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“To innovate forever, in other words, is not an aspiration; it is a design specification. It is not a strategy; it is a requirement. ” – Geoffrey A. Moore

One of the key aspects in designing innovation into your startup is deciding which parts of the value chain your startup will address. In all likelihood, your first product will be a point solution in the value chain. As you look to grow your customer base and revenues, vertical integration is a powerful tool in business strategy.

On Vertical Integration

Vertical integration, or expanding into adjacent parts of a value chain, can be a powerful lever driving innovation forward for companies large and small. Deciding if and when to integrate vertically is a critical decision for startups.

In my first startup, we launched a time billing system for law firms to help them manage their invoices, their customers and their projects. Over time, it became clear that document management was a core feature that tied neatly into time billing so we built document management. Later at Google, I witnessed the replication of this same strategy in as AdWords expanded to AdSense and eventually AdX.

Pros & Cons

In both cases, vertical integration provided some key advantages:

  • It drove higher price points and larger revenues because could sell larger software packages at higher margins. One stop shops garner more share-of-wallet.
  • Sales processes quickened as we cross-sold our products to existing customers – much easier than finding new customers.
  • Vertical integration enabled us to provide more consistent, consequently superior customer experiences.
  • We built a sustainable competitive advantage by landing and expanding inside our customers.

Some of the challenges :

  • In both cases, we began to compete with previous partners.
  • Our sales processes became more nuanced and complex which required additional training and product understanding.
  • The company needed to innovate on three fronts: the first product, the second product and at the intersection of the two products.

Real world success

Nevertheless, successful vertical integration pays off handsomely. For example, recently, several publications commented on Apple’s disproportionate share of profits in the mobile industry based on analysis by investment bank Cannacord Genuity. The disparity between the margins Apple commands compared to existing handset manufacturers is astounding as shown by the chart below.

There are two strategic keys to Apple’s success both driven by vertical integration. By providing both hardware and software, Apple is able to offer a product appealing to a demographic willing to pay higher margins for a great user experience. Secondly, the consequent establishment of a direct billing relationship with the end user – leveraging iTunes, Apple built an alternate billing mechanism to carrier billing. This enables software developers to market directly to consumer, via the iTunes Store, rather than selling software through the carriers. As a result, Apple has been able to generate an estimated 50% gross margin and 30% net margin on its mobile business – best in class by a factor of 2.

The power to design long term innovation into a business model is key to long term success and growth. When building the strategy of a company, whether on a paper napkin or in the board room, consider vertical integration as a key engine for growth and innovation.

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