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A 10-Point Checklist For Building a Great Company
Today: Quality and scale, clients and customers, local and global, cash flow and profits, and much more.
If you’re a CEO or senior executive, it’s easy to be carried away by too many concepts and categories regarding business strategy and where your company should be. Here’s my attempt to bring it all down to a 10-point checklist. It covers most issues related to strategy as your business scales up:
Think about quality and scale, simultaneously
Determine if you’re serving clients or customers
Determine if you’re “default local” or “default global”
Make sure you have “wholesale transfer pricing power” (WTPP)
Even better: Make sure you have a ‘grip’ over your value chain
Draw a flywheel to identify leverage points in your business
Don’t forget the financial loops in the flywheel
Know where you stand between the Northern and Southern Sides
Understand that you can invest in growth
Remember that “corporate happiness is positive cash flow”
1/ Think about quality and scale, simultaneously
Here let me simply quote Nivi’s seminal writing (2013):
Quality measures how far a product advances the customer. Scale measures how many people use it. For entrepreneurs, there is no tradeoff between quality and scale. The job is to do both—not one or the other. If it can’t be done, you innovate.
And in the sequel (The Entrepreneurial Age, also 2013):
[Entrepreneurship is] the ability to serve a customer at the highest level of quality and scale, simultaneously. We will learn to put entrepreneurship to great use and it will be the basis for an organization’s differentiation and victory.
This is not a statement that the winners are going to win. It is a statement that (1) the best strategy is to attempt to deliver the highest quality with the highest scale and (2) other types of differentiation should only be tactics that serve an organization’s entrepreneurial capability.
A corollary, as I wrote in From Startup to Tech Company, One Step at a Time, is that at the earliest stage (when you’re doing those things that don’t scale), you should really focus on your most demanding users: those are the ones that will help you boost quality to the highest level possible before you start scaling up the business in a more standardized way.
2/ Determine if you’re serving clients or customers
When listening to users, you need to be very clear on whether they’re clients or customers. It might be the first time you really think about the difference between the two, but I think it’s one of the most important distinctions in business strategy. Here’s Seth Godin:
Customers hear you say, "here, I made this," and they buy or they don't buy.
Clients say to you, "I need this," and if you want to get paid, you make it.
The key distinction is who goes first, who gets to decide when it's done.
If you make the wrong call here, it’ll likely prevent you from succeeding over the long term. Here’s what I wrote about Justin Kan’s Atrium back in March when it announced that it was closing down:
Atrium’s problem is that it tried to treat clients as customers. The goal was to make lawyers more efficient thanks to technology, using the resulting surplus either to lower the price or to increase the margins and differentiate by adding more services.
But as is often the case in the presence of innovation, the clients didn’t play along: they kept demanding more (that’s what clients do), making it difficult to retain that surplus and use it to improve the business. And there was probably always a competitor ready to add more lawyers so as to better comply with the client’s demands, sending the bill along later.
3/ Determine if you’re “default local” or “default global”
These are categories I’m borrowing from Anish Acharya of Andreessen Horowitz. They are important because they force everyone to reflect on the level of fragmentation in the target market and can hint at what kind of founding team is more likely to succeed. Here’s what I wrote in July:
If the startup is ‘default global’, then you need fearless founders who are eager to have a diverse team from Day One—and, if possible, to switch everything to English as early as possible. Ideally, the team is already international, they already work in English and (assuming we’re not in the middle of a pandemic), they don’t mind travelling a lot—even relocating elsewhere.
If the startup is ‘default local’, you need a founding team that’s passionate about product and sales, because mid-term success will likely be all about selling and then broadening the scope of the company’s value proposition on a local market rather than expanding on foreign markets. Being international is a plus, but not a necessary condition for success. A provincial team working in the local language can always buy international expansion once they have a firm foothold on the local market—so long as the product is good and the scope is broad enough.
4/ Make sure you have “wholesale transfer pricing power” (WTPP)
As I mentioned recently, this is a concept I recently came across in the writings of Tren Griffin about cable magnate John Malone. Here’s my quoting Tren three weeks ago:
WTPP determines who in a value chain gets the biggest share of the profit pool (e.g., do content owners, cable owners or vendors to cable firms have the best WTPP?).
Wholesale transfer pricing = the bargaining power of A that supplies a unique product X to B which may enable A to take the profits of B by increasing the wholesale price of X.
There’s no better approach to determining if you’re likely to have WTPP than to analyze your industry value chain—which, as I often insist, you must know inside out, including from a historical perspective.
Maybe you’re entering a sector that has WTPP and will be able to retain it through the paradigm shift. Or maybe the shift contributes to redistributing WTPP across the value chain and you, an entrepreneur, will be able to harness the power of technology so as to assert WTPP in a sector that was traditionally deprived of it.
Think about Amazon: When did bookstores ever have pricing power over publishing houses? Not until Jeff Bezos realized he could move the bookstore online and trigger network effects.
5/ Even better: Make sure you have a ‘grip’ over your value chain
It’s one thing to have WTPP because you belong to the right sector in the value chain. It’s another to be present at two distinct levels in the value chain so as to have the ‘grip’ that determines exceptional success at doing capitalism:
It’s about balance. You need at least two legs to keep your balance. Since we humans have two legs, we can stay on our feet no matter what—like if we’re on the train and it suddenly brakes, or someone bumps into us on the street, or if we’re a boxer and get hit, we can adjust quickly and stay standing. On the other hand, someone with only one leg needs crutches; and if they don’t have them, they’re unable to stand for very long. The imagery might be a bit far-fetched, but I’m pretty sure it’s the same for a business aiming at dominating its value chain.
Having a ‘grip’ also makes the business more defensible in the face of technological change. A company that’s present at one level may enjoy high WTPP for a while, but then power can shift elsewhere in the value chain (likely downward)—and then, like airlines or car makers, you’re stuck with all the costs but no pricing power. Being present at two levels is a form of diversification that hedges against such a risk.
6/ Draw a flywheel to identify leverage points in your business
I recently mentioned the useful concept of a leverage point (and since then Gonz Sanchez has sent me this article by Donella Meadows, the founder of this approach to analyzing systems: Leverage Points: Places to Intervene in a System).
The best tool to analyze leverage points in a business is the flywheel—which Jeff Bezos supposedly made popular. More recently, Kevin Kwok has introduced the landmark concept of a company as a “sequencing of loops”. Then we had Alex Danco following up on that concept:
A business is a collection of repeatable processes; but it’s worth going the next step to specify: if a process is truly reputable, then it must be a loop, because you have to end at the same place you started if you want to do it again. If you don’t see the loop, then either you don’t understand the loop, or it’s not truly repeatable.
A flywheel is nothing more than the graphic representation of this sequence of loops. It makes it possible to spot a company’s repeatable processes and to make sure they all fit together in a way that generates returns on invested capital (which is what strategy is all about).
I always draw a flywheel when confronted with a new business. This is the best tool for me to understand them, and it’s usually at the core of the “Economics & Financials” section of my investment memos. Here’s the flywheel I once drew to better understand Amazon and its growth:
7/ Don’t forget the financial loops in the flywheel
Founders are usually comfortable drawing their company’s flywheel for the business side. They tend to forget some important loops, however: the financial ones! Behold 👆 just how critical the cash flow loop is to understanding how the whole of Amazon’s business fits together.
Then you have the discussions, alluded to here by Bill Gurley, about cash conversion cycles and why it’s hard to build a marketplace business (hint: in many cases, you need LOTS of working capital—and few founders realize that beforehand):
Using VC $$$s to fund negative cash conversion cycles is a popular trend. https://techcrunch.com/2019/11/26/leavy-co/… 3 warnings. 1 - you are assuming risk. 2- this is the opposite of leverage (scaling consumes cash). 3- businesses with low cash flow to earnings ratios have shitty public multiples.
Amazon excels at mastering the financial loops to make its growth sustainable. But in truth, there are many other examples. One that I analyzed in detail in note #6 of my 11 Notes on Amazon is Vinci:
Construction is a low-margin business that employs little capital; but it generates massive amounts of free cash flow thanks to a low cash conversion cycle (construction contractors take their time in paying their suppliers). On the other side of Vinci’s business model, utilities are very demanding in terms of investment and accordingly employ a lot of capital throughout very long investment cycles (sometimes decades); but in time they generate substantial net income that, ultimately, makes most of Vinci’s profits and dividends. All in all, the two businesses are complementary: without the construction business, it would be very difficult for Vinci to invest in its utility infrastructures, lest they bear the risk of excessive leverage; and without the concession business, Vinci would be incapable of turning substantial profits for its shareholders.
I’d say it’s the financial version of the ‘grip’: don’t put all your eggs in one basket, and make sure to complement the cash-consuming part of your business with another one that’s cash-generating.
8/ Know where you stand between the Northern and Southern Sides
This is another concept I derived from my reflections on Amazon, when I realized that theirs was a business that is half brick and mortar and half technology. It’s an amazing combination because, if done well at scale, it makes it possible to combine the best of brick and mortar (defensibility), and the best of technology (scalability). Look no further than this balance between diminishing and increasing returns if you’re still wondering why Jeff Bezos is the richest man on Earth! Here’s what I wrote back then:
While returns are clearly diminishing on the Northern Side, the opposite trend — increasing returns — is at work on the Southern Side. For Amazon, every new warehouse costs more than the previous one, especially because it has to be located closer to the city so as to shorten delivery time (= diminishing returns). But the new customers that this warehouse will enable Amazon to serve will drive more than revenue: as they join the experience made possible by the architecture of participation on the Southern Side, they create value for Amazon through many channels: revenue, higher volumes, network effects, machine learning, and content-driven virality (= increasing returns).
It’s all the more important to know where a company stands because it has important consequences from a capital allocation perspective. Check out my Principles for Capital Allocation (Round 1):
We’ve long since entered a world where all businesses are hybrid—part software, part non-software. The whole question is the balance between the two. We can see it as a sliding scale, from Category 1 (no software) to Category 5 (pure software)...
From Category 4 upward, the network effects derived from software (demand-side economies of scale) dramatically outweigh the supply-side economies of scale (large volumes, lower unit costs). Unit economics depend on the category to which the business belongs. It then commands a specific approach to capital allocation to make the most of the company’s distinctive value chain. Again, software is all scalability (you can grow very quickly as long as there is room for it); at the other extremity, non-software is defensibility (it's difficult for a new entrant to compete with you).
9/ Understand that you can invest in growth
This is an idea that’s not familiar enough. In fact, when there isn’t one single article to which everyone is referring to when it comes to a given topic—such as Increasing Returns and the New World of Business by W. Brian Arthur or Why Software Is Eating the World by Marc Andreessen—you can be certain that relatively few people understand a given concept or category.
So, here you are: In the old world, investments were made in machines and product development, after which financing growth was all about operational expenses. In today’s world, because there’s such a thing as network effects, a new customer contributes more than cash: they also create additional value for your company that then forms a surplus to be divided between the three parties at the corporate table: customers, shareholders, and employees.
So now, because an additional customer creates value over the long term, spending money on acquisition and conversion is akin to an investment. It might not be treated as such from an accounting perspective (read this brilliant piece by Napkin Math’s Adam Keesling about this), but you, as an executive, should learn to effectively treat it as an investment nonetheless.
10/ Remember that “corporate happiness is positive cash flow”
The fact that there’s such a thing as investing in growth doesn’t mean that you can lose money forever. In fact, what really makes or breaks a fast-growing business these days is figuring out the appropriate level of investment in a users’ network. If you spend more than necessary on that one, you’re simply wasting money—and you make your customers think the product is cheaper than it looks, something that can’t really be repaired along the way.
The conclusion is that, as a rule, even with fast growth that makes drawing profits difficult, you should always focus on cash efficiency. I absolutely love what Kai-Fu Lee wrote about Meituan’s Wang Xing:
From the outside, venture-funded battles for market share look to be determined solely by who can raise the most capital and thus outlast their opponents. That’s half-true: while the amount of money raised is important, so is the burn rate and the “stickiness” of the customers bought through subsidies. Startups locked in these battles are almost never profitable at the time, but the company that can drive its losses-per-customer-served to the bare minimum can outlast better-funded competitors. Once the bloodshed is over and prices begin to rise, that same ruthless efficiency will be a major asset on the road to profitability...
Wang Xing [the founder of Meituan] embodied a philosophy of conquest tracing back to the fourteenth-century emperor Zhu Yuanshang, the leader of a rebel army who outlasted dozens of competing warlords to found the Ming Dynasty: “Build high walls, store up grain, and bide your time before claiming the throne.” For Wang Xing, venture funding was his grain, a superior product was his wall, and a billion-dollar market would be his throne.
(And in case you were wondering, the title of this section is a quote from legendary investor Fred Adler, as often quoted by his mentee William H. Janeway.)
It’s a work in progress, so let me know: Maybe you’re a CEO or a senior executive. Did this resonate with you? If not, why? If yes, do you think about other categories and concepts I should add to this list?
Also, you might remember that I now have an executive sparring practice alongside my job as a director of the Family. This is typically the kind of framework I keep in mind when exchanging with clients. If you want to learn more, read this past edition: Launching My Executive Sparring Practice.
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From Normandy, France 🇫🇷