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Triumph of the underdog: How to beat the odds as a startup

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In 2004, Blockbuster Video was worth $5 billion, and the distinctive blue and yellow ticket stub logo beckoned movie buffs to browse its aisles for the latest releases and beloved classics. That same year, a movie subscription service called Netflix announced $500 million in profits for the first time since its start in 1997.

Blockbuster’s infamous bankruptcy and ultimate closure might seem like a case study in incumbent business failure, but a recent paper from MIT Sloan marketing professorproposes the rental chain’s demise is an example of a resource-based mechanism that leads to some “real but seemingly implausible outcomes.”

Unlike the brick-and-mortar Blockbuster, Netflix didn’t need a physical store, and software was its only initial fixed cost, writes Wernerfelt in his paper “When does the Underdog Win?” And instead of trying to chip away at Blockbuster’s collection of recent releases (which accounted for three-quarters of the chain’s revenue), Netflix focused on older and hard-to-get-movies through a mail subscription service.

“It is not a big surprise to see a small entrant win if it started out with a unique and important resource,” Wernerfelt writes.

Likewise, Google became the company it is today thanks to its unique and important resource: an ad-funded search engine.

However, “It is harder to explain cases in which the entrant, at least initially, had no unique resources, other than perhaps a brilliant manager,” Wernerfelt writes.

To explain this phenomenon, Wernerfelt studied several well-known business rivalries to find common denominators to success, developing a mathematical model to predict a market entrant’s chances of beating the main incumbent business.

According to his analysis, there are three determinants that can predict a market takeover. Here’s a closer look at them, and what incumbent businesses can do to stay alert in their markets.

Resource collection and market investment

A new company’s goal should be to accumulate as fast as possible resources that enhance its performance and can be transferred to its biggest competitor’s main market. These resources can include loyal customers, brand awareness, an installed base, technical skills, and/or manufacturing experience.

Once resources have been collected, entrant companies can focus on turning profits in market areas that are either unserved or considered unimportant by the top competitor. That keeps the new company off its competitors’ radar and out of its crosshairs, while allowing time to establish roots.

“Once you start operations in the main segments served by the incumbent, he will surely notice you and probably pay attention,” Wernerfelt said. “However, being noticed is not the same as being the object of a counterattack. The incumbent might decide that you do not pose a serious threat and that you will ‘go away’ more or less by yourself or at least never gain any significant share.”

When Nike joined the athletic shoe industry in the 1960s, it focused on running shoes instead of going head-to-head with Converse and its hold on the basketball shoe market. Over the decades, Nike expanded its line to basketball sneakers and other athletic shoes and apparel, ultimately acquiring Converse in 2003.

Business model efficiency

A new competitor needs a framework to build its resources, and one way to do that is through a business model that doesn’t attract the attention or imitation of a leading competitor.

General Motors emphasized design over Ford’s engineering and efficiency, and bet on customers being willing to pay more for stylish cars, Wernerfelt writes. This allowed GM to use a multibrand business model, while not relying on the large, specialized assembly lines made famous by Henry Ford.

Strategies like GM’s work because competitors are often slow to adopt a new business model. Reasons for that slow adoption include:

  1. They might not even be aware of the model’s (and startup’s) existence.
  2. They pay limited attention because it’s a model that uses less important resources than its own, and because it’s in a niche market they don’t compete in.
  3. When they do pay serious attention, they find the new business model does not use one or more of the resources that are underpinning their historical competitive advantage, making them less likely to embrace it. Netflix and Amazon didn’t require brick-and-mortar retail spaces like Blockbuster and Barnes and Noble, and the latter two would have found themselves with an excess network of physical spaces had they attempted to match the online reach of the two startups.

“Combined with the fact that most entrants fail, you can see why incumbent managers would have a strong bias toward thinking that challengers with unfamiliar models will fail or remain relatively unimportant niche players,” Wernerfelt writes.

Incumbent response time

A new company is more likely to win against its market’s top competitor when that incumbent is slower to react, and has a lower rate of investment than the startup firm.

Netflix had already been in business for five years before Blockbuster introduced its own version of a subscription service. And it wasn’t until 2011 when the video chain announced a streaming service. That same year Netflix was responsible for the largest internet traffic in North America.

“Even in cases where the advantage of the new business format seems obvious — as was the case for Blockbuster — many firms have proven unwilling to scuttle their core business models,” Wernerfelt writes. “In fact, Netflix’s embrace of streaming at a time when its existing business was mailing CDs through the post office, is often the only example offered of a firm heeding the often voiced but rarely followed advice to ‘keep the cannibals in the family.’”

Options for incumbents

Wernerfelt offers two pieces of advice for firms willing and able to respond to a new competitor. One thing these companies can do is evaluate alternative business models by “disrupting themselves” in a small part of the business unit. To compete with large grocery chains, Walmart, for example, opened several supercenters that included grocery sections, rather than turning all of their stores into super-versions in one move.

Wernerfelt also recommends incumbent companies keep an eye on resource-related industries — not just the ones that serve the same customers or use similar technologies — to catch challengers early on.

For more info Meredith Somers News Writer (617) 715-4216