7 Powers: The Foundations of Business Strategy

Alex: What's up, everyone? Welcome back to another episode of Founder’s Journal. I'm Alex Lieberman, co-founder and executive chairman of Morning Brew. Today's essay breaks down one of the best business strategy books that I have ever read. Startup founder Abi Tunggal breaks down 7 Powers by Hamilton Helmer, which is a book about the seven proven business strategies that lead to sustained competitive advantage for companies and startups. By the end of this episode, you'll understand each of these strategies, why they created powerful moats, and examples of companies like Apple, Netflix, Costco, Tiffany & Co., and more that have won their markets by executing on one or several of the seven powers. So let's hop into it. 

7 Powers: The Foundations of Business Strategy by Hamilton Helmer. A summary and review of Hamilton Helmer's book, 7 Powers, by Abi Tunggal. “So what are the secrets to making a company enduringly valuable? If we are to believe Hamilton Helmer, the answer is strategy and execution. Every celebrated business is underpinned by decisive strategy, choices, and operational excellence in the midst of uncertainty, which leads to some form of competitive advantage.

And what is strategy? To borrow from Nathan Baschez’ Introducing Divinations, every strategy is really just a theory. We bet if we do X, then Y will happen. Strategy as an idea may be easy, but we should never confuse simple with simplistic. Reed Hastings, CEO and co-founder of Netflix, echoes the importance of strategy in his forward to 7 Powers. “Most of my time and that of everyone else at Netflix must be spent achieving superb execution. Fail at this and you will surely stumble. Sadly, though, such execution alone will not ensure success. If you do not get your strategy right, you are at risk. 7 Powers provides a comprehensive strategic framework that can help every business choose what to focus on next.”

Abi then lists out each of the seven powers that Hamilton dives into in his book, and then summarizes each one. The powers are as follows: power one, scale economies; power two, network economies; power three, counter positioning; power four, switching costs; power five, branding; power six, cornered resource; and power seven, process power. Now let's go one by one for each of the powers. Abi will give you a definition. He'll give you the benefit of that specific power, how it creates barriers to entry, and real world examples of the power in practice. 

Let's start with number one, scale economies. “Scale economies are defined as a business where per unit costs decline as volume increases. The benefit of scale economies is reduced costs, and it specifically just means as you get more customers or scale as a business, you can spread your fixed costs more, which means the per unit or per customer cost goes down for you as a company. That leads to the barrier to entry, which is that prohibitive costs of share gains, or said differently, basically, when you're small and you don't have a lot of customers, it's really hard to make the economics of your business work because you cannot spread costs across tons of customers like the market leader can. Scale economies are straightforward, well known, and often overlooked. If your business has a low fixed cost base, it can benefit enormously from scale. This is why many technology companies try to get big fast, not for scale itself, but because being big is one of the best ways to protect their profits. Hamilton uses Netflix and their move toward original content as his example of a scale economy. Prior to creating their own content, Netflix had to negotiate the rights to each TV show or film on a case by case basis, often multiple times across geographies, each with changing terms. This is part of the reason why the US Netflix and the Australian Netflix have different content. Netflix was at the mercy of its suppliers, who could and would charge more based on the increasing number of subscribers that Netflix had. In short, Netflix’s cost base wasn't fixed.

Contrast this with Netflix originals. With originals, Netflix pays a flat fee that can be divided across its global subscriber base who will all get access to the same content on the same day regardless of geography. Now, for what it's worth, this is why I, Alex Lieberman, think Spotify is just a fundamentally worse business than Netflix, because they don't have the luxury of owning their own content and turning variable costs into fixed costs. They are forced to have content being a variable cost that increases even as they increase their subscriber base because of how the music industry works and the relationship that Spotify has to have with labels. This is why part of Spotify's strategy has been to pay a large fixed fee for podcasts and get more into podcasting, and it's also why Spotify has gotten more into audiobooks. Now let's keep going.

“And Netflix never has to pay another cent. Once the content is made, the more subscribers the company amasses, and the higher it can push its pricing, the more content it can produce, which in turn drives more subscribers, more engagement, and more pricing power. This flywheel is endemic to SVOD, or subscription video on demand, but unique in the history of television. Linear television networks have always been bound by a finite number of primetime slots and the size of the total primetime audience. Accordingly, a network with 15 viable slots would only add a new show if it replaced one of its existing 15. The only thing that matters is relative outperformance. Netflix faces none of linear's limitations. Any series that can meet the company's target cost per hour watch contributes to its penetration and engagement, so that's the benefit, but what's the barrier? Scale is a chicken and egg problem. Netflix had to get big enough that it made sense to create its own original content rather than leasing it from others, but in order to get big, it needed content from other providers. Contrast Netflix, which has 207 million subscribers, to Stan, who has 2.3 million. If both companies were to produce an original with a budget of a hundred million dollars, Netflix pays 48 cents per subscriber while Stan pays $43.47 per subscriber. If Stan wants to compete with Netflix's original content, they not only have to make the large initial outlay to produce the content, but they also have a far smaller base of users to spread the cost across.

This is the best illustration of why scale economies are so valuable for companies that achieve it. Even if they were willing to do that, Netflix's superior cost advantage allows them to spend more on marketing, improving their user experience, hiring more people, or just undercutting the competition. As you can see, Netflix’s move toward original content significantly improves its margins, and creates a compelling moat that is not easily emulated. 

Now, just two other examples of businesses that benefit from scale economies. One is Costco, which is able to buy product at crazy bulk, which leads to lower costs of goods, and then it passes on those savings to customers, which leads to lower more competitive prices.

Another great example is AWS, or Amazon Web Services’ high up-front cost of the servers that they had to pay for to operate the cloud, and then they are able to spread that high fixed cost across more and more customers that rent cloud storage from AWS. 

Next up, power two, which is network economies. Network economies relate to businesses where the value realized by a customer increases as the user base increases. The benefit of this power is that you have the ability to charge higher prices or monetize more due to additional value created, and the barrier is that it is hard to gain market share, as users don't wanna switch due to the lower value provided.

Great example of this is there is a reason why basically no successful consumer social network has been created in the last five years, and the biggest social networks, Meta, Snapchat, et cetera, just continue to accrue value and power. If you work in technology, there's a good chance you're already familiar with network economies. They're behind many of the most successful technology businesses including PayPal, Facebook, and Twitter. That said, many people continue to confuse virality with network economies. This is because they're often seen together but don't necessarily have to be. You can go viral without having a network effect and vice versa. A network economy is a business where the value realized by a customer increases as the user base increases.

Facebook is a canonical example of a service that benefits from network economies. As the user base grows, you're able to connect with more of your friends. We all use Facebook because we all use Facebook. This is why Facebook's major focus in the beginning was retention. It's why they rolled out school by school and why the entire Facebook product experience focused on getting users to seven friends in 10 days. Once a user had seven friends, they were much less likely to churn and thus added value to Facebook's network. More importantly, these strong network effects have made it near impossible for anyone to compete with a generalized social network. As I shared earlier, the idea of leaving Facebook to join an alternative network that most of your friends aren't using reduces the potential value of the alternative even if it's a better experience.

This is why network economies often lead to winner-take-all dynamics. And a few other great examples of businesses that benefit from network effects I just wanna share: Wikipedia. More users attract more contributors to Wikipedia pages, which leads to more users being attractive because there are more pages to actually search and consume content on. Another example is Waze. More users attract more contributors. More contributors attract more users because Waze becomes more valuable as a mapping and direction platform. DoorDash, more restaurants attract more users, more users attract more restaurants, and more of both restaurants and users attract more drivers. Amazon, more users attract more sellers. More sellers means more selection, which attracts more users. For Salesforce, more users attracts more third party app developers, which makes the platform more valuable, which attracts more users. And finally, Apple. More Apple customers attracts more app store developers, which makes Apple's products more valuable for customers, which gets more developers interested in developing apps because there are more customers to buy from the app developers. 

Next up is power three, counter positioning. A counter position business adopts a new, superior business model that incumbents cannot mimic due to the anticipated cannibalization of their existing business. The benefit of counter positioning is lower costs and/or higher prices due to a more valuable product, and the barrier to entry is the cannibalization of the existing business. Basically, said differently, the incumbent in the industry would have to cannibalize its existing business in order to compete with the new counter positioned entrant, and we're gonna have an example of that in a minute. Counter positioning tends to come from outsiders and startups rather than existing market leaders. This is because the business environment does not allow market leaders to pursue disruptive innovations when they arise for one of the following reasons. A, the total addressable market looks small. B, it's difficult to see if the total addressable market will grow and by how much, and C, their current cost structure, meaning the cost structure of the incumbent, is based on serving their existing market and not what is required to sell the disruptive technology which may have lower margins at first.

A great example of counter positioning is Vanguard in financial services. Vanguard took on the world of active investing with its low cost passive index funds. While it's easy to spout the benefits of low cost passive investing today, it was a highly contrarian approach. Why would anyone accept the average returns of the market instead of choosing an active equity investor who wanted to beat the market? Well, it turns out it is exceptionally rare for an active fund to beat the market over the long term. As this became apparent, Vanguard saw its assets under management balloon, and while competitors could have easily introduced their own low cost passive index funds, they were extremely slow to do so for the exact same reasons that Kodak had for not adopting the digital camera: It made them less money and their cost base wasn't set up to support it.

Another great example of counter positioning is Netflix. This is from the newsletter Marginal Futility, which says “Blockbuster was in the business of video/movie rentals through brick and mortar stores. At its peak, Blockbuster had 9,000 stores. When Netflix launched its business in 1997, it adopted a counter position business model to that of Blockbuster. DVD by mail instead of in stores, and no late fees, unlike Blockbuster. Both of these aspects obviously sound better from the viewpoint of customers. However, Blockbuster did not imitate Netflix even though it could have easily done so. Why? Because it would have hurt their existing business significantly. Late fees constituted a significant portion of Blockbuster's revenue in 2000. Blockbuster said it made $800 million in late fees, or 16% of its revenue. Further, one of Blockbuster's core value propositions was the superior in-store experience. Launching a DVD by mail service would be counter to one of their key selling points. Further, the stores were also a source of another highly profitable and significant revenue stream for Blockbuster: concessions like popcorn, candies, et cetera. Switching costs occur when it's easier to stay with a product or service than it is to switch, even if the alternative is objectively better. 

Next up is power four, switching costs. Companies with high switching costs create an environment in which customers expect a greater loss than the gain from switching to an alternative, so they do not switch. The benefit is the ability to charge higher prices for the same product, and the barrier to entry is that the competitor has to compensate the customer to justify them switching. So for example, I've seen newer CRM companies offering a free service to switch your company and all your data from Salesforce to their product in order to decrease switching costs as much as humanly possible. Switching costs occur when it's easier to stay with a product or service than it is to switch, even if the alternative is objectively better. Additional products, features, integrations, consulting, and training can make it even harder to switch. This is part of the reason why many companies provide universities with free access to their software to teach students. It means when they get to the workforce, they've already learned the software and would incur switching costs when they have to learn an alternative. Examples of this include Adobe, Matlab, Mathematica, and Atlassian products at Australian universities. In 7 Powers, Hamilton uses the example of SAP, which over time becomes the backbone of organizations. I personally think Salesforce is a more interesting example. Once you rely on Salesforce's CRM, it's often not worth switching platforms. It can take months to retain your workforce and cost hundreds of thousands or even tens of millions of dollars to recreate business logic on the new platform. Beyond CRM, Salesforce now has 14 other products that when used make it even harder to switch. This includes integration, analytics, enablement, productivity, platform engagement, commerce and marketing, and service. 

A key thing to consider is that switching costs often increase with the number of people who rely on it. They're never that large for a single person, but when an organization has hundreds or thousands of users on a certain platform, it can mean thousands of hours of productivity lost. Even if a new solution is 10% better, it may not make sense to switch. This is a big reason for vendor lock-in and why enterprise software can be terrible, overpriced, and have outdated UX but still succeed. Other reasons switching costs are created include the person who uses the software is not the person buying the software, and managers prefer to go with the tried and tested rather than something new that may be better, but they don't wanna risk their reputation on a new shiny solution.

For example, “nobody ever got fired for buying IBM” is what's always said. The other reason is the software is optimized for compliance, complicated workflows, permission management, et cetera, and the user experience just takes a backseat. And finally, no one is in charge of reevaluating the old software solution. So companies just keep paying for whatever they have. 

Another great example of switching costs on the consumer side is Apple. By creating a vertically integrated product experience where they control software and hardware across several categories, it makes switching to Android or PC super painful, whether it's being known as the green text bubble in a group chat if you have an Android, or having a way tougher time uploading new photos to iCloud if you get a PC or an Android. Apple intentionally makes it super high friction to use anything outside of their ecosystem. 

Next up is power five, branding. Branding is simply when a business enjoys a higher perceived value to an objectively identical offering due to historical information about them. The benefit is the ability to charge higher prices due to perceived higher quality or reduced uncertainty. And the barrier is the significant time and uncertainty needed to build a brand. Brand is arguably the most powerful and least understood of the seven powers. It's so durable because of how complicated, time intensive, and lucky you have to be to build a brand. If you look at Warren Buffett's Berkshire Hathaway portfolio, you see a lot of powerful brands: Amex, Wells Fargo, Apple, Hines, Coca-Cola, Bank of America, Goldman Sachs, IBM, and Johnson & Johnson. The key thing to understand is many of these brands sell commoditized goods. There's nothing different between them and their competitors beyond the company or product name. It's so funny, as I say that I think about going to a CVS or a Walgreens and always buying the brand versus buying the generic even when the ingredients are the exact same. With brands, customers are paying for consistent experience and years, even decades of consistent messaging.

Tiffany and Co., the American luxury jewelry retailer, is a classic example of brand. The brand is so strong, people wanna buy used Tiffany boxes on eBay. When Tiffany introduced the diamond engagement ring in 1886, the Tiffany blue box became as desired as what was inside. When you buy Tiffany's, you're not just buying jewelry, you're buying over a hundred years of consistent advertising that says when your partner buys you Tiffany's, they love you. It's an incredibly powerful growth loop. The more people who know the brand, the more they expect to see it, and the more people want it. In the past, the Tiffany blue box meant better placements in malls, and the store itself acted as a new channel for new people to discover Tiffany's.

One caveat to this is that the internet may be changing how brands are developed and how powerful brand is as a power. Just look at how quickly Airbnb was able to build a brand that often surpasses the likes of Hilton and other famous hotel brands. Now, I will say that unlike some of the other powers, I do think brand is the one that takes the longest to build up. Even with the acceleration of technology, I do think there's a max speed that trust and word of mouth spread can happen at, and it looks more like decades than years. This is just my personal point of view as Alex. I just think brand takes a ton of time, and more so than the other powers, placement and brand may not be as important in the internet's infinite mall with unlimited shelf space. Now, I don't agree with that, but we'll see as time goes on.

Near zero cost of distribution means new ways to build brands that can be much faster than traditional methods. See email addresses and razor blades from Stratechery for more on this topic. 

Now, one last thought on power five is something to keep in mind here is that brand can be built through a commoditized product in the same way celebrities have attached themselves to the alcohol space and built brands like Ciroc and Casamigos, but also brand can be earned through differentiation by way of one of the other powers. For example, Airbnb is a good example of a great brand, but I would say they earned that title in lieu of another powerful strategy, in their case, network effects. 

Next up is power six, a cornered resource. This is when a business has preferential access to a coveted resource that independently enhances value. That resource can be talent, infrastructure, intellectual property, or a specific good. The benefit is the ability to charge higher prices, reduce costs, or create better products due to access to a cornered resource, and the barrier to entry ranges from property and patent law to personal preference. For example, retention of key talent. A good example for talent is Amazon, who according to The Information, has a 17-person senior leadership team called the S team who have an average tenure of 15 years, the majority of the company's 23-year lifespan. The S team has a deeper understanding of what it takes to scale a business like Amazon's than anyone else in the world, and have shared almost two decades of experience.

Other famous examples are Apple's design team led by Jony Ive, the PayPal mafia, and Pixar's brain trust. On top of talent, I typically think of a cornered resource as a company that either has a moat created by patents or trade secrets, thinking of like Samsung with 9,000 plus patents, or Coca-Cola with its secret recipe. And then the other type of cornered resource I think of is physical infrastructure. I think of Verizon with their physical network of fiberoptic cables, or BNSF railway, which is the largest freight railroad network in the US and unsurprisingly, owned by Berkshire. 

Next up, and the last power, is power seven, which is process power. This refers to a business whose organization and activity set enables lower costs and/or superior products that can only be matched by an extended commitment. The benefit of process power is improved product and/or lower costs due to superior process, and the barrier to entry is the significant time and/or investment needed to create this process. Process power is one of the hardest powers to copy. Toyota is famously transparent about the Toyota production system, or TPS process, but other companies haven't been able to replicate it. The key difference between process power and operational excellence is even if you know what to do, it takes significant time and effort to replicate. Toyota's Kanban just-in-time manufacturing system allows any worker from janitor to CEO to stop the production line if they see something dangerous or something that could be improved. Despite Toyota providing tours and creating a joint venture with GM, they still couldn't replicate the process power of Toyota's Japanese factories. While checklists are great, see the checklist manifesto, process power is embedded in the organization's culture. It's learned by osmosis and feels natural to employees. To outsiders, it looks like magic, and it sort of is. 

Other good examples of process power are Instagram and WhatsApp. Both were worth billions of dollars with less than 60 full-time employees, 13 employees for Instagram and 55 employees for WhatsApp. 

Now the final section of the essay talks about Hamilton Helm's breakdown of how companies actually establish power in the first place,d then the three phases that allow power to progress. Now it starts with a quote by Peter Thiel, which says “Hamilton Helmer understands that strategy starts with invention. He can tell you what to invent, but he can and does show what it takes for a new invention to become a valuable business.” This is from Peter Thiel, the entrepreneur and investor. “The path to power begins with invention. To understand why, we return to Netflix. When Netflix decided to take on streaming, they had powers in their DVD rental business, counter positioning and process power, that wouldn't transfer over to streaming, and to develop the streaming offering, they had to license content, which increased in cost as subscribers increased. There was no path to creating something that would produce persistent differential returns. But thanks to invention, the streaming service we know today, Netflix, created compelling value and had one power, counter positioning, that allowed them to get to scale.

Scale then allowed them to shift their attention to developing original content that was exclusive and produced at a fixed cost, leading to a second power: a scale economy. Over time, we may see Netflix develop a powerful brand and process power around their original programming, too. In general, change creates new threats and opportunities. The company invents a new product or service, and once the new product creates compelling value for customers, the company can develop a strategy, aka a route to power. 

What I take from 7 Powers is it's as important to decide what to work on as it is to work hard. Netflix would've never become Netflix without its counter positioning and scale economy. 

Now let's talk about power progression. When can you establish a power? There are three distinct phases when a company can craft a strategy to create power. The first phase is origination. Before creating compelling value, counter positioning and cornered resources can be created. The second phase is takeoff. The rapid growth phase that takes place when compelling value is attained is when scale economies, network of economies, and switching costs can be attained. And finally, the third phase is stability. After growth slows, brand and process power become the name of the game. 

And that is a summary of the killer business strategy book, 7 Powers. This essay was written by Abi Tunggal and the book was written by Hamilton Helmer. I'll link to both the essay and the book in the show notes, in case you want to go deeper on the seven proven strategies for establishing power.

As always, I'm your startup sherpa, Alex Lieberman. Thank you for listening to Founder’s Journal and I'll catch you next episode.