Dominance Friction

Jesse Beyroutey, partner at IA Ventures, on why some companies achieve dominance while others get bogged down.

Jesse Beyroutey wants to build dominant companies. And his method for doing it is surprisingly generous.

So far, it’s working. At just 26, he made partner at IA Ventures. IA is quietly one of the most successful seed firms of the last decade, backing billion dollar startups like TransferWise, The Trade Desk, Komodo Health, Datadog, and Flatiron Health. Now, Jesse’s 30, and he plans to continue building IA for the next decade or longer.

So how does he find potentially dominant startups?

The first thing he does is define the term. When most people talk about “dominant” companies, they use it as a general word to mean “big” or “strong” or “intimidating.” 

But when Jesse uses the word “dominant,” he’s thinking of game theory, which defines a dominant strategy as a way of playing a game that your opponents cannot beat, no matter how they play. Kind of like how there aren’t a lot of winning moves to compete against Google in search, or Amazon in ecommerce.

When Jesse evaluates investments for their ability to be dominant he actually inverts the question: he spends a lot of time assessing factors that could prevent a company from becoming dominant — what he calls “dominance friction.”

And dominance friction comes from a pretty surprising place: any time a company’s interests are misaligned with its customers’ interests.

Jesse believes that any misalignment between a company and its customers creates room for a competitor to enter the market with better alignment. And that the company with the best alignment — that’s most generous to their customers — is the company that wins.

This conversation was a real treat. Jesse rarely writes publicly, and doesn’t do many interviews. 

In this discussion we’ll examine what it means to be aligned with your customers’ best interests, and look at some of the common ways a company’s strategy can create dominance friction.

So let’s get started :)

Jesse introduces himself

Hi, I’m Jesse Beyroutey. I just hit my eighth anniversary at IA Ventures, where I lead seed stage investments in startups.

I have two partners at IA, Roger and Brad, and at this point I've spent more time with each of them over the last 8 years than with any other human being.

I joined in my early twenties, and I fell in love with the way we think about and work with companies here. We’ve worked with technology companies in every sector from healthcare, to IT, to financial services, to real estate, to life sciences and more. And somewhere along the way it became my life’s mission to do this work.

What is “dominance”

We’re looking for companies that can be dominant in their category. And that has a very specific meaning to us that comes from game theory literature.

In game theory, a dominant player is one who is occupying a position in which you can’t be beaten by your competitors no matter what their next set of moves are. For example, in the famous “Prisoner’s Dilemma,” the dominant strategy is to confess, because it’s the best action to take regardless of what the other player chooses.

This might seem too abstract to be useful, but there are very real scenarios where companies put themselves in positions that are unbeatable, at least for a time.

The best examples from the last two decades are Google and Facebooks’s multi-sided network effects. People prefer searching and connecting with each other on these properties, so advertisers and content creators keep using them. It creates a virtuous cycle, and makes the self-interested move on every player’s part one that reinforces these companies’ continued success. It’s basically impossible to attack head-on without a major paradigm shift to break the chain.

Using dominance in this way helps us ask more useful questions than just “how large can this market be?” It’s necessary but not sufficient for a company to be able to grow to a large scale for it to be extremely valuable. It also needs to be very profitable when it gets to scale, and likely to retain those profits for a long time. Dominance ensures all of the above.

Dominance isn’t about fighting dirty

One thing that might surprise you about dominance is how companies get it.

You might think it comes from rapacious win-at-all costs business practices, or from raising large amounts of money to snuff out competition. But we’ve found that the primary source for a company’s dominance is whether it designs its product and business model to be perfectly aligned with its customers’ interests.

Any misalignment between a company and its customers or its value chain is a source of “dominance friction.” Why? Because a company whose business model is not ultimately aligned with its customers’ interests is vulnerable to another competitor beating them with better alignment. After all, people want to be treated fairly and have their best interests considered. They don’t want to have to think too hard about whether they’re being duped.

A great test of alignment is whether the company benefits or suffers from increased transparency. If your model will suffer from perfect transparency with customers, you’re not in an unbeatable position. And in a world where information is everywhere and word travels quickly, this is a very precarious position to be in.

A perfect example of this is the subscription-ification of everything. So many companies try to convince customers to buy subscriptions for products that shouldn’t really be subscriptions — in hopes that the customers forget that they’ve subscribed. 

They might display a fixed price per month, without giving you transparent information like the average number of times per month you’re likely to need it. These are often products where the customer has variable, irregular utilization of the service, and it costs the company money to render the service each time the customer uses it. It creates an incentive for the company to minimize the amount their customers actually use the service.

I won’t call anyone out here, so I’ll give a made-up example: imagine if TaskRabbit only offered a subscription, with a fixed monthly price for unlimited tasks. You would pay TaskRabbit the same amount every month, but your need for their services might go up or down significantly. You need it when you’re building new furniture and not at all when you’re living happily.

In this case a subscription model is a bad idea for the customer, because this imaginary version of TaskRabbit would make the most money if you simply forgot to use the subscription.

Once a company is incentivized in this way it can lead to a lot of bad behavior. For example, many companies in this position will make it difficult for their customers to unsubscribe — you have to call or email and fight with a representative to end your subscription.

Or worse, the company decides to act like the “house” at a casino. They set the rules for how much capacity is available to customers so that the customer, statistically, always loses a little bit. 

In our imaginary example, TaskRabbit would make worker availability hours ever so slightly more inconvenient until your usage was low enough for their subscription to turn a profit. Or they might pressure workers to complete complicated tasks too quickly and end up sacrificing service quality.

It’s easy to see from this example how small misalignments between a company’s interest and its customers’ interests can drastically affect how the company operates as it grows. When these misalignments are large enough, they will ultimately leave a company open to competitors, and slow down its growth. 

This is why we have a strong pro-customer position at IA. We believe any company that takes a position that is not fully aligned with its customers is open to being beaten by a company that does.

Avoiding double binds

For founders in search of a dominant model, the trickiest situations are when the value chain of an industry doesn’t allow for customer preferences to be the top priority. 

We call this a double bind. It’s often caused by a misalignment — where what’s good for a critical value chain participant, like a distribution channel, isn’t good for customers. 

[Editor’s note: another way to say “double bind” is trade-offs!]

It’s a trap, because you actually can’t create a business model that’s aligned with your customers’ best interests. You’re bound by the incentives of another critical member of the value chain.

The most common example of this is the U.S. healthcare system. Tons of well-meaning startups enter the industry hoping to reduce our bloated healthcare costs. Yet they end up in a very similar position to incumbents: if they want to grow, they often have to do it at the ultimate expense of their customers. 

For example, any company that provides care to patients, must periodically negotiate for prices and bills with insurance companies. It doesn’t matter if it’s a technology-forward company like One Medical, or an old-school hospital system. If those healthcare providers want to increase their profitability, the path of least resistance is to charge higher prices or bill more aggressively. That profit comes at the expense of insurance companies. And those insurers, in turn, just increase prices for employees and employers that pay premiums. A well-intentioned healthcare startup still ends up increasing overall healthcare costs in a vicious cycle.

Other common examples are industries where customers perform infrequent, high-value transactions. Real estate is a good one, funerals is another. 

In industries like these, there tends to be symbiotic relationships between different providers, like mortgage loan officers and real estate agents, where they send customers to one another frequently. Those providers have little incentive to tell customers about better options in the market. After all, this may be the only transaction any customer ever does. And so a startup looking to disrupt one of those market participants, with a genuinely better solution, will quickly find that their critical distribution channel will want to make the product less transparent or more expensive.

The key to get out of a double bind is to internalize both the product and the distribution channel. Just do it yourself and go direct. Don’t depend on middlemen who create an incentive for you to make things worse for your customers. 

This is leading to a rise in “full-stack” companies that acquire customers directly, with products paid for by the customer solely, at transparent prices. We see this happening in everything from consumer goods, to banking, to medical services, to dentistry.

Fixing the original sin of an industry

One of my favorite things about startup disruption is that often they find a misalignment between incumbents and their customers that everyone in the industry assumes is unchangeable. The startup fixes it and kills the incumbent.

We call this misalignment the industry’s “original sin.”

Financial services are littered with misalignments because, historically, financial institutions have charged customers for all sorts of products on a percentage of a volume of money. This is a “sin” because it actually doesn’t cost a financial services company significantly more to serve a customer with more money. Whether it’s assets under management, or transactions, moving money around is just moving bits of information around, and computers do that for free -- as we wrote about with our investment in TransferWise.

These companies just charge more because it’s tradition (and they can get away with it).

One trap that startups get caught up in is using software to innovate on the customer experience of a product, relative to incumbents, but not simultaneously using that as an opportunity to fix the original sin of the industry. Instead they repeat the misalignment on pricing, or transparency. We see this as a huge missed opportunity.

This mistake happens frequently when a startup builds a software product but charges customers on the basis of volume. 

My favorite recent example of this is robo-advisors. 

With robo-advisors, you saw Betterment and Wealthfront enter the 401(k) business at a much lower price-point than traditional advisors, because they’re using software to automate the investor onboarding and investment management process. Great! 

But they still charged customers an advisory fee as a percentage of assets under management — so the amount you’re paying them increases as you invest more money. They did this because that’s what all other wealth management advisory businesses do — it’s the original sin of the industry.

And it worked for a while, but it wasn’t dominant, because something better was possible. 

Guideline (not an IA portfolio company) entered the market with the same superior product experience, but they didn’t repeat the original sin: they also innovated on the pricing model. 

Guideline charges on a flat fee per month basis, just like SaaS software, because that’s all the product really is. So they have both a great product experience and a much better aligned pricing model than their competitors. 

To summarize, in order to create maximum customer alignment your profit model should align with the drivers of your costs. You should do this even if the incumbents in your industry don’t. Because if you don’t do that, someone else is going to come up with a model that does

Many people will argue, Oh but you’re leaving money on the table by doing that. And I think that’s a fine argument. But they’re forgetting that another term for leaving money on the table is consumer surplus. And that makes consumers so happy that they’ll talk about your product effusively to others.

Consumer surplus is the reason people pay money for things happily. The more there is, the better. It is also, ultimately, the thing that compounds to create dominant brands that spread quickly by word of mouth. 

It’s a great surprise when customers learn that a company isn’t charging as much as it can. Or that it’s offering great customer service when it could have invested less. Or that it’s being transparent when it could have hidden the truth. Or that it made it easy to unsubscribe when it could have locked you in.

The next generation of dominant companies will win because of profound customer love, that stems from deep customer alignment. Doing better for the customer when they could have done less. These are the companies that will stand the test of time.

Book Recommendation

Many of our ideas about dominance are largely related to Helmer’s work. In his book he calls it “power” instead of dominance, but the two terms are fairly interchangeable. I highly recommend 7 Powers for anyone who is interested in learning about strategy.

Jesse Beyroutey is a partner at IA Ventures. You can follow him on Twitter here.

This interview was co-written with Dan Shipper. You can follow him on Twitter here.

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