Why it’s nice to compete against a large, profitable company

cartoon7196A big, profitable company seems like the hardest thing for a small company to compete against. They have everything: money, brand, momentum, existing customers, press, product teams, distribution channels, expertise, market insight, analysts, sales offices, product features, and, by definition, a working business model.

All a little startup has is a decent idea and extremely greasy elbows.

But David has a clear path to slaying Goliath. The insight is: The profitable revenue stream is a prison. It’s the Achilles heel that allows the little guy to win.

A company with a large, profitable, growing revenue stream betrays facts useful to a startup: There’s a huge market to be had (else it wouldn’t be large and growing). This market is willing to pay far more than cost for this product (else profits wouldn’t be generated). This abundance will last for a while (large, profitable businesses typically die a slow, sagging death rather than disappearing in a flash).

This means the market is ripe for an Innovator’s Dilemma-style disruption. A startup with new cost structures, new technology, and new ideas can compete with a good-enough product at 1/2, 1/4, or possibly even 1/10th the price, and start cleaning up.

But wait! The big profitable company can just lower prices, thereby removing the main competitive advantage from the upstart, right? Wrong. The big profitable revenue stream is the goose that’s laying the golden eggs. The goal of a large company is to protect the profit stream at all costs, even if that means giving up on innovation. The current valuation of the company is based on continued growth in revenue and earnings, not erosion due to ankle-biters. Watch how fast your stock plummets when Wall Street thinks your future earnings are in jeopardy.

Don’t forget: Small changes in top-line revenue create massive changes in profitability. A business with a 20% profit margin is very healthy. If you lower top-line prices by 20%, your costs don’t magically decrease 20%, so now your profits are 0%. So if a startup cuts prices by 50% or 80%, the big company cannot chase. In fact, even reducing top-line by a measly 10% still cuts profits in half — a penalty too massive to endure, for an effect (slightly lower prices) which won’t materially change the price conversation in the market.

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Therefore, a large company typically asks: “If we can’t help but lose the low end of the market, how could we charge even more on the top end, to make up for that lost business?” Will that strategy work? It might! Either way, the new startup can grab 1/2 of that big company’s low-end market share, and still be really profitable because it’s working with new ideas, new tech, new business models, and so on.

But wait! Perhaps the big company will sacrifice earnings for growth? Not anymore. That’s a young company’s game. In the big-boy and big-girl world of real, at-scale companies, valuation is about total future earnings. Growth is important only because it leads to more earnings, not because it’s “growth for growth’s sake.” That’s the argument a young company uses, when the primary goal is to become dominant in a market before someone else does, setting up decades of future profitability.

A final word of caution. All this applies only if you’re attacking the product line that generates the massive profits. If you’re attacking a loss-leader, the situation is reversed.

Big, profitable companies often have other lines of business which are not profitable, sometimes extremely so. The profitable business unit funds the others. For example, Google’s profitable search business funds GMail. Amazon’s retail business funded AWS, and now that AWS is closing in on $10B in annualized revenue with 20% profit margins, it’s funding other projects as we speak.

Attacking a profitable business on its loss-leaders is a terrible strategy, because it can use all its powers against you, plus orders of magnitude more dollars, and not care about a direct business model to support those decisions. That is a scary competitor — lots of resources and nothing to lose!

For example, Microsoft decided to make Internet Explorer a loss-leader against Netscape, and destroyed that company. Of course that was after Netscape was a huge, going concern, so that wasn’t a strategic error on Netscape’s part, but rather a clear demonstration of the power of a profitable company who doesn’t care about making money in a certain market. On the flip side, Google built a $1b business apps market that competes against Microsoft, because in this case “Office” is the profitable line of business that Microsoft can’t impinge.

So, competing against a large, profitable, growing business might be the smartest thing you can do! Just make sure you’re hitting them where they’re fat, not where they’re able to beat you at your own game.

  • ronclabo

    Excellent practical application of the Innovator’s Dilemma. I especially appreciate the distinction you draw between the profitable company’s core business and it’s loss leaders. As always, you have a way of making somewhat complex business topics easy to understand. I always enjoy our articles. Thanks!

  • Vincent van Leeuwen

    Cool post Jason thanks! Another great example that came to mind for me is how EasyJet has been disrupting the airline industry.

  • Michaela L.

    I totally agree! It’s even more interesting when you add in some other variables like market/customer shifts. It’s also great to compete against Goliath and use their name/momentum in competitive marketing purposes – then you’re validated in some way. That, combined with the fact that we aren’t the only ‘David’ out there, means that we don’t have to take them down alone; we just have to be the most ‘deadly.’ I think it would be interesting to hear your take on David v. Goliath v. David v. David v. David etc. For instance, how much time should David use, thinking/taking out other Davids that they’re competing with while taking down Goliath?

  • Jeffrey Fry

    ..as the Profit Prophet I have to concur completely with your assessment and advice Jason… BTW, I love your insights and articles in general. <3

  • suzy999000

    As always your posts are worth the lead time between them. Awesomeness.

  • Very insightful post, thank you. I’m curious as to what your thoughts are on how much different/better a startup’s product should be to have a chance at winning against a large, profitable incumbent?

    • “Better” is relative to the customer, not to an absolute, therefore I think all products should be “better” for some interesting subset of potential customers, whether competing with a big guy or not!

  • Jason – Great post as always. Very useful to me as I work to find space for my brand in a very competitive part of the WordPress ecosystem. One advantage I think we have as a company whose main goal right now is to grow our user base is that we can and have to go above and beyond with new user on boarding, even if that means direct intervention/ just do it for them type support. It’s not only something that wouldn’t make sense for a more established company, but also an opportunity to experience the pain points we still need to work out in our products.

    WPEngine has some parts of its value proposition that must scale easier than others. I imagine its easier to add more server bandwidth then it is to keep up the same level of support as you grow. I wonder if you can share what priorities you put in place to ensure support has stayed as good as it has at WPEngine as you have grown?

    • Thanks Josh!

      The servers are not as easy to scale as it sounds. Paying for bandwidth scales, yes, but that’s not what gets difficult at scale. Support a server crashes for no reproducible reason once every 4 years. With 5000 servers, that happens 3-4 times per day. Things which are even a little more common happens dozens of times per day. Not all those things are predictable or preventable. So you can imagine there’s plenty of work there as well!

      Of course the answer to “how do you scale support” is complex. For example, to scale support means to hire many people, which means an entire recruiting departments to feed the “funnel” of sourcing, interviewing, and hiring. Then you realize you can’t hire 200 people who are all experts in WordPress and your platform internals, so you need to hire people with the right attitude and aptitude to learn (as we say), and then train them, and that means a whole training department and process. And you have to do that in multiple shifts and/or remote so you can cover 24/7/365. And then you realize that when someone’s on chat, they have three windows open and can’t go to the bathroom or get lunch, so you need processes where people can cover for each other seamlessly. And technology, because “throwing people at it” is not a good way to scale; you want to understand why people are having to contact you, take the subset of that which could be prevented by putting more control in the hands of customers, or fixing issues, etc., and implementing those, which requires a dedicated engineering team, a product manager to collect, prioritize, and measure it, and some analysis of ticket data so that after the low-hanging fruit you can still detect the more subtle things.

      This is just a slice of the things we have to do to scale support! It’s worth it, because human service is a vital component of what our “service” is.

      This is also why it’s easier for smaller competitors to boast things like “the founder personally helps you on-board,” as you point out in your own post. This is, of course, wise for small companies to do, because it’s an advantage you have that larger companies cannot do, so I commend it! But also as you point out, it can’t scale, so you’re in a catch-22 of having that level of service but never growing that much, or having to deal with scale. I don’t think it’s bad for a small bootstrapped company to decide that in fact it’s a better life to have that level of service and not grow too fast, where the goal is a great company and happy life, not maximizing the size of the company. Sometimes the TechCrunch crowd makes small business owners feel bad about being small, and I think that’s despicable.

      It’s not about “right” and “wrong,” but just different paths, different journeys. Both make sense. To me, the only incorrect choice is to pick one goal but act like you’re trying to reach the other goal — then you’re not optimizing for anything, and thus will probably “fail,” but in a way that’s preventable!

      In any case, I hope I did answer your question before veering off on the tangent. :-)

      • I’m sorry I missed this (you should install Postmatic:) Wow, thank you for the incredibly detailed response.

        It’s really valuable information. Y’all are way ahead of me obviously, but I love watching and analyzing how a companies that do it right work. More importantly for me, I appreciate a reminder of the value of growing slowly.

  • Rishi Dean

    Nice post Jason – I totally agree that your core revenue streams are a critical component of why incumbent’s fail to respond to startup threats. I wrote about this recently, from the other side and called it the “Incumbent’s Dilemma”, and have this and four other factors as part of “5 Cs” as to why incumbents fail to respond to new entrants: http://rishidean.com/2014/12/08/incumbents-dilemma-why-disrupting-yourself-is-hard/

  • Not necessarily always the case Jason. Some markets are so entrenched with structural barriers. New entrants will surely waste a lot of time and energy to ‘innovate’ and win over market share.

  • Albert Varkki

    I heard about the small company producing leather bags for men called Von Baer from Estonia, who are challenging Saddleback Leather company through direct sales to customers and non-traditional marketing. A good example about challenging somebody big by using smart approach: http://vonbaerbags.com/wp-content/uploads/2015/02/von-baer-bags-infographic1-1024×356.jpg

  • Hi Jason – This article applies to us here at Felt. We’re the first app where you can hand-write a card from your iPhone. The card then gets printed and mailed–All in your own penmanship. We’re going up against Shutterfly (900MM 2014). Our advantage is price and product. We charge less because we’ve streamlined the product options making fulfillment simpler. Thanks for your article. It feels like wind at our backs.

  • Lily Rose

    Jason, I totally agree with you. Choosing a strong opponent is the best way to improve, to fight harder and to make more effort, as well as to receive substantial results. I know work in app development field, so I can give an example from that industry. A new web development company wants to find customers and expand. What do they do? First, they for look up to somebody huge, like Apple. But then they realize that they have to lower their expectations a bit and choose other mobile apps developers with large experience and good reputation, like the ones I suggest. They study their audience, their services, style and so on and based on the info develop something unique for themselves. But that’s not the end – the next step is to challenge them.

  • Art Veal

    Grrrreeaaatttt! (Article) In my Tony the tiger voice!