Strategy Taxes, and How Small Businesses Can Leverage Them Against Their Big Competitors

A strategy tax, a term I recently picked up from Dave Winer via Chris Dixon, is when an existing business has to throttle its pursuit of a new market to protect an existing revenue stream. Often this comes at the cost of user experience.

Startups are usually free of these problems, because by definition they have no cash cow which they need to protect. So while it might seem that an incumbent has an insurmountable advantage (e.g., a ton of money and a large user base), it might actually be their Achilles’ heel.

To better explain the concept, here are three real-world examples of strategy taxes, and how they hinder the incumbent company from competing in a new market.

Google AdWords

Google’s primary revenue stream is AdWords, the ads shown next to its search results. Thus, any strategic decision made by Google must take into account its impact on AdWords. This limits Google in some obvious ways, e.g., a redesign of their search page which provides a better user experience but lowers the click through rates on AdWords might be scrapped.

Perhaps more importantly, Google’s existing AdWords business could limit their ability to expand into new markets, such as P2P selling (e.g., eBay, Amazon Marketplace), online payments, and travel search. This is because eBay, Amazon, and Expedia are some of Google’s biggest AdWords buyers, and competing with them directly could reduce their AdWords spend. In fact, this already happened to some extent with Google Checkout in 2007.

This gives new entrants into these markets, such as WePay and Hipmunk, an advantage over the incumbents like Google. They have no existing revenues to protect, so they can innovate in whatever ways they want.

Nike v. RunKeeper

Nike’s core business is selling expensive footwear, and as their recent (unsuccessful) attempts to compete with the smaller and scrappier RunKeeper in the fitness tracking space have shown, that huge revenue stream is kneecapping them. Basically, instead of implementing an app to track your daily run the obvious way (using a GPS enabled device you already own, like an iPhone), Nike’s app insisted that you purchase an expensive pair of Nike shoes to use it. This ridiculous tethering may have sold more Nikes in the short term, but it afforded RunKeeper the room they needed to dominate a category Nike should have owned (and arguably invented).

From the RunKeeper post:

“In June 2009, Nike finally did show up, coming pre-installed on every iPhone & iPod Touch.  Unfair advantage, right?  That’s OK, their solution was still tied to a separate piece of hardware and shoes, as they stayed away from implementing a GPS-based application.  After all, they are a footwear company that needs to sell shoes, so how could they untether users from the very shoes they are trying to sell?”

That’s about as perfect an explanation of a strategy tax as you’re going to get.

Microsoft Office

Microsoft makes almost as much money selling Office as it does Windows. In recent years, many have started using Google Docs, Zoho, or another online, free productivity offering. Microsoft has dipped its toes in this market, but each of their offerings has a tell-tale caveat, signaling that Microsoft is not ready to go full-force after this market.

For example, Microsoft’s provides free, online versions of Word, Powerpoint, and Excel – but you have to use it with your Facebook account. If you want to bypass that pointless restriction, you can buy Office 2010 and get unfettered access to the web based versions, but that’s going to cost you close to $300.

For better or for worse, Microsoft is unwilling to threaten its Office business by providing credible, free alternatives, which leaves the door wide open for Google, Zoho, or a startup to dominate this market.

Here’s The Rub

This doesn’t mean Google, Nike, and Microsoft are stupid or irrational, and it doesn’t mean they won’t eventually enter these markets. In fact, Nike did drop the shoe tethering restriction, and it seems likely that Google will eventually offer a robust travel search. But they will do so only if they decide the benefits gained are worth the lost revenue from their existing businesses, and they’ll take a helluva long time to make that decision.

What it does mean is that if you’re a startup, you’d be wise to attack the market in a way that makes it hard for the 800 lb. gorilla to follow you. For example, if you want to start a P2P marketplace like craigslist, you could make all of your listings free. For eBay to follow you, they’d have to give up their primary revenue stream (commissions and listing fees). Or if you want to build a search engine, focus 100% on the user experience, and don’t compromise it by blending ads into your search results. For Google to follow you, they’d have to give up $8 billion a year in ad revenue (and explain that decision to their shareholders).

The takeaway is that there is always an angle. Take advantage of your small size and ability to pivot quickly, and use them enter new markets while your larger competitors are still crunching the numbers.