writing the business plan is largely packaging. For most other entrepreneurs, the business plan is the design tool. In fact, you can buy business plan software programs where the text of the business plan exists, and you merely fill in the blanks with the specifics for your venture.[18] The design process is thus determining what goes in the blanks. By definition, such an approach will merely provide you with a pedestrian business plan—since thousands of other plans will share 90% of your text.

Accordingly, while we provide extensive guidance on the venture design process, we provide minimal only guidance on writing the business plan itself. What we do offer is an outline of business plan content, some discussion of what the major sections of the outline should accomplish, and guidelines on how the various elements of the venture design process are introduced into the plan. Exhibit 14.11 is the suggested outline for the business plan. The most important element of the business plan is the executive summary. In fact, in most cases, it is the only part of the plan that is read. Because the executive summary is so important, we recommend writing it last.

EXHIBIT 14.11   Detailed Plan Outline

1. Cover Page

2. Table of Contents

3. Executive Summary (Most important component of plan—see Exhibit 14.12 for guidelines)

4. The Need (Chapter 5)

Characterizing the customer

Perceptual Map of current offerings (take credit for having spoken to them in focus groups/interviews)

a. Why those dimensions

b. Current deficiency (use good quotes if you have them)

5. Proposed solution (Chapter 5)

Top-level description of venture product/service

Core benefit proposition—how it satisfies the need

Pictures/drawings if appropriate

Optimal Product Configuration (Chapters 6 and 7)

a. Table of product attributes and their marginal value

b. Corresponding point estimate of demand

c. Corresponding target segments (if applicable)

Optimal price (as determined by conjoint) (Chapters 6 and 7)

a. Show demand curve

6. The industry (Chapter 4)

Market size, growth rate

The competitors and substitutes: How close are they, what are their shares, how profitable are they

Entry barriers: How do they work for and against new venture

7. Marketing Plan

The buyers: Number, segments, where are they

Structure of existing distribution channels (Chapter 4)

Distribution channel decision (Chapter 8)

a. Characterize existing channels (power, reach, effectiveness)

b. Characteristics of product that affect channel length

c. Breakeven analysis, subjective factors, conjoint results if applicable

d. Channels chosen

e. Effective reach

Advertising decision (Chapter 9)

a. Media habits of buyers (MediaMark)

b. Advertising plan

c. Effective awareness

Demand forecast (Chapter 10)

a. Potential demand (point estimate from conjoint)

b. Realized demand (calendarized forecast—considers distribution reach and advertising awareness)

c. Analogy as test of reasonableness

Expected competitor response and any efforts to preempt (Chapter 7)

8. Operations Plan

Value chain (depict graphically and describe) (Chapter 11)

Scope of Firm (Chapter 11)

a. What activities to internalize and why

b. What activities to outsource and to whom

Bill of capacity (Chapter 12)

Calendarized resource requirements (Chapter 12)

9. Operating Economics (Chapter 13)

Operating cycle and corresponding cash conversion cycle

Cost breakdown for bill of capacity

a. Variable cost

b. Semivariable cost

Breakeven volume

Comparison to industry ratios

10. Management Team

Organization structure

Key management personnel

a. Backgrounds

b. Compensation

Board of advisers

11. Overall Schedule

12. Critical Risks, Problems, and Assumptions

13. Financial Plan (Chapter 13)

Pro forma income statements

Pro forma cash flow statements

Pro forma balance sheets

Required financing

Uses of funds (Valuation)

14. Appendices

Conjoint results

Industry ratios

A note on length. Entrepreneurs often ask how long the plan should be. As in most business writing, the goal is to convey all the critical information as briefly as possible. Often that leaves the question of what is “critical.” Since the outline below defines what constitutes the critical information, the remaining challenge for you is merely to convey that information in a compelling and succinct manner. Typically, this results in a plan that is 20 to 30 pages of double-spaced text. Appendices and Exhibits are in addition to the 20 to 30 pages.

A note on editing. Often a business plan is written jointly by several members of the entrepreneurial team—each member writing the section(s) corresponding to his or her area of expertise. While this is a great starting point, it often leads to a plan that is disjointed. Accordingly, you will want to appoint one member of the team as editor. This person should be the strongest writer. Once drafts of the various sections have been written, the editor compiles the sections into a coherent whole and rewrites them to echo a single voice. Each member of the team should then proofread the revision.

The complete business plan for Epigraphs is included as Appendix 14.1.

Cover Page

The cover page includes the formal name of the company, its legal form (e.g., a Pennsylvania S-corporation), full street address, phone and fax numbers, name of principal contact, and date of the plan. Typically, the bottom of the cover page includes a notice regarding the plan’s confidentiality:

This business plan has been submitted on a confidential basis to selected individuals for the sole purpose of soliciting financing for the company. It may not be copied, faxed, reproduced, or distributed without permission.

Executive Summary

The executive summary is the most important part of the business plan. Often it is the only section of the plan that gets read. Think of the summary as the ad for the entire plan. Its main objective is to gain the reader’s interest to induce them to read further or to seek a meeting. Peter Ligeti of Keystone Capital has developed a set of guidelines for writing the summary. These are included as Exhibit 14.12. As mentioned earlier, because the summary is so important you should write it last.

EXHIBIT 14.12   Writing a Summary

Typical VC: 10–20 plans on desk—summary—not read carefully

• Entrepreneur must grab attention, stand out

• Groundwork before plan sent

get introduction—plan, read more carefully

find out about VC firm

Summary—clear and concise, at most 4–5 pages

Summary—meat and sizzle: partly promotional and marketing

• Get attention with few key positive points, lead with strength

entrep: experience background

good management—even if just lined up

recognizable customers—like reference sale

recognizable strategic partners

recognizable board members (board composition)

competitive advantages if strong

• Nevertheless certain key areas must be covered to show thought

product or service upfront

why needed? Few key features (not technical), benefits

target market, market size—if large, say so

sales and marketing—brief unless crowded field

competition—brief unless crowded (e.g., doctor practice management—how different)

stage of company, product

financials:

• 3 years P&L, monthly/quarterly/first year

• keep it credible, reveals thought process

• revenues doubling, 50% net margin

• historical P&L if helps (e.g., 3-year R&D mode), credibility

pricing—affects distribution

$ sought now, later—leave cushion: credibility

use of proceeds

when company started—two-edged sword

Avoid:

• excessive length

• technical detail

• unrealistic projections

• “no competition”

• ignoring sales and marketing

No Mileage:

• “conservative projections”

• “customer focused”

• “proactive anything (marketing, etc.)”

Source: Peter Ligeti, Partner, Keystone Capital, 5/7/97.

The Need

VCs often complain that business plans offer solutions in search of problems. This will certainly not be true of your ventures. While intuition may have taken you in the direction of a solution rather than a problem, the focus group exercise, and the corresponding perceptual map in Chapter 5 will have forced you to characterize customer preferences as well as the degree to which these are currently satisfied.

The need section of the plan should characterize the problem facing the customer. It should identify the dimensions that customers care about in solving that problem. It should demonstrate where current offerings are positioned along those offerings. It should then highlight the current deficiency. This may be best accomplished with the perceptual map. If you have a perceptual map that concisely depicts the customer need, you should include it as a figure in this section. Similarly, the need section is an opportunity to demonstrate that you have firsthand knowledge of the customer from the interviews and/or the focus group. Briefly describe the interview sample and process. If you have pithy quotes that capture the customer need, this is the place to feature them.

Product Description (Proposed Solution)

This section should define the core benefit proposition for the venture’s product or service, linking the proposition to the customer’s need from the previous section. The meat of the section describes the venture’s product or service in detail. If there are drawings, block diagrams, or pictures of the product or service they would be included here.[17] The discussion should convince readers that the product fulfills the core benefit proposition, and satisfies the customers’ need.

This section will include discussion of the product configuration as determined from conjoint analysis. While you won’t get into details of the analysis, you want to mention that the data came from a conjoint survey of customers in the target market, then describe what attributes were selected and why. This will include a discussion of price and the corresponding demand, so you might include the demand curve.

The Industry

The industry description should characterize the market, define its size (both dollars and units), its growth rate, and discuss any important trends. This section should discuss the competitive structure of the industry. It should identify the competitors and closest substitutes, and summarize their market shares. Finally, the section should describe any entry barriers and discuss the extent to which these work in favor of or against the new venture.

Marketing Plan

The marketing plan is a substantial portion of the business plan. It includes a number of subsections: Buyer characterization, choice of distribution channel, the advertising plan, and the corresponding demand forecast.

Buyer Characterization. This section should characterize the target market in terms of its size, buyer demographics and psychographics. This information comes initially from MediaMark. To the extent your conjoint results indicate there are segments in the market, you want to define the segments and characterize them in the same terms as the overall market.

Distribution Channel. This section should characterize the existing channels in terms of power, reach, effectiveness and economics (costs/markups). It should also discuss characteristics of the product that drive its distribution in the direction of long or short channels. This should set up the discussion of which channel was chosen and why.

Advertising Decision. This section should define the communication objective for advertising. It should then describe the media habits of buyers as specified by MediaMark and the media questions in your conjoint survey. This should set up a discussion of the final advertising schedule (number of ads in what vehicles).

Demand Forecast. This discussion should follow the methodology from Chapter 10. You should define potential demand from the conjoint analysis. You should then apply the limits to realizing that demand imposed by your distribution decision (availability) and your advertising plan (awareness). If there is a suitable analogy you would include it to demonstrate the plausibility of your forecast. Finally, you would discuss the optimistic and pessimistic versions of these forecasts.

Expected Competitor Response. The demand forecast is predicated on customer choice from among your offering and all existing offerings. In this section you will discuss the likely response of competitors to the introduction of your product. You would then discuss possible counter-responses. Ideally, your initial strategy leaves little room for rational response (as in Chapter 7).

Operations Plan

The operations plan is another substantial section of the business plan. You should characterize the value chain both graphically and textually. From this you would define which activities will be internalized, which will be outsourced, and the factors driving the decision in each case. For activities that are outsourced, you want to identify the leading supplier candidates. For internal activities you will specify the bill of capacity. Finally, you would match the demand forecast with the bill of capacity to calendarize resource requirements. Note, lest you think that this is too much detail, let me point out that one venture capitalist said that his litmus test for a credible business plan is one that not only calendarizes human resource requirements but also takes into account replacement hiring. Thus, his expectation for business plans was that they specify expected employee turnover rates and the cost of those turnovers: recruiting costs, training costs for new employees, lost production before the old employees are replaced, and less efficient production of new employees before they become fully capable.

Operating Economics

This section applies cost information to the operations plan. Here you will define the operating cycle and the corresponding cash conversion cycle and draw implications about working capital. In addition, you will apply cost information to the bill of capacity to define unit cost (both variable cost and allocation of fixed cost). From this cost information you should be able to specify a breakeven volume. You should also demonstrate that your operating economics are comparable to industry averages, and where different, explain why.

Management Team

The goal of this section is to demonstrate that you have the right team (qualified and committed) and the appropriate allocation of responsibility to execute the venture design. Accordingly you will provide an organization chart and a brief biographical sketch of key management personnel. If you have a board of advisers, you would provide brief biographical sketches of them as well. The function of the board of advisers is to fill holes in your experience base or to provide links to key industry players that you might not otherwise be able to access.

Overall Schedule

This schedule defines all the critical development activities leading up to launch and the major milestones that occur after launch. Ultimately this schedule will be used to trigger funding activities and force periodic reassessment of the venture design.

Critical Risks, Problems, and Assumptions

The intent of this section is to provide a sense of the underlying risk in the venture design. You will define the major assumptions on which the design is based, and will specify any other outstanding risks. This is not the comprehensive boilerplate you might find in a legal prospectus. Rather, it is your best assessment of what risks the venture is most susceptible to, and how you expect to handle those risks. Absence of risks is usually an indication that you have your head in the sand. Ironically, too many risks convey a similar message. If you list an excessive number of risks, it appears you are just working from boilerplate and thus aren’t treating any risk seriously.

Financial Plan

This section is primarily an introduction to the pro forma statements. In addition you will specify the amount of financing that is required, and define how those funds will be used. Do not specify the financial structure. This will be defined through negotiation with your investors.

Appendices

Most of the figures that illuminate previous discussions should be imbedded in the text of those sections. However, some exhibits are sizable and complex and should be left to the appendix section. Examples of these are the financial statements, data summaries, and regression results from conjoint analysis.

CONCLUSION

Congratulations! At this point you have completed your venture design. While the most visible output of this work is your business plan, the most valuable output is the venture simulation you have created to support your decision making. You now have a set of spreadsheets that stretch from the demand curve for your product or service to the valuation. If you want to modify your strategy at any point in the future you can test that change in the simulation in minutes before you test it in the real world. If a new competitor enters your market with a different product configuration, you can go back to your raw data to see which product each customer will choose. You can do that not only for your current product configuration/price but can also test alternative configurations/prices. This kind of costless experimentation makes adaptation far more likely and effective. Finally, because you have actually done much of the venture design work, you should have momentum. I hope you decide that the marginal effort to start the venture is relatively minor.

APPENDIX 14.1: EPIGRAPHS BUSINESS PLAN

Epigraphs

A California S-Corporation

Corporate Offices:

1234 ABC Street

Los Angeles, CA 90045

Phone:

Fax:

Principal Contact is Anne Marie Knott—President

This business plan has been submitted on a confidential basis to selected individuals for the sole purpose of soliciting financing for the company. It may not be copied, faxed, reproduced, or distributed without permission.

1. TABLE OF CONTENTS

2. Executive Summary

3. The Need

4. Proposed Solution

5. The Industry

6. Target Market

7. Distribution

8. Advertising

9. Demand Forecast

10. Operations

11. Operating Economics.

12. Management Team

13 Overall Schedule

14. Critical Risks, Problems and Assumptions

15. Financial Forecast

2. EXECUTIVE SUMMARY

Epigraphs is a new business venture that will manufacture and distribute an innovative wallcovering product. The product is an affordable, creative, and easy-to-install alternative to wallpaper, targeted primarily at the residential do-it-yourself market. The product line consists of a collection of quotes manufactured in strips of vinyl letters with an adhesive backing. The quotes can be used as (1) a border around the perimeter of a room, (2) sidewall to cover an entire wall, or (3) an accent to a room. The letters are applied to a painted wall by simply pulling off the adhesive backing of the letters and pressing them onto the wall with a squeegee that is included in Epigraphs’ packaging.

Epigraphs fill a gap in the wallcovering market, particularly in the do-it-yourself segment. For the past 3 years, sales in the wallpaper market have declined at a rate of approximately 7% per year. This decline has been attributed to at least four factors. First, the industry has failed to innovate. Consumers complain that wallpaper designs are stale because companies have not kept pace with current trends in interior design. Second, wallpaper is difficult to install. Consumers and designers complain that problems with paste mess and seam matching detract from their using the product. Third, wallpaper is considered unsuitable for some spaces due to the architecture of these rooms. Because wallpaper comes in large rolls, it is difficult to paste onto angular spaces. Fourth, wallpaper designs are not unique or exclusive, yet consumers desire products that allow them to express themselves in unique ways.

Preliminary reactions to Epigraphs’ prototypes from interior designers indicate that the product is attractive in that it is affordable, whimsical, customizable, and functional in enhancing odd spaces. Consumers echoed the designers’ sentiments regarding the product’s design features, but because they often do their own installation, they were relatively more impressed with the installation advantages.

Primary market research with consumers estimates a market potential of 4.1 million rolls at the optimal price of $50 per roll. This yields profits of $22.8 million over the product’s 3-year life. The estimate of 4.1 million rolls is well within historical ranges for wallcovering sales over the product life cycle. On average, wallcoverings generate sales of 7 million rolls over their life (with a minimum of 2 million rolls and a maximum of 200 million rolls).

Because the product life is short, investments in production facilities are unwarranted. Accordingly, the firm plans to outsource production and fulfillment. Retail sales of the product will be exclusively through Sherwin-Williams. Sherwin-Williams provides complete coverage of the market, and provides an opportunity for consumers to view the product firsthand in store displays before purchase. Thus the chain serves both a distribution function and an advertising function, in exchange for 40% product markup. We augment store display advertising with highly targeted cable and print media to trigger sales in the first 3 months surrounding introduction.

Epigraphs seeks an equity investment of $470,000. This amount is required to finance tooling of the production dyes ($100,000), development of the supply chain integration Web site ($50,000), as well as working capital of $320,000 necessary to fund initial production over the 45-day cash cycle. The firm expects to achieve positive cash flow by month 4.

3. THE NEED

Epigraphs is an innovative do-it-yourself (DIY) wallcovering that combines the distinctive look of wallpaper or faux finishing with the durability, flexibility, and reliability of paint. The initial inspiration for Epigraphs grew out of the founder’s desire for a unique look in a room that was ill-suited to wallpaper due to numerous windows, entryways, protrusions, and cutouts. Additional aversion to wallpaper came from the founder’s recent experience with an installation in another room: throwing away whole lengths of paper when the matching didn’t work, having one side of the paper stretch more than the other side, and having the paper fall down and rip when trying to fit it around a window.

Focus groups with interior designers and surveys of consumers revealed similar widespread dissatisfaction with wallpaper. The goal of the focus group was to elicit detailed qualitative understanding from industry experts of the range of wallcovering options, and the factors that affect choice among those options. The ultimate goal of the consumer survey was to obtain quantitative estimates of demand among end users, though we used the survey to gather qualitative comments as well.

The interior design group was successful in identifying a broad range of wallcovering products and identifying a set of dimensions along which they compared these products. This set came primarily from discussion of their engagement experiences rather than from direct questions about dimensions and product rankings. For example, the group was asked what wallcovering products they used and why? They were also asked to describe wallcovering successes and wallcovering disasters.

The group identified six categories of wallcovering: paint, vinyl, wallpaper, fabric, faux finishing, and borders. The factors the group felt were important in choosing from among these product categories were budget, durability, ease of installation, uniqueness, versatility, product consistency, and the lag time from ordering the wallcovering to having the installation completed. A diagram ranking each of these products along each of the dimensions is given in Exhibit 1.

In general each product category represents trade-offs between the various factors. Paint, for example, is inexpensive, durable, and easy to install, but not very distinctive. In contrast faux finishes are expensive and difficult to install, but create a unique effect. Wallpaper is less expensive than faux finishes, but more expensive than paint. While it offers some degree of uniqueness, it suffers from difficult installation, poor consistency in product quality, and often involves long lead times.

Interior designers were interviewed to represent industry experts. They have extensive experience with a broad range of wallcoverings. Additionally, they are lead users—their current views on design anticipate future mass market views on design. However, because they deal almost exclusively with affluent clients their views will exhibit an affluence bias. Similarly, their experience with wallcovering is secondhand—they neither install the wallcovering nor live with it after the fact. Thus the designers’ focus group was complemented with consumer surveys.

Consumers generally felt that wallpaper installation was tedious, messy, and led to unreliable end results. With regard to the tedium they complained of the need to strip and prepare walls to create a smooth surface, of having to match the seams, of having to measure and cut around doors and windows, having to work around corners, and of troubles aligning patterns from one sheet to the next. With regard to the mess, they complained about getting glue from the new sheet on the sheets that had just been installed. With regard to the product quality, they complained that wallpaper quality seems to be getting cheaper, that the paper is too thin and tears easily, and that it is too difficult to avoid bubbles, wrinkles, rolled edges, and mismatched seams.

EXHIBIT 1

Given the complaints of designers and consumers, it is not surprising that sales of wallpaper have been declining at a rate of 7% a year for the past 3 years.

4. PROPOSED SOLUTION

Thus the interior designers and consumers confirmed the need for a product with the durability, flexibility, and affordability of paint, but with the uniqueness of papers and faux finishes. This forms the core benefit proposition for Epigraphs. This proposition is captured in the product description from preliminary advertising copy.

Epigraphs is a new product that can be applied to painted walls to create a custom look. Epigraphs have the look of stencils, but with less repetition, and far less work. Single lines of epigraphs can be used as an accent, or several lines can be used in lieu of wallpaper to create a whimsical room.

Epigraphs come in strips of self-stick graphics ready for installation. The product is applied dry, so it has none of the mess of stencils, borders, or wallpaper, nor any of the rush to apply the product before it dries. Further, because there is space between words, epigraphs do not have the alignment and abutment problems of wallpaper. This leads to two advantages over wallpaper: (1) Epigraphs tolerate minor installation problems that wallpaper won’t, and (2) there is no need to buy 20% extra Epigraphs to compensate for matching problems, and waste around doors and windows. Experience indicates that an entire 10’ X 15’ room (400 square feet of wall) can be installed in less than 8 hours.

Epigraphs come in seven standard colors (including gold, silver, hunter, burgundy, sapphire, black, and white), and five standard themes (including literary, humorous, inspirational, sports, and movies). For each of the standard colors, Epigraphs has identified coordinating paints for three different looks: tone-on-tone (a very subtle look), complementary (a subdued look), and contrasting. These combinations create 105 different patterns. While this is a good deal of variety, there is also an option for you to create your own unique look with custom colors and graphics.

We tested interior designer response to Epigraphs using product prototypes, and tested consumer response to Epigraphs using the advertising copy. Both groups indicated sufficient interest in the product to justify going forward with development. While interior designers felt that the product was ill-suited to high-end residential living rooms, they did see a number of other applications:

“I could see doing it where you would do a big floral. I could see doing it in a powder room. It would be kind of fun”

“Media room or game room”

“I could possibly use it in a child’s room”

“As a panel at the end of a long corridor”

“Church or library”

“Elevator lobbies”

“I know from personal experience that going into office buildings where there is a waiting room, I will read anything”

“Your mentioned elevator lobby, what about the elevator itself?”

In general the designers felt the product was attractive in that it was affordable, whimsical, customizable, and functional in enhancing odd spaces. Thus interior designers characteristically focused on Epigraphs’ design potential.

Consumers echoed the designers’ sentiments: “novel,” “unique,” “whimsical,” “creative possibilities,” “conversation piece,” “a new idea in decorating,” “adds personal touch, unique, subtle, yet noticeable,” However, because consumers often do their own installation, they also paid attention to the installation advantages: “It’s a do-it-yourself project,” “easily installed,” “no messy cleanup,” “tool is packaged with product; directions included.”

In addition to assessing general reactions to the product, the survey asked consumers to evaluate various configurations of the product. From this data we could determine the optimal price, set of features, and distribution channel, and characterize the corresponding demand. Results of the survey indicate that the base configuration of the product (with standard themes and colors, sold through paint/wallpaper chains at a price of $35.00) leads to demand of .40 rolls for each person in the target market. Assuming the estimate is correct, total demand for the product is .40 rolls times the target market (10,000,000 households that purchase wallpaper each year), or 6 million rolls. This estimate is an average over those who like the product and would need 8 or more rolls, and those who dislike the product and would not purchase any rolls.

The base configuration is not necessarily the optimal approach. To determine the optimal approach we examined the sensitivity of demand to changes in price, distribution channel, and product features. Exhibit 2 presents the demand curve (demand versus price) for distribution through both wallpaper chains and the Internet. (Survey results indicated that they saw no difference between the chains and home superstores, so we treat them as synonymous.)

EXHIBIT 2

By multiplying quantity times price, and subtracting unit cost, we can also determine the profits associated with each price level. In essence we can trade off higher profits per roll but low sales volume (high price), against lower profits per roll but high sales volume (low price). This profit curve is shown in Exhibit 3. The Exhibit indicates that the optimal price for sale through a chain is $51.55, yielding sales of .26 rolls, and average profits of $6.80 per person in the target. The optimal price for sale over the Internet is $38.06 with average profits of $7.18 per person in the target market. The Internet generates higher profits despite lower price, because it is a zero-stage channel—there are no intermediaries. Thus wholesale price equals retail price. The revenue to the firm for each roll sold is the optimal retail price of $38.06. In contrast, the revenue to the firm for each roll sold through chains is $36.82 (the wholesale price corresponding to a retail price of $51.55 given a 40% markup).

The only other product feature (other than price and distribution) was whether to offer custom or standard genres and colors. Survey results indicate that custom genres and custom colors yield lower profits than do standard genres and colors. This stems from the fact that they are more costly to produce, yet are no more attractive to customers than are the standard genres and colors. This is consistent with the focus group comment that too many options overwhelm customers.

Given the decision to offer standard genres and colors, we also examined whether we should offer the full complement of 7 colors X 5 genres, or whether we should merely offer some subset of that. We looked not only at the best strategy as a monopolist (before competition), but also the best strategy to either prevent competition or constrain entrants options and maximize profits in the presence of competition.

EXHIBIT 3

Our results indicate that the optimal strategy for Epigraphs is to introduce a product line consisting of 4 color-genre options (Hunter and Black) X (Literary and Inspirational). These products should be sold through wallcovering chains at a price of $50.00 per set. This strategy should produce average sales of $8.78 per person in the target market. The corresponding profits are $6.90 per person in the target market.

This strategy appears to be the best strategy not only in monopoly, but also in anticipation of later entry. Epigraphs would cede distribution in superstores to entrants, with the anticipation that the entrant would match Epigraphs product line. This will reduce the rate of subsequent sales of Epigraphs products by 50%. However, since 60% of product line sales occur in the first year, and the entrant will take time to respond, the net impact on life cycle sales is minimal.

5. THE INDUSTRY

Epigraphs would compete most closely with wallcovering. Thus we examined that industry (SIC 267952) to assess the likely environmental conditions we would face. The structure of that industry is summarized in Exhibit 4.

EXHIBIT 4

Rivals. The wallpaper industry appears to be a mature industry of good size. The wholesale value of industry sales is $870 million (roughly $2 billion at retail). The maturity conclusion is based on the recent steady sales decline (7% in each of the last 3 years), and the trend toward consolidation—four major U.S. manufacturers control 92% of the market. The market leaders and their respective market shares are given in Exhibit 5. Despite consolidation, the behavior of rivals does not appear to be particularly competitive. If the industry were competitive we would expect to see greater advertising expenditures (currently less than 1% of sales), and greater innovation. The fact that “the product was sorely lagging behind other home textiles in terms of trends” is evidence that there isn’t sufficient innovation, much less “hyperinnovation” (innovations whose aggregate industry cost exceeds resultant profits). One of the reasons rivalry is likely to be suppressed in the industry is that the product is highly differentiated. There are hundreds of patterns, no two of which are perfect substitutes.

EXHIBIT 5

Product life cycle. The life of a typical collection (set of coordinating patterns/colors) is 3 years. The minimum life cycle is 1 year; the maximum is 10 years. Sixty percent of sales occur in the first year. This information can be combined to form a characteristic sales profile for wallpaper sales. This is shown in Exhibit 6.

Average lifetime sales over this cycle is 7 million single rolls, while the minimum is roughly 2 million rolls, and the known maximum is 200 million rolls.

EXHIBIT 6

Buyers (intermediaries): Wallpaper is sold through three channels: paint/wallpaper chains (SIC 523035), building supply/department stores, and independent retailers (through wholesalers). Shares of distribution through each channel are summarized in Exhibit 7.

The relative balance between the various channels tends to suggest that no single channel is crucial to the success of a manufacturer. However, there are dominant players in two of the channels: Home Depot in the “department stores,” and Sherwin-Williams in the paint/wallcovering chains. It is possible that there are also dominant wholesalers in the independent channel as well. The fact that retailers have to buy pattern books is some evidence of limited channel power; however, this should be offset by the evidence that the manufacturer holds large inventories. Thus it is premature to draw conclusions on the power of retailers.

One recent trend is that independent retailers’ share of market is increasing at the expense of chains. Customers are attracted to independent outlets because they believe it is less likely to see the same wallpaper in their neighbor’s house.

While consumers are moving toward independent retailers, manufacturers are moving in the opposite direction. The recent sales decline has prompted changes in manufacturers’ distribution strategy. One of these changes is a manufacturer’s emphasis on sales through the chains and superstores where the margins are higher (no wholesaler). Additionally, manufacturers are attempting to differentiate themselves in terms of service and availability (in addition to product design). Recognizing that 90% of sales come from stock rather than special orders, manufacturers are offering retailers a 30% discount on any pattern for which retailers stock a 24-roll-minimum inventory. Additionally, manufacturers are offering 24-hour delivery for book orders. (90% of sales are from stock; 10% are orders from pattern books.)

EXHIBIT 7

Suppliers. We don’t dwell on suppliers since the new product uses vastly different materials and technology than conventional wallcoverings. The relatively low cost of materials in the wallcovering industry tends to suggest that suppliers have little impact on industry profitability. One thing to note is that the primary industry in the conventional industry is paper. While paper is a commodity, its price tends to fluctuate considerably. The new venture would not be subject to those fluctuations.

Substitutes. The dominant substitute for wallpaper is paint, “Approximately 90% of American Walls are painted.” The other substitute is borders (a subset of the wallcovering industry distinct from “sidewalls”). Currently 50% of wallcovering sales are borders. It is unclear whether border sales have increased total wallcovering sales to enhance what would have been painted walls, or whether borders have cannibalized sidewall sales. The tone of industry articles and the recent sales decline suggest the latter. Because borders are a subset of the wallcovering industry it makes little sense to consider them here as a competitive product.

The main external substitute is paint. To assess the power of a substitute we are interested in assessing cross price elasticity—to what extent does a 10% change in the price of either paint or wallcovering lead to a shift from one product to the other. Since the prices are so widely divergent to begin with, it seems unlikely that demand for wallpaper is affected by a decrease in the price of paint. Paint is roughly $20 for 400 square feet of coverage (excluding labor). In contrast, wallcovering is approximately $200 for the same coverage (excluding labor).

Entry Barriers. The final consideration is entry barriers. To what extent are there factors keeping the industry profitable precisely because they preclude entry? The most likely barrier candidates are generally high fixed cost, significant scale economies or learning curves, early mover advantages in building brand, or control of scarce resources. None of these seem to be present in the wallcovering industry. Fixed costs are minimal (sales/fixed assets = 1000%), production scale economies also seem to be minimal (this makes sense given the fact the product variety is wide—if there were large-scale economies we would expect to see fewer wallcovering patterns). Branding does not seem to be terribly important since consumers can rely on the brand of the retailer for quality assurance. Note however that there is a trend toward designer labeling of patterns—a means of “taste assurance” rather than quality assurance. Here the wallcovering manufacturers form license agreements with prominent designers from other arenas to provide wallcovering designs that bear their name. Thus consumers who are uncertain of their own taste can rely on a designer’s.

The most scarce resource seems to be access to the distribution channels, but as mentioned previously, there are multiple channels. Since entry appears to be unimpeded, the profitability of the industry is puzzling. The main entry barrier must be a required scale and scope of entry. New entrants must provide at least a whole pattern of books (probably more), and must produce sufficient number of those books to fill the distribution channel.

Summary: Is this industry hospitable to entry?

The preliminary conclusion is that wallcovering is an attractive industry. There is limited competition among existing rivals, little threat from suppliers and buyers, and no close substitutes. Ratio analysis confirms that this is a profitable industry—return on sales (ROS) is 5.5%, return on fixed assets is 48%.

The paradox here is that there appear to be minimal entry barriers. Normally the absence of barriers would tend to suppress industry profitability. The dominant entry barrier appears to be a relatively high minimum scale and scope of entry. Scope (variety of patterns) is required to make your offering attractive to retailers; scale is required to fill the distribution channels.

Thus entry into this attractive industry is feasible for large-scale ventures (a large firm play) OR for small ventures that innovate around the distribution system. Some feasible innovations are forming an exclusive arrangement with a single chain, working through designers rather than retailers, or selling direct to consumers.

6. TARGET MARKET

The broadest definition of the target market for Epigraphs is homeowners. The Statistical Abstract of the United States indicates that there are roughly 64 million owner-occupied households, and that the annual expenditures by those households on paint (there is no breakout for wallpaper) was roughly $6.5 billion, growing at 12% per year.

These data are aggregate statistics of the market. Ultimately we want to know which of these households to target. To help with this, we augmented the Statistical Abstract data with demographic data from American Marketplace. American Marketplace allows us to examine buying behavior as a function of consumer demographics. As with the statistical abstract, there is no specific breakout for wallcovering. There is, however, data on home textiles, which is closer to wallpaper than is paint. These data are summarized in Exhibit 8.

The data indicate that home textile expenditures grow with age, reaching a peak of $150 per household at age 45–54. Thereafter expenditures decrease fairly rapidly as home owners enter retirement. Expenditures also rise with income. Households with incomes greater than $70,000 spend an average of $250 per year on home textiles. With regard to household composition, textile expenditures are most likely in two-person households (married without children). Finally, home textile purchases are most prevalent in the North, East, and South (sales in the West are roughly half those in the East).

We gathered demographic data in our consumer survey and found general patterns to be similar to those of American Marketplace. There were exceptions however. First, we only tested the Philadelphia market, and thus have no data with which to compare regions. We assume our demand will overstate West Coast purchasing. Second, we tested more income brackets, and found that sales peaked at $100,000–$150,000 for Epigraphs. This matched the focus group intuition that the product is ill-suited to the high-end market. Third, while textile expenditures are most likely in two-person households (married without children), we found instead that Epigraphs was most popular in households with children. The opposing results may have to do with the fragility of many home textiles vis-à-vis the durability of Epigraphs. Finally, while American Marketplace tested households, we also tested individuals. We found that females are twice as likely to purchase the product as males. This may have implications for advertising.

7. DISTRIBUTION

Industry analysis indicated that there were approximately 15,000 independent retailers served by 100 distributors with an estimated reach of 15 million consumers. Because there are 40% markups both at the distributor and at the independent retailer, the unit revenue through independent retailers is 0.51*retail price (=price/(1.4)2).

While there are fewer chain/superstore outlets, approximately 3,000, they have approximately the same reach as independents. This is due to the branding advantages of the chains. Because manufacturers sell directly to the chains and superstores, without distributors, there is only a single markup of 40%. The unit revenues through this channel are therefore 0.71*retail price.

We combined these contribution numbers with considerations for inventory and other fixed costs to derive the breakeven volume for each channel. Breakeven analysis indicates that the channel with the least operational risk is direct sales through the Internet. The three channels have breakeven volumes that differ by an order of magnitude: Breakeven volume for the Internet is 626 units; for sales through chains or superstores, breakeven volume is 6,556 units; for sales through distributors to independents, breakeven volume is 50,038 units.

EXHIBIT 8

While the Internet appears at this point to be the most attractive channel, there are two other issues: the demand issue—will the Internet attract sales, since the customer can’t “feel” the product, and if so, at what volume? The other issue is the life cycle issue: Is there value in initiating sales through a channel that packages design consulting with the wallcovering sales? This is the advantage of independent retailers over the other channels.

To answer these questions we return to the results from the survey analysis. Exhibit 4 indicated that the optimal price for distribution through chains was $50. This yields demand of .27 rolls and contribution of $6.79 per person in the target market. The Internet has a lower sales forecast (.24 rolls), at its optimal price of $40, but this is still a very healthy demand. Moreover, it yields higher profit per person: $7.17. Thus if consumers have equal access to both channels, then the Internet is most lucrative.

The final issue in comparing the distribution channels is the reach. So far we know the breakeven volume for each channel, and the average demand for each person through each channel. The TOTAL demand for each channel applies the average demand per person with the total people reached by the channel.

Since we can choose a chain through which to distribute the product, we will choose the largest—Sherwin-Williams. The chain has approximately 2,200 stores, with 1,500 transactions per quarter. This number exceeds the number of wallcovering transactions per month, and the markets are assumed to be identical; thus we conclude that distribution through Sherwin-Williams provides 100% coverage of the target market.

In contrast, the Internet truncates reach in that only 17.8% of households purchased over the Internet as of 1999 (Forrester, March 2000). The penetration rate of Internet purchasing is growing rapidly, but at a decreasing rate. Given past growth trends, we assume that the penetration growth rate in each future year will be 65% of its growth rate in the prior year. Thus by the end of year 3, we anticipate 48% of households will be making Internet purchases. Accordingly, we tentatively conclude that distribution through chains is preferable—creating total revenues three times that through the Internet.

8. ADVERTISING

Audience. We identified the broadest target market for wallcovering as the 67 million owner-occupied households. However, in any given year only about 10 million households purchase wallpaper. Thus we are more interested in focusing advertising on that group. American Marketplace indicated that peak household textile use among households was for married couples, age 45–54, with annual incomes in excess of $70,000. Our market survey generally confirmed these basic trends for Epigraphs demand. However, we found that demand was highest for households with children with incomes of $100,000–$150,000.

It is unclear whether the same 10 million households purchase wallpaper annually or whether subsets of the homeowner population cycle in and out of the market. Regardless, we make the plausible assumption that those currently in the market for wallcovering will be actively seeking decorating information. Thus any movement in and out of the market for wallcovering will be matched by movement in and out of the decorating audience.

Objectives. Ultimately our advertising objective is to induce purchase in the entire wallpaper market. Before discussing more specific objectives, it is worth commenting on some idiosyncrasies of the wallcovering market. First, sales are “skewed left.” An average wallpaper pattern sells 7 million single rolls over a 3-year life. Sixty percent of the rolls are sold within the first year. (This was shown in Exhibit 6.) Second, ratio studies of the industry indicate an advertising intensity of less than 1%. Thus a wallpaper firm with first year sales forecast of $75 million at wholesale ($105 million retail) only spends $750,000 on advertising. The low level of advertising, as well as the fact that sales peak early, tend to suggest that advertising is a relatively unimportant component of the communication process. It appears rather that 20–25% of homeowners decide to purchase wallcovering each year irrespective of advertising, and then shop among patterns. In fact, our survey data indicates that store displays are the second most prominent source of ideas.

An additional issue raised in the focus groups is that consumers seek uniqueness in their décor. To the extent that customers repeatedly see a wallcovering in advertisements, they may reject it as something that is no longer unique. The skewed 3-year life cycle corroborates the importance of uniqueness—a wallcovering’s greatest sales occur when it is new and unique, and then diminish as it becomes more common.

The implications for advertising in this context are first that ads at most play an attention/interest role. The final stages of the decision process occur at the retailer, where the consumer makes on-site comparisons of wallcovering alternatives. Second, and more importantly, any advertising beyond that point may truncate sales by overexposing the product and eliminating its novelty. Thus wallcovering by nature, rather than strategic choice is a low advertising intensive industry.

If we examine the wallcovering life cycle once again, we see that demand peaks in month three. We recommend advertising to create awareness only until the product reaches this critical mass, and rely on the retailer thereafter.

Message. While we will leave the structure, format, and source decisions of the message design to an ad agency, we need to supply the content. The content of the message is the core benefit proposition that emerged in the focus group and was confirmed by the consumer survey. The proposition is a whimsical and affordable wallcovering with the versatility and uniqueness of custom finishes (faux, stenciling), with greater durability, and easier installation than wallpaper.

Vehicles. Exhibit 9 summarizes circulation, demographic, and rate information for a subset of home and shelter advertising vehicles. In general, the demographics are comparable across the vehicles: The audience is predominately female, 40–45 years old, median household income of $50,000–$60,000, and 80% home ownership. Aside from advertising reach and cost, which we discuss in a moment, the main feature discriminating these vehicles is “% medium devoted to home furnishings.” Here HGTV (broadcast media), and House Beautiful (print media) dominate Living and Better Homes & Gardens. This distinction is evident in comparing samples of the print media—Living primarily focuses on crafts/entertaining and Better Homes & Gardens deals broadly with house, family life, and gardening in addition to home furnishings. Thus House Beautiful and HGTV are a better match to the product—the audience is more conditioned to respond to home furnishings advertisements.

One of the interesting features of the media kits from which this information was obtained is that they are “magazine advertising to advertisers.” Thus advertising vehicles conduct their own market research in an effort to distinguish themselves from other similar vehicles. House Beautiful, for example, did a set of interesting studies that compared spending generated by their magazine with that of competing magazines. In addition, they created a perceptual map of the competitors. The perceptual map brought clarity to intuitions we had about the distinctions between the editorial focus of the various “shelter” magazines. Unfortunately, for them, the map confirmed that the offering of the best editorial match for Epigraphs was Home.

Plan and budget. Our goal is to reach the 10 million homeowners who purchase wallcovering in a given year. Because we don’t want to destroy product uniqueness through over-exposure, we only want to achieve awareness/interest through advertising—thus only one or two attention episodes per target member. Assuming failure to gain attention in some episodes, but no forgetting between episodes, we estimate two exposures per attention episode. Thus total exposures per target is (1 to 2) * 2 = 2 to 4.

A third page color ad in Home costs $27,100 and reaches an audience of 1,024,000. This yields a CPM (cost per thousand) of $26.46. In contrast, a 30-second spot on HGTV is only $1,500 and reaches an audience of 1,140,000. Thus we could purchase 24 spots on HGTV, and reach a larger audience with more exposures. Additionally, HGTV offers the opportunity for more focused targeting than Home—each show has a particular topic. Thus Epigraphs ads could be aired during shows having to do with wallcoverings, or do-it-yourself projects, rather than gardening.

HGTV appears to be the most cost-effective means to reach the target. While each show has only 1.1 million viewers, the total subscribers to the channel is 55 million. Thus there is the possibility of reaching the entire target. If so, the total advertising budget would be

15,000,000/1000 * 1.32 * 3 exposures = $59,400.

One caveat is that our primary research indicates that magazines outrank television by a factor of 2:1 as a source of decorating ideas. Thus we plan to augment HGTV advertising with print advertising in three issues of Home: 3 * $27,000 = $81,000.

Combining advertising expenditures of $140,000 with forecasted first-year sales of $25.7 million at wholesale yields an advertising intensity of 0.6%. This is comparable to the industry average.

9. DEMAND FORECAST

We examine the demand forecast in two ways. The primary approach is aggregating demand utilizing survey data and decisions specific to Epigraphs, but as a test of reasonableness of that approach we first examine historical analogy.

Historical analogy. We have already discussed information from historical analogy in the previous section. The analogy of past wallcovering sales patterns provides the skewed shape of the distribution curve (Exhibit 6), as well as the distribution of lifetime sales over the population of wallpaper patterns. This distribution indicates that the average wallpaper sells 7 million rolls, but there is substantial variance across wallcoverings. Minimum lifetime sales is around 2 million rolls; the maximum is approximately 200 million rolls.

In addition, from industry analysis we estimate that the target market for all wallcovering is 10,000,000 households per year. We obtain this estimate by comparing annual wallcovering sales at retail of $2 billion, with an average dollar value per transaction of $200. Thus the number of transactions is 10,000,000 (or 2,500,000 per quarter). This market size is given in row 3 of the Epigraphs demand forecast (Exhibit 10).

Aggregated demand forecast. The potential demand for Epigraphs is defined by survey responses for our chosen price and product features. The dynamic unfolding of that potential demand is driven by our decisions regarding product availability (distribution) and customer awareness (advertising). Exhibit 10 is a spreadsheet that builds the dynamic forecast given our decisions. The spreadsheet applies survey estimates for demand per person to the total market size in each quarter, and adjusts that for awareness and availability.

Potential demand. Remember that for distribution over the Internet, the optimal price for Epigraphs (to the nearest $5.00), is $40.00. This corresponds to demand of 0.245 rolls per person. For distribution through chains, the optimal price to the nearest $5.00 is $50.00. This corresponds to demand of 0.272 rolls per person. If we apply these estimates to the target population (10 million households purchasing wallcovering each year), we arrive at point estimates of 2.45 million rolls per year over the Internet, and 2.72 million rolls through chains.

If we assume that these figures capture first-year sales, and we apply the rule of thumb that 60% of lifetime sales are in the first year, then total lifetime sales are 4.08 million rolls (2.45/.60) over the Internet, or 4.53 million rolls through chains. We can assess the plausibility of this estimate by comparing it with the historical distribution of wallcovering sales. Our estimates are above the minimum of 2 million rolls, but below the mode of 7 million rolls. Thus our estimate appears plausible. Moreover, we may have overcorrected for respondent optimism, in which case, sales will be higher.

We insert the per person point estimates in rows 1 and 2 of the Epigraphs demand forecast spreadsheet. These point estimates assume full awareness and availability. To generate dynamic sales forecasts, we need to incorporate awareness and availability estimates arising from our advertising and distribution channel decisions.

Awareness. Our preliminary plans for advertising are the same for Internet and chain distribution. Ultimately, we assume that the Internet will require more advertising in that it has no counterpart to the store displays that provide supplemental “free” advertising. We adopt the advertising plan defined previously, which provides advertising on HGTV and Home magazine in the first 3 months of product introduction. This produces the three exposures generally needed to stimulate sales. After that period, we will terminate advertising, so that the product does not become overexposed.

HGTV has an audience of 1,100,000, and Home magazine has an audience of 1,000,000. For simplicity, and because neither HGTV nor Home has data on overlap, we assume that the two audiences are distinct. Thus the advertising program should create awareness in 2.1 million households. We assume that this audience is a complete subset of the market for wallcovering—that neither vehicle is “wasting” advertising outside the market. Both of these assumptions may be optimistic, but because we are ignoring the free advertising associated with Internet and store displays, we feel the assumptions are warranted.

Our estimates of awareness are captured in row 4 of Exhibit 10. In all periods after the first quarter, we assume awareness of 21% of the target households (2.1 million audience/10 million households purchasing wallcovering annually). In the first period, we assume awareness is half the ultimate value, as the ad exposures accumulate.

Availability. We continue to examine both Internet distribution and distribution through chains. The Internet truncates reach, in that only 17.8% of households purchased over the Internet as of 1999 (Forrester, March 2000). The penetration rate of Internet purchasing is growing rapidly, but at a decreasing rate. Given past growth trends, we assume that the penetration growth rate in each future year will be 65% of its growth rate in the prior year. Thus by the end of year 3, we anticipate 48% of households will be making Internet purchases. The corresponding quarterly penetration rates are given in row 5 of Exhibit 10.

For distribution through chains, we assume that the product will be distributed through Sherwin-Williams. The chain has approximately 2,200 stores, with 1,500 transactions per quarter. This number exceeds the number of wallcovering transactions per month, and the markets are assumed to be identical, thus we conclude that distribution through Sherwin-Williams provides 100% availability to the target market (row 6 of Exhibit 10).

Sales Projections. We obtain quarterly sales projections by merely multiplying per person demand, awareness, availability, and market size within each of the distribution channels. This leads to the quarterly unit sales in rows 7 and 8 of Exhibit 10. Note that Internet sales grow throughout the period, due to growth in Internet penetration, while sales through chains are stable after the first quarter. Maximum quarterly sales of 143,000 rolls occur in chain distribution for quarters 2 through 12. Maximum Internet sales are less than half that: 62,000 rolls in quarter 12.

The corresponding revenue projections are given in rows 9 and 10 of the Exhibit. Maximum quarterly revenues are $5.1 million in quarters 2–12 for sale through chains. The quarterly maximum for Internet sales is $2.5 million in the final quarter. Finally, we display cumulative unit sales, and cumulative revenues in rows 11–12, and 13–14, respectively.

Total lifetime sales for chain distribution are 1.6 million rolls and $56 million revenues. Total lifetime sales for Internet distribution are 500,000 rolls and $20 million revenues.

10. OPERATIONS

Epigraphs is somewhat unique in that it is a transient venture—one product with a 3 year life span, with no plans to develop new products beyond that. Accordingly, it makes little sense to make substantial investments in facilities and equipment. However, we want to ensure successful execution of the plan defined so far. Thus we carefully assess where each of the major activities in the value chain is best performed.

EXHIBIT 11

The overall value chain for Epigraphs is given in Exhibit 11. That diagram distinguishes between development activities (those that occur only once upfront), primary activities (those that are recurring and whose level of effort is a function of the level of output, essentially those things driving variable cost), and support activities (recurring activities unrelated to the level of output, essentially fixed costs). We link interrelated activities into modules, since in general, activities with a high degree of interrelatedness ought to be performed together. The major modules and corresponding decision on whether to internalize or outsource the activities in the module are as follows:

Design module (Design of the product and packaging):

Internalize because these activities determine the extent to which the product satisfies the core benefit proposition

Customer interface module (Order taking, dealer support, customer service):

Internalize since this is the critical link to the sole customer (distributor)—ensures their satisfaction, but also helps to facilitate rapid production response to changes in demand

Manufacturing module (Material purchase and inventory, manufacture rolls):

Outsource since manufacturing requires substantial investment in equipment and facilities that won’t be needed after year 3. Also Epigraphs has no expertise, and the necessary manufacturing capability is competitively supplied

Fulfillment module (Package and inventory rolls, fulfill orders):

Outsource since not strategic, no expertise, and fulfillment is competitively supplied

Misc support activities (Advertising, human resources, legal, accounting):

Outsource since Epigraphs’ scale is too small to justify maintaining in-house

While Epigraphs tends toward a virtual configuration, the firm maintains competence and control over design activities as well as dealer/customer interface. The strategic value of the dealer/customer interface is that it provides data on product demand and quality to facilitate rapid reconfiguration of manufacturing and the product mix. This minimizes the risk of obsolete inventory on one side, and product shortages on the other. It may also provide insights for future venture ideas.

11. OPERATING ECONOMICS

While our plan is to outsource production, we wanted an understanding of the scale of resources required to produce the product in-house. Accordingly, we developed a bill of capacity (machine and labor hours, plus materials required to produce a unit of output) (Exhibit 12). We applied the bill of capacity to the demand in Exhibit 10 (shifted to accommodate shipping and inventory lags) to develop the calendar of resource requirements shown in Exhibit 13. Exhibit 14 then translates the calendarized requirements into whole units of capacity needed under an assumption of single shift operations. The resulting capacity requirements in Exhibit 14 define a very large-scale operation. Such scale is infeasible for a new operation without prior production expertise. Even if the managerial challenges could be solved, the financial investment is significant—the 236 plotters are approximately $1,500,000. Moreover, the physical space necessary to accommodate the plotters and the weeding tables is approximately 100,000 square feet. Even in an industrial location, this implies monthly rent of $100,000 (with a likely requirement for a long-term lease). Given the short expected life of the venture, these investments seem unwarranted. Thus the resource requirements analysis supports the decision reached earlier—that Epigraphs should outsource production.

EXHIBIT 14   Capacity Requirements for Epigraphs

Resource

Resource Capacity

Graphics Computer

Machine

Labor

23

23

Cutter/Plotter

Machine

Labor

236

—

Slitter

Machine

Labor

40

—

Weeding/Taping

Table

Labor

236

236

Assumes single shift operation for equipment and labor (168 hours/month * 3 months per quarter)

12. MANAGEMENT TEAM

Epigraphs is largely a virtual corporation, thus we do not plan to build a large organization. The firm consists of two managers/officers.

Anne Marie Knott, CEO, has a BS in Math and Pre-Architecture from the University of Utah, an MBA from UCLA in marketing and production/operations, and a PhD from UCLA in Management. She has 15 years’ systems engineering and program management experience at Hughes Aircraft Company, and 5 years’ experience as a professor of entrepreneurship at Wharton. As part of her Wharton experience, she has supervised approximately 75 consulting engagements and guided development of 150 business plans.

Patricia Knott, COO, has a BS in Economics/Accounting from Claremont McKenna College and is a CPA. She has 5 years’ experience in tax accounting with Arthur Anderson, and 10 years’ experience as CFO and treasurer of Wolff-DiNapoli. At Wolff-DiNapoli, Ms. Knott was responsible for performance of commercial properties and 1,500 hotel rooms.

13. OVERALL SCHEDULE (SEE EXHIBIT 15)

14. CRITICAL RISKS, PROBLEMS AND ASSUMPTIONS

The main risk in the venture is that we are unable to secure a distribution agreement with Sherwin-Williams on favorable terms. We believe this risk is low. We are offering Sherwin-Williams exclusive retail distribution of the product (we will retain rights to distribute the product through interior designers). Additionally, we will be providing free promotion for Sherwin-Williams in all of Epigraphs’ magazine and cable television advertising. If we are unable to secure such an agreement, we will revert to Internet distribution.

The second risk is that we are unable to identify a material for the product that will reliably adhere to walls, but has the capability to be cleanly removed (possibly through the application of heat) when the consumer redecorates. If we are unable to identify such a material, we will give priority to a known material with good adhesion (the one we used for the prototype).

The third risk is that the full demand forecast is not realized, and we are left with obsolete product. Since we will be using EDI technology, we will be able to detect when demand slows, and can adjust production accordingly. Additionally, we will not give retailers the option to return unused product.

The final risk is that demand exceeds expectations, that we therefore experience delivery lags, and induce entry by rivals. If this happens, we assume we will cede half of the market from that point forward (as discussed in section 4). Since this scenario combines higher-than-expected demand with later competition, our profits will be greater than 50% of pro forma profits.

15. FINANCIAL FORECAST

Exhibits 15 through 23 are the pro forma financial statements for Epigraphs. Exhibit 15 is the income statement for the nominal case, Exhibit 16 is the cash flow statement for the nominal case, and Exhibit 17 is the balance sheet for the nominal case. Exhibits 18 through 19 are the comparable statements for the optimistic case. Exhibits 21 through 23 are the comparable statements for the pessimistic case.

The optimistic scenario was created by adding the normalized standard error to the demand forecast. The normalized standard error is merely the standard error divided by its corresponding coefficient. In the case of Epigraphs, the intercept coefficient is 4.04, and the corresponding standard error is 0.29. Thus the normalized standard error is 0.072 (=0.29/4.04). To add this to the demand forecast we merely multiply through by 1.072.

The pessimistic scenario is simply the mirror image of the optimistic scenario—we subtract the normalized standard error from the demand forecast. Thus we multiply the nominal demand forecast by 0.928 (= 1–0.072).

Diagnostics

Cash conversion cycle. Under the final plan of outsourcing production and distributing through a chain, we make the following assumptions: The purchase credit period for AP, and finished goods inventory are 30 days, while the average collection period for AR is 45 days. Thus the cash conversion cycle is: 30 days (inventory) + 45 days (AR) – 30 days (AP) = 45 days. This is a rather long conversion cycle and thus will drive a significant requirement for initial working capital.

Financial ratios. We compare Epigraph’s ratios to industry averages for SIC code 5231 from Robert Morris and Associates. Note this is the SIC code for paint, glass, and wallpaper retailers. Ratios for wallpaper manufacturing were not available. (These ratios are presented in Appendix I.)

The average collection period for Epigraphs is 45 days. This corresponds to an AR turnover of 8. Comparing this number to the industry ratios, indicates that Epigraphs is comparable to larger retailers. Smaller retailers have better (higher) AR turns due to cash and credit card sales, whereas larger retailers are more likely to have commercial sales involving purchase credit. Since Epigraphs will be selling exclusively to a single commercial customer, the assumption of a 45 day collection period seems plausible.

The average purchase credit period for Epigraphs is 30 days. This corresponds to an AP turnover of 12. This is consistent with medium-sized firms in the industry and actually conservative relative to smaller or larger firms. Thus the assumption of a 30 day purchase credit period also seems plausible.

Finished goods inventory is estimated at 30 days. (Since production is outsourced, there are no materials and work-in-process inventories.) This corresponds to an inventory turnover of 12. This assumption appears to be somewhat optimistic. Medium and large retailers turn inventory only about five times per year. The argument in favor of higher turns for Epigraphs is that it will have only one product and will control its production through real-time tracking of retailer sales. Thus it should be able to avoid producing inventory that becomes obsolete.

Epigraph’s return on sales in year 1 is 60%. This is much higher than the retailer norm of 1 to 3.5%. The higher returns stem from monopoly sales of a new product class, and the fact that Epigraphs is the manufacturer rather than the retailer.

Financial requirement

Basic requirement. The most negative cash balance for Epigraphs occurs at the end of month 3. The cash flow statement indicates that Epigraphs will need $466,000 of external financing. The requirement in month 3 is driven by the up-front costs for production of dyes and development of customer interface software. The real cash requirement; however, arises from funding early production over the 45-day cash cycle.

By the end of the second quarter this deficit disappears and is replaced by a cash surplus of $683,000.

Contingency requirement. To assess the potential requirement for contingency funds, we examine the cash flow statements for the optimistic and pessimistic cases. We look first to see which scenario poses the greatest funding requirement, and then compare that requirement to the nominal case. The pessimistic case exhibits a most negative cash balance of $451,000 in month 3, while the optimistic case exhibits a most negative cash balance of $481,000 in month 3. Thus the optimistic case places greater strains on financing than does either the nominal case or the pessimistic case. This is because there is more early production to fund.

The contingency requirement for Epigraphs is the difference between the greatest funding requirement and the nominal funding requirement. In this case it is $481,000 (optimistic forecast) minus $466,000 (nominal forecast), or $15,000.

Valuation

The only relevant valuation for Epigraphs is a cash flow valuation since the extent of physical assets is trivial ($135,000), and since those assets have no alternative use. Moreover, the assets’ cost is below the amount of funding sought. Similarly, multiples valuation pertains primarily to firms for which there is a terminal value. We anticipate that the product’s life cycle will be exhausted in 3 years. The only intangible assets of value at that point will be the brand name and the relationships with both the manufacturer and Sherwin-Williams. If these were to be of value to anyone, it would likely be existing wallpaper manufacturers. We assume wallpaper manufacturers already have comparable brand name and relationships, and therefore would not be interested in those of Epigraphs.

Cash flow valuation is merely the present value of the cash stream discounted at the appropriate rate. To determine discount rate for Epigraphs we begin with the implicit discount rate for Sherwin-Williams. Sherwin-Williams trades at a price-to-earnings ratio of 14, and its earnings have been growing at 9.9%. The corresponding discount rate is therefore

1/(P/E) + g

1/14 + 9.9 = 17.04%.

Thus the implicit discount rate for a comparable publicly traded firm is 17.04%. We need to adjust this rate to account for the fact that Epigraphs is a private firm, with a keyperson, who is also a majority shareholder. Thus we need to apply an illiquidity premium (factor of 1.4), a key person discount (factor of 1.3), and a minority discount (factor of 1.25). We assume the valuation will exceed $2.5 million, thus no size premium is warranted. The resulting discount rate is therefore

17.4 * 1.4 * 1.3 * 1.25 = 38.77%.

Exhibit 24 is a spreadsheet that applies this discount rate to Epigraph’s cash flows for the nominal scenario. The resulting valuation over the 3-year venture life is $11,925,000.

*Assumes unit cost of $12.50.

**Assumes two workstations from ...

***At 34% (corp tax rate above $335,000).

* Assumes AR days = 45.

**Assumes inventory days = 30.

***Assumes AP days = 30.

****Purchase of dyes.

* 3-year straight line.

*Assumes unit cost of $12.50.

** Assumes two workstations from ...

***At 34% (corp tax rate above $335,000).

* Assumes AR days = 45.

**Assumes inventory days = 30.

***Assumes AP days = 30.

****Purchase of dyes.

* 3-year straight line.

* Assumes unit cost of $12.50.

**Assumes two workstations from . . .

***At 34% (corp tax rate above $335,000).

*Assume AR days = 45.

**Assume inventory days = 30.

***Assumes AP days = 30.

**** Purchase of dyes.

* 5-year straight line.

NOTES

1. Gompers, P., & Lerner, J. (2001). The venture capital revolution. Journal of Economic Perspectives, 15, 145–168.

2. Gompers, P. A. (1995). Optimal investment, monitoring and the staging of venture capital. Journal of Finance, 50, 1461–1489.

3. Guler, I. (2003). A study in decision making capabilities and performance in the venture capital industry. PhD dissertation, University of Pennsylvania.

4. Hellmann, T., & Puri, M. (2000). The interaction between product market and financing strategy: The role of venture capital. Review of Financial Studies, 13, 959–984.

5. Hellmann, T., & Puri, M. (2002). Venture capital and the professionalization of start-up firms: Empirical evidence. Journal of Finance, 52, 169–197.

6. Hochberg, Y. V. (2005). Venture capital and corporate governance in the newly public firm. Working Paper.

7. Gompers (1995) cited above.

8. Gompers (1995) cited above.

9. Guler (2003) cited above.

10. Headd, B. (2003). Distinguishing between closure and failure. Small Business Economics, 21, 51–61.

11. Macmillan, I., Siegel, R., & Subba Narashima, P. N. (1985). Criteria used by venture capitalists to evaluate new venture proposals. Journal of Business Venturing, 1, 119–128.

12. Shepherd, D. A., & Zacharakis, A. (1997). Conjoint analysis: A window of opportunity for entrepreneurship research. In J. A. Katz (Ed.), Advances in entrepreneurship, firm emergence, and growth. London: JAI Press.

13. Kaplan, S. N., & Stromberg, P. (2000). How do venture capitalists choose investments. Working Paper, University of Chicago.

14. Bhide, A. V. (2000). The origin and evolution of new businesses. New York: Oxford University Press.

15. Ibid.

16. Under some circumstances there are additional design issues beyond those covered in this text. If you have a retail site for example, a critical issue is site location.

17. Except for your time and incidental expenses associated with focus groups and surveys.

18. See, for example, Biz Plan Builder.

19. Note that these figures should never be sufficiently detailed to allow readers to duplicate your offering.

Index

Action space, 197

Added value, 63

Adoption, 261–263

diffusion curve, 254 (exhibit)

for new products, 257 (exhibit)

for recent innovations, 257 (exhibit)

for XM satellite radio, 256 (exhibit)

Advertising, 221–243

audience, 383

budget, 233–234

catalogs and, 234–235

conclusion drawing, 223

emotional appeals, 223

format effectiveness, 222–223

infomercials, 235–236

macro level, 223–227

message, 384

micro level, 222–223

objectives, 383–384

order of presentation, 223

plan and budget, 384–385

rational appeals, 222

response hierarchy models, 222

structure, 223

television shopping shows and, 235

vehicles, 234–236, 384

Advertising decision:

goals of, 221

principles of, 221–227

worksheet, 245–248

Advertising design:

macro level, 223–227

micro level, 222–223

Advertising effectiveness:

macro level, 223–227

micro level, 222–223

Advertising program:

budget, 233–234

communication objectives, 228–229

developing, 228–234

media and vehicles, selecting, 229–233

media characteristics comparison, 230–231 (exhibit)

message design, 229

target audience, identifying, 228

Affordability, of innovations, 260

Alliances, strategic, 281–283

American Airlines, 104

American Marketplace (Heslop, ed.), 79, 236

American Research and Development, 346

Analysis, of raw data on color and genre preferences, 194 (exhibit)

Analytical process:

competitive strategy, 186–203

conjoint analysis, 149–169

distribution channel decision, 209–210

financial requirements, 318–341

Ancillary data, competitive strategy and, 193–197

Angel investors, 350, 351

Application service providers (ASPs), 152

Argument dimensionality, 223

Art of Poetry (Aristotle), 38

ASPs (Application Service Providers), 152

Attribute matrix, 149–152

automobile, 151 (exhibit)

Attribute price, worksheet for determining, 193 (exhibit)

Attributes:

demand curve, effect on, 192 (exhibit)

marginal values of, 191–193

AuctionWeb, 36 (inset)

Audit Bureau of Circulations, 239

Automobile, attribute matrix of, 151 (exhibit)

Automobile manufacturers:

factors explaining failure of, 33 (exhibit)

trends in the number of in the U.S., 32 (exhibit)

Ayres, Ian, 53

Balance sheet, 319, 320

epigraphs, 324–325, 329–331, 335–336

Bass diffusion model, 225

Beane, Billy, 8

Behavioral reliability, 158

Bertrand Competition, 65, 66, 72, 91

Bertrand Differentiation, 66–67, 93–94

Bertrand Duopoly, 91

Better Homes and Gardens, 240, 241, 384

“Better-than-average” effect, 25

Bhide, Amir, 1

Bias

in high school seniors, 25 (exhibit)

Bill of capacity, 297–299

epigraphs, 299 (exhibit)

Bloomberg, Michael, 26–27 (inset)

Bloomberg Financial Markets, 26

Book values, 313

Bottom-up demand forecasting, 250–253

Brainstorming, 53–54, 104

Brandenburger, A., 70

Breakeven analysis, 210–212

Built to Last (Collins and Porras), 1, 34

Business plan:

appendices, 366

content guidelines, 359–366

cover page, 362

editing of, 361–362

executive summary, 362–363

financial plan, 366

goals of, 345

industry description, 364

length of, 361

management team, 365

marketing plan, 364–365

need for business, 363

operating economics, 365

operations plan, 365

outline of, 359–361 (exhibit)

product desctiption, 364

proposed solution, 364

risks, problems, and assumptions, critical, 366

schedule, overall, 366

summary, 362–363 (exhibit)

venture capital, 345–415

Calendarized resource requirements, 300–301

epigraphs, for, 301 (exhibit)

Capacity planning:

analytical process of, 296–302

bill of capacity, 297–299

epigraphs, 303

operating cycle, 297

output units, 297

principles of, 295–296

Capacity requirements, epigraphs, 302 (exhibit)

Capitalism, Socialism, and Democracy (Schumpeter), 2

CAQ (Creative Achievement Questionnaire), 40

Cartel, 64–65, 89–90

Cash conversion cycle, 308–310, 309 (exhibit), 320, 396

Cash flow statement, 318, 319–320

epigraphs, 322–323, 327–328, 333–334

Cash flow valuation, 397

Catalogs, 234–235

CBC. See Choice-based conjoint

CDNow, 1, 6, 29, 68–69, 279

Channel:

breakeven volumes and cross-over volumes, 211 (exhibit)

characteristics driving length of, 208 (exhibit)

length, 207

Choice-based conjoint (CBC), 158, 159, 160

Compatibility, of innovations, 259–260

Competition, four diamond determinants, 71

Competitive Advantage of Nations (Porter), 70, 71, 72

Competitive dimension, 68

Competitive industries, 70–73

Competitive strategy:

analytical process, 186–203

ancillary data, 193–197

attributes, marginal value of, 191–193

cost function and, 187–188

monopoly price and, 186–197

preemption, opportunities for, 202–203

price and product configuration

under competition, 197–203

principles of, 186

product configuration, 186–197

venture design, in, 185–203

Complementarities, scope of, in venture operations, 275

Complements, of products and services, 69–70

Complexity of innovations, 260

Concentrated industries, Five Forces and, 62–63

Conjoint analysis, 10, 104, 147–173, 228

analytical process of, 149–169

attribute matrix, 149–152

data analysis in, 162–169

demand forecasting, of, 250–253

epigraphs, of, 170–173

goals of, 147–148

principles of, 148–149

summaries of ancillary data, 163–166 (exhibit)

worksheet, 181–182

Conjoint surveys, web-based, 152–153

Conjoint utility, 168

Consumer Reports, 109

Contingency requirements, 397

Control premium, 314 (exhibit)

Co-opetition (Brandenburger and Nalebuff), 70

Core benefit proposition, 106

Cost:

competitive strategy and, 187–188

dealer attributes affecting, 206–207

Cournot Competition, 65–66

Cournot Duopoly, 91–92

Cover letter, epigraphs survey, 155 (exhibit)

Creative Achievement Questionnaire (CAQ), 40

Creative behavior, personality correlates and, 42 (exhibit)

Creatives, versus noncreatives, 40 (exhibit)

Creativity:

age and, 44

biological bases of, 39–41

birth order and, 43

creative personality, 41–42

developmental context, role of, 43–44

environment and, 44

genetics, role of in, 42–43

immediate context and, 44–45

inventive process, 37–39

knowledge of, 39

principles of, 37–45

psychology of, 41–42

sociology of, 44–45

Cross-price elasticity, 67

Customer interface module, epigraphs, 288

Data analysis, in conjoint analysis, 162–169

DCF (Discounted cash flow), 315

Dealer attributes:

effect on cost, 206–207

effect on demand, 206

DeBeers’ diamond cartel, 65

Debt Management Services, 35 (inset)

Decision biases, exploiting, 5–7

Decision errors, 6 (exhibit)

Decision-making perspective, 1–14

Decision theory, monopoly and cartels, 89–90

Dell, Michael, 47, 48 (inset)

Dell Computers, 48 (inset)

Demand:

characterizing, 147–173

conversion, 169–170

dealer attributes affecting, 206

distribution of, 170 (exhibit)

potential, 250–251, 255

potential versus realized, 251 (exhibit)

question, 160

realized, 250–251

Demand curve:

epigraphs, of, 187, 187 (exhibit)

for internet and chain distribution, 171 (exhibit)

monopoly price and, 186–187

product configuration and, 186–187

shift from addition of attribute, 192 (exhibit)

Demand forecasting, 11, 300

adoption, commercial, 261–263

availability, 388

awareness, 386–388

bottom-up forecasting, 250–253

conjoint analysis, 250–253

epigraphs, 263–267

epigraphs, availability, 266

epigraphs, awareness, 266

epigraphs, estimate of total demand, 264–265

epigraphs, sales projections, 266–267

goals of, 249

historical analogy, 253–261, 386

potential demand, 386

principles of, 249–263

sales formation models, 250–253

sales projections, 388

worksheet, 269–270

Demographics, of home textile customers, 80–81 (exhibit)

Design module, epigraphs, 288

Differentiated products, 150

Diffusion:

of cable television, 261 (exhibit)

coefficients for major innovations, 258 (exhibit)

curves for adoptions, cumulative and current, 254 (exhibit)

of industrial products, 262 (exhibit)

Direct response television (DRTV).

See Infomercials

Discounted cash flow (DCF), 315

Discounted cash flow valuation, 340 (exhibit)

Discount rate:

adjustments for private firms, 313–315

for earlier periods, 315

Distribution:

catalogs and, 234–235

infomercials, 235–236

television shopping shows, and, 235

vehicles that combine with advertising, 234–236

Distribution channel decision, 205–220

DomiNicks Pizza, 52

Domino’s Pizza, 52

Durant, Bill, 33

Early adopters, 223

Early majority, 223

eBay, 36 (inset)

EDI (Electronic Data Interchange), 274

Edison, Thomas, 39

Efficiency ratios, 311

Electronic Data Interchange (EDI), 274

Ellison, D., 277

Emotional appeals, 223

Emotional stability, entrepreneurship and, 22

Employee Retirement Income and Security Act (ERISA), 346

Entrepreneur, 19–29

Entrepreneurial failure, 27–29

Entrepreneurship, 1–3, 20–22

Entrepreneur’s paradox, 68–69

Epigraphs, 12–14, 54–55

ad copy, 156 (exhibit)

advertising budget, establishing, 241–242

advertising media and vehicles, 239–241

advertising plan, 236–242

advertising program, 243 (exhibit)

aggregate utility for, 167 (exhibit)

awareness, 265–266

balance sheet, 324–325, 329–331, 335–336, 400–401 (exhibit), 405–407 (exhibit), 411–413

(exhibit) bill of capacity for, 299 (exhibit)

breakeven analysis of, 215–216

(exhibit) breakeven and indifference volumes, 217 (exhibit)

calendarized resource requirements, 301 (exhibit), 391 (exhibit)

capacity planning, 303

capacity requirements, 302 (exhibit), 393 (exhibit)

cash flow statement, 322–323, 327–328, 333–334, 399 (exhibit), 403–404 (exhibit), 409–410 (exhibit)

communication objectives, 236–237

conjoint analysis of, 170–173, 189–191

customer interface module, 288

demand, 373 (exhibit)

demand curves of, 187 (exhibit)

demand forecasting, 263–267, 385 (exhibit), 387 (exhibit)

design module, 288

discounted cash flow valuation, 414 (exhibit)

distribution channel decision and, 213–216

distribution of, 198

equity stake, corresponding to financial requirement, 339–341

focus group transcript, 117–140

fulfillment module, 289

historical analogy, 263–264

impact of pricing on market share, 202 (exhibit)

income statement, 321, 326, 332, 398 (exhibit), 402 (exhibit), 408 (exhibit)

manufacturing module, 289

master production schedule, 300 (exhibit)

message design, 237–238

moderator’s guide, 108 (exhibit)

new product information and perceptual mapping, 115

normal form of game, 201 (exhibit)

operating cycle, 298 (exhibit)

optimal price of, 190 (exhibit), 374 (exhibit)

overall venture schedule, 394–395 (exhibit)

perceptual mapping and, 113–116

postsession analysis, perceptual mapping, 115–116

product configuration, 198–200

profits across configurations, 191 (exhibit)

reactions to, 114–115

resource requirements, 303

rivals, 376

sales formation forecast, 264 (exhibit)

sales profile, lifetime, 265

sales projections, 266–267

scope worksheet, 286–287 (exhibit)

screening guide, 107 (exhibit)

support activities, 289

survey cover letter, 155 (exhibit)

survey instruction, 157

target audience, identifying, 236

valuation, 339

value chain, 285 (exhibit), 389 (exhibit)

venture, diary of, 13–14 (exhibit)

venture feasibility and, 76–87

venture operations, scope of, 288–289

Epigraphs, business plan, 367–415

advertising, 383–385

basic financial requirements, 396–397

business need, 370–371

demand forecasting, 385–388

diagnostics, 396

distribution, 380–383

executive summary, 369

financial forecast, 393–397

industry, the, 375–379

management team, 392

operating economics, 390–392

operations, 388–390

proposed solution, 371–375

risks, problems, and assumptions, critical, 392–393

table of contents, 368

target market, 379–380

valuation, 397

Equity, foregone, 318

Equity stake, corresponding to financial requirement, 339–341

ERISA (Employee Retirement Income and Security Act), 346

FastSigns, 50 (inset)

Financial analysis:

principles of, 307–318

for the venture, 307–341

Financial ratios, 320–337, 396

retailers, paint, glass, and wallpaper, 338 (exhibit)

wallcovering retailers, 415 (exhibit)

Financial requirements, analytical process of, 318–341

Financing, sources and rates versus venture stage, 316 (exhibit)

Firms:

correct configuration advantage, 33

private, discount rate adjustments for, 313–315

Firm scope:

evolution of, bicycle industry, 282 (exhibit)

evolution of, emerging industries, 282 (exhibit)

evolution of, PC industry, 280–281 (exhibit)

First mover advantage, 66

Five Forces, 59, 60, 62 (exhibit), 63, 72

concentrated industries and, 62–63

wallcoverings, 85 (exhibit)

Flash Report, 35 (inset)

Focus groups, 104–106

designing and conducting, 106–109, 113–115

recruiting participants, 113

wallcovering products and attributes, from, 114 (exhibit)

Ford, Henry, 33

Ford Motor Company, 33

Four diamond determinants, 71–72

Fulfillment module, epigraphs, 289

Game theory, 63

oligopoly, 90–95

primer on, 88–95

Gates, Bill, 314

General Motors, 7, 33, 34

Genetics, creativity and, 42–43

Goals, of conjoint analysis, 148–149

GoFish, 36 (inset)

Gordon growth model, 313

Guerilla Marketing Handbook, The (Levinson and Godin), 229

Hamilton, Bart, 28

Hammacher-Schlemmer Institute, 206

Head, Howard, 47

Hedonic price. See Attribute price

Hicks, D. A., 29

Historical analogy:

epigraphs, 263–264

forecasting, to, 253–261

Home Magazine, 242, 265, 266

Hotelling differentiation, 68, 69

Hou, K., 60

House Beautiful, 240, 241

Household profiles, 381–382 (exhibit)

Hughes Aircraft, 7, 8

Idea:

generation processes, 45–55

markets, 52–53

protection of, 34–37

role of, 34–37

unique, 34

as venture raw ingredient, 31–55

Ideation, 53–54

Illiquidity premium, 313–314

Income, entrepreneurial, 28

Income statement, 318–319, 320

epigraphs, 321, 326, 332

Inc 500, 45, 45 (exhibit)

Industrial Creativity (Rossman), 37

Industrial Organization (IO), 59, 60

Industries:

comparing concentrated and competitive, 61 (exhibit)

competitive, 70–73

equilibrium outcomes in, with homogeneous goods, 67 (exhibit)

Industry analysis:

goals of, 59

venture feasibility and, 59–95

worksheet, 97–101

Infomercials, 235–236

Initial Public Offering (IPO), 346, 351, 356

Innovation:

adopter categories, 224 (exhibit)

adoption of, 223

affordability of, 260

diffusion coefficients for, 258 (exhibit)

patterns of diffusion, 226 (exhibit)

Innovators, 223

Intellectual property (IP), 34

Intelligence Quotient (IQ), 40, 41

Internet purchasing, distribution of, 208 (exhibit)

Interviews, diminishing returns from, 105 (exhibit)

Inventive process, 37–39

Investment decision criteria, comments from entrepreneurs and capitalists, 357 (exhibit)

IO. See Industrial Organization

IP. See Intellectual property

IPO. See Initial Public Offering

IQ. See Intelligence Quotient

Jarvis, Ed, 47

Keillor, Garrison, 25

Kelleher, Herb, 49, 49 (inset)

Key person discount, 314

King, Rollin, 49 (inset)

Klepper, S., 33

Knott, A. M., 29

Kroc, Ray, 46–47 (inset)

Laggards, 223

Lake Wobegon, 25

Lerch, M., 314

Leverage ratios, 311

Liquidity ratios, 311

Living, 240, 241, 384

Local monopoly, 64

Logistics, survey, 162

Managers:

personality traits in common with entrepreneurs, 23 (exhibit)

personality traits that distinguish from entrepreneurs, 24 (exhibit)

Manufacturers, wallpaper:

market shares of, 79 (exhibit)

retailer ratios, comparison to, 78 (exhibit)

Manufacturing module, epigraphs, 289

Market behavior, understanding, 63–70

Marketing literature, distribution channel decision and, 207–209

Marketing plan, 364–365

Marketing principles, relating to vertical contracting principles, 207–209

Market segment simulator, output, 199 (exhibit)

Market share simulators, 166

Market structure, understanding, 63–70

Master production schedule (MPS), 300, 300 (exhibit)

Matrix, attribute, 149–152

McDonald brothers, 298

McDonald’s, 46–47 (inset)

Media characteristics, comparison of, 230–231 (exhibit)

MediaMark, 232, 239

MES. See Minimum efficient scale

Message cascading, 227 (exhibit)

Microsoft, 34

Minimum efficient scale (MES), 64, 285

Minority discount/control premium, 314

Monaghan, Tom, 52

Moneyball, 8

Monopoly, 63–64, 89

Monopoly price:

competitive strategy and, 186–197

demand curve and, 186–187

Monopsony, 63

Monte-Carlo study, 159

MPS (Master production schedule), 300

Multiples valuation, 315–318

multiple of discretionary earnings, 315

selling price to discretionary earnings, 317 (exhibit)

Nalebuff, Barry, 53, 70

Nash equilibrium, 90, 92, 94

National Venture Capital Association, 353

Natural monopoly, 64

Neiman-Marcus, 152

Net income, 308

Network effect, 69

Network externalities, 64

New product development (NPD), 4, 5, 8

Observability, 258–260

Observing, as stimulus for invention, 38

Oligopoly conditions:

Bertrand Competition, 65

Cournot Competition, 65–66

Stackelberg Competition, 66

Omidyar, Pierre, 36 (inset)

OPEC (Organization of Petroleum Exporting Countries), 65

Operating cycle, 297

Operating economics, 308–312

Operating income, 308

Operations:

customer interface module, 389

design module, 389

fulfillment module, 390

manufacturing module, 389

miscellaneous support activities, 390

Optimal price, epigraphs, 190 (exhibit)

Optimism, rescaling survey questions for, 161 (exhibit)

Organization of Petroleum Exporting Countries (OPEC), 65

Organization scope, versus activity characteristics, 278 (exhibit)

Origin and Evolution of New Businesses (Bhide), 1, 34

Output costs, per unit of production, 390 (exhibit)

Parker, John, 49 (inset)

P/E ratio (Price-to-earnings ratio), 313

Perceptual dimensions, 149

converting to physical attributes, 150 (exhibit)

Perceptual mapping, 103–146

dimensions of, 114

epigraphs, reactions to, 114–115

epigraphs focus group, 113–116

epigraphs focus group transcript, 117–140

focus groups, 104–106, 113

goals of, 103–104

home decorating magazines, 241 (exhibit)

identifying opportunity and, 112–113

postsession analysis, 115–116

principles of, 104–106

process, 106–113

wallcovering and, 116 (exhibit)

worksheet, 142–146

Perceptual maps:

constructing, 109–111

dimensions of, 104, 114

of small sedans, 111 (exhibit)

Perfect competition. See Bertrand Competition

Personality, creative, 41–42, 42 (exhibit)

Physical asset specificity, 272

PIMS (Profit Impact of Market Strategy), 60

Planning tool, venture design and, 358–359

Porter, M., 59–60, 63, 70–72

Porter’s Five Forces, 59

Posen, H. E., 29

Potential demand, 250, 251, 255

Preferences:

paired color and genre, 195 (exhibit)

raw data on color and genre, analysis of, 194 (exhibit)

Price configuration:

competitive strategy and, 197–203

equilibrium strategies, 200

payoffs, defining, 200

Price-to-earnings ratio (P/E), 313

Principles:

advertising decisions, 221–227

conjoint analysis, 148–149

demand forecasting, 249–263

venture operations, scope of, 271–283

Processes, of idea generation, 45–55

Process summary, 72

Product configuration:

competitive strategy and, 186–203

equilibrium strategies, 200

payoffs, defining, 200

Products, differentiated, 150

Profit Impact of Market Strategy (PIMS), 60

Profit ratios, 311

Pulos, Dan, 50 (inset)

Question, demand, 160

R&R, 252

sales formation analysis for, 253 (exhibit)

Ratings-based conjoint, 158

Ratio analysis, 310–312

Rational appeals, 222

Ratios, typical for firms, 312 (exhibit)

Raw data, exploiting, 7–8

Realized demand, 250, 251, 319

Reference group neglect, 25

Regional Advantage (Saxenian), 70, 71

Relative advantage, 258, 259, 262

Remodelers, demographic and media habits of, 238 (exhibit)

Repertory grid, 107, 108

Replacement values, 313

Resource requirements:

analytical process of, 296–302

bill of capacity, 297–299

epigraphs, 303

operating cycle, 297

output units, 297

principles of, 295–296

worksheet, 304–306

Retailer ratios, comparison to wallpaper manufacturers, 78 (exhibit)

Retail shares, of wallpaper distribution channels, 82 (exhibit)

Robinson, D. T., 60

Rossman, J., 37, 43

Rules, disregard for and entrepreneurship, 22

S2K Graphics, 50 (inset)

Sales formation models, 250–253

Sales profile, life cycle of wallpaper, 84 (exhibit)

Salomon Brothers, 26 (inset) Saxenian, A., 70, 71, 72

Schulz, Howard, 49

Schumpeter, J. A., 2, 19, 37

Scope decisions, rules for, 288 (exhibit)

Scope worksheet, epigraphs, 286–287 (exhibit)

SeaFax, evolution of, 35–36 (inset)

SeaFax Red Book, 36 (inset)

Seafood Credit, 35 (inset)

Sedans:

attributes of small, 110 (exhibit)

perceptual map of small, 111 (exhibit)

snake plot of small, 111 (exhibit)

value map of small, 112 (exhibit)

Segmentation analysis, demand versus income, 172 (exhibit)

Self-reliance, entrepreneurship and, 22

Shane, Scott, 52

Simmons Marketing Research Bureau, 232

Simulator, market segment, output from, 199 (exhibit)

Site specificity, 272

Six forces analysis, concentrated and competitive industries, 73 (exhibit)

Size premia, 315

Snake plot, 109

for small sedans, 111 (exhibit)

Southwest Airlines, 49 (inset)

Specificity:

physical asset, 272

site, 272

Stackelberg Competition, 66

Stackelberg Duopoly, 92–93

Strategic alliances, 281–283

Strategic perspective, of venture operations, 274–275

Strategies, equilibrium:

price configuration and, 200

product configuration and, 200

Support activities, epigraphs, 289

Survey:

design, 153–162

logistics, 162

responses, 161, 174–179

web-based, 152–153

Switching costs, 66

Textile, customer demographics, 80–81 (exhibit)

Thatcher, Mark, 47

Transaction cost economics, 272–274

Trialability, of innovations, 258, 260

Trilogy Development Group, 341

Uncertainty:

controllable, 22

uncontrollable, 22

Units of output, 297

Utility curves, 166

for internet and chain distribution, 168 (exhibit)

Utility data, 166

Utility to demand conversion, 166–169

Valuation, 307, 313–318, 339

Value-added, colors and genres, 196 (exhibit)

Value chain, 62

dimension, 68

epigraphs, 285 (exhibit)

manufacturing firm, 284 (exhibit)

Value maps, 112, 112 (exhibit)

VC. See Venture capital

Venture:

analyzing, 73–76

data gathering, 74–76

feasibility analysis, 76

five forces and, 76

idea for, 31–55

industry boundaries, 74

Venture capitalists, 345–357

Silicon Valley, most influential, 354 (exhibit)

Venture capital survey study results, 355 (exhibit), 356 (exhibit)

Venture capital (VC), 1, 2, 5, 8, 345

business plan for, 345–415

criteria, 352–357

industry, 345–346

investment by region, 351 (exhibit)

investment by venture stage, 352 (exhibit)

investments by industry, 349–350 (exhibit)

trends in, 347 (exhibit)

Venture design:

advertising decisions, 221–243

business plan for, 345–415

capacity planning, 295–303

competitive strategy, 185–203

conjoint analysis and, 147–173

decision making process and, 1–14

demand forecast and, 249–267

distribution channel decision, 205–218

entrepreneurs and, 19–29

financial requirements, 307–341

industry analysis and, 59–95

perceptual mapping and, 103–146

resource requirements, 295–303

scope of operations, 271–289

valuation, 307–341

venture idea and, 31–55

Venture feasibility, industry analysis and, 59–95

Venture financing, sources of, 353 (exhibit)

Venture funding, 346–352

shares by source, 348 (exhibit)

Venture idea, 31–55

consumer experience and, 47–48

immediate strategies for finding, 52

importance of, 32–34

imported, 49

long-term strategies for finding, 51

medium-term strategies for finding, 51–52

principles, 32–37

prior employment and, 46–47

researched ideas, 49–50

sources of, 45–50

strategies for finding, 51–54

Venture operations:

analytical process of, 283–288

complementarities, 275

dynamics of, 279–281

empirical evidence, 276–277

epigraphs, 288–289

findings, summary of, 276 (exhibit)

goals, 271

outsource bias, 277–279

principles of, 271–283

strategic perspective, 274–275

transaction cost economics, 272–274

value chain, 283–284

worksheet, 284–288, 291–292

Venture requirements, financial

analysis, 307–341

Venture success curves, 4 (exhibit)

Vertical contracting:

distribution channel decision and, 206–207

relating to marketing principles, 207–209

Vertical Net, 274, 275

Video motion capture, from single image stream, 53 (inset)

Wallcovering:

demographics and rates, vehicles, 240 (exhibit)

entry barriers to market, 379

industry, 375 (exhibit)

manufacturer’s sales, 376 (exhibit)

product life cycle, 376–378

product rankings, 371 (exhibit)

retail shares, by vendor types, 378 (exhibit)

sales over time, 237 (exhibit)

substitutes, 378–379

suppliers, 378

vehicle characteristics, comparison of, 239 (exhibit)

Wallcoverings Association, 81

Wallpaper, sales profile, 377 (exhibit)

Wal-Mart, 64, 152

Walton, Sam, 64

WebMail Service, 36 (inset)

WebMail Watch Service, 36 (inset)

Willingness to pay (WTP), 166, 169

Woods, Tiger, 232

Working capital requirements, various cash conversion cycles, 310 (exhibit)

Workman, Neal, 35 (inset)

Worksheet:

advertising decision, 245–248

conjoint analysis, 181–182

demand forecasting, 269–270

distribution channel decision and, 219–220

industry analysis, 97–101

resource requirements, 304–306

venture operations, scope of, 291–292

WTP. See Willingness to pay

Xerox, 7

XM satellite radio, adoption patterns for, 256 (exhibit)

About the Author

Anne Marie Knott is Professor of Strategy at the Olin School of Business, Washington University, Director, Berkeley Research Group. Previously, she was an assistant professor of management at Wharton, where she taught entrepreneurship from 1995 to 2004. Her general research interest is the interplay between market conditions, firm innovation (both entrepreneurial firms and those doing large scale R&D) and economic growth. Her work is published in the Journal of Economic Behavior and Organization, Journal of Small Business Economics, Organization Science, Management Science, and Strategic Management Journal, Harvard Business Review.

Prior to her academic career, she spent 1 year managing her father’s start-up print shop, 15 years at Hughes Aircraft Company doing R&D on missile guidance systems, and 7 days on Family Feud. A clip from one of the episodes can be seen every 30 minutes on the Family Feud slot machine at the MGM Grand in Las Vegas. She received a B.S. in Math from the University of Utah, an MBA in marketing and operations management from the University of California at Los Angeles (UCLA), and a Ph.D. in management from UCLA.