In the past couple of years, I have worked with multiple startups in an advisory capacity, and these experiences have provided an opportunity to think about strategy in innovative ways. The “faster, better, cheaper” problem (speed to market, with the right differentiators and at the right price to remain relevant) comes up in most cases, and vertical integration offers a way to solve it. The conventional wisdom has been that startups, like Fortune 500 companies, need to think about vertical integration and identify the areas to focus on in-house versus partnering or outsourcing. Even more so than for established firms, this is a critical issue for new companies, given that they are typically bootstrapped or working on limited funds.
What Is Vertical Integration?
Vertical integration defines the components of a supply chain that the company will own as opposed to those that it will outsource. While the concept of vertical integration appears to apply naturally to companies that manufacture hardware, it could not be further from the truth. Microsoft, for example, depends on manufacturers (Dell/HP) and retailers (Best Buy) to sell its software. While the SaaS model has disrupted this thought process, enterprise software is still dependent on integrators.
Companies can integrate in two directions:
- Backward integration is a decision to either make or buy the raw materials required to make the final product. Typical reasons to integrate backward are to control cost, maintain quality, and mitigate against market vulnerabilities. Sometimes, companies integrate backward because the parts have a custom component.
- Forward integration is the decision to own the logistics of distributing the product further down the supply chain. It is a decision to determine if the company requires a middleman to be successful.
While traditionally spoken about in terms of a product life cycle (source, make, sell), vertical integration applies equally well to other critical activities of an organization, including marketing, human resources, and IT.
When addressing “faster, better, cheaper,” one must also consider sustainability. Vertical integration delivers a level of control, but it also requires incurring costs that a startup may not be able to afford, e.g., staff augmentation and management. Vertical segregation, conversely, delivers economies of scale but leaves the possibility that the supplier might wield significant power. Other considerations include an exit strategy and the capability to scale and diversify after the initial launch.
Vertical Integration in Practice
Startups often identify a gap in a certain segment of a market and look to address it in a way that adds value to the customer. The startup creates a proof of concept to determine the viability of the solution. The problem occurs when the organization intends to scale or switch to production from beta testing. How does one, for example, address a support call at 2 AM because the market requires a mission-critical response? Should one build a workforce and incur fixed costs, or should this function get outsourced and incur variable costs and better economies of scale but potentially compromise service-level agreements (SLA)?
Case Study: CB Enterprise
CB Enterprise uses Internet of Things (IoT) solutions to combat conditions such as Alzheimer’s and related problems with wandering—a situation in which the person with Alzheimer’s can step away from a protected environment and which can escalate to a life-or-death condition within minutes. This is achieved by using a purpose-built wearable around the patient’s arm that connects to a private wireless network.
Key decisions for vertical integration were made based on the following considerations:
- CB Enterprise’s business model was to serve senior living homes.
- The product offering required continuous monitoring and real-time notifications, usually within minutes. In that context, managing the recurring costs of staging the solution in the cloud while maintaining the quality of service at a large scale was critical.
- Operations required the installation of private wireless networks and subsequent management to provide reliable service. This required working with local authorities on permits and installation per code, as well as maintaining service uptime of 99.95% (which requires 24/7 staff). Owning instead of leasing network equipment required another decision. Owning requires not only capital assets but also higher upfront and lower operational costs, while leasing requires lower upfront and moderate operational costs.
- Onboarding of the staff and patients and ongoing support to staff, which required additional marketing materials and the intake of purchase orders and subscription payments.
- A go-to-market strategy that meets the threshold where senior living homes would collaborate with a startup in an industry especially resistant to change.
Vertical Integration Strategy
One of the challenges that startups face, especially in a risk-averse market such as senior living, is the fear of adoption, no matter how transformational the solution might be. This is reasonable considering the legal issues associated with even a single instance of failure. Therefore, it was important to identify channel partners and value-added resellers from a market entry perspective. Several potential partners that already had a presence in senior living homes were screened and narrowed down to those that specialized in minimizing problems related to wandering. A working partnership was created with a technology provider that had the right economic incentives given this solution, delivered differentiation beyond the current offering, and had the potential to expand their customer base (a critical win-win from a transaction cost economics perspective). In addition to product placement, the selected partner brought additional marketing attributes, including promotions and pricing strategies. The partner also collaborated in creating marketing material and enabling better self-service capabilities. Work was then done on a consumption model, in which the partner was invoiced monthly based on the number of active devices.
From an operational perspective, while the proof of concept with a standards-based, low-cost IoT network went well, coverage problems arose eventually. The standards-based solution had limitations when designing a solution for all parameters and constraints. Therefore, it was decided to build a private network for which the company would own the gateways and to collaborate with a professional telecom network installer to build and manage the network. This was a critical decision because, despite initial capital cash outflows, owning the network allowed control and built strategic capabilities for subsequent years. Collaborating with a network installer allowed the company to build the network faster and provide better adherence to regulations and SLAs. Given that such partners have also built out a strong 24/7 operational team across the country, it meant that the cost of maintenance was considerably lower than if the company had done it alone. The handling of acquisitions and other problems such as bankruptcy was de-risked by working with multiple partners from the onset.
A Framework for Vertical Integration Strategy
This graph illustrates how companies could think strategically about vertical integration. The case analyzed here is based on the CB Enterprise case study discussed previously, therefore the parameters and positioning of the items can be different for other companies.
The Y-axis depicts how critical a function is to a business. Sales were crucial to the product’s success, whereas payroll management (HR) wasn’t a core capability. The X-axis determines the ease of vertically integrating that function. Given the risk-averse market nature, the implementation of the product was challenging and warranted finding partners.
The size of the bubble determines the economic value or output that a function or process could bring to the company. A strong product strategy and flawless implementation were relatively more important than human resources operations.
The green color of the bubble signifies a competitive advantage (or lack thereof if red). Implementation was critical and potentially brought a lot of economic value, but the actual processes were standardized, and various partners in the market were able to deliver such capabilities on a more cost-effective basis. Therefore, it did not create a competitive advantage to the company, and the function was ripe for segregation. Similarly, while IT operations are easier to undertake, it is extraneous and would cost more to integrate from the economies of scale perspective.
General Considerations for Vertical Integration
The example of CB Enterprise illuminates how some components of the product life cycle can be vertically integrated or segregated. However, product leaders can consider other areas within a company when creating a vertical integration strategy.
For startups, some functions are obvious candidates for outsourcing or use of variable cost resources. These functions are typically in accounting (e.g., managing financials, taxes) and human resources (e.g., managing payroll, onboarding). However, decisions regarding some other functions aren’t as black and white. Marketing is one example. Some aspects of marketing might be critical—such as front-end operations of marketing—including industry analysis and market segmentation, whereas the opportunity to outsource some other aspects might exist (such as managing blog posts and social media as a part-time effort).
Another typical function for consideration is software development. Should the organization work with an outsourced development company (say, in India, Vietnam, or Ukraine)? Does the startup have the structure to work with such design centers? It has been my experience that startups, given their innovative approach to a problem, often have to build their team in the country of origin.
Operations fall in the same category. It is critical to determine if the startup will need to work with a value-added reseller to get a foot in the door. As suggested earlier, a proof of concept doesn’t automatically make up a successful operational structure. Installing a solution (such as a private wireless network that requires adhering to building code) at scale might not be simple. It is also important to consider questions such as support and the way the market structures SLAs as they are often driven by market needs.
If the startup has the selling power because of the niche nature of its offering and the target market is relatively small, it is reasonable to have a dedicated sales team and support staff. In other cases, a startup might have to contract it out.
While an industry might seem ripe for disruption, it might not be accessible due to political or regulatory considerations and could require a partner strategy. In other cases, regulations might be the way to transform industries. As an example, the hospitality vertical is seeing a surge in employee safety devices driven by a few companies that were making panic buttons for the B2C segment and saw a better alignment in the B2B segment, subsequently lobbying the appropriate associations to drive market need.
Another consideration is tariffs and regulations associated with manufacturing in one country and selling in another. Startups seldom begin with the perspective of expanding internationally and often are ill-prepared for it, which makes channel partner strategy critical.
Economic considerations might include the availability of capital markets and capital intensity. A startup in North America should have far fewer concerns with access to capital than a startup in Asia. A solution might be allowing a partner to deploy and maintain the solution and, in turn, pay a subscription fee to another partner.
Technological considerations must include the collection and use of data. Telecommunication capabilities have improved exponentially, especially with 5G and LoRaWAN, to the point that it is now possible to deploy, own, and monetize these networks at scale. Cloud and Edge solutions have minimized barriers to entry. These circumstances have shifted the threshold for vertical integration and segregation in both ways. For example, incumbents such as Monsanto (now Bayer), traditionally in the agriculture vertical, have transformed themselves as a digital company through acquisitions and now provide data as a service, while Amazon has chosen to partner with Verizon for its Edge services. Startups should analyze the incumbent perspective to be able to compete with them. At the same time, this analysis could reveal partnership opportunities—or even exit strategies—with the leading market players.
Another consideration is the kind of organization a startup envisions itself becoming. A value-driven startup should consider vertical integration to minimize costs, within reason. If the company has no entry into discrete manufacturing, then it might have no choice but to work with a value-added reseller (VAR) that might already have a presence in the industry. The VAR might also help in terms of initial sales or implementation and subsequently help deliver effective maintenance (e.g., recurring subscriptions, troubleshooting) and, in some capacity, as a customer success team (driving better customer lifetime value and net promoter scores). A startup focused on differentiation should consider methodologies in which customer experience and time to market are high on its totem pole and potentially manage its manufacturing and distribution to maintain a strong inventory.
Considerations Against Vertical Integration
Some circumstances warrant against vertical integration as Professor Devaki Rau identifies in her book Behavioral Strategic Management. Firstly, avoid risk mitigation that shifts the problem from one area to another. As a startup with little to no reputation to speak of, poor customer experience could mark the end of the company. For example, a company that uses a system integrator to reduce revenue recognition anomalies might add risk from a customer experience perspective.
Similarly, the need for co-location doesn’t imply vertical integration, nor should segregation solve geographically disparate entities. Working with an offshore team doesn’t imply the need to integrate vertically, for example. The question always goes back to the overall value chain analysis.
Focus on Core Competencies That Are Difficult to Copy
Every organization has a dominant logic, however, startups are significantly more malleable than Fortune 500 companies. The influence of the company founders, who typically also occupy key roles such as CEO, CFO, or CTO, is critical in determining the eventual shape of the organization. The key point here is that the company should focus on core competencies and build on them sustainably so that they are difficult to copy.
In a B2B environment, write a set of SLAs as one would define in a Statement of Work and ask the following questions to identify options for vertical integration:
- How can SLAs be achieved without penalties, which can be monetary or include such things as loss of customer trust?
- How does one identify processes that yield a set of competitive advantages and that are hard to copy?
Vertical integration strategy is a complex topic and requires consideration, analysis, and planning before making any final decisions. At a minimum, it can drive incremental improvements and improve profitability, while the most successful strategies can transform a startup into a market leader.
Understanding the basics
A vertical integration strategy defines the components of a supply chain that the company will own versus those that it will outsource.
An example of vertical integration would be a company deciding to produce its product in-house versus outsourcing the process to an external company.
Horizontal integration describes the process of expanding the product or service portfolio at the same level of the supply chain. Vertical integration means expanding into other parts of the supply chain like owning the production or retail capabilities.
Advantages of vertical integration include quality control and reduced costs. Vertical integration can be disadvantageous because it is costly and harder to scale.
Vertical integration is important because it can create competitive advantages that transform a startup into a market leader.