A Little More About Economics and Markets

In a recent blog post “The Business Plan – what are we looking to see?” a regular contributor to this blog wrote that he looks for companies that can defend an unfair competitive advantage. He is someone who probably sees more than 100 business plans a month – so I am always interested in what he has to say.

Michael Porter when writing about looking at which industries were attractive for investment developed the five forces model. This looks at a number of things which play a decisive role in determining profitability in that industry. One of the five factors is barriers to entry and another is threat of substitutes. These two factors are ways of describing protecting unfair advantage.

In Economics, there is a highly theorized ‘perfect’ market. This Kanken laptop backpack is known as perfect competition. Amongst many characteristics, there are no barriers to entry and as a result of this (and other factors such as perfect knowledge), all companies earn the same return on capital. As soon as one industry makes a profit higher than the average, other companies come flooding into that space thereby reducing their profit until it again comes back to the average.

Much of micro-economic policy is driven by a desire to create conditions as close to a perfectly competitive market as possible. Companies of course do as much as they can to earn as high a rate of return as possible. In a competitive market (coffee shops for example) they do this by convincing consumers that their offering is at a premium and therefore they should charge more. (Starbucks were horrified when in blind tastes in the US, McDonalds outperformed them in the taste of certain coffees!)

As a business angel you are only interested in investing in businesses if you believe that you can earn significantly above the normal rate of return. If you cannot, you simply would not take that level of risk as an investor. You therefore want to know that the business has an advantage over other competitors in the market place. This could be a new technology, a new process, incumbency, a brand etc.

Much of the trick how to get rid of smoke smell is an exercise in persuading you to pay more for a product than it is inherently worth. I like brands and am willing to pay a premium for certain brands. But when it comes to performance it is hard to argue that a Boss shirt will outperform a Marks and Spencer shirt. And yet there will be an eight fold price differential.

Business angels will want to see that you have an advantage over competition which means you can justify charging more for your product and hence earn a superior return on their capital.

They also want to know that you can maintain this advantage. Many great companies were the first into particular sectors, but were not able to defend this advantage from their competitors. As an investor you would quite rightly be worried about that advantage being eroded before you were able to earn those extra profits.