In a previous post I wrote about how all businesses do is create X amount of value and then capture Y% of X. As long as Y% is greater than the companies expenditures you will have a profitable company.
A common misconception about capturing Y% of X, is that Y% is always a large proportion of X. In actual fact, the opposite is often true, which is something that catches a lot of entrepreneurs / sole traders / freelancers / employees out.
I was recently speaking with a software engineer I know and explaining this concept to her. What was interesting to me was that she thought that she would be able to capture a very large of the proportion of the value that she is creating for one of her clients. Looking at the client she is working for, it is likely that she is creating tens of thousands of pounds of value every time she sits down to code. She is being paid a very small proportion of the value she is creating. However, her contention was that as the project scales she would be able to capture a larger amount of the value. This is incorrect as market forces are in play and if she demands too much then she’ll simply get replaced with another engineer. She has no leverage in the situation and when engineers aren’t hired for more than their coding skills they can be replaced. This is what happened to my original engineers in my own startup – they got replaced by better engineers at a fairer price.
Sometimes it’s not just the means of employment which limit how much value you can capture. Sometimes you can have all the leverage in the world and create a lot of value and still not capture a large fraction. A good example of a an industry where it is difficult to capture value is the airline industry. The worldwide airline market is worth trillions of dollars, however the majority of airlines have either lost money over time or not made any money at all.
Now compare the airline industry with internet search. It may be that internet search is only worth a few hundred billion dollars, but Google is able to capture a massive proportion of the value they are creating and is much more profitable than any airline company ever has been.
This is an important consideration for entrepreneurs. How much measurable value can you create? Has anyone else managed to capture as much of the value as you think you will be able to capture?
A difficult question to answer is: Do you really have leverage or are you easily replaceable? Don’t underestimate the market, if someone can really do what you are doing for cheaper, then you will be replaced. You can’t trick the market!