Counterintuitive Competitive Advantages
This is all that’s left of the Irish elk. The poor thing went extinct 10,000 years ago. The reason why is a good example of how being blessed with a competitive advantage can seed your undoing.
Irish elk antlers were comically large. Rather than branch-like antlers of modern elk, Irish elk antlers were solid plates, several inches thick. They could weigh over 100 pounds, approaching 10% of its body weight.
Big antlers are a competitive advantage. They fight prey and show mates you’re the real deal.
But Irish elk antlers grew out of control. Without an evolutionary check saying, “OK, that’s big enough, no more,” the elk said, “hold my beer” until antler growth killed the whole species.
It went like this: Growing big antlers requires enormous amounts of nutrients, particularly calcium and phosphorus, which are rare. If an Irish elk couldn’t eat enough in the summer, energy destined to maintaining body mass in the winter was diverted to antler growth. That led males to get weak when climate change made food even slightly scarce – and the bigger the antlers, the more vulnerable they were to environmental changes.
Young males faced an impossible tradeoff: Small antlers were required to survive low-food winters, but big antlers were required to impress females to mate. The species spiraled to extinction. Researchers from the University of Minnesota explain:
The rate of change in the environment was apparently sufficiently great that Irish elk could not decrease antler size fast enough to meet mass balance constraints of nutrient availability and at the same time meet the sexual selection requirements for large antlers.
Other species of European elk survived the same ecological conditions. All had smaller antlers than Irish elk.
The irony: small, weak antlers that looked like a disadvantage were actually the key to survival.
Competitive advantages are hard to get and hard to maintain. They can also be great at one level and backfire at another.
As a corollary: some things that don’t look like competitive advantages can, at some level, be just that.
A few of them in business and investing:
1. A little debt
This hurts admitting because I’m so against debt. Debt is an impediment to having options. But having zero debt can give you so many options that you lack focus.
A little debt can keep you away from distraction. It makes you think about backup plans, rainy day funds, and cutting bloat. There’s no way to learn the value of money without feeling the power of its scarcity, and a little debt is a constant reminder that you can’t get too comfortable. If you want Macgyver-like resourcefulness, bet on the single working parent who has to track every penny of cash flow, not the trust funder who’s never had to budget.
Another version of this: When Zynga went public years ago it warned investors that its employees would make so much money from the IPO that “it may reduce their motivation to continue to work for us.” Nassim Taleb writes: “Abundance is harder for us to handle than scarcity.”
2. Being forced to start clean
A friend’s family lost 60% of their avocado farm to California wildfires last year. It was devastating. But there’s a neat side story.
Avocado trees take a decade to fruit, so once they’re planted, you leave them there. The old farm, before the fire, had trees planted in a formation designed for outdated irrigation technology. But they left it like that because the cost of ripping out and replanting trees that take a decade to fruit was out of the question. The fire now gives the farmers a clean slate: plant new trees in the ideal way they always wanted to. They’ll go through many hard years. But look 10 years out and on an annual basis they’ll likely be better off than they were before the fire, and more productive than neighboring farms the fire spared.
The two highest costs many companies face are employee compensation and an attachment to sunk costs. Sunk costs are so entrenched that it often takes a disaster to wipe them away. Part of the reason the German military was so powerful in the early years of World War II is because it had to forfeit every gun, tank, ship, and plane to the Allies after World War I, which meant it rearmed in between wars with brand new, state-of-the-art supplies while other armies used outdated equipment. Having everything taken away from them in 1917 was a counterintuitive competitive advantage.
A practical example of this is when successful new industries can only be run by young people because they’re not burdened with past conceptions of what a product is or how an industry should be managed. Investor Dean Williams once said: “Expertise is great, but it has a bad side effect. It tends to create an inability to accept new ideas.”
3. A low valuation
Every startup wants to raise money at a huge valuation. Founders, employees, and previous investors reap big rewards, if only on paper.
But there’s a downside to a high valuation, especially when it’s a crazy valuation built on a story vs. results.
Reversion to the mean is the most powerful and unforgiving force in finance. A crazy valuation today increases the odds that subsequent fundraises will have to be done at a lower valuation, which does two things: It can repel potential investors who don’t want to fund a down round in an industry where up and to the right is the only accepted direction. Worse, it can put employee equity option compensation underwater, reducing their incentive to stick around. There can be offsets, with 409a valuations creating low strike prices and granting new options to employees who are underwater. It’s most dangerous at public companies. Here’s 2008, the last time the tide went out:
more than 80% of Silicon Valley’s 150 largest publicly traded companies have employees holding underwater options, according to executive compensation research firm Equilar. CEOs at 90% of those companies also held options worth less than their strike price.
A crazy valuation can become the equivalent of huge antlers – too big to maintain during lean years, and coming at the expense of what you need to survive.
4. Having just enough competition
Taleb again: “Men destroy each other during war; themselves during peace.”
The same thing with lower stakes: Business competitors destroy each other; businesses without competitors destroy themselves.
Over time few businesses avoid direct competition. But there are periods when little/no direct competitors can be found, especially with new products. These times seem like gifts, but can be treacherous. The first-mover advantage idea has largely been shown to be a myth, with three times as many counterexamples. Part of the reason is because without a direct competitor you have no one to learn vicariously from, no one chasing you out of bed in the morning, no customers threatening to switch if you don’t get better. Scared and running > fat and happy.
A little more on this topic: