Category Archives: Innovation Management

TAM, SAM, SOM and the Beachhead Market

Most investors agree that the two most important factors in a decision to invest are the market size and the quality of the team. This chapter focuses on market size.

The most common ways to think about market size, and the estimates most institutional investors expect to see are:

  • Total Available Market (TAM – pronounced as a word like “ham.”). Sometimes total addressable market The market value of the job to be done for all segments.
  • Serviceable Addressable Market (SAM as in a person named “Sam.”) – sometimes also segmented addressable market, serviceable available market. The size of the market you could reasonably serve with your solution and business model in the medium term.
  • Serviceable Obtainable Market (SOM, as in the nickname for a sommelier) – sometimes also share of market. essentially the market the company may credibly expect to obtain with available resources in the near term, say 24 or 36 months.

Some investors, advisors, and entrepreneurs (including me), prefer to define an additional category, the beachhead market. Getting a company up and running is really hard. Going after the biggest market segment is not necessarily the best strategy. Often the biggest market segment will demand aggressive pricing and thus significant cost efficiencies. Most start-ups won’t be equipped to tackle the biggest segments from the start. A beachhead market is one that provides the easiest access, allowing the fledgling business to get started, to develop a little traction, to build some scale, and to refine its products. The beachhead market is always a subset of the SAM. The desirable characteristics of a beachhead market are:

  • The needs of the beachhead market are not being served well by competitors.
    • You can access the customer using focused, efficient acquisition techniques as opposed to broad-based awareness campaigns.
  • Specific customers are readily accessible for engagement in refining a solution.
  • Your value proposition, even as a young company, is compelling.
    • For goods and services requiring physical operations and logistics, the beachhead market is often geographically close to the start-up location.

The boundaries of these definitions are somewhat arbitrary, and so my primary recommendation is to be extremely clear about your definitions and careful with your assumptions. One of the biggest sources of delusion in entrepreneurs’ pitch decks is wildly unrealistic estimates of market sizes.

Top Down Estimates

There are two ways to think about market definition and sizing, top-down and bottom-up. With the top down approach, start with all economic activity on earth – that’s the maximum size of the market for “do everything.” Then, successively narrow the definition of the market until you get to the “market for the job that we aspire to do in society.” That’s your total available market (TAM). Then, further narrow to markets for which you can offer a value proposition in the medium term with your solution – the serviceable addressable market (SAM). Then, further narrow to the first market segment you will focus on and for which you offer a value proposition — the beachhead market. Each narrowing is a defined subset of a larger market.

For example, let’s revisit MakerStock (originally described in the handbook as “University Panel Supply”).

The GDP of the entire planet (c2023) is approximately USD 100 T.

The subset of that GDP representing the market for plastic, wood, and metals used in making things, and excluding construction, is approximately USD 6 T.

The subset of that market for plastic, wood, and metal panels (e.g., large sheets of material) used in making things is approximately USD 700 B.

The subset of that market comprised of specialty plywood (which excludes softwood plywood used in construction), medium-density fiberboard, and acrylic sheet is USD 44 B.

The US portion of that market is USD 5 B. (Now we are focusing geographically.)

The US market for these materials in which the customer’s ideal format is a less-than-full-sheet custom size with delivery by conventional ground freight is USD 500 mm. This is the subset of the market for which a cut-to-size supplier of materials would offer a value proposition. This particular focusing step is where you might sense we are pretty much guessing. There is no place to look up market sizes for the “cut to size” panel market, and we are left to doing some back-of-the-envelope calculations. For this reason, top-down estimates become a bit shaky as additional focusing assumptions are made. Still, USD 500 mm is a reasonable estimate of the TAM for MakerStock — the market is certainly smaller than USD 1 B and it’s more than USD 100 mm. The definition of your TAM is somewhat arbitrary. For instance, this estimate of TAM is for the US only, but might we reasonably consider serving customers in Europe, for example? Given that many different assumptions are possible, just be very clear about the focusing decisions that underly your estimate of TAM.

MakerStock’s TAM includes cabinet makers and raw materials for factories producing finished goods in relatively large quantities. MakerStock is unlikely to be competitive for these segments in the medium term. The company is likely to offer a stronger value proposition to customers that prefer custom sizes and that order a variety of different materials, both wood and plastic, for use in their fabrication processes, largely laser cutting. The US market for such materials for university maker labs, do-it-yourself individual makers, and small- and medium-sized businesses such as sign making shops is approximately USD 100 mm. This is a reasonable estimate of the SAM for MakerStock.

Now, how will MakerStock get started? Where will it focus initially? MakerStock will focus on university maker labs. It will focus on those labs that can be served by FedEx ground freight within three days of Scranton, Pennsylvania. The beachhead market is for pre-cut specialty plywood, medium-density fiberboard, and acrylic sheet for university maker labs located within the three-day ground shipping territory from Scranton, Pennsylvania. Top-down estimates are going to be very approximate for the beachhead market. To do a top-down estimate, we might gather some estimates (guesses?) of a few knowledgable people and average them and assume that 10 percent of the SAM is the beachhead market, delivering a market size of USD 10 mm. Bottom-up estimates are much better for tackling this estimate, the approach I will explain below.

With each successive focus on a subset of a larger market, we are making a decision about which narrower market will be more readily addressable by the new venture. Each narrowing reflects a belief which may or not be correct. For instance, commercial sign makers may be a better beachhead market than university maker labs. So, as with any problem solving activity, considering alternatives and testing beliefs will likely result in better outcomes.

For the top-down approach, conventional internet search and current AI tools are probably the best source of raw data. By using a variety of queries and triangulating on the result, you are likely to be able to make estimates that are well within one order of magnitude of the actual value.

TAM and SAM depend on the definition of your core business

Estimating TAM and SAM requires that you assume some boundaries for your core business. For instance, if I conceive of my panel supply business as providing panels of any type to any user of panels globally, my TAM is USD 700 B. But I really have to stretch my imagination to believe I can address the need for particle board panels purchased by the Chinese factories that make the best-selling IKEA Billy bookcase. Those factories are likely purchasing many full truckloads of those panels per week directly from the mill that makes them. The definition of available and addressable determines your TAM and SAM. I like to think of addressable customers as those customers who have a job to be done for which the core business could reasonably be competitive in delivering a solution. For MakerStock, that core business is sourcing sheet goods by the full truckload, breaking the bulk delivery into sheets, cutting sheets to custom sizes, and delivering pieces by conventional ground freight. The job to be done is to deliver an assortment of the right materials, at the right time, in the right sizes, all with minimal fuss. The serviceable addressable market is the size of the market for which that value proposition makes sense, a market not of USD 700 billion but rather about USD 100 million.

Bottom-Up “Counting Noses” Approach

The top-down approach is a useful way to put the business into a larger context, and to reveal possible additional market segments, and their sizes. However, the bottom up approach is usually more credible and less speculative. WIth the bottom-up approach, you start with a hypothesis about the beachhead market — the very first market you will tackle. You estimate the size of that market by creating an inventory of every potential customer in that market. This approach is called counting noses.

For example, the beachhead market for MakerStock is university maker labs located within the geographic region served by three-day ground shipping from Scranton, Pennsylvania, the initial location of the business. The business was located there because I as founder already had a facility and an available team member in that location, and because that location is a logistics hub, serving about one third of the US population within two days by conventional ground shipping. The geographic cut off reflects a belief that freight costs would be decisive in the value proposition to our customers.

Once that beachhead market is defined, counting noses is easy. First, there are about 5300 colleges and universities in the United States. Now, look up the ground delivery time map that FedEx provides. Identify those universities within the three-day shipping territory. That subset is about 2500 institutions. This set of 2500 potential customers can be identified and cataloged precisely and entered into a database. For each potential customer, say PennWest Edinboro University, an internet search can reveal whether or not it has a maker lab, and possibly unearth a name and contact information for the lab manager. In fact, an internet search for the PennWest Edinboro furniture design program yields a great description of the program, including photographs displaying specific details about the equipment and furniture in the shop. That search even produces a name of the program director, Karen Ernst, along with her contact information. We can now count Professor Ernst’s nose in our beachhead market. Doing a comprehensive search for all 2500 potential customers is probably not a good use of time until the business is actually launched, but doing that search for a sample of potential customers, say a hundred, produces an accurate estimate of how many labs would eventually be found in all 2500 universities. For this example, a preliminary search suggests that about 64 percent of these universities have at least one maker lab, a potential customer base of 1600 labs.

At this point, some assumptions are required about the average level of spending on speciality plywood, medium-density fiberboard, and acrylic by each lab. That estimate can be based on interviews with a sample of customers. By talking to about five potential customers, we found that the average spending seemed to be roughly proportional to the size of the university, with a university spending an average of about USD 4 on these materials per year per student enrolled. The labs serve an average of 1250 students each, so their average spending on materials is about USD 5000 per year. These figures lead to an estimate for the total size of the beachhead market of USD 8 million per year (i.e., 1600 labs at USD 5000 per year). This a pretty solid number. The real value might be USD 10 million or USD 6 million, but it’s not USD 50 million or USD 1 million.

Consider Adjacencies for a Bottom-Up Estimate of SAM

Once you have identified and characterized a promising beachhead market, now consider the immediately adjacent markets. The adjacencies might be geographic. So, after considering colleges and universities in the northeast, consider those in the mid-Atlantic region, or the mid-west. The adjacencies might be in the goods and services offered, for instance extension of the product line from wood and plastic to metals. The adjacencies might be in the types of target customers, for instance from colleges and universities to secondary schools, or to small and medium-sized businesses using laser cutters. These adjacencies taken together comprise your SAM, as estimated using the bottom-up approach. As a matter of good planning hygiene, consider how your bottom-up estimate of adjacent markets compares with your top-down estimate of your SAM. These two ways of getting to SAM should not deliver wildly different results.

Estimating SOM

Recall that SOM is the market you plan to actually serve within your planning horizon, usually 24 or 36 months. For my taste I prefer estimating SOM with a bottom-up, counting noses approach of the beachhead market integrated with some estimates of the rate of customer acquisition of the go-to-market system.

Recall that we estimated that there are 1600 potential customers in this beachhead market. I believe we can acquire an average of two new repeat customer per week with the likely sales and marketing resources we will have, net of churn. (See the chapter on go-to-market systems for how to think about this.) Thus, within three years, we will have approximately 300 university maker labs as repeat customers. We estimated earlier that each lab orders approximately USD 5000 in materials per year. Thus the recurring revenue for the customer base at year three will be approximately USD 1,500,000 per year, at which point we will have about 19 percent market share of the beachhead market of USD 8 million. Of course, even though we will focus on the beachhead market, we will unavoidably reel in some customers from adjacent markets, and likely will also sell to some do-it- yourselfers via the MakerStock website. It’s even possible that an adjacent market will prove to be a better fit for the company than the beachhead market we had originally envisioned. Still, the bottom-up nose counting along with some realistic modeling of the go-to-market system is a grounded approach to forecasting the scale of the business.

Fables Versus Realism

None of you readers are too excited about recurring annual revenue from the beachhead market of USD 1,500,000 after three years. Investors likely would not be too excited either. Yet, that’s actually an above-average outcome for a start-up in year three. I have invested in over 50 start-ups. About five of those have achieved recurring annual revenue of USD 1,500,000 by the end of year three.

Every founder faces many dilemmas. One of the most pressing is whether to spin a compelling fable in the pitch deck, which probably represents a 95th percentile outcome, or to provide a realistic forecast of what you believe to be a highly obtainable outcome. I believe the level of conservatism in the forecast depends on the audience. If you are planning to be a closely held, likely bootstrapped, company, then you should strive for hard, cold realism, even pessimism. That was my approach with MakerStock. I funded the business with my own money. I wanted to have a realistic sense of how the business would unfold and how much cash I would need to burn to get to positive cash flow. MakerStock actually did substantially better than the forecast, largely because do-it-yourselfer and small- and medium-sized business customers turned out to be fairly easy to acquire and serve alongside universities. That was a pleasant surprise easily accommodated as the business developed.

If, however, your audience is institutional investors, then they are highly conditioned to see forecasts at about the 95th percentile. My advice is to be excruciatingly clear about your assumptions and logic in estimating TAM and SAM. Those need to be highly credible. Then, the estimate of SOM should likely skew a bit optimistic, assuming that you have all the resources you need, including that investor’s capital, and that things go well. Your SOM is going to be discounted by institutional investors seeing your pitch, so you should account for that fact in your presentation. (Yes, I realize this is a pernicious cycle of optimistic forecasting and assuming discounting by the investor. I don’t see a clear way around it.)

Market Size Graphics

The most common way market sizes are shown in pitch decks is with nested circles, sometimes called an onion diagram, in which the area of the circle is proportional to the market size. Data graphic purists may prefer bar charts of some kind, but I think the nested circles work pretty well and you probably want to avoid bucking convention here. You can, of course, annotate this graphic heavily to support the numbers.

Notes

VC Factory Article on TAM, SAM, and SOM. Decent article from a venture capitalist’s perspective.https://thevcfactory.com/tam-sam-som/

Customer Persona and the Job to be Done

I enjoy cooking. I’m not one for recipes, and I especially like making savory stews and soups from seasonal vegetables, and with interesting spices, especially cumin. I usually make a big pot and after enjoying a nice dinner, I’ll stow away a few leftovers in serving-size containers in my freezer. Few moments give me greater happiness than when I remember I have something yummy in my freezer ready to heat up for lunch. 

A while back I had an idea. Why don’t I create a service, which I’ll call 99 Bowls, which periodically sends me a carton of 12 containers of interesting soup? That way I always have something yummy to eat when I’m on my own at home for a meal.

I’m a serial entrepreneur, and this is how a new venture often starts for me. I’ve got some itch myself and I conceive of a company to scratch that itch. Let’s call this the raw opportunity.

A jobs analysis is a good first step in exploring an opportunity. It results in a clear and deliberate articulation of the job to be done for a focal customer (Christensen et al. 2016).

Let’s first talk about that focal customer. Before you even consider how to solve a problem, you really need to think about “for whom”? Returning to the 99 Bowls example, the product I would create for delivering pre-made meals to a school cafeteria would be dramatically different from the one I would create for a professional office worker or for a graduate student.

Two concepts are useful in identifying the focal customer. First, for zero-to-one products, you should identify the beachhead market. By this I mean the very first group of customers you will target. The best beachhead markets are those with the biggest need, the most acute pain point, and those that you can most easily reach. These markets are usually not the biggest markets. (See this chapter on defining markets for more.) The biggest markets usually have to wait until you have some experience and have started to spin up the flywheel of greater cost efficiency in your business. For 99 Bowls, a beachhead market could be relatively affluent professionals working from home at least two days per week.

The second useful concept is the persona. A persona is a description of a hypothetical customer that is highly representative of your target market. This is useful in making the challenge real to your team and to other stakeholders. A persona is usually constructed with specific attributes like age, gender, professional role, and even personality characteristics. 

Let me tell you about the persona for 99 Bowls. Her name is Grace. She works as a product manager at Facebook. She’s 32 years old and lives alone with her cat Milo. She’s super fitness-conscious religiously going to a yoga class near her house in San Francisco every day. She works at home most days, although occasionally takes the Facebook shuttle to the main office about an hour away in Menlo Park. Grace is Korean-American and finds most prepared food too bland. She’s a foodie and likes a lot of heat and flavor. Makes it real, doesn’t it?

Persona Grace via Midjourney

Your target segment will probably change, and after launching your solution you will almost certainly discover that there are other customer segments that your solution can address. You’ll also inevitably want to expand into adjacent segments. But, you have to start somewhere and specificity helps guide the creation of a solution.

I do a weekly podcast with entrepreneurs and my informal tally of past guests suggests that for about half of them the genesis of their business was a need that they themselves experienced. This raises the question of whether or not it is good practice to use yourself as a target customer.

Here are a few thoughts. First, you will find yourself in many professional situations in which you are not the target customer. If you are creating heavy equipment for the mining industry, you probably are not also a mine owner or equipment operator.

Second, when you are representative of your target market, I believe you are highly likely to create a product that satisfies at least one customer. You. That’s actually no easy feat. It’s a real luxury in entrepreneurship to have an immediate intuition about whether a solution is near the mark or not.

Still, designing for yourself does not guarantee a big market. You represent one data point and in most cases you aspire to serve thousands or even millions of customers. Disciplined and experienced entrepreneurs are able to leverage their own deep intuition about the job to be done while understanding that they need to be able to assume the perspective of the broader market for long-term product success.

Jobs Analysis and the Abstraction Ladder

In one of the most highly cited articles ever in Harvard Business Review, Theodore Levitt wrote “customers don’t want a ¼ inch drill, they want a ¼ inch hole.” Levitt’s insight was that when customers consider your product, they have a job to be done. They don’t typically want your product per se, they want the results of a job it can do for them.

But think about this example a bit more. I don’t know many customers who really want a ¼ inch hole either. They want to fasten a bookshelf to the wall. And do they really want to fasten a bookshelf to the wall, or do they want to store their books?

Every gap, as you first sense it, exists within an interconnected network of alternative problem statements, some more abstract and some more specific.

Here’s a technique called the abstraction ladder for elaborating the alternative ways you could state the design problem. You use the abstraction ladder for divergent thinking, to consider alternative ways you could frame the job to be done.

First, state the problem at the top of mind using the phrase “How might we…” For example, recall the 99 Bowls opportunity, which I could state as “How might we periodically deliver containers of prepared soup to work-from-home professionals?”

As an aside, we use the phrase “How might we…” really just to put ourselves in a divergent frame of mind, considering many possibilities, some of which may not even be feasible.

Now, ask yourself what desirable outcome would be achieved if you solved the problem as stated. Or, in other words, why is that problem worth solving? 

For example, we hope to deliver prepared soup so our customer always has something readily available to eat for lunch. Now, use that desirable outcome as the foundation of a second, more abstract, problem statement — “How might we provide a work-from-home professional with something to eat for lunch that is always readily available?”

You see what we’ve just done? We’ve moved up a rung on the abstraction ladder to state our problem a bit more generally. Now why is this a good thing?

Put simply, abstraction opens up additional solution concepts. For example, we’ve now opened up the possibility of a pre-scheduled daily lunch box drop-off, or of a meal kit that allows quick preparation of a fresh meal, or of a club in which a group of five people take turns making lunch for each other once a week. By broadening the definition of the problem, we have opened up the possibility of many more alternative solutions.

But why stop there? What is the benefit of providing readily available lunch? Well, perhaps a key motive is to increase available work time during the day? So, we could rephrase the job to be done as “How might we increase available work time during the day?” That would open up even more solution directions, maybe a virtual personal assistant to help with mundane tasks, professional or otherwise.

Of course, even this statement can be broadened. How might we be more productive? How might we better provide for ourselves and our families? As we ask why we would want to do a job, we broaden the problem definition until eventually we end up with jobs to be done like how might we improve well being in society?

Note that these increasingly general statements are not always strictly arranged on rungs of a linear abstraction ladder.  There are typically many motives for any particular job to be done. Maybe a more significant motive for our target customer is to be able to control diet, or to introduce meal variety, or to enjoy more delicious food. Any given statement of the job to be done is located in a network of alternative problem statements, some more general, and some more specific.

<sketch of post-it network>

When is the job to be done too abstract?

Stating the job to be done more abstractly, and thereby opening up additional solution concepts seems like a great thing. But, at what point is the job to be done too broad, too abstract? If you state the job to be done as “How might we improve well being in society?” then a solution might be to provide free neck massages in waiting lines at the airport. Somehow that solution would not motivate me to quit my job and start a company. You, specifically, as an entrepreneur have a vision.

When you set out to create or improve something, it’s motivated by a gap you have sensed. You own that gap. If you embark on a process to create something that improves the well being of individuals in society, and it does so, but it does not achieve your goals, then you have defined the job to be done too broadly.

OK, let’s wrap these ideas into a step-by-step jobs analysis:

  1. State the problem top of mind using “How might we…” For example, how might we periodically deliver a supply of prepared soup to work-from-home professionals?
  2. Now, ask yourself what desirable outcome would be achieved if you solved that problem, and use that desirable outcome as the foundation of a second, more abstract, problem statement — “How might a work-from-home professional always have something available to eat for lunch?”
  3. Now, repeat step 2… For example, “how might we increase the available work hours for work-from-home professionals?” Repeat again and again until the problem statement is something like “How might we increase well-being among members of the community?” the most abstract possible motive for solving the problem. In this step, you might use self-stick notes placed on a wall with each note capturing a different job to be done. Place the notes in a hierarchy or network with more abstract statements higher on the wall.
  4. After all that divergent thinking, it’s time to converge. Deliberately choose the most abstract statement of the problem that if addressed would still satisfy your personal vision and goals as an entrepreneur. That statement is the job to be done.

I’ve described this process as a single effort that is one and done. In reality as you proceed in developing the opportunity you may find that you benefit from further broadening or focusing of the job to be done to better align with your mandate and vision as you better understand it.

Notes

Christensen, Clayton M., Taddy Hall, Karen Dillon, and David S. Duncan. “Know your customers’ jobs to be done.” Harvard business review 94, no. 9 (2016): 54-62.

Levitt, Theodore. “Marketing myopia.” Harvard business review. 82, no. 7/8 (2004): 138-149.

Alpha Assets and the Five Flywheels

Karl T. Ulrich | Original Version June 15, 2018 | This Version November 1, 2022

This is a concise note describing the alpha asset framework, and intended for students and busy professionals. It may be reproduced and used for non-commercial purposes with citation. I am writing a book Alpha Assets: Building and Sustaining Competitive Advantage, but it’s not yet finished. Here also is a PDF version.


Here are all the restaurant companies that are publicly traded in the United States. You’ll recognize many of these names, and in case you don’t know, Yum is the parent company of KFC and TacoBell among others.

As a group, they earned an average cash flow return on investment over the ten year period of 2006-2015 of about 6 percent per year. This measure of financial performance is the return on invested capital above and beyond each company’s weighted average cost of capital. This measure is sometimes called economic value added, or EVA.

But, why did those at the top earn so much more than those on the bottom? To some extent this is the most important question in business. For a given job to be done, how and why can an organization sustain competitive advantage and therefore earn an exceptional return on invested capital?

Of course something idiosyncratic can destroy a company or propel its fortunes. Yum brands made a huge bet on Asian markets and that bet paid off. The great recession in the United States hurt some sit-down restaurants over the first five years of this period.

But fundamentally the only way one company can earn more than another over the long term is to experience some combination of greater demand, which is reflected in higher revenue, OR greater efficiency, which shows up as lower cost. Higher demand or lower cost. That’s it. But, how can one company enjoy greater demand than another, or lower costs? To do so, it must possess some resource or asset that enhances performance but that can not easily be acquired by its competitors. Yum has to have something special that PotBelly can not easily get.

Two such assets, fairly self-evident from the list of companies are strong brands – say Starbucks – and huge scale – say McDonalds. I call these special types of resources a company’s alpha assets, a concept that is based on a key idea from the academic field of competitive strategy called the resource-based view of the firm.

I define alpha assets as resources owned or controlled by an organization that (a) enhance performance and that (b) are hard for others to acquire. Let’s take those two conditions in turn.

The presence of a performance-enhancing asset can uniquely cause significant improvements in profits relative to not having the asset, for most competitors. For example, electricity is a performance-enhancing asset for a restaurant company. Without electricity, your restaurant would likely be nothing more than a food cart on a street corner.

But can access to electricity be a source of competitive advantage? Probably not for a restaurant. Performance enhancement is a necessary condition for an asset to confer advantage, but it is not sufficient. 

For restaurants, access to electricity can not be an alpha asset because that asset is not hard to acquire. All competitors can acquire electricity and so there will not be meaningful differences in its possession. (Although in some industries, say for computing infrastructure, perfect reliability of power is actually not that easy to acquire.) 

An asset is hard to acquire when doing so requires a large amount of time, effort, or money, or is not possible at all. 

For example, McDonald’s scale is essentially impossible for In-and-Out Burger to acquire in any reasonable amount of time or with any reasonable investment. And because scale is also performance enhancing, it is definitely an alpha asset.

Some assets can be hard to acquire, but not be performance enhancing. For instance, Starbucks is headquartered in Seattle. It would be expensive and take a long time for Luckin Coffee, a Chinese competitor to Starbucks, to move to Seattle. But, doing so would not significantly enhance performance, so the Seattle location is not an alpha asset for Starbucks.

I don’t have a precise technical definition for how much time and money comprises “hard to acquire” but you can think about required investments of say greater than 10 percent of revenue and/or time periods of five years or longer.

Let’s look at another example from another industry. Consider Amazon.

We’ve already discussed electricity and a Seattle headquarters – neither of these can be alpha assets for a restaurant or for Amazon. However, the Amazon brand confers advantage and can not be acquired by others. It’s an alpha asset. Amazon’s huge assortment of retailers on its platform confers advantage and is not easily acquired. It’s an alpha asset. Amazon’s vast trove of customer data is an alpha asset. Amazon’s massive scale is an alpha asset. And, although Amazon is embarking on a leadership transition, the founder, Jeff Bezos, has unambiguously been an alpha asset.

Some of you may criticize this framework for being unreasonably static. You are right. Almost no asset can remain alpha forever. That Chinese company, Luckin Coffee, pioneered the use of a mobile-first, all digital transaction system. In fact, I remember once trying to buy coffee in a shop in Shanghai and not having the app. The barista eventually abandoned the effort to set me up with the app and just gave me the coffee for free. Despite the barriers it imposed for foreign visitors, Luckin’s mobile-first strategy and implementation was an alpha asset for years. But, today, most coffee shops are fully app-enabled.

Where do alpha assets come from? In some cases, they come from an inventive spark or the conditions of the founding of the company. In other cases they are the result of good fortune. For example, if I can invoke an analogy, one of the alpha assets of Michael Phelps, the world champion swimmer, is his body dimensions, including his feet, which are US size 14 (or European size 48). Phelps didn’t do anything to acquire that alpha asset – it was endowed on him at birth. Similarly some alpha assets for companies are essentially random endowments, like when DuPont accidentally discovered the molecule polytetrafluoroethylene, which became its proprietary product Teflon.

But, more interesting are alpha assets that can be developed over time and as a result of deliberate action and managerial attention, such as cost efficiency or product performance. Fortunately these are the most important alpha assets in most organizational settings. These alpha assets are often the result of accumulation of strength via five mechanisms that I (and others) call flywheels. They represent tremendous sources of strength and resilience for organizations that can create them.

The Five Flywheels

In 2015, taking inspiration from Warren Buffet, I bought stock in Wells Fargo, one of the “big four” US banks. Oops. I’m now strictly an index investor, having learned my lesson watching the company’s stock decline over the next five years. Scandal after scandal plagued the bank. It seemed that every quarter some new crisis would arise. Yet, Wells Fargo has operated continuously since 1852. It seems pretty nearly impossible to kill this organization. In fact, it’s recovered again from its recent setbacks and its stock price is back up. (This of course after I sold my position. Go figure.) While few companies last as long as Wells Fargo, incumbent companies are remarkably resilient. If a company survives infancy, its prospects for living a few decades are very high, either as an independent company or as an operating unit within an acquiring company.

Why are incumbents so powerful, and how can a start-up chart a path to such strength?

I call the sources of incumbent power flywheels. In a physical system, a flywheel receives power and stores it as kinetic energy, which can then be tapped when and if necessary to overcome episodic demands.

An organization can also be thought of as a system, a machine for doing a job. It also has ways of accumulating energy.

There are four flywheels that are almost always present to a greater or lesser extent in every company.

  1. Customer Network
  2. Cost Efficiency
  3. Product Performance
  4. Brand Equity

I’m going to add a fifth flywheel I call Organizational Capability and Culture. This fifth flywheel will reflect a focus of an organization on doing a few things well or on a distinctive culture.

Let me illustrate the first four flywheels with a graphic.

All businesses deliver a solution to a customer, and this essence of a business is what powers the flywheels. In order for the company to acquire customers it must offer a compelling value proposition and deliver on that value proposition through its customer experience. When and if the value proposition increases, the company’s rate of customer growth will also increase, and of course if the value proposition decreases, so will the rate of customer growth. Implicit is the reality that the net rate of customer growth depends both on acquiring new customers and on retaining existing customers, or minimizing so-called churn.

Delivering solutions with value is the engine powering the flywheels. Now, the flywheels themselves.

1 – Customer Network

The first flywheel is the customer network. This flywheel is important for products that enjoy network effects. Growth in new customers increases the number of customers in the customer base. For products with network effects, as the customer base increases, the value proposition of the product increases. This further increases the rate of customer growth. Not all products exhibit network effects. I enjoy drinking Peet’s coffee. The value proposition of Peet’s Coffee to me does not depend at all on how many other customers enjoy the same coffee. However, I also like the mobile payment app Venmo. It was useful to me when just my college-age children were users. But, Venmo became even more valuable when the guy who removes snow from my driveway became a user. Venmo is a product with huge network effects and really benefits from the first flywheel. (See James Currier’s article for a very thorough taxonomy of types of network effects.)

2 – Cost Efficiency

The second flywheel is cost efficiency. Cost efficiency improves with deliberate effort and the application of good process, but the biggest explanatory factors in lowering costs are cumulative units delivered and the current rate of production. Any organization that does something repeatedly can enjoy lowered costs because of the learning that occurs over time. This is called the learning curve. For example, just consider what happens as you take on any new task, say making a cup of coffee. The first time, it takes you 10 minutes as you figure out how to measure out the beans, heat the water, filter the brew, and clean up the mess. Now imagine you make 100 cups every morning working at a coffee bar. I’m pretty sure by the time you’ve made 1000 cups, you’ve figured out how to make each cup in less than a minute. That same kind of learning occurs in all organizations as the cumulative number of units produced increases. A second type of cost efficiency comes from scale economies. This is not the result so much of the cumulative number of units produced, but rather from the rate at which you produce them. If you are making 100 cups of coffee each hour you will adopt very different methods than if you are making 1 cup each hour. For example, you’ll invest in a big coffee grinder and massive drip brewing system. Those investments reap huge productivity improvements, but are only possible as the rate of production increases. Put this all together and you see the second flywheel at work – the unrelenting improvement in efficiency that comes both from accumulating experience and from investing in better processes enabled by increased scale.

3 – Product Performance

The third flywheel is product performance. Only the most tone deaf organization fails to improve its products with experience. A company observes where the customer complaints are and seeks ways to enhance its performance relative to rival products. These opportunities become a queue of product improvement projects and over time the product just keeps getting better. 

In some settings, that product improvement flywheel leads to nearly insurmountable product performance advantages. For instance, the product of semiconductor company TSMC is a fabrication service it offers to chip designers like NVIDIA and Apple. Its primary alpha asset is the accumulated know-how and trade secrets embedded within its semiconductor fabrication process. For TSMC, product improvement is a flywheel propelled by powerful positive feedback – as its processes become more capable, its value proposition increases, and it wins the most demanding production challenges, further increasing its scale and learning, and making it even more likely to garner future orders. Some people believe that what TSMC does is the hardest single task in the world. No one else comes close to being able to do it. That product performance advantage is likely to persist for decades.

A proprietary product can in relatively rare settings be an alpha asset because of a legal monopoly obtained through patent protection or trade secrets. Patents as alpha assets exist primarily in the pharmaceutical industry in which a patented product is identical with a specific molecule for which regulatory agencies have granted approval for use. In such cases, the product performance advantage arises not from a flywheel of continual product improvement, but from a regulatory barrier. In most other settings, patents serve more as a deterrent to blatant copying, or as a tool for intimidating much smaller competitors with the threat of expensive legal action.

4 – Brand Equity

The fourth flywheel is brand equity. Especially for engineers, the notion of brand is pretty strange. Why is it that a label on a product can enhance the value proposition of a product? The short answer is that brand serves as a proxy for attributes of product quality that the consumer can not directly observe, brand reduces the time and effort required for a consumer to find and select products, and brand directly confers desirable brand associations to the consumer as a kind of badge. While these benefits are all intangible, brand is a shockingly powerful and therefore valuable alpha asset. Brand is a flywheel because the value of a brand, its brand equity, accumulates over time, and typically increases with market share, time in the market, and with improved product performance.

5 – Organizational Capability and Culture

Remember I said the fifth flywheel was the focus on a few organizational capabilities or elements of culture. Let me give you an example. When I was the Vice Dean of Entrepreneurship at Wharton, I led an organization of about 30 people. Early on, I placed a heavy emphasis on building an organization with a highly diverse workforce. I felt this was important in order to foster creativity and innovation and to best serve our student and alumni stakeholders, who were themselves a highly diverse population. A group of 30 middle-aged men who grew up in rural America like me was not my goal. As we worked to attract and retain staff who did not look or think like me, the diversity of our team increased. This diversity in turn made it much easier to attract and retain additional team members who didn’t fit the mold. After three or four years, the composition of our workforce became a source of high performance for us, and we became one of the most sought after places to work within the university, further enhancing our ability to attract and retain a talented and diverse team.

The fifth flywheel might comprise a culture of innovation, a culture of customer service, a passion for environmental sustainability, a focus on reliability, or almost any other distinctive element of organizational capability or culture. Such elements are very hard to acquire or build, and to the extent that they enhance performance, they can be alpha assets.

The Role of New Products in Kick Starting the Flywheels

Even Wells Fargo was once a start-up with flywheels at a standstill. How does a new enterprise get the flywheels going in the first place, and when does that company stand a chance against incumbents?

An idiosyncratic endowment of any single resource could in theory kickstart a flywheel, and therefore a company with advantage. For instance, when the musician John Legend co-founded LVE Collection Wines, he himself was the alpha asset for the company and immediately spun up a brand flywheel. However, this strategy is not available to the rest of us. More typically, a better mousetrap –  a new product resulting from the invention of a new technology or the recognition of an emergent market need – is the alpha asset for a new company.

Peter Thiel famously wrote in his book Zero to One “as a good rule of thumb, proprietary technology must be at least 10 times better than its closest substitute in some important dimension to lead to a real monopolistic advantage.” The 10x rule is mostly rhetorical, but I do agree that when there is some disequilibrium in technology or in the market, then an organization has an opportunity to move with speed and agility to take advantage of that disequilibrium and to create a product that is dramatically better than the pre-existing alternatives. At the dawn of the covid pandemic of 2020, the videoconferencing company Zoom offered a product that just worked. It didn’t require registration. It didn’t require a download. It didn’t require any special gear. It just worked. Despite the fact that there were dozens of other solutions in the market at the time, including BlueJeans, Skype for Business, Google Hangouts, and WebEx, Zoom was able to seize the market and gain significant share. This was almost entirely because Zoom had a better product, at least on the important dimension of ease of use and reliability. 

Better product is often an alpha asset for a relatively brief period following some type of disequilibrium. But, the organization must use this precious window of product superiority wisely in order to oversee the acceleration of the other flywheels for sustained advantage. Indeed, Zoom took advantage of its initial product performance and prospered. But, predictably Microsoft eventually followed with an improved enterprise product, Teams, that was at parity on many features and superior in others. Google was jolted awake and improved its product Meet as well. Zoom remains a key player, but its brand and customer network, perhaps even more than its product per se, have become its alpha assets.

In very dynamic markets – those for which some combination of enabling technologies, competitive actions, or customer behavior are changing very quickly – the organizational capability of product management can itself be an alpha asset. For example, consider the fitness app Strava. Strava does weekly product releases, which include incremental improvements and, less frequently, substantial product changes. Any particular version of the Strava app could likely be easily replicated by a team of developers and so the product per se is not much of an alpha asset. However, the system that Strava employs to engage its users, understand opportunities for improvement, and prioritize the changes in its product roadmap, benefits from experience with millions of users and a refined organizational process of product management. This organizational capability is an example of a fifth flywheel and a compelling alpha asset.

I need to be clear that not all things that are important are alpha assets. For example, an excellent sales process is very important for enterprise software companies. That doesn’t imply that a sales process could necessarily be a significant source of sustained competitive advantage. It’s more that if you fail to do sales well, you are unlikely to be successful in enterprise software. We could say the same thing about operational competence for a restaurant, or accurate and timely finance and accounting processes in a bank. None of these things are likely to be sources of sustained advantage, yet they all need to be done competently to ensure success. In the same way, good products and effective product management are critically important for all companies, even if not alpha assets for all companies.

Notes

  1. My central concept of alpha assets is essentially a reframing of the dominant intellectual paradigm in the academic field of competitive strategy, the resource-based view of the firm, first articulated comprehensively by Professor Jay Barney. Jay is an affable and enthusiastic man, now a professor at the University of Utah. We worked together on an interesting consulting project in healthcare, and have occasionally kicked around ideas on entrepreneurship, innovation, and teaching. The resource-based view (or RBV in the alphabet soup of obfuscating acronyms so often found in specialized fields) attempts to explain competitive advantage, and I think it does a pretty good job of doing so. But, it is far from clear. For instance, RBV argues that VRIN resources are the sources of competitive advantage. (Got it?) VRIN refers to valuable, rare, inimitable, and non-substitutable. (Got it now?) I made a good faith effort to use the VRIN framework in my book Innovation Tournaments (with Wharton colleague Christian Terwiesch), but it’s just too wonky for a non-academic audience. The resource-based view of the firm is both one of the most powerful ideas and one of the most poorly marketed ideas in social science. A makeover and rebranding is needed. As a first step, let’s just relabel VRIN assets as alpha assets, evoking some of the oldest tricks in branding, the use of alliteration, alphabetical primacy, the soft flowing sounds of a greek word, and the positive associations with the word alpha. Next, let’s simplify and make more intuitive the definition of VRIN. Alpha assets are (a) performance enhancing and (b) hard for others to obtain. This reframing now seems to work in the classroom, at least for me.
  2. While there are a lot of antecedents to RBV, this is the paper that explained the concept most clearly: Jay B. Barney, (1996) The Resource-Based Theory of the Firm. Organization Science 7(5):469-469.
  3. James Currier. The Network Effects Manual: 16 Different Network Effects – 2022 https://www.nfx.com/post/network-effects-manual Last accessed November 1, 2022.
  4. Peter Thiel and Blake Masters. Zero to One: Notes on Startups, or How to Build the Future. Crown Business. 2014.

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Here is the content in video format. I don’t think the graphics (which I did not create) are very good in these videos, so I suggest referring to my graphics in the note above. These videos are from my Wharton on-line course on Product Management and Strategy. Reach out if you need a referral in order to get a discount.