Macro- and micro- industry.
Just as serious entrepreneurs prefer to serve attractive markets, so they also prefer to compete in industries in which most participants are successful and profitable, rather than in industries where many firms struggle to survive. Serious entrepreneurs also prefer to compete on the basis of some sustainable advantage that their competitors do not enjoy. How might these crucial judgements be made?
Michael Porter, in the late 1970s, identified the forces that determine industry attractiveness.8 These forces – five of them – are powerful determinants of the overall profitability of any industry, not a bad thing for an aspiring entrepreneur to know:
- Threat of entry
- Buyer power
- Supplier power
- Threat of substitutes
- Competitive rivalry.
Assessing these forces and any ongoing or likely future changes therein lies at the heart of a macro-level assessment of industry attractiveness.
So, how should a five forces analysis be done? What should be its outcome? The aspiring entrepreneur first identifies what industry his or her new business will be in – retailing, food manufacturing, software, or whatever. Doing this is not a trivial exercise. Industries can be defined broadly or narrowly.
The entrepreneur then asks a series of questions (see Appendix 3 for an industry analysis checklist) about each of the five forces to determine whether that force is favourable or unfavourable on balance. The more forces that are favourable, the more attractive the industry, and vice versa. As it turns out, most industries are not very attractive. Would-be entrepreneurs should note that severe problems on just one force can be enough to tip the balance, so the weighing must be done in a thoughtful manner. Identifying such problems in advance enables the entrepreneur to craft plans to deal with them, or to abandon the opportunity altogether, if the problems are too severe.
Once all five forces have been assessed, the key outcome is to reach a clear conclusion about the attractiveness of one’s industry. This step is crucial to the overall assessment of your opportunity, and it is one issue that professional investors always examine. If necessary, admit that your industry just isn’t very attractive. Note, however, that all is not necessarily lost if the verdict is unfavourable. Other factors elsewhere in the seven domains analysis may compensate for these concerns.
As in the case for the macro-level assessment of market attractiveness, gathering secondary data is necessary here, but such data tell only part of the story. Additional, first-hand industry knowledge or primary data are usually required to develop a clear understanding of how the industry works and how it is changing.
One might imagine that a macro-level assessment of industry attractiveness would be sufficient, provided the micro-level market assessment has indicated that customers want to buy what the new entrant offers. For entrepreneurs who seek to build small but stable firms serving narrow market niches, this may sometimes be true. For more growth-oriented entrepreneurs, however, there’s another important piece of the puzzle: the micro-level.
Even if customers like what the prospective new entrant offers and most firms in its industry are successful due to favourable industry structure, a new venture is not likely to grow over the long term if the initial advantage it brings to its customers cannot be sustained in the face of subsequent competitors’ entry or if its business model lacks economic viability. Thus, identifying and assessing the sustainability of the proposed new firm’s competitive advantage is necessary to fill in the micro-level industry piece of the opportunity assessment puzzle.
How might these micro-level industry judgements be made? Assessing the sustainability of the proposed venture’s competitive advantage requires examining, in relationship to its competitors, the proposed venture itself – whether a new firm or a venture within an existing firm. The goal is to determine whether certain factors are present that would enhance the ability of the venture to sustain any advantage that it might have at the outset. These factors are:
- The presence of proprietary elements – patents, trade secrets and so on – that other firms are unable to duplicate or imitate.
- The likely presence of superior organizational processes, capabilities or resources that others would have difficulty duplicating or imitating.
- The presence of an economically viable business model – one that won’t quickly run out of cash! This factor, in turn, involves a careful look at some more detailed issues:
- revenue, in relation to the capital investment required and margins obtainable;
- customer acquisition and retention costs, and the time it will take to obtain customers;
- gross margins and their adequacy to cover the necessary cost structure to operate the business;
- operating cash cycle characteristics, i.e. how much cash must be tied up in working capital such as inventory, how quickly will customers pay, and how slowly may suppliers and employees be paid, in relation to the margins the business generates.
Information on the economic structure of most industries can be found from published sources such as the Risk Management Association’s Annual Statement Studies, available in most business libraries and on the Internet, e.g. the Risk Management Association’s website, www.rmahq.org.
Aspiring entrepreneurs who plan to compete based on price should note that building a business by giving away your products for less than they cost to acquire or produce is not a sustainable strategy in the long run, as numerous dot.com entrepreneurs learned in the turn-of-the-millennium dot.com bust. Another economic viability issue often overlooked by entrepreneurs is this:
Too often entrepreneurs fail to understand how long it will take (and thus how much capital) to actually close a sale, no matter how good the opportunity looks.
It’s worth noting here that first-hand experience in the industry makes all the difference in addressing these issues. Entrepreneurs who know the territory will have the necessary answers. Those who don’t must find people who do. Adequate answers for most of these issues are not likely to be found on the Internet. If the entrepreneur doesn’t have such experience, then they must obtain it from others. Picking up the phone and calling those who know can help, and it helps build your network, too, a topic we address further later on.
The point addressed by the micro-level assessment on both the market and industry sides is that even in generally attractive markets and industries – such as financial services and pharmaceuticals – not all new ventures succeed. Favourable industry conditions at the macro-level are not a panacea. Positive results from your investigations into these micro-level conditions are typically far more important.