7 Powers: The Foundations of Business Strategy by Hamilton Helmer

A summary and review of Hamilton Helmer's book, 7 Powers.

“Silicon Valley correctly places enormous value on execution and on culture. However, I think this sometimes leads to insufficient importance being placed on strategy. Hamilton Helmer’s deeply incisive work will hopefully help correct that.”Patrick Collison, CEO and Co-Founder of Stripe.

Execution is what helps us find product/market fit. To get there, we follow Superhuman’s lead and build an engine for product/market fit and listen to those who have come before to tell us when we’ve arrived.

We echo John Doerr’s famed line: Ideas are easy. Execution is everything.

But what we often overlook is product/market fit is necessary, but not sufficient, to build an enduringly valuable business.

Operational excellence alone does not ensure success.

So, what are the secrets to making a company enduringly valuable?

If you are to believe Hamilton Helmer, the answer is strategy and execution. Every celebrated business is underpinned by decisive strategy choices and operational excellence in the midst of uncertainty that led to some form of competitive advantage.

And what is strategy? To borrow from Nathan Baschez introducing Divinations: Every strategy is really just a theory: “We bet if we do x, then y will happen.” 

Strategy, as a discipline, is the art of choosing what to do. As Louis Pasteur says: Chance favors only the prepared mind.

The ideas in 7 Powers cannot, and were never intended to, replace operational excellence but rather to provide a “prepared mind” that can point toward enduring value.

Strategy as an idea may be easy, but it’s important. We should never confuse simple, with simplistic.

Reed Hastings, CEO and Co-founder of Netflix, echoes the importance of strategy in his foreword to 7 Powers:

Most of my time and that of everyone else at Netflix must be spent achieving superb execution. Fail at this, and you will surely stumble. Sadly, though, such execution alone will not ensure success. If you don’t get your strategy right, you are at risk.

Beyond Reed and Patrick, other fans of 7 Powers include:

  • Spotify CEO and Co-Founder - Daniel Ek;

  • Entrepreneur and investor - Peter Thiel;

  • Former CEO of Adobe - Bruce Chizen; and

  • Chairman of Sequoia Capital - Mike Moritz.

The crux of the issue is a business can try to improve its strengths, mitigate its weaknesses, eliminate competitor risk, better serve its customers, maximize shareholder value, or take advantage of its pricing power.

But there are very few times when a business can do all at once.

7 Powers breaks fresh ground by constructing a comprehensive strategy framework that can help every business to choose what to focus on next.

Strategy Statics: Defining the 7 Powers

We begin with our central concepts, the seven Powers:

  1. Scale Economies: A business where per unit costs decline as volume increases.

  2. Network Economies: A business where the value realized by a customer increases as the userbase increases.

  3. Counter Positioning: A business adopts a new, superior business model that incumbents cannot mimic due to the anticipated cannibalization of their existing business.

  4. Switching Costs: A business where customers expect a greater loss than the value they gain from switching to an alternate.

  5. Branding: A business that enjoys a higher perceived value to an objectively identical offering due to historical information about them.

  6. Cornered Resource: A business that has preferential access to a coveted resource that independently enhances value.

  7. Process Power: A business whose organization and activity set enables lower costs and/or superior products that can only be matched by an extended commitment.

Power 1: Scale Economies

  • Scale Economies: A business where per unit costs decline as volume increases.

  • Benefit: Reduced costs

  • Barrier: Prohibitive Costs of Share Gains

Scale economies are straightforward, well-known, and often overlooked.

If your business has a low fixed cost base, it can benefit enormously from scale. This is why many technology companies try to get big fast. Not for scale itself but because being big is one of the best ways to protect their profits.

Hamilton uses Netflix and their move toward original content as his example of a scale economy.

Prior to creating their own content, Netflix had to negotiate the rights to each TV show or film on a case-by-case basis, often multiple times across geographies, each with changing terms. This is part of the reason why the US Netflix and Australian Netflix have different content.

Netflix was at the mercy of its suppliers who could, and would, charge more based on the increasing number of subscribers Netflix had. In short, Netflix’s cost base wasn’t fixed.

Contrast this with Netflix Originals. With Originals, Netflix pays a flat fee that can be divided across its global subscriber base who will all get access to the same content, on the same day, regardless of geography.

And Netflix never has to pay another cent once the content is made.

The more subscribers the company amasses and the higher it can push its pricing, the more content it can produce – which in turn drives more subscribers, more engagement and more pricing power. This flywheel is endemic to SVOD, but unique in the history of television. Linear television networks have always been bound by a finite number of primetime slots and the size of the total primetime audience. Accordingly, a network with 15 viable slots would only add a new show (say #16 or #22) if it replaced one of its existing 15; the only thing that matters is relative outperformance. Netflix faces none of linear’s limitations – any series that can meet the company’s target cost per hour watched contributes to its penetration and engagement (as do those that don’t, albeit less efficiently).

Source: Netflix Isn't Being Reckless

So that’s our Benefit, but what’s our Barrier? Scale is a chicken and egg problem. Netflix had to get big enough that it made sense to create its own content rather than leasing it from others, but in order to get big, it needed content from other providers.

Contrast Netflix, which has ~193 million subscribers, to Stan who has 1.8 million.

If both companies were to produce an original with a budget of $100 million, Netflix pays ~51 cents per subscribers (100m/193m) while Stan pays $55.55 per subscribers.

If Stan wants to compete with Netflix’s original content they not only have to make the large initial outlay to produce the content, but they also have a far smaller base of users to spread the cost across.

Even if they were willing to do that, Netflix’s superior cost advantage allows them to spend more on marketing, improving their user experience, hiring more people, or just undercutting the competition.

As you can see, Netflix’s move toward original content significantly improves its margins and created a compelling moat that is not easily emulated.

If you want to dive deeper into why Originals are an important strategic decision for Netflix, I highly recommend Redef’s services:

  • Part 1 explains that Netflix spends far more on content than is typically reported.

  • Part 2 explains how (and why) Netflix uses product and technology to economically outspend its competitors. 

  • Part 3 explains why Netflix risks so much. 

  • Part 4 explains why the term ‘Original Series’ if often a lie – and how Netflix uses this fact to beat its competitors. 

  • Part 5 explains why 2019 and 2020 don’t represent significant threats to Netflix despite the volume of new entrants and their impact on Netflix’s library.

  • Part 6 explains that quality in SVOD is a distraction, if the concept is even real.

  • Part 7 explains why Netflix has been so resilient over the past decade – and why this is likely to continue even as competition intensifies.

Not to mention…

Source: Screenshot Essays

Power 2: Network economies

  • Network Economies: A business where the value realized by a customer increases as the userbase increases.

  • Benefit: Ability to charge higher prices or monetize more due to additional value created

  • Barrier: Hard to gain market share as users don’t want to switch due to the lower value provided

If you work in technology, there’s a good chance you’re already familiar with network economies. They’re behind many of the most successful technology businesses including PayPal, Facebook, and Twitter.

That said, many people continue to confuse virality with a network economy. This is because they’re often seen together, but don’t necessarily have to be. You can go viral without having a network effect and vice versa.

A network economy is a business where the value realized by a customer increases as the userbase increases.

Facebook is a canonical example of a service that benefits from network economies.

As the user base grows, you’re able to connect with more of your friends.

We all use Facebook because we all use Facebook. This is why Facebook’s major focus, in the beginning, was retention. It’s why they rolled out school by school, and why the entire Facebook product experience focused on getting users to seven friends in ten days.

Once a user had seven friends, they were much less likely to churn and thus added value to Facebook’s network.

More importantly, these strong network effects have made it near impossible for anyone to compete with a generalized social network.

The idea of leaving Facebook to join an alternative network that most of your friends aren’t using reduces the potential value of the alternative, even if its a better experience.

This is why network economies often lead to winner-take-all dynamics.

Compare this to virality, virality means each user that signups up invites more users. There are many examples of viral games on the Facebook platform that quickly declined in popularity because the additional users provided no additional value and the existing users churned.

The most important thing to understand is businesses can be viral and not have a network effect. Virality can disappear and churn can eat away at the user base.

Highly recommend diving deep into network effects by reading this a16z deck and listening to Anu Hariharan from Y Combinator (who wrote the a16z deck prior to moving to Y Combinator).

Power 3: Counter positioning

  • Counter Positioning: A business adopts a new, superior business model that incumbents cannot mimic due to the anticipated cannibalization of their existing business.

  • Benefit: Lower costs and/or higher prices due to more valuable product

  • Barrier: Cannibalization of existing business

Counter positioning is when a new business adopts a new, superior business model that incumbents can't mimic due to anticipated damage to their existing business.

Counter positioning is similar to Clayton Christensen's disruption theory but lacks the emphasis of moving from the low end of the market to the upper.

Counter positioning tends to come from outsiders and startups rather than existing market leaders. This is because the business environment does not allow market leaders to pursue disruptive innovations when they arise for one of the following reasons:

  • The total addressable market looks small;

  • It's difficult to see if the total addressable market will grow (and by how much); or

  • Their current cost structures are based on serving their existing market and not what is required to sell the disruptive technology, which may have lower margins.

The story of how Eastman Kodak invented the digital camera in 1975 but failed to develop it is one of the most notorious examples of a failure to adopt counter positioning.

You would think that Kodak of all places was best positioned to be the leader in digital cameras, after all, they were in film.

But what Hamilton (and Clayton) offer us is an opposing explanation. The reason Kodak wasn’t able to react was precisely because of its expertise and existing business model.

Kodak as a business was designed to profit from selling film cameras that needed an endless supply of film and services like film development. Not to mention, film cameras were used by professionals while digital cameras were seen as toys.

But as Aaron Harris says in Toy Markets:

Investors should know how important it is to bet on toy markets. They’re the ones who have learned, again and again, that the biggest companies start out looking like toys. Amazon was for selling books online when relatively few people used the internet. Google was a search engine in a landscape crowded with search engines that weren’t themselves gigantic businesses. eBay was for selling beanie babies.

Disruption and counter positioning comes in two forms: business model and changes in technology. Digital cameras had both.

Digital cameras didn’t need film and photos didn’t necessarily need to be developed, at least not in the way that Kodak was used to.

This meant that if Kodak were to develop a better digital camera, they would cannibalize their existing profits.

What they failed to realize is that things that look like toys improve and often become good enough for professional users. And Kodak’s management probably knew this.

But it’s a difficult decision even for the best executive.

Do you take the money and your best people away from what makes you money (film) to work on something that will likely make you far less in the future (digital) when your customers aren't currently using it?

Or do you keep profiting what you've got until it's gone?

Contrast Kodak to Vanguard, who is Hamilton’s example of counter positioning.

Vanguard took on the world of active investing with its low-cost passive index funds. While it’s easy to spout the benefits of low-cost passive investing today, it was a highly contrarian approach.

Why would anyone accept the average returns of the market instead of choosing an active equity investor who wanted to beat the market?

Well, it turns out, that it is exceptionally rare for an active fund to beat the market over the long-term. As this became apparent, Vanguard saw its assets under management balloon.

And while competitors could have easily introduced their own low-cost passive index funds, they were extremely slow to do so, for the exact same reasons that Kodak had for not adopting the digital camera.

Power 4: Switching costs

  • Switching Costs: A business where customers expect a greater loss than the gain from switching to an alternate.

  • Benefit: Ability to charge higher prices for the same product

  • Barrier: Competitor has to compensate the customer to switch

Switching costs occur when it’s easier to stay with a product or service than it is to switch (even if the alternative is objectively better). Additional products, features, integrations, consulting, and training can make it even harder to switch.

This is part of the reason why many companies provide universities with free access to their software to teach students. It means when they get to the workforce they’ve already learned the software and would incur switching costs when they have to learn an alternative. Examples of this include Adobe, Matlab, Mathematica, and Atlassian products at Australian universities.

In 7 Powers, Hamilton uses the example of SAP which over time becomes the backbone of organizations. I personally think Salesforce is a more interesting example.

Once you rely on Salesforce’s CRM, it’s often not worth switching platforms. It can take months to retain your workforce and costs hundreds of thousands or even tens of millions of dollars to recreate business logic on the new platform.

Beyond CRM, Salesforce now has fourteen other products that when used, make it even harder to switch.

A key thing to consider is that switching costs often increase with the number of people who rely on it. They’re never that large for a single person but when an organization has hundreds or thousands of users on a certain platform, it can mean thousands of hours of productivity lost.

Even if a new solution is 10% better, it may not make sense to switch.

This is a big reason for vendor lock-in and why enterprise software can be terrible, overpriced, and have outdated UX - and still succeed.

Other reasons include:

  • The person who uses the software is not the person buying the software. Managers prefer to go with the tried and tested rather than something new that may be better – they don't want to risk their reputation on a new shiny solution. Nobody ever got fired for buying IBM.

  • The software is optimized for compliance, complicated workflows, permission management, etc and the user experience takes a back seat.

  • No one is in charge of re-evaluating the old software solutions, so companies just keep paying for what they have.

Power 5: Branding

  • Branding: A business that enjoys a higher perceived value to an objectively identical offering due to historical information about them.

  • Benefit: Ability to charge higher prices due to perceived higher quality or reduced uncertainty

  • Barrier: The significant time and uncertainty needed to build a brand

Brand is arguably the most powerful and least understood of the 7 Powers. It’s so durable because of how complicated, time-intensive, and lucky you have to build a brand.

If you look at Warren Buffett's Berkshire Hathaway portfolio you see a lot of powerful brands: American Express, Wells Fargo, Apple, Heinz, Coca Cola, Bank of America, Goldman Sachs, IBM, and John & Johnson.

The key thing to understand is many of these brands sell commoditized goods. There is nothing different between them and their competitors beyond the company or product name.

With brands, customers are paying for consistent experience and years (even decades) of consistent messaging.

Tiffany & Co, the American luxury jewelry retailer, is a classic example of brand. The brand is so strong people want to buy used Tiffany's boxes on eBay.

When Tiffany’s introduced the diamond engagement ring in 1886, the Tiffany Blue Box became as desired as what was inside.

When you buy Tiffany’s, you’re not just buying jewelry, you’re buying over 100 years of consistent advertising that says when your partner buys you Tiffany’s they love you.

It’s an incredibly powerful growth loop, the more people who know the brand, the more they expect to see it, and the more people want it.

In the past, the Tiffany Blue Box meant better placements in malls and the store itself acted as a channel for new people to discover Tiffany’s.

One caveat to this is that the Internet may be changing how brands are developed and how powerful brand is as a Power. Just look at how quickly Airbnb was able to build a brand that often surpasses the likes of Hilton and other famous hotel brands.

Placement and brand may not be as important in the Internet’s infinite mall with unlimited shelf space. Near zero cost of distribution means new ways to build brands that can be much faster than traditional methods, see Email Addresses and Razor Blades.

Power 6: Cornered Resource

  • Cornered Resource: A business that has preferential access to a coveted resource that independently enhances value.

  • Benefit: Ability to charge higher prices, reduce costs, or create better products due to access to a cornered resource

  • Barrier: Ranges from property and patent law to personal preference, e.g. retention of key talent

A company has a cornered resource when it has preferential access to limited resources or talent.

A good example for talent is Amazon, who according to The Information, has a 17-person senior leadership team, called the S-team, who have an average tenure of 15 years – the majority of the company's 23-year lifespan.

The S-Team has a deeper understanding of what it takes to scale a business like Amazon’s than anyone else in the world. Not to mention how rare it is for a technology company to retain team members for 15 years.

Other famous examples:

Power 7: Process Power

  • Process Power: A business whose organization and activity set enables lower costs and/or superior products that can only be matched by an extended commitment.

  • Benefit: Improved product and/or lower costs due to superior process

  • Barrier: The significant time and/or investment needed to create the process

Process Power is one of the hardest powers to copy, Toyota is famously transparent about its processes but other companies haven’t been able to replicate it.

The key difference between Process Power and operational excellent is hysteresis, even if you know what to do it takes significant time and effort to replicate.

Toyota’s Kanban just-in-time manufacturing system allows any worker from Janitor to CEO to stop the production line if they see something dangerous or something that could be improved.

Despite Toyota providing tours and creating a joint venture with GM, they still couldn’t replicate the Process Power of Toyota’s Japanese factories.

While checklists are great, see The Checklist Manifesto, Process Power is embedded in the organization’s culture. It’s learned by osmosis and feels natural to employees.

To outsiders, it looks like magic – and it sort of is.

Other good examples of Process Power are Instagram and WhatsApp, both were worth billions of dollars with less than 60 full-time employees, 13 employees for Instagram, and 55 employees for WhatsApp.

Dynamics: Getting to Power

“Hamilton Helmer understands that strategy starts with invention. He can’t tell you what to invent, but he can and does show what it takes for a new invention to become a valuable business.”
– Peter Thiel, entrepreneur and investor

The path to Power begins with invention. To understand why we return to Netflix.

When Netflix decided to take on streaming, they had Powers in their DVD-rental business (counter positioning and process power) that wouldn’t transfer over.

Further, to develop the streaming offering they had to license content which increased in cost as subscribers increased. There was no path to creating something that would produce persistent differential returns.

But thanks to invention, the streaming service we know today, Netflix created compelling value and had one Power (counter positioning) that allowed them to get to scale. Scale then allowed them to their shift attention to developing original content that was exclusive and produced at a fixed cost leading to a second power, a scale economy.

Over time, we may see Netflix develop a powerful brand and process power around their original programming too.

In general:

  • Change creates new threats and opportunities;

  • The company invents a new product or service; and

  • Once the new product creates compelling value for customers, the company can develop a strategy (a route to Power).

What I take from 7 Powers is it's as important to decide what to work on as it is to work hard. Netflix would never have become Netflix without its counter positioning and scale economy.

Power Progression: When can you establish a Power?

There are three distinct phases when a company can craft a strategy to create Power:

  • Origination: Before creating compelling value is created counter positioning and cornered resource can be created.

  • Takeoff: The rapid growth phase that takes place when compelling value is attained is when scale economies, network economies, and switching costs can be attained.

  • Stability: After growth slows brand and process power become the name of the game.

Summary

Hamilton develops strategy from first principles and uses specific nomenclature throughout 7 Powers that is useful to walk away with:

  • Power: the central concept of the book, is the set of conditions creating the potential for persistent differential returns. Power is what makes a business durably valuable and is created if a business line is simultaneously superior (improves free cash flow), significant (the cash flow improvement is material), and sustainable (the improvement is largely immune to competitive arbitrage).

  • Strategy (with a capital S): The intellectual discipline, is the study of what conditions create the potential business value.

  • strategy (with a lowercase s) or The Mantra: The specific approach of a single business, is a route to continuing Power in significant markets.

The notion of Power (and the impact of its lacking) is what underlies Warren Buffett’s famed line: When a manager with a reputation for brilliance tackles a business with a reputation for bad economics, the reputation of the business remains intact.

Like John Doerr, Warren is correct for his stage of investing. A lack of Power in public companies is rarely fixed by brilliant management.

Read my post on High Output Management to learn more about management

At the same time, brilliant management is often required to create Power in the first place.

This is why Strategy as an intellectual discipline must be further broken down into two underlying topics:

  1. Statics–i.e. “Being There”: Statics are what makes a business durably valuable, the specific conditions that result in materially improved cash flow, while simultaneously inhibiting competitive arbitrage.

  2. Dynamics–i.e. “Getting There”: Dynamics are the decisions that result in the creation or attainment of Power.

This is a good place to flag that Hamilton’s definition of strategy, the specific approach to a single business, is considerably narrower than the traditional definition of strategy. It is solely focused on creating a persistent Power, Power that leads to persistent differential returns.

It’s important to understand that the fundamental assumption behind good strategy is unchanging, differential margins. This is because the bulk of a business’ value comes in the future. For high-growth companies, this reality is accentuated. Remember, Power is reserved for conditions that create durable differential returns.

Each Power is associated with a magnitude and duration:

  • Benefit: The conditions created by Power must materially augment cash flow. It can manifest as any combination of increased prices, reduced costs, and/or lessened investment needs. This is the magnitude aspect of Power.

  • Barrier: The Benefit must not only augment cash flow, it must also persist. There must be some aspect that prevents existing and potential competitors from engaging in value-destroying arbitrage. This is the duration aspect of Power.

Benefits are common, but alone bear little positive impact on company value as they are generally subject to arbitrage. This is why Power must have a Barrier to prevent such arbitrage.

Power is a relative concept. It’s about your advantages relative to specific competitors. Good strategy involves assessing Power with respect to each competitor, including potential, direct, and functional equivalents.

Remember, Power is not a panacea. All the Power in the world won’t save you from an industry that is rapidly contracting.

Additional resources

If you found this post interesting, I recommend reading 7 Powers in its entirety. Below are some additional resources you may find interesting. 

Books

Podcasts

Videos


Thanks to Jordan Hughes for creating the images you see in this post, if you’re looking for your next read check out his project Good Books. And thanks to Anna Cheng, Guy Proops, and Jack Walsh who reviewed drafts and provided feedback that made this post much easier to read.