Correct business planning starts with a market analysis, i.e., understanding its demands and examining the existing solutions, as well as the solutions that are expected to be in the market around the time when the company's products are launched. The role of the company's concept, the market, and the solution offered by the company were briefly discussed in an earlier section in Chapter 2. Any plan of the company's strategy must be made in consideration of the company's competitive position, as well as its development and sales potential, given the technology and production and managerial capabilities that are available to the company. A great risk is involved in decisions that are based on intuition only. Intuition usually expresses a decision process that takes place in the analyst's mind, but without any concrete quantification of the facts. In order to convince both outside and inside the company, it is important to quantify the decision-making process.
The bottom line of the market and strategic analyses is reflected in the company's business plan, the main components of which are reviewed in a later section in this chapter. This section will review various tools that may assist entrepreneurs in assessing target markets and the competition they should expect when the company enters such markets.
The Essence of Strategic Planning
A startup's strategic plan looks at the possibilities available to the company, identifies the preferred routes, and points to the path to implementing such recommendations. The analysis must be made in consideration of any existing and potential competitors, and of any response they may have to the startup's actions. When performing such planning, it is important to examine the cost to the startup of every possible route, both financially and from the point of view of the risks it poses. It should be understood that although many decisions are technically reversible, they are irreversible after implementation from the economic and competitive points of view. Let us assume, for example, that an entrepreneur invented a revolutionary algorithm for the efficient transmission of data that can be employed in numerous applications. However, due to budgetary and manpower constraints, the company chooses one of the possible applications and invests the majority of its resources in it. Although the company can technically go back and develop the other applications should the first one fail, it is possible that other companies that focused on such other applications have already achieved an unbeatable competitive edge. Furthermore, in contrast to large companies that have the resources to rectify erroneous choices and start new and different applications, a startup that makes an erroneous fundamental choice of application may not get a second chance.
Moreover, decisions with respect to the financing of the startup affect the manner in which it will be able to compete in the market. If the startup raises capital for a certain project that constitutes a material part of its activities, then a considerable amount is engaged in favor of the particular target market of such project, and it is entirely unclear whether financiers will be interested in investing in a different direction.
When performing its business planning, the company should examine decisions that could have a material effect on its flexibility. On the one hand, startups often want to preserve their flexibility in shifting between different areas. On the other hand, such flexibility, given the scarcity of economic resources, could result in a lack of focus and loss of all potential markets.
Analyzing Target Markets
In order to enable entrepreneurs to choose between alternative strategic paths, they must correctly assess the target market of their future products. Besides an analysis of the target market, it is important to assess the projected competitive situation of that market when it is entered into by the company. For instance, if several similar companies will be launching a similar product on the same market simultaneously, the company will obviously find it more difficult to take a significant share of that market than if it were operating in such a target market with no competition.
In many cases, and in particular when the target market is essentially technological, its size is difficult to quantify. Sometimes the target market does not yet exist or is still forming. Therefore, it is necessary to assess the scope of the market and the percentage of such a market that will require the solution provided by the company. The extent to which the company's products or services are capable of meeting such demands and the size of the relevant market should thereafter be estimated.
Every market analysis should address the basic components that will determine the future profitability of the industry. Material components are, for instance, the balance of power between suppliers and consumers in the target market, the expected competitive situation when the product is launched, and the availability of substitutes. A market analyst must examine developments of substitute technologies which, even if they do not currently constitute an alternative to the company's products, could become such an alternative in later stages of the product development. As mentioned above, market research can often characterize future market demands, according to which the company can choose its target market, direct the development of its products, and determine how they will be launched in the market.
In every industry there are many specific sources of information that the company can utilize. In addition, there are several major research companies that supply current reports on various technological industries, the projected scope of the markets, and the projected trends within such markets. Although the reports of research companies such as Jupiter, Gartner, and Forrester may provide an excellent starting point for market research in many fields, it should always be kept in mind that many competitors in the same target markets are using the same reports and reaching the same conclusions at the same time, thus reducing the value of the projects. In other words, when examining market analyses that are widely available to the public, it is essential that the reaction of potential competitors also be examined. Many sophisticated companies actually use such reports to identify smaller markets in which the company's competitive situation could be easier. Ultimately, it is not the size of the market in itself that will determine the company's future, but rather the potential for profit from the activities of the company. Such potential is a function of the company's market share in such target market and of its competitive situation. Paradoxically, from this perspective, a market in which there are no ready-made reports is often preferable, since the lack of readily available reports on such markets indicates, among other things, that the firm's competitive situation may be more favorable.
It is essential to examine different scenarios in which competing companies will be active in the target market when the company is about to launch its products. Many startups tend to examine the competitive situation when they start the development and ignore any developments that are made at the same time in other companies. For this reason, they might estimate their market share unrealistically. Likewise, many startups take into account the possibility of being bought out by a large company in the field, while disregarding the possibility that when their product is launched, other companies may offer comparable services that could also be of interest to such large companies.
Other than research companies, experts in the field should also be sought. These could be people who work in the field, analysts in investment banks who focus on public companies in the field, and so on. Over and above the information they can provide on the size of the projected market, such people can assist in analyzing potential competitors, in addition to providing contacts in the industry.
Naturally, Web-based research should be performed, including the use of industry-specific databases, some of which are available within larger databases such as Nexis or Dow Jones. In this area, those who compile data on the industries and markets in which the startup is interested are becoming increasingly important. Additional information is always vital to make informed decisions with respect to the startup's future.
While analyzing the target market, the company should examine not only the existing and projected competition in the direct target market, but also in close markets that could provide alternatives to the planned products of the company. For instance, if the startup will deal with broadcasting movies over the Internet, it should examine not only the projected competition in the same market, but also in alternative markets such as home movies, theatres, and movie theatres, and so on.
An option is the possibility of making a decision in the future under pre-determined terms or a function of terms. In the capital market, for instance, if an investor holds an option to buy one share of a company for X dollars for one month, then he will exercise the option only if the price of the share during that month is higher than X.
Similarly, if a company has an option for one month to buy an inventory for $100, it will exercise the option only if, during that month, purchasing the same inventory elsewhere would be more expensive.
In any decision-making process pertaining to an investment, the company must examine whether it is creating new options for itself or rather realizing existing options and canceling others. For instance, the decision on the application of the algorithm, as explained in an earlier section on the essence of strategic planning, entailed the loss of the options for market entry in markets where the forecasted competition was strong.
Many companies in diverse industries utilize different techniques of real options in their strategic planning in oil companies such as Mobil and Exxon, computer companies such as Apple, and industrial companies such as the aircraft manufacturer Airbus.
The importance of having options has a material effect on the value of companies in general, and of high tech companies in particular. One of the reasons for this is that decisions pertaining to investments of large amounts of capital may often be postponed until after different developments are completed or become clear. See Chapter 9 for a broader discussion of the importance of real options and their relationship to valuations.
Generally speaking, the value of an option is measured in accordance with the value of the underlying asset it is associated with, the degree of volatility of the asset during the term of the option, the current interest rate, and the investment required to exercise the option. There are various models for pricing options, but this book will discuss only the principles of such pricing.
Typically, price volatility in the target market has a positive effect on the value of options, since it raises the possibility that the value of the asset will rise during the period above the required investment. For instance, let us assume that a company has a one-year option to start manufacturing memory chips, and that the cost of production will be one dollar per unit, with a required investment of $2,000 to begin the production. Let us assume further that the company has no competitors in that market. Clearly, the decision to manufacture depends on whether potential users will be prepared to pay more than one dollar for the chip, and whether their number will justify the investment. Alternatively, if the chips are used by the company as part of a product, the company will examine if the cost of purchasing the chips from another source will cost more than to self-produce them. When will the company make the decision? If it starts manufacturing immediately, it will lose the value of waiting before starting to manufacture (for instance, until the market for the product grows bigger) that is incorporated in the option. On the other hand, it will start generating revenues from such production. These issues are analyzed by various option pricing models, some of which are discussed in Chapter 9.
Using Decision Trees for Strategic Decisions
Decision trees can dramatically facilitate the choice of the more favorable routes from among those available to the company. The decision-tree method provides a flow chart for the variety of alternatives available to the company and includes the company's projections in different scenarios. Hypothetically, every point of decision requires a separate evaluation and can be the subject of a separate assessment project. This would render the entire process impracticable, unless the number of decision points is not large, the assessment of the projects is not complicated, or accurate estimates are being used. Decision trees also enable various real options to be taken into consideration, as seen in an explanation of the real options method in Chapter 9.
For the sake of simplicity, let us assume that a startup, which had developed an innovative software tool, has raised capital and has two potential projects. The idea has already been developed, and the startup must now decide whether to penetrate the market with a large investment in production, marketing, and distribution, or to make a more moderate market-entry. In order to start producing at a high volume, the startup would need to invest $1 million, whereas a smaller capacity would require an investment of only $250,000.
The future situation of the market is unclear, and the startup estimates that the size of the market will be $150 million with a 30% probability, or $50 million with a 70% probability. If the company chooses the extensive investment, it will obtain a market share of 20% with a 50% probability, and a market share of 10% with a 50% probability. However, if the company chooses to penetrate the market cautiously, it will get a market share of 10% with a 50% probability, and a market share of 5% with a 50% probability. These two scenarios naturally reveal the correlation between the investment in entering the market and the results of such investment. Whereas no possibility is affected by the degree of penetration into the market, the different probabilities for the market shares are affected by the investment. For the sake of simplicity, we shall further assume that the company will reach its projected market share immediately and that the life span of the project is one year only.
The company forecasts that its gross profit margin will be approximately 60%. This high rate results from the fact that after the development stage, the company expects only installation costs to account for the majority of its expenses. Other than that, the company expects to incur other operating expenses of $500,000 if its entry into the market is aggressive and of $200,000 if it is modest. These differences reflect the intensive hiring of sales employees required to break into the market aggressively, which also involves higher accommodation expenses for its sales personnel.
After multiplying the projected revenues in every scenario by each of the forecasted market shares, each of the possible results is then multiplied by the gross profit margin in order to assess the gross profit in each of the four scenarios. Subsequently, the other operating costs are deducted, to calculate the forecasted operating profit at each level of investment and in each of the four possible pairs of the state of nature and the market share.
In order to choose one of the two paths, the startup must calculate its return from each of the two scenarios. The calculation is based on an examination of all possible scenarios, in accordance with the different options and the different levels of investment, and weighting the various results in accordance with the probability that they will materialize. With the larger investment scenario, the startup will have an NPV (Net Present Value), namely, the weighted average of all the different profit options according to the probabilities of their realization in excess of $5.7 million net of the investment. With the smaller investment scenario, the startup will have an NPV of approximately $3.15 million net of the investment. (See Table 3-3.)
It would appear that, in this case, the startup should clearly choose the larger investment, which is more profitable from its point of view. However, it should be noted that a startup will not always choose the route that is most profitable, both to itself and to the outside investors, if it implies an investment that would require extensive external financing for unfavorable prices that would substantially dilute the entrepreneurs' holdings (which is where conflicts between the best interests of the company and those of its entrepreneurs may come into play).
The guiding principle is that the results have to be calculated after every decision point and weighted according to the probability of their achievement. Since some of the decision points depend on situations that are independent of the company and some depend on decisions by management, calculations should always be made from the last decision node backward, i.e., the scenarios on each branch of the tree involving a managerial decision should be calculated first, while assuming that, given the information at that decision point, one of the branches will be chosen.
Decision trees are also helpful in examining possible reactions by competitors in the planned area of business. A correct strategic examination must be performed, one that will take into account all the main decision points and the possibility that the competition often makes the same calculations at more or less the same time. In these analyses, it is important to prepare decision trees also for the potential competitors in order to try to predict which alternatives they will choose. Clearly, the information which the company has with respect to its competitors is less accurate than the information it has about itself. However, valid conclusions may often be reached based on such partial information.
Such consideration of the competitors' reactions is vital, since without it a startup could choose investment alternatives that would appear illogical in hindsight because they did not account for potential competitors, who become quite real when the product is launched on the market. On the other hand, such analyses can explain why certain fields may appear to have no competition, although on the surface they seem profitable. In such cases, the reason could be the fear of potential contestants of the competition after the company invests in developing the market and clarifying its condition.
All of these analyses use various components of the mathematical branch called "Game Theory," but any detailed expansion of this issue lies beyond the scope of this book. The use of these tools is essential to understand the expected changes in the company's future target markets, from the points of view of both competition and the company's financial and strategic needs.