Note: The essay below is one I completed for my International Baccalaureate extended essay for high school, back in 2012. I’ve had a few questions about it recently (there are some links out there to an old blog post of mine on the topic) and so am re-publishing it now. At the time I was working on a startup of my own and was interested in how Eric Ries’ Lean Startup methods had become so popular that they were being used in all kinds of inappropriate circumstances. I wanted to work out the limits to their use.
The original essay is published unedited (excuse the youthful writing) and footnotes have not transferred across.
Empirical studies show that over a period of five years, seventy-eight percent of all early-stage Internet technology companies can be expected to fail. This is a dire result; interestingly, the vast majority of these companies utilize similar strategies for bringing their product to market.
In recent years, a subset of early-stage Internet companies (companies whose primary product is a website or Internet application) have been following different principles – lean methods – and have taken a step away from traditional methods for bringing a product to market. These new companies refer to themselves as “Lean Startups” (a term credited to Eric Ries, who has written an influential book by the same name), and label companies using traditional methods as “Fat Startups”. They take their name from lean manufacturing, which saw success in Japan with companies like Toyota being revolutionized. Lean manufacturing, and subsequently lean startups, at their core revolve around removing any activities that are wasteful.
Lean startup methods are tools and philosophies that allow early-stage companies to bring a successful product to market by focusing on learning through validation of hypotheses. A company will make a guess as to who their users are, and what product they want, and will then test this assumption in real life through a low-cost, basic version of the product. It will then continually adjust the product, or start all over again, based on the evidence shown through its customers’ usage. They do not spend on marketing or sales until they have a validated product, and therefore consume less capital than fat startups. They are capital efficient as they recognize sooner if they are heading towards success or failure. Other advantages and disadvantages of lean methods will be made clear throughout this essay.
As a number of companies utilizing lean methods reach success, the methods are increasingly being adopted. The vast majority of new Internet technology companies use lean methods. At the same time, numerous lean companies are failing, or not living up to expectations made of them. It is likely that there are scenarios under which utilizing lean methods will aid a company in bringing a successful product to market, and there are also definable scenarios where the use of lean methods will hinder a company. By defining these scenarios, we could help new companies to make more effective decisions about the methods they use to bring a successful product to market.
The aim of this essay, therefore, is to explore and discover the circumstances under which lean startup methods are appropriate for use by early-stage Internet technology companies. While lean methods are applicable to companies of all ages and industries, this essay is limited to early-stage Internet technology companies so that its findings can be particularly relevant, and therefore beneficial, to a specific group of companies.
Through this essay, circumstances where lean methods should and should not be used will be made clear. As a result, the failure rate of early-stage Internet technology companies could be reduced, as they begin to use methods appropriate to their individual situation.
Entrepreneurial ventures, if successful, can create jobs and growth in an economy. This leads to an improved standard of living for many individuals in society, and will lead to wider benefits for multiple reasons, such as the company’s ability to pay additional tax.
Therefore, if the failure rate of early-stage Internet technology companies is reduced, many people in society will be better off.
Appropriate Use Circumstances
i. Introduction to extreme uncertainty
For decades, traditional early-stage business methods (now referred to as fat startup methods) have been suitable for use by all businesses. The majority of new companies simply bring an existing product into a new local context, or bring a new product into an existing market. In each case, the conditions are predictable, as numerous other businesses have carried out the same process. Eric Ries notes that this is why most traditional businesses can be funded by a bank loan – they are so predictable that a loan officer can assess their risk and give loans.
However, since the creation of the Internet, many new ventures are bringing new products into new, or re-segmented, markets. In these cases, the business knows nothing about its customers or their desires – it is operating under conditions of extreme uncertainty, or ambiguity.
Fat startup methods involve traditional, milestone-based product development. A concept is created and then undergoes development, including the development of marketing materials based upon market research. Next, it is tested, and finally it launches to users. Under scenarios where the market is known, these product development methods work well as the only variable the company needs to focus on is execution. The traditional product development method is illustrated below.
For Internet technology companies, the product development method is largely ineffective. Companies will go through the cycle, consuming resources as they do, without knowing if the product is what the market wants. It can lead to a large waste of resources, as in the classic example of a failed fat startup, WebVan, an online grocery retailer that consumed approximately USD$1.2 billion in venture capital, and entered bankruptcy shortly after.
Lean methods, in comparison, are inherently useful to companies operating under extreme uncertainty. They focus on validated learning – “…a rigorous method for demonstrating progress when one is embedded in the soil of extreme uncertainty…”. Whereas the product development method is linear, lean methods (which include Steve Blank’s theories on customer development) are circular – a company will repeatedly carry out certain tasks in order to find what is successful. In extreme uncertainty, a company’s knowledge of its customers and product is limited. Lean methods therefore force the company to focus on learning before investing and acting.
The following part of this essay explores the circumstances where it makes sense for an early-stage Internet technology company to utilize lean methods. It is assumed that all of the following scenarios are within the boundaries of extreme uncertainty.
ii. Entering a new or re-segmented market with a new product
Ansoff’s Growth Matrix is a tool that can simplify, and describe, the activities companies should undergo when entering different combinations of new and existing markets with new and existing products. According to Ansoff’s Matrix, companies are diversifying when entering new markets with a new product. However, Ansoff’s Matrix is designed for use by existing companies that are looking to grow – it is not ideal for use by early-stage companies with no existing product and no defined market.
For the purposes of early-stage Internet technology companies, I have developed a specifically revised version of Ansoff’s Matrix. Let it be called the Startup Strategy Matrix. It retains the axes and labels of Ansoff’s Matrix, which are still applicable and useful, but makes different recommendations to early-stage companies. It builds on the research of both Steve Blank and Eric Ries in making recommendations to companies on appropriate strategies.
The Startup Strategy Matrix tells us that if we are bringing a new product into a new market, lean startup methods should be pursued, and there should be a focus on innovative customer development. This is the corner of the Matrix where there is the most uncertainty – almost nothing is known about the company’s customers or their desires. The company should therefore focus on learning and discovering customers’ desires and preferences before embarking on any other activities. Lean methods will allow the company to do exactly this, while preserving capital.
It is worth noting that if a company is re-segmenting an existing market as either a low-cost or niche entrant, the company essentially falls into the bottom-right of the Startup Strategy Matrix and should use lean startup methods. They have no solid evidence of their customers’ preferences, and are unsure which customers from the whole market will be a part of the re-segmented market. Therefore, they should use both lean and customer development methods in order to discover truths about their precise market.
There are very few circumstances in which it would make sense for a company with a new product entering a new or re-segmented market to use fat startup methods instead of lean ones. The company would be making too many imprecise inferences about fundamental parts of the business, such as their value proposition and growth strategy. If they do not know their customers yet, it is impossible to have any evidence on whether these assumptions are correct.
iii. Companies with an in-house technical development team
An early-stage Internet technology company employing a number of technical developers will be heavily advantaged through the use of lean startup methods. Here, business theory is heavily linked with technical development processes.
Traditional development methods are referred to as Waterfall, or Stage-Gate. A development team is given a brief with multiple milestones for a feature. They will complete multiple features, and then launch many features in one batch. This is a slow development method that gives a company little time to learn from its customers about how they actually use the product – this is not in line with the goals of a company using lean startup methods.
A lean startup, by contrast, will have its technical development team utilizing “Agile” development methods. The creators of such methods describe them as valuing “individuals and interactions over processes and tools, working software over comprehensive documentation, customer collaboration over contract negotiation, and responding to change over following a plan”. This description lies in stark contrast to the workings of Waterfall methods, which value the opposite concepts.
With Waterfall methods, if there is an error in a piece of code, the company will not discover this until it pushes the code to users, which will happen in a large batch along with many other features once every month or so. An error could potentially cause the failure of all of the company’s software, rendering its business temporarily unable to function. Because the company has also pushed other features and code to users at the same time, it will be hard to discover the error that caused the problem.
Agile development is one of the tenets of lean startup methods. It requires that the company publish code to its users the moment it is written, and then monitor the results. In terms of manufacturing, it is the equivalent of small batch sizes, which are proven to be more efficient. If there is a problem with the code, it will be discovered immediately, and can be fixed straight away because there will only have been one piece of code that could have caused the problem.
If a company employs an outside software or web design and development firm, it likely has little control over how its product is developed. However, if the company employs an in-house development team, and if one or more co-founders of the company is part of the technical team, then lean startup methods (and therefore agile development methods) should be used. Using agile methods will reduce the risk that an error in code could disrupt the company’s functioning, and will also allow the company to test many additional features on its users.
iv. Where virality is a company’s growth strategy
The nature of the Internet allows many technology companies to achieve organic viral growth. A user of a company’s product, such as a social network, will derive additional benefit from the product if more people are using it. Users therefore have an incentive to share the product quickly and with many people, allowing a company to gain very large numbers of new users, or customers, in a short space of time.
Many early-stage Internet technology companies base their entire growth forecasts upon Metcalfe’s Law; namely, that the value of the network of users as a whole is proportional to the square of the number of participants of the network. In order for their business model to function, the company is required to achieve viral growth. It should be noted that viral growth is a form of organic growth as it is achieved using the company’s existing resources.
Viral growth is a process that is not easily replicated, and many companies try in vain to achieve it. There are few rules for achieving viral growth, and so companies go about achieving it in their own ways. In order to best achieve viral growth, a company should carry out significant amounts of testing.
If the company were to use traditional fat startup methods, they might invest heavily in developing a product that turned out not to achieve viral growth. Lean startup methods, by contrast, involve testing different methods for achieving viral growth until one works.
We can see that by utilizing lean methods, a company can preserve resources until it has a working model for achieving its growth formula.
Inappropriate Use Circumstances
i. Entering existing markets with new products
Referring to the Startup Strategy Matrix (fig. 2), the top-right corner corresponds to a company entering an existing market with a new product. When a company enters a new market with a new product, it must first discover who its customers will be. Lean startup methods allow it to do this by continually testing different hypotheses to discover its market and their preferences. However, if a company is entering an existing market, it is not necessary for it to test hypotheses to discover its customers.
Instead, there will be existing knowledge of customers within the market and their likes and dislikes. The company can draw on this knowledge to create their new product, or can carry out market research to find out what their customers will buy before embarking on building the product.
The Startup Strategy Matrix states that innovative product development methods should be used when entering an existing market with a new product. As much is already known about the market, a company must simply carry out market research and then execute its plan correctly in order to succeed. Traditional product development methods (see fig. 1) will allow the company to execute successfully, while innovation will ensure that the company builds a new product with points of difference that the market will respond to favorably.
Were lean startup methods to be used in this situation, the company would waste time trying to gain knowledge that it could have discovered much more quickly through other methods. Because of this wasted time, the company could potentially be beaten to market by another company and miss the opportunity. Ben Horowitz, a successful entrepreneur and venture capitalist, says about using lean methods; “you may lose your opportunity to win the market, either because you fail to fund the R&D necessary to find product/market fit or you let a competitor out-execute you in taking the market.”
ii. Entering new markets with existing products
Groupon is an Internet technology company that saw huge success in the United States, quickly becoming the fastest-growing company the world has ever seen. Their business model involves selling coupons to large number of consumers who are incentivized to share the coupon with their friends. While Groupon quickly expanded and launched their service in many cities within the United States, other entrepreneurs saw their success and began replicating their business model and product (in this case their website) in new markets.
Again drawing upon the Startup Strategy Matrix (fig. 2), these Groupon “clones”, as they are referred to, correspond to the lower-left corner. They are companies entering new markets with existing products.
Groupon’s success was not market-specific. In every state within the United States that Groupon expanded into, the result was similarly large growth. It was clear that Groupon’s product was one that humans in many different markets desired.
It appears that having first-mover advantage is hugely important in launching companies based on Groupon’s business model. Indeed, the first four companies following this business model to launch in major cities in the United States now control an estimated 89% of the market.
Lean startup methods can take longer to execute than fat startup methods because they require a circular approach. Multiple hypotheses are tested until the company has a model that is proven to be working and has discovered its market. However, since companies have seen Groupon’s business model work in multiple markets, they can be sure it will work in any new market that they introduce it to. They have no real need to execute lean startup methods, as they already know what product should be built. They are also heavily incentivized to be first to market in order to gain large market share. Were lean startup methods to be used, companies could miss out on being first to market by working to prove hypotheses that had already been proven correct by existing companies in other markets.
It is clear that in scenarios such as that of a Groupon clone – when entering a new market with an existing product – utilizing lean startup methods will lead to missed opportunities for many companies.
Utilizing fat startup methods, in contrast, will lead to faster execution because they take a linear approach, and allow the company to spend on marketing to take advantage of being amongst the first to market, gaining market share.
iii. When selling to quality-conscious market segments
Certain market segments, such as the super-wealthy, value quality as one of the most important factors in making a purchasing decision. As a result, the majority of companies, and fat startups, build products according to the theories of W. Edwards Deming. Deming believed that the customer was the most important part of the production process, and therefore high quality should be focused on to boost efficiency. In addition, companies will utilize Kaizen theories of continuous improvement, as well as a Total Quality Culture, to ensure that quality is kept high.
Lean startup methods require that a “minimum viable product” (MVP) is created and launched to users in order to test assumptions about the market and product. An MVP allows the company to preserve resources by producing a product that is missing many features and is of lower quality, while still testing assumptions.
This essay argues that if a company is entering a market segment that is conscious about the quality of the product, lean startup methods should not be used. The low-quality MVP may damage the company’s reputation, and cause it to lose many sales in the future.
iv. When following an external growth strategy
Some early-stage Internet technology companies find themselves in situations where an external growth strategy will best allow them to take advantage of opportunities. For example, Twitter pursued external growth strategies by acquiring products such as Tweetie, a mobile-application version of Twitter. Twitter had no mobile application of its own, and found that it could best take advantage of the opportunity in the mobile space through an acquisition, rather than building its own product in-house.
If a company finds that it can best respond to an opportunity through an acquisition, merger, or takeover of another company, then fat startup methods should be pursued. These methods will enable the company to raise sufficient capital in order to carry out external growth.
A company using lean startup methods, by contrast, would be unable to carry out external growth due to the time it would take to validate hypotheses about the opportunity being pursued. For example, Twitter noticed an opportunity in the market for mobile applications and decided it should enter this market immediately. If it had used lean methods, it would have had to first validate its hypotheses about the market. The time needed to do this could have allowed another company to take advantage of this market opportunity first.
Two things are worth noting here. Firstly, a company may at first follow lean startup methods but then spot a market opportunity. If the opportunity is large, it may be beneficial for the company to change to a fat startup strategy in order to pursue that opportunity quickly through external growth. Secondly, it can be said that companies using fat startup methods therefore carry more risk, as they do not take time to validate assumptions. They will simply enter a market to ensure that an opportunity is not missed, even if some of their assumptions later turn out to be incorrect.
The benefits of lean startup methods are clear. They allow companies operating under conditions of extreme uncertainty to reduce the risk inherent in their venture through validating hypotheses based on experience. They enable companies to operate using small batch sizes, and better manage in-house technical development.
However, it is also clear that lean startup methods are not appropriate for use by early-stage Internet technology companies in all situations. The use of lean startup methods in certain situations will damage a company’s ability to grasp an opportunity, and to react boldly enough with large amounts of financial capital.
The results of this essay – based on research by both scholars and entrepreneurs, as well as first-hand observations of companies – have led to a set of clearly defined scenarios where lean startup methods should, and should not, be used.
In initially deciding on a startup strategy, companies must examine the type of market they are entering, and what product they are entering it with. The Startup Strategy Matrix (fig. 2) was developed as part of this essay. It clearly describes the strategies that companies should use based on their market and product combinations. This should be the main factor in a company’s choice of startup strategy.
The Startup Strategy Matrix allows us to say that in general, if a company is entering a new market with a new product, it should use lean startup methods. However, a company must continue to examine whether lean startup methods remain relevant throughout its process of discovering its market and product.
This research has also shown that if a company discovers that it is entering a quality-conscious market segment, it should change strategy to traditional fat startup methods in order to take advantage of Deming’s theories on quality. Additionally, if a company deems that it needs an external growth strategy to take advantage of a market opportunity, it should alter course and utilize fat startup methods.
Many of the insights in this essay are non-exclusive. For example, if a company begins using lean startup methods because it is entering a new market with a new product, but then finds a lager opportunity in a different market segment, it should change its strategy accordingly. The initial strategy chosen should merely guide a company to discovering new information, at which point a company may be required to change strategy.
It should be noted that some unexplored areas could have added to the conclusiveness and scope of this essay. First, the real-life applicability and usefulness of the Startup Strategy Matrix should have been tested in order to understand how the Matrix affects the strategies that a real company uses. By giving the Matrix to various companies, and monitoring their results in comparison to new companies not using the Matrix, the effectiveness of the Matrix on company development could be tested. While this would have been ideal, it was not within the scope of this essay, as it would have required a large amount of time to determine differences between the companies’ development.
Secondly, additional examples of companies using different startup strategies would have helped to clarify the circumstances presented in this essay, such as a real-life example of a company trying to achieve viral growth. However, early-stage Internet technology companies are by nature protective of their internal company information, to ensure that competitors cannot prepare a similar product before the company launches its product. This made the finding of real-life examples difficult and outside the scope of this essay.
The findings of this essay offer clear scenarios relevant to all early-stage Internet technology companies. It is hoped that the conclusions will help companies to find the most relevant strategy, and to adjust it in the light of new information. Companies following startup strategies relevant to the circumstances presented in this essay should increase their chances of success.
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