If you are looking to sell a business idea to venture capital firms, demonstrating an understanding of your industry is important.
This is the first of a two-part series on how industry analysis can take the guess work out of starting a new company and secure venture capital.
The facts and figures presented in a business plan can be manipulated to portray the viability of a new business.
Industry analysis however, is far more objective. It is often written by independent financial analysts and research organisations, whose job is to study different industries and report on their status and direction, based on hard data.
So before writing a business plan, work on an industry analysis, which should answer three basic questions:
- Should we enter this industry?
- What part of the industry do we want to be in?
- What strategy should we adopt to penetrate the industry?
The best way to begin analysing an industry is using Michael Porter’s Five Forces. Michael is getting a little old now, but his recipe is still good eating. According to Michael, the Five Forces which govern any industry are:
- Bargaining power over suppliers. There are few suppliers compared to the number of companies it sells to in an industry, and its products or services are such that they attract few substitute decisions from end-customers. Bargaining power over oil companies is low because they are a cartel.
- Bargaining power over buyers. When buyers are able to purchase in bulk or products are a commodity, buyers can seize bargaining power and drive down industry profits. Daily-deal sites (group buying), is an example of buyers driving down retailer profits.
- Threat of substitute products and services. How likely are customers to use a substitute product or service from another industry? Electric motors are a substitute for petrol engines, but substitution of electric motors remains low because electric power cells are inconvenient to recharge.
- Threat of new competition entering the market. Include economies of scale, product differentiation, switching costs and capital requirements. The automotive industry has a high barrier to entry because of the large economies of scale in marketing, distribution and manufacturing necessary to compete.
- Intensity of competition between existing players the market. This is how fast an industry is changing and the tactics used by players to gain market share.
1. Should we enter this industry?
I recently conducted industry research on the mobile gaming industry. In short, Porter’s Five Forces revealed the following:
- Barriers to entry are low. The cost of creating mobile games is the lowest across all gaming platforms. Licensing titles of games is one barrier to entry.
- Casual gamers have few substitutes. Casual gamers use their mobiles for gaming because it is the most convenient gaming platform, and are unlikely to switch to console or PC online.
- Bargaining power over customers. Retail app stores have flattened retail prices and to an extent commoditized games. However, casual mobile gamers are becoming brand loyal to Apple and Android and game developers such as Zynga. This brand loyalty will open the way for product differentiation.
- Bargaining power over the retail app stores is low. Android and Apple will control 81% of the handsets and retail stores by 2015, commanding 30% of all sales. For the moment the retail stores are a duopoly, but Android’s open platform will see more retail app stores like GetJar enter the market and a price war among the retail app stores is inevitable.
Whatever industry you decide to move into, ensure you thoroughly understand the implications of the Five Forces.
Invariably these forces apply with different weights to different industries. Each industry has its own characteristics. For example if you are launching a low-cost airline, bargaining power with suppliers will be low (it is a duopoly) and barriers to entry will be high (airlines are government regulated and require enormous cap ex).
However if you are launching a blog shop, your barriers to entry will be low (creating an online store is easy), and your substitution to brick and mortar retailers will be low (blog shops are a price leader).
2. What part of the industry do we want to be in?
The next question to answer is where in the value chain should your company position itself. Recognise where profit zones exist in your industry. Postulate how the value chain will shift over time, and where profit zones will materialise and evaporate.
Where will brand loyalty exist in five years from now, and what parts of the value chain will become a commodity? Commodities generally attract thinner profit margins than value-added products and services.
Here’s an example of the value chain of mobile gaming in the early years.
Here’s how we predict the value chain will shift in five years.
3. What strategy should we adopt to penetrate the industry?
There are three broad strategies you can opt for, and you may switch strategies over time to compensate for shifts in the value chain.
Price leadership. Sell your products and services at a price below your competitors in the long term. It could require investment in machinery to gain economies of scale or purchasing raw materials in bulk to drive down the cost of goods.
Differentiation. Create products or services that are perceived industry-wide to be unique. This strategy provides a buffer against competitive rivalry by creating brand loyalty and a lower sensitivity to prices.
Focus. Satisfies the needs of a select group, geography or pushes one product line. It assumes the business can serve the target audience more effectively and efficiently than its competitors.
There are a few factors to consider when choosing a strategy.
- Commodity or value-add? If you are a commodity and you cannot add value, your best bet is to take a cost leadership position.
- How will your competition retaliate to your entry? If competitors are aggressive and the market is transparent enough for competitors to study each other’s moves, you have to think ahead. For example, competitors may drop prices to try to push you out of the market.
- How much capital are you prepared to raise? Capital restrictions will place some strategies out of your reach. For example if you have restricted funds, you may not be able to achieve product differentiation because you do not have advertising dollars to build brand against competitors.
Draw your conclusions
Ultimately decide whether the industry is a sunset industry, or one of growth. A sunset industry is one which industry profits are falling and its future is in doubt. Stay clear of these industries unless you can disrupt them and create a new profit zone in the value chain.
Conduct financial analysis on an industry to check its vitals like gross profit margins, profit margins, earnings per share and price to book ratios. Compare these ratios across the top few competitors to gauge industry averages.
For example, we undertook financial analysis on the top three global luxury brands and found the industry achieves 63 percent gross profit margins, but marketing and sales alone consumed 50% of the gross profit.
Hypothetically you will not beat these averages unless your company can disrupt a fundamental pillar and gain a competitive advantage.
Anthony is the founder of Futurebooks. Futurebooks offer affordable incorporation, bookkeeping, business planning and business brokering in Singapore and South East Asia. Anthony has helped corporate firms build subscription models, conduct industry analysis and develop brand positioning for new firms. He was founder of Firestarter, a digital marketing agency, acquired by Novus Media in 2010.
Front page image: Lumaxart
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