Is Market Diversification A Good Growth Strategy For Me? (Part 2)

This is the second part in a two-issue series on growth strategies for software SMEs. Go read the first part, which was published in this blog on 21 Aug 2012. Here is a short summary of the previous episode:

Market vs value diversification 101

This comic strip was generated at http://www.MakeBeliefsComix.com. Used by permission of author and site creator Bill Zimmerman.

Where trouble hides

What emerged was a four-dimensional life cycle pattern that consists of two branches that originate from the same area. We called it the "Competence Jump Pattern".

Competence Jump Pattern revealed

The Competence Jump Pattern

"Number of markets addressed" is the X axis, "Number of engineering domains covered" is the Y axis. The size of companies was represented by corresponding surface of their dots, and time is here not represented but permeates the graph, as companies in the cloud (bottom left corner) are the youngest, and companies get older by moving along either one of the two arrows.

Let's start with the origin of the pattern at the bottom-left corner. The source of all companies is the graph region where companies are created, usually to serve one market with one product that aims at one engineering domain. That's where start-ups are.

The first branch of the pattern starts at the origin and consists of companies that continuously create new products to cover ever more engineering domains for customers in a small, almost fixed, number of markets (teal arrow). They do so typically by adding more products and services to their offerings, by delivering more tools, methods, services etc. to help their customers in an ever-broader range of engineering tasks. By doing so, these companies grow from start-up to middle size and beyond, and later seem to hit a ceiling. Once stuck, some of these companies seem to choose to grow by entering new markets, either by developing specific new products and services, or by swallowing smaller players. These companies stand a chance at achieving sector leadership, which is located at the top right corner of the graph.

The second branch of the pattern (green arrow) consists of companies that have a low count of served engineering specialties - they tend to specialise in satisfying a limited range of engineering needs. Then, they grow by adding new markets to their portfolios of customers. Despite additional markets, these companies tend to remain small. We could not find any gorilla-sized company in this category.

What did we discover?

In growth strategies of technology-driven SMEs, there is a fundamental choice that must be made early on in the life of a company. This choice strongly influences its future.

The choice is this. "Should we grow 1) by adding more products and services to serve the same types of customers, or should we grow 2) by bringing our set of products and services to new types of customers?". Should the answer be the first alternative, the company usually seems on a clear path to growth than in the second one, where companies remain small and sometimes end as growth acquisitions in portfolios of large players.

We also realised that this fundamental decision is probably not conspicuous enough among the sea of decisions the CEO of a typical SME faces every day. However, going too soon into market diversification instead of product diversification may sentence the company to a life of paltry growth and scrawny profits.

How do we explain the Competence Jump Pattern?

After the initial surprise, we wondered if the Competence Jump Pattern could be an illustration of predictable consequences of other strategic theories.

We reasoned that companies in the low branch are actually entering new markets faster than they can create value for their existing portfolios of customers. Perhaps they are under pressure to valorise their sunk R&D costs. By jumping into new markets, they probably spread thinly first their Sales dept. resources, then their Development resources, and could rather quickly end up hunting marginal business. This could be reflected in their lower profitability no matter how advanced their products are, no matter how large the share of reinvested cash in R&D, and how little earnings they pay back to shareholders.

We reckoned that companies moving from the lower to the upper part of the high branch are progressively building stronger positions in markets they know well. They build ever more value for their customers, perhaps through deeper customer intimacy, and progressively extract more profit from them. In doing so, they risk hitting a ceiling if facing an entrenched contender. However, it seems that the odds of finding a good niche or segment they can entirely capture may be high enough.

Their R&D efforts are then focused towards solving more challenges in the tasks performed by their customers, and their Sales depts. can concentrate on accounts they already know well.

Beyond a certain size and profitability, these successful companies have the resources to jump into new markets, or acquire companies from the lower part of the pattern. The resulting profitability is pretty impressive, as it compares very favourably with the smaller players. Some large players seem to have developed the ability of acquiring valuable yet poor SMEs then incorporating them quickly enough in their organisation and contributing to their own growth.

For those who are interested, and although we did not do subsequent research on this topic, some of us felt that the pattern is an illustration of Frederick Lanchester's power laws, and of the derived business strategy recommendations developed by Nobuo Taoka and Shinichi Yano in the 1980s.