Summary of ‘Zero to One’, Chapter 5: Last mover advantage
Summary: Since a company’s value is its future cash flow, high growth is not enough: the company must also endure. Trendy companies can be over-valued: a nightclub lives for a few years; Zynga can’t make more Farmvilles; and Groupon can’t retain companies. Truly valuable companies are monopolies in durable markets. There are four common properties of a market which makes its monopolies durable. Property 1: significantly superior proprietary tech (e.g. Google Search) is monopolistic because no one can reproduce it. Property 2: network effects (e.g. Facebook friends) are monopolistic because smaller companies have a smaller network. Property 3: high fixed costs (e.g. software development) are monopolistic because smaller companies are punished more relative to their revenue. Property 4: branding is by nature monopolistic, and the best monopolies integrate their brand deeply into the product, e.g. Apple Macbook Pro. To build a monopoly, you should monopolize early. Sequence the markets you target: start small and build out (e.g. eBay originally only targeted obsessive collectors; Amazon only sold books). Don’t “disrupt”; instead find a niche where you don’t have to disrupt. But don’t be the first mover into a big market; instead, wait and be the last mover once you’re big enough to keep the market.
Monopoly is only great if it can endure. Twitter is valued higher than The New York Times because of the expectation that it will capture monopoly profits in the future. “The value of a business today is the sum of all the money it will make in the future.” To compare companies, compare their projected future cash flows: this is why a nightclub (low-growth, short-term, trendy) is worth less than a startup (high-growth, long-term, monopolistic). Tech startups often lose money for many years, in the expectation of future revenue. “Most value will come 10-15 years in the future.” LinkedIn is projected to have almost all its lifetime cash flow in the future.
So companies must grow and endure; not just grow. Investment is frequently thrown at high-growth companies without long-term durability. Zynga is fashionable, but they don’t have a recipe for making another Farmville. Groupon convinced lots of companies to join, but doesn’t know how to keep them.
So don’t focus on the growth numbers. Instead focus on the factors which result in big future long-term cash flows. There are four common factors: proprietary tech, network effects, economies of scale, and branding. They all lead to big future cash flows because they all lead to monopoly.
1: Superior proprietary technology is monopolistic because it is difficult to replicate. Think Google Search - no one else knows how to do it. The easiest way to get superior proprietary tech is to create something new in a new market (say, a cure for baldness). In an established market, such technology must be at least 10x better - a quantum improvement. PayPal was at least 10x better than the previous payment system on eBay. Amazon was 10x better than other online bookstores because it was really a “book broker” ordering from other suppliers, allowing it to sell any book. The iPad was 10x better than any existing tablet because it was a full integrated product.
2: “Network effects make a product more useful as more people use it” - they have positive feedback. Networks are monopolistic because new companies have no network. You cannot build on network effects alone - your product must be useful to the very first users. You can increase network effects by gradually expanding the target network - Facebook first targeted Harvard students, where network effects are intense.
3: Economies of scale are monopolistic because smaller companies are punished by the fixed costs. Software is an extreme: the fixed costs are everything, and the costs of a new user are near zero. Service businesses are the other extreme: you can’t scale a yoga class.
4: All companies are granted a monopoly on their branding. True monopolies have a powerful brand. Apple’s brand is hard to imitate even if it were legal: it is built into the core product (superior machining and proprietary tech). Yahoo has tried to rebrand as cool, but has a worrying lack of substance - brand alone is not enough.
How do you build a monopoly? By monopolizing as early as possible. Try to dominate a small, specific market. (But don’t try to monopolize a non-existent market!) Targeting “1% of a giant market” is a red flag: it’s actually extremely hard to get that 1%, and it will compete your profits to 0.
From there, sequence your markets. Amazon started with books and monopolized it. It expanded into DVDs and software: similar markets which it could use the same distribution system on. eBay targeted the obsessive hobbyist collector trade first, like Beanie Babies.
Sometimes there are hidden obstacles to scaling. The eBay auction house works well for collectibles but not for generic goods. This was not seen in 2004, and eBay’s value today is smaller than predicted. “Disruption” is a buzzword. It originally meant the replacement of an older tech with cheaper, newer tech, e.g. PCs disrupted mainframes, and mobiles may be disrupting PCs. Seeing yourself as “disruptive” encourages the language and behavior of competition. PayPal wasn’t really disruptive: it didn’t challenge anyone directly, and gave Visa (et cetera) more money than PayPal took.
“First mover advantage” is fragile: someone will come along and unseat you. Better to be the last mover, and you do that by sequencing markets, taking your true target market when you are powerful enough.
I wrote this because I felt like it. This post is not associated with my employer. This site is hosted by Netlify (who are great, but I'm not associated with them either).