Beyond “Cheaper, Faster, Better” — Vertical Integration for Startups
In the past couple of years, I have worked with multiple startups in an advisory capacity and this has provided an opportunity to think about strategy in innovative ways. The conventional wisdom has been that startups, just like the Fortune 500 companies, need to think about vertical integration, identifying their core competencies quickly, thereby identify areas that the startup needs to focus on in-house versus partnering/outsourcing. Even more so than for established firms, this is a critical issue for startups given that they are typically bootstrapped or working on limited funds and have to determine where best to focus on the resources at their disposal. The article discusses an approach to solving the “Cheaper/Faster/Better” problem from the lens of Vertical Integration. I apply this lens to a startup that develops solutions in the health-tech market.
Going from concept to production and subsequently getting the product in the hands of a customer takes significant effort. The success of a Proof of Concept can often mislead the organization to believe that “it is easy”, whereas it often might not. While this article focuses on startups in B2B markets, we can extend it to B2C and B2B2C, while some considerations might be different.
As one might already be aware, Vertical integration is defining the components of a supply chain that the company will own versus outsource. Companies could integrate backward and forward. While the concept of vertical integration appears to apply naturally to companies that manufacture hardware, it cannot be further from the truth. Microsoft, for example, depends on manufacturers (Dell/HP) and retailers (Best buy) to sell its software. While the SAAS model has disrupted this thought process, enterprise software very much depends on forward integrators.
Additionally, while traditionally spoken about in terms of a product life cycle (source/make/sell), vertical integration applies equally well to other critical activities of an organization such as Marketing, Human Resources, IT, which we will discuss.
In Practice with a Startup
Sustainability is a crucial consideration in Vertical Integration
The conscious mindset
Startups often identify a gap in a certain segment of a market and look to address it in a way that adds value to the customer. The startup hacks a PoC to determine the viability of the solution. The problem occurs when the organization intends to scale or switch to production from a beta. How do you, for example, address a support call at 2 AM in the night because the market requires a mission-critical response? Should you build your workforce incurring fixed costs or should this function get outsourced incurring variable costs and better economies of scale, potentially compromising SLAs?
While addressing “Cheaper/Faster/Better”, one must also consider sustainability. Vertical integration delivers a level of control but also requires incurring costs a startup may not be able to afford, e.g., staff augmentation and management. Vertical segregation, conversely, delivers economies of scale but the supplier might wield significant power. Other considerations include an exit strategy and the capability to scale and diversify after the initial launch.
Background, Criteria, and Decisions
The following section describes a health-tech company “ZB Enterprise”, the considerations and culminating decisions.
ZB Enterprise uses IoT solutions to combat conditions such as Alzheimer’s and the related problem with wandering (a situation where the person with Alzheimer’s can step away from a protected environment, this can quickly escalate within minutes to a life or death condition). We made key decisions based on the following considerations:
- ZB Enterprise’s Business model was to serve senior living homes; (a model to serve a B2C market did not offer the economies of scale due to a multitude of reasons beyond this article).
- The Product offering required continuous monitoring and real-time notifications, usually within minutes. In that context, managing the recurring costs of staging the solution in the cloud while maintaining the quality of service at a large scale was critical.
- Operations required the installation of private wireless networks and subsequent management to provide reliable service. This required working with local authorities on permits and installation per code and maintaining uptime of 99.95% (which requires a 24x7 staff). Owning versus leasing of network equipment was another decision point required. Owning requires capital assets, higher upfront and lower operational cost versus leasing which requires lower upfront and moderate operational costs.
- Onboarding the staff and patients, and ongoing support to staff, which required additional marketing materials and intake of Purchase Orders and subscription payments.
- A Go-to-market strategy that meets the threshold where senior living homes would collaborate with a startup. This industry is especially resistant to change for a multitude of reasons (beyond this article).
Decisions
From a Go-to-market perspective, we screened several potential partners that already had a presence in senior living homes, and we narrowed these down to ones that specialized in minimizing problems related to roaming. We entered a working partnership with a technology provider that had the right economic incentives given this solution, delivered differentiation beyond the current offering, and had the potential to expand their customer base (a win-win, which is critical from a Transaction-Cost-Economics perspective). Besides product placement, the partner we selected brought additional marketing attributes including promotions and pricing strategies. The partner would also collaborate with us to create marketing material to show and enable better self-service capabilities. We subsequently worked on a consumption model where we invoice our partner monthly based on the number of active devices.
From an operational perspective, while our PoC with our LoRAWAN network went well, we ran into coverage problems. This had much to do with not being able to design for all parameters and constraints. We, therefore, decided to build a private network where we would own the gateways and collaborate with a professional telecom network installer to build and manage the network for us. This was a critical decision because, despite initial capital cash outflows, owning the network allowed control and build strategic capabilities for subsequent years. Collaborating with a network installer allowed us to build the network faster and better given adherence to the regulations and SLAs. Given that such partners have also built out a very strong 24x7 operational team across the country, it implied that the cost of maintenance was considerably lower than if we did this by ourselves. The handling of acquisitions and other problems such as bankruptcy was de-risked by working with multiple partners from the onset.
We used several considerations that are further explained in the next section. To address a broad audience, I present these and additional considerations in general terms.
Considerations
Every organization has a dominant logic. That includes startups, except that they are significantly more malleable than Fortune 500 companies
Organizational functions
For startups, some functions are obvious candidates for outsourcing (or use variable cost resources). These functions are typically in accounting (e.g. managing financials, taxes) and human resources (e.g. managing payroll, onboarding). Decisions regarding some other functions aren’t as black-and-white though. Marketing is one example. Some aspects of marketing might be critical such as front-end operations of marketing including industry analysis and market segmentation, whereas the opportunity to outsource some other aspects of marketing operations might exist.
Similarly, functions in Sales and R&D also require a conscious determination. Should the organization work with an outside consulting company (e.g. low-cost design centers in India, Vietnam, Ukraine). Does the start-up have the structure to work with such design centers? It has been my experience that startups, given their innovative approach to a problem, often have to build their team in the country of origin.
Operations fall in the same category. It is also critical to determine if the startup will need to work with a value-added-reseller to get a foot in the door. As suggested earlier, a PoC doesn’t automatically make up a successful operational structure. Installing a solution (especially when it concerns hardware) might be easier. It is also important to consider questions such as support and the way the market structures SLAs as often driven by market needs.
If the start-up has the selling power because of the niche nature of their offering and the target market is relatively small, they might have to build the sales team and dedicated support staff because of the solution and scale. In other cases, they might have to contract it out.
External Considerations
While the business might seem ripe for disruption, it might not be accessible due to political considerations, which, in turn, drive regulation. This might require a partner strategy. In other cases, regulations might be the way to transform industries. Hospitality is seeing a huge surge in employee safety devices driven by a few companies that were making panic buttons for the B2C segment and saw better opportunities in the B2B segment, subsequently lobbying the appropriate association to drive the market need. Another consideration is tariffs associated with manufacturing in one country and selling in another (Startups seldom begin with the perspective of expanding internationally and often are ill-prepared for it, which makes channel partner strategy critical).
Economic considerations might include the availability of capital markets. A start-up in North America should have much lesser concerns with access to capital than a startup in Asian countries. This again should drive considerations around capital intensity. A recent study on the chocolate industry demonstrated the need to have at least $120M in liquidity for a 10% market share. An alternative might be to allow a partner to deploy and maintain the solution and in turn, pay a subscription fee to another partner.
Technological considerations must include the collection and use of data. As IoT has shown, telecommunication capabilities have improved manifold, especially with 5G and LoraWAN, where it is now possible to deploy and own these networks at scale (and possibly even monetize them). Cloud and Edge solutions have minimized the barrier to entry. These considerations have shifted (in both ways) the threshold for vertical integration and segregation. For example, an incumbent such as Monsanto (now Bayer), traditionally in the agriculture vertical has transformed itself as a digital company (through acquisitions) and provides data as a service while Amazon has chosen to partner with Verizon for its Edge services.
Organizational Strategy
Another consideration is the kind of organization a startup envisions itself as becoming. A value-driven startup should consider vertical integration to minimize costs within reason. if the founder has no foot-in-the-door in discrete manufacturing, then they might have no choice but to work with a Value-Added-Reseller (VAR) who might already have a presence in the industry producing related products in the hospitality industry, for example. The VAR might also help with terms of initial sales/implementation and subsequently help deliver effective maintenance (e.g. recurring subscriptions, troubleshooting) and in some capacity as a customer success team. A startup focused on differentiation should consider methodologies where customer experience, time to market, etc. are high on their totem pole and potentially manage their manufacturing and distribution to maintain a strong inventory.
Firm Capabilities
Every organization has a dominant logic. That includes startups, except that they are significantly more malleable than Fortune 500 companies. This influence of the founders of the company, who typically also occupy key roles such as the CEO/CFO/CTO is critical in determining the eventual shape of the organization. The key point here is that the company should focus on core competencies and build on them sustainably so that they are very difficult to copy.
For example, if the organization has the choice between finding system integrators to deploy their product versus building their team, they should consider the value of building this in-house. If this provides a competitive advantage (because customers might prefer an end-2-end solution and potentially a lot of customization that is enabled by the company itself), then it should build an organization that delivers that need. Alternatively, it could consider 3rd party integrators and make it easier for the integrators to customize the offering from the company, and focus on building innovative capabilities because 3rd party companies such as Accenture have a better capacity to absorb slow times.
Conclusions and Recommendations
Define market-appropriate SLAs and determine its sustainability under various scenario; Make long-term growth a priority
In a B2B environment, write a set of SLAs as we would define in a Statement of Work and ask a conscious question.
- How do we achieve SLAs without being penalized considering penalties doesn’t have to be monetary but also a loss of customer trust.
- Which functions should be vertically integrated (note that these include processes that provide competitive advantages and are hard to copy)?
- Which of these functions can be segregated? How will this allow the organization to focus on its core competencies, future growth, and vertical diversification?
As an example, If a 4-hour turnaround is critical in a limited geographical area and a high volume, that would allow consistent work for one or more full-time employees; This might be a viable strategy than pursuing a large geographical presence and a support call that occurs once a month.
It is only appropriate to finish with a questionable rationale for vertical integration. For starters, avoid risk mitigation that shifts the problem from one area to another. As a startup with little to no reputation to speak of, poor customer experience could sound a death-knell to the company. For example, a company that uses a system integrator to reduce revenue recognition anomalies might add risk from a customer experience perspective (as a tangent: do nothing suspect, especially with financial accounting, no matter what the incentives appear to be).
Similarly, the need for co-location doesn’t imply vertical integration, nor should segregation solve geographically disparate entities. Working with an offshore team doesn’t imply the need to integrate vertically, as an example. The question, in my personal view, always goes back to the overall value chain analysis.
Eventually, in strategy, there is no right or wrong and a retrospective doesn’t always yield the right perspective because companies don’t have a crystal ball. The most important aspect is to approach vertical integration and segregation with an open mind, but also consider the consequences in the long-term.
Acknowledgments
I would like to thank Professor Devaki Rau (College of Business, Northern Illinois University) for being an inspiration in writing this article. The book, Behavioral Strategic Management, and her impeccable teaching style has enabled my advisory work for several startups. Thank you!
Footnotes
Backward integration is a decision to either make or buy the raw materials required to make the final product. Typical reasons to integrate backward is to control cost, quality and mitigate against market vulnerabilities. An additional reason is that the parts have a custom component to it.
Forward integration is the decision to own the logistics of distributing the product further down the food chain. It is a decision to determine if it requires the middleman to be successful. The answer, as is often the case with business strategy, is not straightforward.
