EXIT STRATEGIES: Sustainable competitive advantage

Whether it is a financial or strategic exit, the premium on sale is usually delivered through the growth potential of the business being sold. In the case of a financial sale, it is the potential revenue and profit growth from the existing business and in new areas of growth which will drive the premium on sale.

Protecting the existing business and enhancing the competitive position of new business is critical to securing the premium on sale. In the case of a strategic sale, the vendor has to ensure the buyer has time to exploit the strategic assets and capabilities being transferred with the sale. In both cases, providing greater protection to future revenue streams enhances the sale proposition but also reduces the risk to the buyer.

Identifying strategic assets and capabilities which can underpin a strategic sale strategy is a key part of preparing the business for a strategic exit. However, unless the buyer has some reasonable time to exploit the high growth potential, the strategic value will be undermined. An important part of our preparation for sale and a critical part of the message to be delivered to the potential buyer must be that the seller can offer a sustainable competitive advantage for the assets or capabilities beyond the sale date to convince the buyer to pay strategic value in the deal.

High growth is most often achieved by seizing a segment of a market and protecting it rather than chasing a large potential market where the venture has marginal competitive advantages. The business which can gain a strong foothold in part of a market often has the luxury of time to work out how best to grow the business. While many entrepreneurs focus on growth strategies, the smart ones build a wall around their business which can protect them and allow them to exploit the underlying potential in their products and processes.

The vendor needs to construct the foundations for such a wall for the buyer to allow them time to exploit their acquisition. Once the sustainability conditions are established, the entrepreneur then should think about how best to position the asset or capability for growth. Many owners are so focused on the next deal or short term gains that they forget to structure their businesses for growth. This involves packaging and structuring the product or service so that it can be rapidly scaled and /or replicated as well as putting in the other elements to enable the new buyer to exploit its potential.

Sustainability characteristics

There are two critical factors in sustaining a growth strategy; getting the business and keeping the business. The size of the market or the growth in the market does not guarantee you will have a share in it and your competitive advantage today may not be a competitive advantage next year. Your major threat may be that your best customers may be purchasing from your competitor next time they buy.

Most entrepreneurs understand the concepts associated with creating a competitive advantage to win the business in the first place, few however, seem to understand what action they should or can take to protect that business from competitors. Protecting the growth potential in the business is critical to generating a high premium on sale. This is especially important in fast paced businesses where product innovation is rapid.

The basic principal behind sustainable competitive advantage is to ensure you have the only viable solution which can solve the critical need of your target customer. You don’t necessarily need to have the best solution, only the one which your customer is willing or able to buy. Basically, you need to deny your competitors access to your customer base by building a wall around the supply chain to the customer.

Competitive advantages are transient. There are numerous forces acting within markets which will undermine competitive positions. These include such factors as:

• Expiration of patents, licenses and copyrights.
• New inventions which provide better, cheaper and/or more effective solutions.
• New processes which increase productivity or provide new benefits.
• New ways of doing business which customers prefer.
• Competition arising from more open trade agreements.

Thus a strong position at one point in time may be eroded either by the passage of time or by new products and/or new competitors coming into the market. Competing in any market with a constant stream of new products and penetrating new markets is hard work and fighting it out prospect by prospect puts a considerable strain on the business and it’s staff. In the absence of some overpowering long term competitive advantage which allows the business some margin for error, you are going to have to battle for each new customer.

Few businesses have the ability to sustain a superior competitive advantage which will ensure a constant stream of new customers. To survive the downturns and competitive attacks you need to build a buffer which will give you time to regroup and come back with new products and/or services. That buffer needs to be built from the existing customer base through recurring revenue, cross selling and account penetration. In order to do that, you need to protect your current customer base from erosion, even in the face of superior products or services from your competition. The task of the entrepreneur is to anticipate new competitors, better products and new business models and to create barriers to these so the current customers either can’t move or don’t want to move to a competitor.

Many entrepreneurs think their business is sufficiently protected by having a superior product or service or by making the product or services offering different in some way from their competitors. This is normally achieved through a combination of features and functions which customers value or it could be through superior customer service, availability, after sales support and so on.

It is highly likely that a winning combination can help secure the initial sale, however, this does not stop the competitor from copying what you do, maybe doing it better and then chipping away at your customer base.

Some entrepreneurs are mesmerized by the size of the potential market. They take comfort in the fact that there will always be new customers to sell to.

They seem to think that because there are large numbers of potential customers, they have some divine right to get their share of the potential customers as they pass by. However, the rate of company failures would suggest otherwise. It is not just the competitors you can see that should give you cause for concern; it is new entrants which come into your market with a different business model which can turn an industry on its head. Your hard won competitive advantage goes out the door and your current customer base is under attack. Holding onto your current customers and protecting your recurring revenue is an imperative for survival. The firm which has not bothered to block off the competitors will be the most vulnerable to such changes.

Many entrepreneurs search for the holy grail of ‘first mover advantage’. Certainly being first to market can often provide a business with an opportunity to gain premium prices. For example; new markets can sometimes be readily harvested if the new business solves an important problem. Early demand often allows ‘cherry picking’ – taking those with the highest needs or those who are the most innovative as early customers. First mover advantages are most often associated with new inventions but can also be associated with new ways of doing business. However, there is nothing in this strategy which suggests that you can sustain the initial advantage. Once competitors imitate your product or service, they can attack your customer base.

Whether you have an overpowering competitive advantage or not, you should still implement blocking mechanisms to protect current customer business. The planning question is: “What is going to stop my competitors taking away my customers?”

Protecting the business

Blocking out competitors 100% is an ideal. It is unlikely you can develop a business concept which can protect you from competitors over a very long period of time. However, having an understanding of the ultimate or ideal techniques of protection can help you to identify ways in which you can protect your business from competitors. Each link in the supply chain from component to customer provides you with opportunities to block competitors. Any link which is blocked from competitor access may be sufficient to protect the business. Combinations of blocking techniques over several links will increase the probability of success.

The objective of a blocking strategy is to find ways to protect each link in the supply chain so that a competitor is denied access. Where that is not 100%, you want to make it difficult, time consuming or expensive to overcome your blocking factors thus limiting the erosion of current customers. For example, if you have an early warning of an approach to a customer, but the competitor working with the customer to create further impediments.

Customer blocking techniques

Most firms have repeat sales to their existing customers. Once the initial sale is made, you need to move immediately to closing the door behind you to your competitors. You need to construct a situation which will ensure future purchases are sent your way and not to your competitors. If you can prevent your competitors from selling to your customers, you have effectively protected that part of your income stream. Your objective is to lock down your customer so they have no choice but to buy from you even when your competitor introduces a better product or service which could more effectively satisfy the customer’s needs. I am not suggesting you do anything illegal or unethical to gain the business, only that you undertake sensible and legal blocking techniques.

Clearly the most effective way to lock down the customer is through an exclusive purchase agreement. This need not be to the customer’s detriment. There are some very good reasons why the customer may allow or even encourage this arrangement:

• Reduction in costs of preparing procurement agreements.
• Economies of scale in ordering, freight, receiving and storage.
• High learning curve costs in understanding the complexities of each organisation, their ordering and fulfillment processes.
• Time and resources required in building relationships at multiple layers in each firm.
• High start up costs in bringing on a new technology or process. This could involve organisational changes, data conversion and training costs.
• Committed capacity to customer’s business.

Many companies have implemented single source procurement agreements to provide stability with their suppliers and to show that long term relationships are more important than short term cost savings. It is very common for this structure to be used to implement the exchange of intellectual property, joint design teams and sharing of cost savings.

This arrangement can be sold to the customer if the customer can be convinced that such an exclusive agreement is in their long-term interest. The customer has to be presented with a convincing argument of benefits, economies or efficiencies which would accrue to them from locking themselves into such a relationship. This is the ultimate in customer lock-in and the time taken to design products, services and relationships with this end in mind can be the key to long-term protection of recurring revenue. The sales process needs to see long-term protection of recurring revenue to be as important as the initial sale. Once the relationship is in place, not only will it protect repeat purchases of the same products or service but it can result in lower cost of sales for cross selling products and services.

Some corporate customers are prepared to agree long term procurement agreements in return for discounts, additional customer services or simply to keep life simple. Many corporate buyers believe in building relationships with a smaller number of suppliers in order to gain better attention from the supplier and to ultimately drive costs down and improve quality by working together on procurement programs. You should try to move a preferred supplier agreement to an exclusive arrangement.

Complex products which require considerable up front installation and ongoing support are also effective ways of capturing customers over a long period. The ‘switching costs’, which includes costs, time and stress of moving to another product, can often be very high, thus once sold, customers tend to stay with the initial supplier for a long time. This relationship can be used to leverage cross selling opportunities, especially where additional products can be easily integrated into systems or products already in place. Many software products fit this category.

Some products have a lock in feature due to the conditions under which they are acquired. Life insurance and health insurance, for example, can be prohibitive to change if personal circumstances change and a new policy would be difficult and/or costly to acquire. To retain the benefits, the customer has to stay with their existing policy.

While not 100% perfect, many membership programs create some form of lock in for the customer. Airline frequent flyer programs or store frequent purchaser programs attempt to create loyalty and to provide the customer with additional benefits which only accrue with frequent or volume purchases.

Example:

Arthur Leontaritis, former part owner of the Basque tapas and wine bar in lower Chapel Street in Melbourne, was highly enthusiastic about his loyalty program. They gave one free coffee for every six purchased. “We have been open since September 2003 and introduced the loyalty cards about three months later” said Arthur. “The effect on the business is significant. At the time of introduction we were doing about 9-10 KG of coffee per week, now we do 15 – 20 KG. Our takings are up 4 fold.” Arthur was emphatic about the effect of the loyalty cards. “We get about 80% to 90% retention due to the program. There are a lot of good coffee houses in this street. These cards really make a difference”.

Outbound distribution channel blocking techniques

Gaining control over the point of sale to the customer is an effective way of controlling the customer purchase. While the customer may have a range of choices in theory, they may be willing to limit their choice through a preference for a particular method or place of purchase. The corporation which habitually buys office supplies from Office Works or Office Depot chooses only from those products stocked there. When they use a mail order catalogue, they limit their choice to the products listed. A customer who only buys groceries at the local supermarket is restricted to the product range offered. When you choose your mobile phone company you may limit which mobile phones you can use.

Gaining access to a preferred channel, or owning or controlling a preferred channel, gives you effective control over the final purchase. The question which the seller needs to ask is “Where does my customer buy?” Can you then construct a blocking strategy so that you are the product or service of choice? If you are the only product in your category at Office Works or Toys R Us, then you have greater influence over the ultimate customer purchase. Supermarkets understand this and use shelf space as a bargaining chip with their suppliers.

Internet sites which have frequent return rates provide sellers with a greater chance of selling to the loyal user. Internet portals like Yahoo or MSN can be used to offer customers limited choice. While this does not deny customers the right to go elsewhere, the purchase decision is made easier where access is already set up through a favourite portal. If you can be the only product in a category offered by such sites, you have some control over the channel to the customer.

Airline booking systems can act as channel conduits. Some customers will prefer to have all their flights managed through the one system rather than have to deal with multiple carriers themselves. Linkages through such systems to hotels and rental cars can provide the secondary service providers with advantages.

You might be able to use the synergies of an existing preferred channel to reduce costs and gain premium profits or lower your price and undercut competitors. Some firms are able to significantly reduce their costs by using distribution channels which already serve the desired customer. A firm which introduces a new product to an existing distribution channel need only recoup the marginal costs of using that channel. Excess capacity in the channel can be used to cross sell additional products thus achieving deeper account penetration.

Supplier blocking techniques

Owning, controlling or being able to influence the availability of a limited, unique or rare input can give you effective control over the entire supply chain.

Companies which have integrated backwards to own specialist components or rare commodities have greater influence over the consumer buying decision than competitors who must work with less favourable inputs.

Inputs can be physical, like a commodity or a component, or information or expertise. For example; specialist staff with deep expertise who are in limited supply can be an effective blocking factor if you can develop some form of exclusive supply arrangements. Many situations require an accredited specialist or highly trained or experienced or knowledgeable expert, the firm which has long-term access to them through their supplier has a sustainable advantage.

Another form of exclusivity exists where specialist stores and wholesalers have an arrangement with their suppliers where the supplier will not place another store or use another distributor in their immediate vicinity or region.

This protects their immediate market and should assure them of limited competition. This is especially effective where the supplier provides brand name products which have high customer loyalty.

In-bound distribution channel blocking techniques

Another effective way of controlling the supply chain is to limit the access of other competitors to the point of supply. Owning or controlling the inbound delivery channel can provide this level of protection. The most obvious example of this type of control is unique distribution agreements with overseas suppliers.

Where the distributor has an exclusive distribution agreement, they have effectively locked out their competitors. This is especially effective where the product solves a unique or difficult problem and has a high customer compelling need to buy.

A good example of this is where Australian firms have been founded on the exclusive importation rights to a new or novel product. Being first to secure the rights to the product or service is a common strategy for a start up firm. They then use this leverage to build their business. I have often said to entrepreneurs.

“Go find something overseas which you can sell here and tell them that Australia has only 20 million people and that the market is too small and too far away for them to bother with”. The aim is to secure a long term distribution contract which you can use to build a secure revenue stream. Many companies have grown on the back of such initial contracts. Sometimes they have taken the risk with new brands or products and as their supplier has become more successful, so have they.

Protecting your product or service

The last point of protection is with the business itself. There are two layers of protection, stopping someone coming into the industry and stopping a competitor from copying your product or service. ‘Barriers to entry’ is the common term used to describe the blocking factors which inhibit new entrants from coming into a market. Many industries have significant industry based entry barriers but, while they protect you from new competitors, they don’t protect you from the competitors which are already there.

Industry barriers are those things which build a wall around the industry to exclude potential new entrants or require considerable cost or time to overcome. The number of ways in which this type of protection can be achieved is extensive but would include such things as:

• Licenses, accreditations, registered rights.
• Regulations which limit new entrants.
• High cost of set up.
• Extensive network of outlets or contact points.
• Deep expertise of a situation, process or market.
• High economies of scale or high learning curve effects.
• Ability and capacity to retaliate.
• Protection through subsidies, trade barriers or quotas.

If you are already in the industry, you want as many of these as possible. If you are entering a market or trying to grow the business, these can be serious impediments. They can also have negative consequences. For example, high costs of set-up might limit the number of effective competitors in a market but the same high costs may lead to intense price discounting when business levels decline. It may deter others from coming into the market but it may not be sufficient to protect the profits of those which are already there.

Many companies see their relationships with their customers as an important blocking factor to new entrants. Some firms have nothing else going for them other than strong customer loyalty, but this has been sufficient to protect their business over a long period of time. Their level of customer service, customer empathy and willingness to go the extra mile to delight their customers is their strength. You should closely examine how effective your relationships are with your customers and find out how important that is to their willingness to place future business with you.

Employees can themselves be a major competitive strength. In many businesses recruiting and retaining the best people is the key to long-term success. Retaining the best people for research and development may give the firm the ability to bring great products to market quicker and cheaper than competitors.

As an example, from 1985 to 1999 I was fortunate enough to have an outstanding team of software developers who moved with me from Northampton in the UK, to San Diego in California and then to Atlanta in Georgia. During that time I was involved in three separate businesses and this team came with me each time. Many people tried to recruit individual members of the team but they stayed together, not because of the salaries, but because I offered an interesting and challenging environment in which they were respected and treated well. I ended up with a real star team which was incredibly knowledgeable and productive.

However, these factors merely deny easy access to the industry by outsiders, they don’t normally provide sufficient protection against close competitors. Other blocking techniques are needed to fence off your customers. Such things as:

• Patents, trademarks and copyrights.
• Highly prized locations.
• Well established brand.
• High customer loyalty.
• A way of doing business which is highly valued by your customers but is not understood by others.
• Secret formulas or processes.

A patent which solves a unique problem can be a powerful blocking strategy. The other techniques may be more or less effective but are not guaranteed and they may only work in some circumstances. They are, however, all factors which can impede the effectiveness of a competitor. The greater the time and/or cost to duplicate or overcome, the greater the level of protection.

Few of these barriers are, however, permanent or 100% effective. Many people believe that patents and other registered intellectual property rights provide the ultimate protection. In truth, these rights are only effective if you have the money to defend them. Many patent holders have been worn down by the time, stress and expense of litigation. A large corporation might be willing to take the risk of an infringement suit or be willing to spend a large amount of resources finding a way around the patent

Integrated solutions

Few companies can achieve long-term sustainability without re-inventing themselves and developing new innovative products or services. In the short to medium-term, the best approach is to develop a combination of strategy, protection and employee and customer relationships which can best meet the business needs. Implementing an integrated solution of blocking techniques or factors across the entire supply chain will be the strongest mechanism you can apply to ensure protection of future revenue from existing customers.

One hundred percent protection is an ideal but that should not stop you from implementing a range of blocking techniques to give you the strongest position. Competitive advantage simply gets you into the game. Building sustainable protection to secure your existing customer base can help ensure survival and growth. Each element of the supply chain should be examined for mechanisms which can protect the business. At the same time, the impact of building great relationships with customers, employees and suppliers should not be underestimated as a form of competitor blocking. In the long run, those that have the most effective blocking techniques are more likely to be more successful.

Applying a range of competitor blocking techniques across the supply chain will result in a much higher valuation on exit. For a financial exit it provides a more convincing basis for revenue estimates while at the same time reducing the risks that those revenues will be achieved. This has a direct effect on the discount rate used in the NPV formula. In a strategic exit, the buyer needs to have time to exploit the acquired strategic asset or process. The competitor blocking techniques provide the basis for the competitive advantage the buyer needs to fully exploit the underlying potential of the acquisition.

Tom McKaskill is a successful global serial entrepreneur, educator and author who is a world acknowledged authority on exit strategies and the former Richard Pratt Professor of Entrepreneurship, Australian Graduate School of Entrepreneurship, Swinburne University of Technology, Melbourne, Australia. A series of free eBooks for entrepreneurs and angel and VC investors can be found at his site here.