The Internet revolution began as a land grab with swarms of startups throwing business on the web in the hope of grabbing market share early. But, in the rush to get customers many of these companies thought the marketing rules were completely different, made many mistakes in judgment, and forgot to think about barriers to entry. Before long, virtually every domain in cyberspace was overcrowded with competition, and today we are seeing an ugly shakeout.
So now that we've seen the demise of so many startups, it's time to get back to basics and put barriers to entry back into your marketing plan.
But what are barriers to entry, anyway? Barriers to entry are any number of strategic, economic, cultural or logistic requirements that may impede or even prevent a company from entering a market or industry.
Below we list a number of major barriers to entry. Think about how these barriers exist or don't exist in your industry, and to what extent they might pose a risk to your company or business idea. If you're starting a company, think about how you plan to overcome these barriers. Or think about how to make these barriers higher if you want to keep competitors out.
Capital Requirements - These are essentially the costs of becoming established in your industry. The amount will depend, of course, on your industry. Capital is typically required for research & development and production facilities. But capital is also necessary for things that fall under the heading of "working capital," which funds such things as inventories, credit for customers, and advertising.
A key idea to think about here is whether any of these investments can be recovered if your company or business folds. A recoverable capital requirement might be machinery or property. Advertising, however, is a non-recoverable investment because you don't get your money back from advertising if you company folds. As you can see, capital requirements for investments that are non-recoverable are typically larger barriers to entry.
Cost Advantages - Many cost advantages exist that may act as barriers to entry. Many of these are obvious, such as government subsidies, best contracts with suppliers or distributors, or favorable access to materials. In the case of the Internet, perhaps a cost advantage might be cheap content.
One of the more interesting sources of a cost advantage is the so-called "learning curve." The learning curve is based on the idea that the more you do something, the more experience you acquire, and thus the better and more efficient you get at it.
This is a well-known concept, and it's tempting to think that if you sell a lot of products, you'll get that experience curve benefit. But it is also well known that experience doesn't lead to cost advantages unless the experience is actively managed. Texas Instruments, for example, has had a long history of being able to manage costs via an experience curve. In fact, they were able to use this effectively in the early 1970s to take over the burgeoning pocket calculator market from Hewlett Packard.
In any event, watch out for competitors who create "process innovations" - better ways of doing day-to-day business routines - for they can quickly eliminate whatever experience you've built up.
Economies of Scale - Scale economies act like the learning curve, but while the learning curve deals with cumulative experience or volume, economies of scale deals with volume per period (i.e. producing and selling a lot this quarter).
This distinction is important, for it reveals that economies of scale say that you get cost advantages by being big. How? By allowing the bigger firms to spread their costs over larger volumes, or get "synergies" out of combining functions and operations.
Economies of scale are a barrier to entry because they force potential entrants to come in at a large scale - something that is difficult for many potential entrants to do in a new industry or product category.
Product Differentiation - You have identified an opportunity to provide a product or service profitably. Your success is going to attract attention. One problem you will face is when another firm with name recognition and brand loyalty for their current offerings decides to follow you. You will have to spend large amounts on promoting and differentiating your offering to combat an established firm's goodwill. If there is no major established player in your industry, who in a related industry would be likely to follow your lead?
Anything you do to create strong customer loyalty can be a barrier to entry because it helps to differentiate your product. But because this can be bid away by other firms who also have strong brand recognition, loyalty can be a tenuous barrier. And if you spend your time differentiating on price, you will surely have no long term differentiation -- and hence no barrier to entry -- since price is typically bid away quickly by competitors.
Distribution Channels - Because distribution channels typically have limited capacity, existing companies will receive preferences as they generally have less associated risk. Often to overcome these preferences, a start-up company will have to pay premium prices.
The Internet may have raised questions about traditional channels as a barrier, so if all you have is a web site, you might look to how you've organized the other channel functions as potential barriers. For example, think of how the brick and mortar stores have now begun to demonstrate the importance of having physical stores for people to see products (and return products). These investments in physical distribution channels may ultimately be the barriers to entry for e-commerce players in the future.
Legal Restrictions - Many claim that the only barriers that cannot be overcome with shrewd planning and business sense are those created by government. It is necessary to investigate and explain any ordinances, laws and taxes that will impact on your business.
So, always consider what the government can do by way of licensing requirements, access to raw materials, standards for pollution and safety, and product testing. This isn't just for big companies to worry about. Consider the case of startup e-stamps.com, which ultimately got caught in the barriers to entry erected by the US Postal service.
Retaliation - If you're entering the market of other established businesses, do not expect your company to be welcomed without response. There are a host of responses available to the competition depending on their market position. Reactions can range from price slashing to negotiating exclusive arrangements with suppliers and distributors you would have worked with. Time must be spent anticipating the reactions of existing businesses and determining the impact these reactions will have on your organization (see our tutorial on Predicting Competitive Reactions).
Intellectual Property - Intellectual property includes licenses, patents, copyrights, and trademarks. Intellectual property is the legal way to protect a business from others. Typically, patents have been issued for product technologies, but on the Internet companies have been applying for process patents (Amazon's One Click ordering service or Priceline's reverse auctions, for instance). Each of the intellectual property mediums is distinct in their use and scope. The cost of administering a trademark or patent may seem excessive at first; however, the long-term protection and profitability will overshadow any early costs.
Rather than assume you have barriers to entry, think about the potential barriers we just described. If you have any leverage to build them up in your existing business, think about doing that to limit competitive entry.
If you're thinking about opening up a new product category, think about whether or not you face any of these barriers to entry. Without barriers to entry, expect competition to rapidly enter your new business if it seems profitable.
And finally, don't rest assured if you think you have high barriers to entry. Barriers that keep competition out may make it difficult for you to change your position if the technology or industry changes.