“I skate to where the puck is going to be, not where it has been.”
When I started my first company, I was a broke, 18-year-old college freshman struggling to pay for my textbooks. My scholarship had a requirement that I could not hold a job during school terms. The idea probably made sense to the person (obviously wealthy) who endowed that scholarship. But for me, it presented a real challenge since the scholarship didn’t cover all of my expenses…like, say, textbooks.
In need of cash, I would need to find a way to earn money without receiving a W-2. I figured if I could make money without actually being employed, then I would “technically” be within the requirements. So a few days later, I decided I would start my very own business. The only problem was I didn’t know anything about starting a business, and I didn’t even have a business idea.
As I sat in my dorm room trying to develop an idea, I started wondering what exactly makes a good business? There was no shortage of books, blogs, podcasts, videos, and more on the topic of starting a business. However, many of them tended to skip right to the execution phase by focusing on the “how to’s.”
I was interested in more fundamental questions: How do you develop an idea for a business in the first place? If you have an idea, how do you evaluate whether it is worth pursuing?
Now that I’ve started multiple companies and have invested in many others, I’ve come to understand that all good businesses share a few key attributes. That is true regardless of industry or domain. It applies to moonshot technologies that could change the world as much as it does small, lifestyle businesses. So when someone pitches me on a new idea or when one pops into my head, I go through the same process to evaluate whether it possesses the essential components of success.
Real Market Needs
The first component of any good business idea is a well-defined need for the product or service. That seems obvious, but I’m constantly amazed at how often this doesn’t receive appropriate attention. Instead, all too often, people come up with ideas for things for which they are personally passionate. Being passionate about what you’re doing is important and can help keep you going when things get tough, but passion alone is insufficient. Just because you think doing something would be fun or exciting does not mean there is a broad need in the market.
For example, you might be passionate about Ethiopian food and frustrated that there are no Ethiopian restaurants nearby. But that does not mean that starting an Ethiopian restaurant in your small town is a great business opportunity.
For a business idea to have merit, there must be a well-defined need in the market. Here are some of the questions I ask when evaluating the market need for a business concept:
Who are the potential customers for this business?
Can I verify through market research that those potential customers have a real need for the product or service?
How big is the Total Addressable Market (TAM)?
Check out our blog post on Evaluating the Problem Space for more guidance on how to establish that there is a real market need for your idea.
Defensible Competitive Advantage
Once you’ve established a real need for the product or service, the next component of a good idea is the ability to construct a defensible competitive advantage relative to satisfying that need.
Using our previous example, let’s say that you discover that there are a lot of people in your community who share a love of spicy tibs and injera and who wish they could get their Ethiopian food fix locally. That would seem to indicate a potential unmet market need. However, this alone doesn’t justify opening a restaurant. You must also know that you can develop a sustainable competitive advantage. Otherwise, what keeps someone else from seeing your success and copying your idea?
In his seminal work Competitive Strategy, Michal Porter explains the types of competitive advantage firms can pursue. According to Porter, there are three types of generic competitive strategies that firms can pursue.
Cost Leadership Strategy: As the name suggests, this strategy is pursued by firms that set out to be the lowest cost option in an industry.
Differentiation Strategy: This strategy involves offering something unique across some dimensions important to buyers in the market. That could be a strong brand or proprietary technology or any host of differentiating factors that are difficult for others to replicate.
Market Segmentation or Focus Strategy: A firm can focus on a specific narrow segment of the market with sufficiently unique characteristics that allow the firm to achieve meaningful cost leadership or differentiation within that limited industry domain.
In other words, you have to either produce a good or service at a lower cost than the other guys or offer something for which there are no suitable substitutions. And you have to be able to achieve that in a manner that is difficult for current or would-be competitors to replicate. So here are some questions I ask when evaluating an idea’s competitive advantage:
What is the competitive landscape? Who else is competing in this space, and what competitive strategy are they pursuing?
How are potential customers currently satisfying this need? How happy are they with the alternatives available to them?
Which competitive strategy is this business pursuing and why?
How capable is the business of effectively executing this strategy? Do they have the people, processes, assets, knowledge, etc. to deploy this strategy more effectively than someone else could?
How difficult would it be for a competitor to replicate this business’s competitive strategy?
Alright, so you’ve determined a real need in the market for this product or service. You’ve also established a competitive strategy that is highly defensible and that you’re uniquely capable of executing. So what’s left to talk about?
There is one last component to consider before moving forward on your big idea. Is the juice worth the squeeze? Can you pursue this market and deploy your chosen strategy in such a way that makes it economically viable? If not, then you probably want to head on back over the whiteboard and reconsider your approach.
In MBA-speak, sustainable economics means that you can consistently produce Returns on Equity at or above alternative uses of the associated equity capital deployed in the business. In ordinary human language, it just means that you have a good chance (a reasonable amount of risk) of producing a sustainable profit relative to the amount of money you have to invest into building your product, acquiring your customers, and operating the business.
So let’s say your competitive strategy for your Ethiopian restaurant is to be the lowest cost restaurant in town. You do the research and price your menu accordingly. However, the ingredients you need are harder to source and more expensive. You realize that when you factor in these higher food costs, you’re going to be hard-pressed to turn a profit. That would suggest a lack of sustainable economics and would lead you to assume this is not a good approach for this business. Might want to look at the differentiation approach instead of cost leadership (obviously).
Here are some questions to help you assess the economics of an idea:
How much upfront capital is needed before reaching a breakeven point?
How much working capital will be necessary to operate the business?
What is the likely profitability of this business at maturity?
What is the projected total shareholder equity at maturity?
What is the implied Return on Equity (ROE)?
How believable are these projections? What’s the likelihood of these projections being accurate?
When confronted with a business idea, always be sure to take the time to step back and evaluate these three components. Ensure that there is a real market need and that the business can execute a defensible competitive strategy that produces sustainable economics. Only when an idea possesses all three of these components can it be considered a good business opportunity.