I was in a business presentation session with a large engineering firm last week, which got me thinking about what I like to see in new product strategies. In this instance, the firm was considering a move into the renewable energy industry, based upon how big this industry might be in the years ahead.

Now this sort of thinking concerns me because it it is often the first step to failure. While Tim and I talk about the value of experimentation and trying things out, there is a real tendency for managers to talk themselves into big bets when new businesses and potentially big markets are involved. In the spirit of Tim’s excellent post on the value of checklists, I’d like to put forward a simple checklist that tests for three main reasons for failure when committing to a new business.
1) The company doesn’t have competitive advantage in the industry.
2) The industry is chronically unprofitable for structural reasons.
3) Interdependencies in the value network within the industry means that buyers and suppliers face a significant cost in using your product.

While these tests are based on established thinking in strategy, my conclusions are not based on years of exhaustive statistical research. Instead, they are based on my investing in (and mostly losing money on!) small technology stocks.

Many years ago I would look at a stock and if the potential market was huge then I would probably go ahead and buy some shares. It’s probably the same optimism bias that makes us buy lottery tickets. When there is a big pot of money at stake there is a real tendency for rational thinking to go out the window.

So let’s look at examples of failure in each of these tests and an example of an innovation that meets the three criteria.

No Competitive Advantage- Jackgreen
Jackgreen was an Australian specialist green energy retailer that went into administration in late 2009. I’m happy to say that this isn’t one of my failed investments, but it did catch a very high profile Australian fund manager. While consumer demand for renewable energy has been growing steadily in Australia, there is absolutely nothing to stop other energy companies doing exactly what Jackgreen has been doing. The two main drivers of competitive advantage are providing a product or service that is valuable to customers AND having something in the production chain (such as IP, skilled staff, exclusive alliances, location, brand) that makes it hard for competitors to imitate. Jackgreen never had any barriers to imitation.

Bad Industry- Australian Biodiesel
A few year ago when oil prices were spiraling upwards towards $200/barrel it seemed that the obvious bet in energy was biofuels. Australian Biodiesel had IP rights over a process that allowed a wider variety of oils, including animal fats to be turned into diesel. It passed the first test of competitive advantage but it soon became apparent that this was always going to be a very low margin industry and almost impossible for small players. What made the industry so tough can be easily described with Porter’s five forces model of industry profitability. Buyers didn’t have to buy biodiesel (they could do just as well with ordinary diesel) and suppliers could find other industries that could use canola oil and animal fats. Margins in the industry were always going to be a problem and volume was the only answer. In the end, the rising cost of canola and fat finally put the company into administration.

Value Network Interdependencies- Magnesium International
Magnesium International was an Australian company that bought exclusive rights to the Dow process for producing magnesium. In addition they also had exclusive patents for rolling magnesium into thin sheets. Once again, in a era where we are trying to make cars and electronic goods lighter, there should have been a massive global market and a rapidly rising magnesium prices as it became more widely used by manufacturers. Nice idea, but even with the thin sheet product interest in magnesium was at best marginal, mainly because manufacturers faced massive switching costs in changing production equipment to use the new material. In the absence of a profitable business model the company went looking internationally for government support. After committing to Egypt, the company soon went into receivership.

Meeting the Checklist- Nanosonics Limited
Nanosonics is an Australian company that produces devices that disinfect hospital equipment. Nanosonics meets the competitive advantage test because it can disinfect faster than existing methods with the use of less toxic chemicals and has a fairly strong IP position (although defending patents can be tough and expensive). The industry looks good because hospitals must have fast and effective disinfection processes and are therefore relatively insensitive to price. Switching to the new disinfection process has minimal costs for the buyers as well.

These three simple tests should provide a reality check for scoping new businesses. I only wish that somebody had told me about them ten years ago. I wonder if my accountant will let me write off my losses as an educational expense?

Case studies used in this post are not intended as investment advice. John is famous in his MBA strategy classes for putting the kiss of death on successful firms by using them as case studies.