Saturday, July 30, 2011

Business Model Analysis, Part 9: Outsourcing

This post is part of a series on business model analysis for entrepreneurs. The first post in the series presents a comprehensive list of issues (available as a downloadable PDF) entrepreneurs should consider when designing a business model. Others delve into specific issues; this one looks at factors that determine whether a startup should keep key activities in-house, versus outsourcing them.

The key word in the last sentence is "key." Serial entrepreneur Furqan Nazeeri has argued that startups, because they are resource constrained, should outsource all activities that do not contribute to long term, sustainable competitive advantage. VC Fred Wilson generally agrees, and notes that startups often make the mistake of outsourcing product development due to a lack of in-house skill, but in doing so they sacrifice the crucial ability to iterate the product designs (a point echoed by Vivek Wadhwa). Wilson also says that startups often outsource customer service due to perceived cost savings, but in doing so they forfeit valuable customer feedback.
Another consideration in deciding whether to outsource key activities is the prospect of asymmetry in bargaining between a startup and powerful partners. HubSpot's Dharmesh Shah has warned about the many risks that a startup confronts when negotiating with big companies. Serial entrepreneur and VC Marc Andreesen has likened dealing with big companies to the long, frustrating, and harrowing pursuit of Moby Dick.

I won't try to expand on those insights here. Rather, I'll focus on the microeconomics of in-house vs. outsource decisions, which, in economists' parlance, are choices about vertical integration. According to Yale Professor Oliver Williamson, there are economic advantages to completing transactions between two units within a vertically integrated company—rather than between two independent firms—when the transactions entail high levels of uncertainty, small numbers bargaining, and asset specificity.  With transactions between independent firms, uncertainty makes it difficult to draft a contract that specifies each party’s obligations under any contingency that might arise.  Absent a complete contract, the parties periodically will need to renegotiate transaction terms. If either party is subject to “small numbers bargaining,” that is, if it has few potential transaction partners, then that party may be vulnerable to hold-up when it renegotiates. Finally, if either party’s assets are tailored for a specific transaction type and cannot be redeployed into other uses, then failing to complete a crucial transaction—for example, securing an input required for production—may lead to bankruptcy with little liquidation value.

Startups frequently face the conditions that encourage vertical integration. By definition, they confront high levels of uncertainty. Also, when they target new markets with radical innovations, startups may require access to idiosyncratic assets controlled by only a few potential partners.

However, vertical integration poses challenges for resource-constrained startups, because it often requires major investments. Cake Financial, a service that gave investment advice to consumers based on analysis of their online stock trades, illustrates this dilemma. Cake’s founder had a choice between building software that could extract a customer’s trading data (with their permission) from their online brokerage accounts, or licensing access to the data from a firm that had already developed similar software. Concerned about that firm’s fees and whether it would be responsive to a small startup’s needs, Cake’s founder chose to build the software. This consumed most of the $9 million in venture capital that Cake had raised, and put the startup in a precarious position when demand for its service was slow to emerge and then capital markets slammed shut during the 2008 global economic crisis.