Creating effective barriers to entry can be the single most important driver defining the profit potential of a company. In today’s B2B and B2C web markets, barrier to entry boils down to one thing: demand-side benefits of scale.
To be successful, every web start-up needs to be thinking about how it can build demand-side economies of scale. Here’s why.
The background: the web has leveled the playing field
The tech industry has always had relatively low barriers to entry – as rapid and perpetual innovation cycles “self-correct” entrenched market power. However, the web has leveled the playing field even more:
- Lower customer switching costs: With the cloud, customers can more easily switch software vendors without having to worry about a major hardware re-tool or complex IT implementation.
- Lower capital requirements: The cloud lowers the upfront R&D costs for a software start-up. Servers can be rented and product/market fit can be achieved faster than ever before.
- More equal access to distribution channels: The web gives software start-ups the ability to efficiently reach consumers and business customers through search, social, and mobile channels. Success is no longer based on the size of a vendor’s sales force, getting shelfspace in a large retailer or investing a large print ad campaign to build up a brand.
With the consumerization of IT, we’re living in a more product-centric world. Better products win out. Supply-side economies of scale (which in the software industry traditionally centered around marketing and sales resources) have become less important. That leaves the demand side…
Demand-side benefits of scale are the only important barrier to entry a web business can build up
Demand-side benefits of scale occur whenever customers are more likely to choose a company’s product as that company’s customer base gets bigger. This is often known as “network effects.”
Why does this happen? First, buyers trust established companies more than unproven upstarts (think of the old saying that no one would lose their job for buying from IBM). Second, in some industries, users want to be in a large network with other buyers and users. We see this in auctions, marketplaces, and social networks.
In the post “Traction is the new IP,” I argued that superior traction can help a web company become a category leader, which accelerates word of mouth. Network effects can lead to “winner takes it all,” where a company has the opportunity to lock in users.
While network effects on the frontend (i.e. the number of users) are well documented, benefits of scale can also happen on the backend. A good example here is pooled data where a software or service vendor will combine data sets from multiple sources into a large collection. A larger data pool can provide more value and better insights than just looking at a smaller data set from a single site and might therefore lock buyers into using the product as they would otherwise lose access to the data.
For example, Mailchimp’s Wavelength product allows users to find similar publishers and discover at a high level what other content their readership is engaged with. This feature enables Mailchimp users to better understand their audience; and the more publishers there are, the bigger the data set, and the greater the value to each publisher.
The key takeway
In order to be successful long-term, every start-up should think about how it can prevent others from a taking a hold in the market. Focus on demand-side benefits of scale (either on the frontend or backend), as that’s the only viable barrier to entry in today’s market.