Notes on 7 Powers
Note: I’ll be posting future posts on my site rather than Medium. You will find this post here: https://jacobwallenberg.com/posts/notes-on-7-powers
I recently read the book 7 Powers — The Foundations of Business Strategy by Hamilton Helmer. It lays out in very clear and concise terms the seven ways in which a business can create a sustainable advantage vis a vis its competitors, and comes recommended by a bunch of smart people like Daniel Ek, Michael Moritz, and Peter Thiel.
I wrote up my notes to make sure that I had understood the concepts properly. Hopefully they can also be a useful reference if you’ve already read it, or give you an idea of what it’s about if you’re interested in picking it up — which I highly recommend if your idea of fun is reading 200 pages on strategy with accompanying equations.
I’ve tried to add my own examples wherever possible. If you disagree with them I’d like to hear it!
You can read more about the book on its website (http://7powers.com/) and buy it on Amazon.
Overview & Definitions
Helmer defines the key terms of the book as:
Strategy: the study of the fundamental determinants of potential business value.
Strategy (capitalized) is distinguished from strategy (lower case) and is divided into Statics (or “being there”) and Dynamics (or “getting there”).
Power: the set of conditions creating the potential for persistent differential returns.
Power is the core concept of Strategy, and the book explains what it looks like when a company has power (Statics) and how a company can get power (Dynamics).
strategy: a route to continuing Power in significant markets.
strategy is also referred to as The Mantra, and will only carry the above meaning throughout the book. If you take away only one thing from the book, it’s The Mantra (in its entirety).
Benefit: the way in which the power improves cash flows, such as through lower costs or ability to charge higher prices. Aka the magnitude of power.
Barrier: the way that competitors are prevented from arbitraging the Benefit of the power. Aka the duration of power.
Each power creates a benefit for the winning company, and a barrier for its competitors. A benefit is common, but a barrier is rare.
Lastly, Helmer defines the math used to calculate the intensity of a given power. I don’t cover these in detail since it would just be copying directly from the book, but I’ve included the high level formulas at the end of the post to give you an idea of the approach.
Part 1: Statics — Defining the 7 Powers
The 7 Powers are Scale Economies, Network Economies, Counter-Positioning, Switching Costs, Branding, Cornered Resource, and Process Power.
1. Scale Economies
- TLDR: Per unit costs decrease as volume increases
- Benefit: Reduced cost
- Barrier: Prohibitive costs of share gains
- Example: Salesforce (or any SaaS company). The cost to develop software is (mostly) fixed. For each additional customer acquired, the development cost per user decreases
Scale Economies aren’t just about fixed costs. It also applies to volume/area relationships (Amazon fulfillment centers), distribution network density (UPS), learning economies, and purchasing economies (Wal-Mart).
2. Network Economies
- TLDR: The value of a product to a user increases as the number of users increases
- Benefit: Ability to charge higher prices thanks to more valuable product
- Barrier: Prohibitive cost of share gains (as users would need to be compensated for the lower value provided)
- Example: Windows. More users lead to more developers writing software, which made the platform more useful to additional users, attracting more developers, etc…
Additional relevant concepts: Winner Take All, Boundedness (limited to specific domains, e.g. Facebook & LinkedIn don’t compete), and Decisive Early Product (first network to get past a certain threshold will hold on to their lead).
3. Counter-Positioning (CP)
- TLDR: A new company adopts a new business model that incumbents won’t copy because it would hurt their existing business
- Benefit: Lower cost or higher prices due to more valuable product
- Barrier: Collateral damage to existing business
- Example: Warby Parker. By going direct to consumer online, they were able to cut out distribution costs and licensing fees. Luxottica likely did not copy due to milking (see below)
Helmer created this one himself. It’s worth looking closer at as the definition is more narrow than one first believes, due to how the barrier arises. To determine if counter-positioning is at play, we look at why an incumbent would not copy the business model.
- Is the Net Present Value (NPV) of investing in the new business model positive on a standalone basis? If yes, check next step. If it is not, it is not CP.
- Is the NPV positive on a standalone basis, but negative on a joint basis? If yes, then it it is CP. This is case 1 aka Milking, and is what Fidelity experienced when Vanguard came about.
- Is the NPV positive on both a standalone and joint basis? If yes and they still don’t invest then it is either due to cognitive bias about the value of the new model (case 2, also called History’s Slave), or due to agency issues where management is incentivized to retain the current structure (case 3, also called Job Security). If yes and the incumbent does invest, it is not CP.
4. Switching Costs
- TLDR: A customer loses value by switching to an alternative supplier for an additional purchase
- Benefit: Ability to charge higher prices for the same product. It’s important to note that it only applies to follow-on products, as you can’t have switching costs without an original product
- Barrier: High costs, as the competitor has to compensate a customer for the switching cost
- Example: Hotels — specifically loyalty programs and statuses
Switching Costs can be financial, procedural, or relational.
5. Branding
- TLDR: Durable attribution of higher value to objectively identical offering, due to historical information about the seller
- Benefit: Ability to charge higher prices due to either perceived higher quality, or reduced uncertainty
- Barrier: Significant time needed to build it up — aka hysteresis
- Example: McDonald’s. People know what they get!
The higher value attributed to a strong brand stems either from affective valence (i.e. Coca Cola is preferred to store-brand’s Cola, irrespective of flavor), or uncertainty reduction (i.e. I know that the coffee will be OK at Starbucks).
The challenges in Branding are brand dilution, counterfeiting, changing consumer preferences, geographical boundaries, narrowness, non-exclusivity, and type of good.
6. Cornered Resource
- TLDR: Preferential access, at attractive terms, to an asset that can independently increase value
- Benefit: Ability to charge higher prices or reduce costs, due to access to the cornered resource
- Barrier: Ranges from property and patent law to personal preferences e.g. when retaining key talent
- Example: Patents
It’s easy to fool yourself into thinking you have a Cornered Resource. To qualify, it needs to pass these five screening tests. 1) Idiosyncratic — it repeatedly generates returns, 2) Non-arbitraged — the price paid does not exceed the additional profit, 3) Transferable — it could create the same returns at another company, 4) Ongoing — the resource creates benefits over long period of time, 5) Sufficient — the resource must be sufficient to create continued differential returns.
7. Process Power
- TLDR: Embedded sets of company organization and activity which enable lower cost and/or superior product
- Benefit: Improved product attributes and/or lower costs due to superior process
- Barrier: Hysteresis. Significant time and investment needed because the process is highly complex and difficult to imitate
- Example: Apple’s production process. From design, to supply chain, through distribution
The key difference between Process Power and operational excellence is hysteresis — it takes significant time and effort to copy. Again, it is the barrier that is hard to come by, not the benefit.
Part 2: Dynamics — Getting to Power
The second part of the book is divided into two parts: what is needed to get to Power, and when you can establish it.
What’s needed to establish power
To answer this question, Helmer shares Netflix’ story of establishing power in streaming. The company had power in their DVD-renal business (CP, Process Power, and some Scale Economies), but these did not transfer to the opportunity they were gunning for— streaming.
Netflix focused on content, a core part of their product, and their biggest cost. Since all content was licensed, Netflix paid content-providers per view, which meant that costs rose with revenues. Had they continued on this path, power in streaming would not have been attainable. But thanks to two decisive actions, Netflix created a path to power. First, by creating an attractive new service — the streaming app we know today — they secured an early scale advantage that remains to this day. Second, they turned content into a fixed cost through exclusives and original content, which created Scale Economies in streaming.
The general model is:
- Flux in external conditions creates new threats and opportunities.
- Based on fluxes, the company invents new products and solutions.
- Once an attractive product is invented, find a route to Power.
But to recall our original definition of strategy, the “significant markets” component is missing. To create such a market, the invention from step 2 has to be drastically better than any alternatives. Helmer calls this Compelling Value.
When to establish Power
Helmer describes three distinctive stages, based on market revenue, during which companies can craft a route to power. These are:
- Origination: before the company is creating compelling value. Powers: Counter-Positioning, Cornered Resource
- Takeoff: the rapid growth that takes place once compelling value is attained. Powers: Scale Economies, Network Economies, Switching Costs
- Stability: after growth slows down. Powers: Branding, Process Power
In each case, the challenge is to create the barrier associated with the power. The benefit is, relatively speaking, easy to attain, but the defense is difficult to establish unless the market is at the appropriate stage.
This concludes the book. If you find it interesting I’d highly recommend reading it in its entirety. (Amazon)
Appendix: How to measure a Power
Helmer defines the math that will be used to calculate the intensity of each type of power. The value of a firm is defined as the NPV of future free cash flow (FCF), which he calculates in the following way:
This is referred to as the Fundamental Equation of Strategy. I’ll refer to these as M, g, s, and m.
The product of M and g reflects market scale — i.e. the “significant markets” component of strategy. The product of s and m is the quantitative measure of power. M and g are the subject of dynamics, s and m are static.
For each power, we will calculate the Surplus Leader Margin, which is quantitative measurement of the advantage gained by a company with power. It is the margin that the strong company S can maintain while keeping the weak company W at bay. As mentioned, to dig into these properly, get the book.
1. Scale Economies = (Costs/Leader Sales) * ((Leader Sales/Follower Sales)-1)
2. Network Economies = 1–1/[(∂/c)*(sN — wN)+1].
∂ = marginal benefit of additional user, c = cost per unit, and sN wN= user base of strong and weak company
3. Counter Positioning = om * [oP/nP]* ∂
om = margin of old business model, oP&nP = profits in old and new business model, and ∂ = weak company’s induced cannibalization ratio of Old model into New model (alternatively written as: -∆oQ/nQ, where oQ and nQ are the quantities of the old and new business model, and -∆ is negative change).
4. Switching Costs = ∆,
∆ = the Switching Cost per unit
5. Branding = Surplus Leader Margin: 1–1/B(t)
B(t) = branding price multiple at time t. Takes into account time, maximum potential branding multiple, and brand cycle time.
6. Cornered Resource = ∆/(∆+ wP)-k(∆+wP)* sQ
∆= additional profit from Cornered Resource (CR), k= additional fixed cost from CR
7. Process Power = 1- 1/D(t)
D(t)= The winner’s cost multiple at time t.
