Shooting for Start-up Success? Take a Detour

By Knowledge@Wharton | September 30, 2015

Every start-up dreams of having the billion-dollar troughs of Uber, industry-disrupting business model of Airbnb or brand recognition of Snapchat. Reality check: The vast majority of tech start-ups are far from achieving the status or financial backing of these high-profile companies. Instead, these firms have to work harder to make sure their product or service makes it to market, whether they go solo or with a corporate partner. But successfully shifting from a beta version to the marketplace needs thoughtful planning and — surprisingly — perhaps a strategic detour as well.

“We have these ‘unicorns’ and ‘decacorns’ [start-ups valued at billions of dollars] that everyone recognizes as being disruptive and whose valuations are incredible. But for most new ventures, there’s going to be a healthy amount of skepticism” about their business models, says Wharton management professor David Hsu. “A lot of times, entrepreneurs believe they could just jump into a particular way of commercializing or making money from their innovations. There are two dominant ways — one is entering into the product market directly and competing with others, and the other is a partnership type of strategy. The problem is, each of these strategies might not initially be feasible.”

That means a start-up might want to sell directly to customers, but lack the necessary supporting infrastructure such as those in marketing, distribution and services. The business does not have these “complementary assets” because it cannot afford or does not know how to build them by itself. Conversely, a start-up might prefer to license its technology to a big corporate partner, but cannot land a strategic alliance because its product is unproven. These are two scenarios that can beset many start-ups.

Hsu says start-ups should consider taking a strategic detour if a direct path seems unattainable at first. While people might see victory as a straight ascension, sometimes the road to success goes sideways before going straight up. Hsu details these findings in a new paper scheduled for publication in the journal Research Policy, “Strategic Switchbacks: Dynamic Commercialization Strategies for Technology Entrepreneurs,” which he wrote with MIT professor Matt Marx.

They advocate a “switchback” strategy, a technique used by mountain trains such as the Darjeeling Express. These trains navigate steep inclines by going sideways while still continuing to ascend. “The analogy that we use in the paper is the idea of scaling a mountain,” Hsu says. “The most efficient way of doing that is to bolt straight up to the top. But a lot of times, while that may be the most efficient way, it’s not very feasible.” Instead, start-ups can use a switchback just like the mountain trains. “If you could zig and zag your way up to the mountaintop, you’re going to take some detours that may feel a little bit less efficient. But the payoff there is you could easily get up to the top.”

Hsu and Marx point out that a switchback strategy is not the same as a pivot, in which a business changes course only after its initial strategy failed. In a switchback, start-ups deliberately plan on changing course later after their initial strategy succeeds. The authors examine two kinds of switchbacks in their paper: temporary cooperation and temporary competition.

The Case of Genentech

Start-ups that want to sell directly to their customers but do not have the supporting infrastructure such as marketing and distribution can adopt the temporary cooperation switchback strategy. That means leadership would seek to temporarily cooperate with a corporate partner that has the resources and infrastructure to take the start-up’s product to market. In the partnership, the start-up learns from the corporation how to market its product. Eventually, the goal is to break free and go directly to customers.

Take the example of biotech firm Genentech, now a unit of Roche Holding AG. In its early years, the company knew it wanted to make and market drugs by itself to better control distribution and maximize profits that can be channeled into research and development. But it did not have enough skills or the market power to do so at first. Thus, Genentech decided to license its first products to others until it developed enough experience navigating clinical trials and garnered adequate skills in marketing and sales, the paper said.

This rationale led Genentech to license human insulin to drugmaker Eli Lilly, which held 80% of this market and sold through pharmacies. It would have been tough to market the product alone, given Eli Lilly’s dominance. Meanwhile, another product by Genentech — growth hormone — was being distributed by a quasi-government agency and had no entrenched competitors. This drug was easier for the company to take to market itself; Genentech also said its version was safer. Here, the biotech firm is “cooperating initially while learning from partners and developing complementary assets, then later switching to a competitive strategy,” Hsu and Marx write.

It worked. In 1980, 80% of Genentech’s products were sold through its partners. Four years later, the figure had dropped to 38% of new products. And the company is not unique in using this strategy. In an analysis of 169 U.S. biotech firms that went public, Hsu and Marx determined that once these companies went past the median age of seven years, they were only half as likely to enter into alliances or joint ventures and also 20% more likely to end existing partnerships. These findings support the idea that many biotech firms initially license their innovation but later go to market themselves, the researchers write.

However, start-ups have to be smart in the way they execute a temporary cooperation switchback strategy. It is important to ensure that the agreement with the partner is structured in a way that the start-up can learn from the experience — such as retaining the right to co-market the product and participate in clinical trials. What gives start-ups leverage in contract negotiations is if they own valuable innovation or are backed by influential venture capitalists. If these do not apply, start-ups should consider taking smaller fees in exchange for participation rights, Hsu and Marx suggest.

Also, start-ups will find it easier to execute a temporary cooperation strategy if they have a pipeline of products instead of just one. Genentech was able to license earlier drugs, but kept the development and marketing of later drugs to itself. In contrast, speech-recognition software developer Nuance Communications had a tougher time because it had a single product, the researchers note. It started out with a partner, but when Nuance decided to so solo, the partner suddenly became a rival, creating tensions.

From the incumbent’s point of view, partnering with a start-up that might eventually become a competitor presents a challenge. One way to protect against enabling a future rival is to insist on long-term exclusivity in licensing rights or of wide industry scope. Another could be inclusion of “grant-back” clauses for technology advancements — in which any improvements have to be disclosed — to avoid enabling a direct competitor, Hsu and Marx write. Also, the firm could disagree to any co-marketing or similar arrangements.

When Partners Are Skeptical

Start-ups that are having a tough time finding a bigger partner to license their technology or through whom they could sell their products might wish to consider going to market themselves — at first. This is what Hsu and Marx call the temporary competition switchback: Compete in the market to prove the worth and usefulness of the product or technology as a way to get a future licensing deal or strategic alliance. This strategy would work for start-ups facing skepticism from potential partners, which arise because the most valuable applications for the technology are not clear, could not be measured or because an industry standard has not yet emerged.

Take the case of Qualcomm. Back in the 1980s, mobile phone calls were handled using the time-division multiple access, or TDMA, protocol where one frequency was used per conversation. Qualcomm introduced the code-division multiple access, or CDMA, protocol that enabled multiple calls to be handled on one frequency. While it was more efficient, makers of mobile phones and base stations were reluctant to adopt it because they did not believe the technology would work. Qualcomm then decided to build its own CDMA-enabled devices and years later, sold the hardware business to focus on licensing.

The experience of Qualcomm is especially common to other companies with “disruptive” technologies, according to the paper. The incumbent companies might see them as being “too radical” as well as “serving unattractive customers and having little value.” A start-up that decides to go to market itself benefits in several ways: It gets an opportunity to get market validation and it also receives market feedback that can be used to improve its products. Moreover, sometimes just the threat of going to market can bring a potential partner to the negotiating table.

To be sure, there are risks to the temporary competition switchback strategy even if the start-up successfully secures a partner later on. These include the possibility that it might not be able to recoup its initial investment in complementary assets; it gets further removed from the customer; and early public exposure could dilute the value of licensing the technology because rivals could reverse-engineer the device.

Look at the case of the Pebble smartwatch, for instance. Pebble Technologies raised $10.2 million in a five-week period in 2012 from nearly 69,000 backers through crowdsourcing platform Kickstarter, the paper said. “However, some analysts believe that the highly visible oversubscription provided valuable market information to possible competitors, and may raise barriers to a subsequent cooperative strategy,” Hsu and Marx write. But the dilemma is that without proving the Pebble’s public popularity through crowdsourcing, it might not have been possible for the company to raise $15 million in venture capital later on.

So when is it not feasible to adopt a switchback strategy? One answer is when there are many providers of similar strategies and the start-up’s innovation struggles to gain acceptance, the researchers say. But too few rivals also signal that the demand for a product or service might be limited, clouding the pipeline of future licensing revenues. Another reason that a start-up would not need a switchback is when it has enough funding to pursue s desired strategy without needing backing from a big corporate partner.

Looking ahead, Hsu says the next step for their research is to document the performance of start-ups that deploy switchback strategies. “,” he says. “We have some anecdotal evidence of that, but what we hope to show is that companies and entrepreneurs and ventures that undertake these switchbacks in an appropriate manner are much more likely to succeed.