The Most Important Question to Understand a Business

Lessons from Netflix and Costco on why extracting value from customers is a short-term trap—and how to build (and invest in) businesses on solving friction instead.

In September 2000, Netflix tried to sell itself to Blockbuster for $50 million.

Blockbuster wasn’t interested. Why would they be? Netflix was bleeding money, on track to lose $58 million that year. The economics of Netflix in the year 2000 were terrible: shipping DVDs back and forth cost more than customers were willing to pay. Blockbuster, meanwhile, was collecting what they called “revenues generated by rental product that was kept beyond the initial rental period”—corporate speak for late fees. In 2000, this totaled $796 million of revenue that had no incremental expenses, making it pure, juicy profit.

Theoretically pure profit, but not quite in reality. Blockbuster reported $28 million in expenses against this revenue. What could possibly cost money when charging customers penalties? Legal fees. Customers were so enraged by excessive late fees that they were suing Blockbuster, and the company had to spend millions defending its right to gouge the very people they exist to serve. When your most profitable revenue stream requires a legal defense fund, you’re not solving customer problems—you’re creating them.

Ten years later, Netflix was worth billions, and Blockbuster was bankrupt. What happened? Both companies were in the exact same industry, serving the same customers, with access to the same movies. The difference wasn’t strategy, capital, or execution. The difference was how they answered one fundamental question: What problems are we solving for our customers with our products and services?

Reed Hastings famously claimed he founded Netflix after paying $40 in late fees for a lost copy of Apollo 13. Netflix’s entire business model was built to exploit Blockbuster’s dependency on late fee revenue. “No Late Fees Ever” wasn’t just a marketing slogan—it was a battle cry that resonated with millions of customers who felt exploited by Blockbuster.

Blockbuster thought they were in the “movie rental store” business. Netflix understood they were in the business of offering convenient entertainment to their customers. You don’t have to drive to the rental store to pick-up and drop off the DVD’s. We’ll deliver them to your house. And we will never charge you late fees. When you think you’re running movie rental stores, you focus on prime real estate, inventory management, and late fees. When you understand you’re solving the problem of convenient entertainment, you focus on delivery, selection, and eliminating friction. Same industry. Same customers. Completely different way of running the business. Completely different outcomes.

The Plot Twist: When Blockbuster Almost Won

Here’s the part of the story that most people don’t know. By 2006 - 2007, Blockbuster had finally awakened to the threat. Under CEO John Antioco, they launched “Total Access,” a program that leveraged their 9,000 physical stores. Customers could order DVDs online but exchange them instantly at any store for free. Blockbuster started charging subscription fees and stopped charging late fees.

For a moment, it worked spectacularly. In one quarter of 2007, Netflix actually lost 55,000 subscribers (still ending the year with 7.5 million subscribers) while Blockbuster’s online subscriber base surged past 3 million. Netflix’s stock price plummeted. The unit economics were brutal for Netflix: they were spending about $2 per DVD shipment (postage both ways plus handling), while charging $8 per month. If a customer rented 5 DVDs per month, Netflix was underwater.

Marc Randolph, who had left Netflix by then, admits things got “very scary” for Netflix once Blockbuster mobilized: “They were hurting us, and they were making tremendous gains. They had the true strength that we couldn’t match, which was a blended model of online and stores.”

Netflix CEO Reed Hastings was worried enough that he approached Antioco with a proposal to buy Blockbuster’s online business. The two companies that had faced off in that Dallas conference room seven years earlier were now discussing a different kind of deal.

But then came the fatal moment that sealed Blockbuster’s fate. Activist investor Carl Icahn, who had acquired nearly 10 million Blockbuster shares, intervened. He saw Total Access losing $2 per exchange and considered CEO Antioco’s compensation “egregious.” When Hastings made his offer, Icahn refused to let the company “lose more money” on Total Access. Antioco was pushed out in July 2007.

The new CEO, James Keyes, had a plan to restore profitability: bring back the late fees. Not directly—that would be PR suicide—but through “restocking fees” and other penalties that were late fees by another name.

These are the kind of old school capitalist maneuvers that show good numbers on the financial statements in the short-term but destroy business models in the long-run because it milks value from customers, instead of creating value for customers by serving them.

He raised online DVD rental prices, ended the free exchange program, and refocused on the brick-and-mortar stores. Blockbuster Online’s growth stopped.

Then came 2008. The financial crisis hit, and suddenly Blockbuster’s leveraged balance sheet—built on the assumption that late fee revenue would continue forever—became a death sentence. The company had borrowed heavily, including the hidden leverage of long-term, contractual rental lease obligations at thousands of stores, assuming that they could continue to charge customers additional fees. But customers in a recession had less tolerance for penalties, and Netflix’s “no late fees” proposition became even more attractive when every dollar mattered. Blockbuster had leveraged their most hated feature, betting their entire company on revenue from customer frustration.

The math was devastating: Blockbuster was losing $2 per Total Access exchange but protecting the fee revenue. That seemed rational. But here’s what they missed: those late fees were driving customers straight to Netflix. Every late fee created a customer angry enough to try Netflix’s free trial. Every “restocking fee” was a recruitment ad for the competition. Blockbuster was funding Netflix’s customer acquisition by angering their own customers into defection.

This is classic “Innovator’s Dilemma” as analyzed by Harvard Business School Professor Clayton Christensen. Blockbuster’s late fees weren’t just revenue—they were handcuffs. Every rational analysis said protect this high-margin income. Every financial model showed that Total Access was “losing money” compared to late fees. But Netflix wasn’t competing against Blockbuster’s business model—they were competing against customer frustration. By the time Blockbuster realized that customers would rather have no late fees than immediate gratification, it was too late.

As Icahn himself later admitted, calling Blockbuster “the worst investment I ever made,” Total Access “might have helped Blockbuster fend off Netflix” if they had stayed the course. The company that addicted itself to late fees couldn’t stomach losing $2 per transaction to solve their customers’ actual problem. They protected their most profitable revenue stream without realizing it was also their most toxic.

What problems do the business’s products and services solve for its customers?

This is the most important question you should ask to understand a business model. For most people, this question will sound dumb and obvious. Most people, especially in professional settings, are afraid of sounding stupid, desperately grasping at trying to sound smart and polished. This psychological defect is a powerful obstacle to intellectual growth. If you find yourself working in an environment where asking questions like this is perceived as stupid, you’re likely swimming in an ocean of intellectual insecurity. Get out of there as fast as you can and find a place where you can think with clarity from first principles. It is no fun being a closeted first principles thinker stuck in a jargon loving, rigid thinking organization. Ideally, our K-12 education system would have trained us to think from first principles and make it socially acceptable to ask questions like this. But most people have been infected by the wanting to sound smart and polished disease, so this is a difficult behavioral shift to make. But it is a worthwhile journey to embark on. As Blockbuster learned the hard way, getting this wrong can destroy billion-dollar companies. It can also create businesses worth over $100 Billion, as Netflix learned.

This concept is also captured in Professor Christensen’s book, Competing Against Luck. His framework is that customers hire products to do jobs. Turns out that people hired McDonald’s milkshakes to keep them entertained and prevent hunger on a long drive. The product was not necessarily only competing against Burger King milkshakes, but against bananas and bagels, which don’t give much of a sugar kick and are difficult to consume while driving a car. Understanding this allowed McDonalds to focus on what the customer actually cared about. It had very little to do with understanding the customer’s demographic data (which is what McDonald’s was measuring), but everything to do with the job / problem.

Exercises to Apply This Framework

Most people think about businesses backwards. They look at what a company sells and assume they understand what problem it solves. What a company sells is just its current solution to the underlying customer problem.

Let’s go through some examples. Pretend you have to explain the following businesses to a friendly, curious English speaking alien.

1. Apple

2. Amazon Marketplace

3. Costco

4. Amazon Web Services (AWS)

5. Carvana

Take real time with this exercise. The deeper you think about your answer, the more benefit you will get. Put yourself in the customer’s shoes and consider:

1. What would you do if this business didn’t exist?

2. How painful is the problem they solve?

3. What do you currently pay for the solution?

4. What would you be willing to pay for the solution? (Forget the current price)

Apple

First level thinking: “Apple sells phones, laptops, and tablets.”
Second level thinking: “Apple solves the problem of technology complexity. They serve customers who want powerful technology without the learning curve—people who value their time more than customization options and will pay a premium to avoid technological frustration. They solve this problem by developing their own software and hardware.”

Amazon Marketplace

First level thinking: “Amazon sells stuff online.”
Second level thinking: “Amazon solves the problem of shopping friction—the time lost driving to stores, the disappointment of out-of-stock items, the hassle of price comparisons. They’ve turned a multi-hour shopping expedition into a 30-second transaction.”

Costco

First level thinking: “Costco sells bulk groceries and random products in a warehouse.”
Second level thinking: “Costco solves the problem of middle-class purchasing power erosion. They help families stretch their budgets by offering wholesale prices on quality goods, but more importantly, they solve the decision fatigue problem—every product is pre-vetted for quality and value with limited selection in each category. Customers pay a membership fee not for access to a warehouse, but for someone else to do the exhausting work of finding the best deal on every product category.”

Amazon Web Services (AWS)

First level thinking: “AWS rents computer servers to companies.”
Second level thinking: “AWS solves the capital expenditure and distraction problem for businesses. Before AWS, launching a tech company meant raising millions just for servers that might sit idle. AWS transformed computing from a massive upfront investment into a monthly expense that scales with revenue. Running servers is not the core focus of most businesses, so it makes sense to outsource this to AWS. Amazon does not simply rent servers—they remove the single biggest barrier to starting a technology business and allow a business to focus on its customers’ problems.”

Carvana

First level thinking: “Carvana sells used cars online with weird vending machines.”
Second level thinking: “Carvana solves the trust and time problem in used car buying. They eliminate the worst parts of buying a used car: spending weekends at dealerships, negotiating with salespeople you don’t trust, and wondering if you’re being scammed on price or quality. The vending machines aren’t a gimmick—they’re a physical symbol that subliminally says ‘buying a car can be as straightforward as buying a Coke.’

The Pattern You Should Notice

Look at these examples again. The first level thinking descriptions are all about what the company does. The second level thinking descriptions are about why customers pay the company to do it.

This isn’t just semantics. When you understand the problem, you can predict the future:

• Apple entered categories where technology is not simple and intuitive (watches, headphones)

• Amazon Marketplace sold items where shopping friction exists (groceries, pharmacy)

• Costco expanded into various other product categories where there are inefficient costs in the supply chain that the consumer must bear (eye care, pharmacy)

• AWS transforms other large upfront fixed costs into variable costs to make it easier for technology companies to get started and focus on their customer instead of non-core functions to run the business (analytics software, security services)

• Carvana entered other vehicle transactions that currently broken due to lack of trust and inefficiency (finance, insurance)

When you only see the solution, every new product looks random. When you see the problem, business strategy becomes more clear. You begin to think like an owner, instead of a trader slapping multiples around.

Your Turn: Testing Your Understanding

Now try this with a business you think you know well. Maybe it’s your employer, your favorite brand, or a stock you own. Write down:

1. What problem does this business solve?

2. Who specifically has this problem?

3. How painful is this problem for them?

4. What did people do before this business existed?

5. What would people do if it disappeared tomorrow?

If you can’t answer these questions clearly, you don’t understand the business—no matter how much you think you know about their products, strategy, or financials.

Remember: Blockbuster’s executives knew everything about their business except the one thing that mattered. They could tell you profit per square foot, optimal inventory turns, and demographic purchasing patterns. They just couldn’t tell you what problem they were actually solving for customers.

The Three Rules of Customer Problems

Rule #1: Your Real Competitors Aren’t Who You Think They Are

When you understand the customer problem, you realize that competition comes from everywhere. Macy’s thought they were competing with other department stores. They were actually competing with anyone who could give customers more selection and convenience—which turned out to be a company that started selling books online.

Taxi companies thought they were competing with other taxi companies. They were actually competing with anyone who could solve the problem of “getting from here to there quickly and cheaply”—which turned out to be people sharing their personal cars through an app.

Why the Financials Mislead You: The financial statements show you what happened yesterday. Understanding the customer problem shows you what will happen tomorrow. We should think about business like we drive: looking through the windshield 80% of the time and the rearview mirrors 20% of the time.

The businesses that survive are obsessed with staying ahead of any solution to their customer’s problem, not just direct competitors. When Jeff Bezos says that “Amazon is the most customer focused company on Earth,” this is what he is referring to. It is not some political statement with no meaning—it is a powerful mantra that permeates the entire organization.

By focusing on the customer problem, businesses can make their competition irrelevant and find uncontested market space. It is a powerful mental model for business owners and employees to add to their toolkit of business strategy. But it is also important for investors to identify these types of businesses. I learned about this mental model from Blue Ocean Strategy by W. Chan Kim and Renee Mauborgne.

For example, Southwest realized that airlines were competing for the same business travelers that demanded first class cabins and fancy lounges at airports. But everyone had to bear the cost of these amenities by paying higher prices. But most people aren’t playing with other people’s money through cushy expense accounts. So Southwest got rid of those costs and passed the savings to customers through lower prices, unlocking new demand from people that wouldn’t have flown before. Herb Kelleher, the founder, used to say that he was competing with buses, not other airlines.

Planet Fitness is another example of this. By getting rid of day care, pool, steam room, and sauna, they could charge much lower prices and went after the 80% of the market that didn’t have a gym membership.

Rule #2: Delighted Customers Are Your Best Salespeople

Companies that truly solve customer problems don’t need to spend much on advertising. Their customers do the sales for them. As Frederick Reichheld proved in his landmark research at Bain & Company, increasing customer retention rates by just 5% can increase profits by 25% to 95%. His book The Loyalty Effect is the most powerful business book I have ever read.

While software companies religiously track retention and churn because it is easy for them, most other businesses don’t measure it because is it hard for them. And investors get used to it. They demand retention metrics from software companies but never ask retailers, restaurants, or service businesses for the same data—even though customer retention is just as critical for them!

We look for the data that is available, and ignore what isn’t readily available. A restaurant chain’s customer retention is just as important as it is for a software company, but because it’s harder to measure, companies don’t measure it and investors don’t ask for it.

The Mathematics of Customer Lifetime: The formula is deceptively simple, as Reichheld documented:

1 – Retention Rate = Churn Rate

Average Customer Lifetime = 1 ÷ Churn Rate

If your annual churn rate is 20%, your average customer lifetime is 1 ÷ 0.20 = 5 years. This isn’t just theoretical—it’s how businesses should think about every customer relationship.

Let’s break this down with real numbers:

The Basic Math of Customer Acquisition: Say it costs $100 to acquire a customer through advertising, and each purchase generates $20 in profit. A new customer needs 5 purchases just for the company to breakeven on the advertising cost ($100 ÷ $20 = 5 visits).

The Loyalty Multiplier: Now imagine that customer becomes loyal and visits 20 times per year. That’s $400 in annual profit ($20 × 20 visits). But here’s where it gets interesting—if that loyal customer refers just one friend, you now have two customers generating $800 in combined profit from the same $100 initial investment. A traditional advertising approach would require spending another $100 to acquire that second customer. The loyal customer approach gets you the same result for free. The business’s return on advertising spend doubles and this flows into higher margins and return on capital (metrics we will discuss in depth in the coming chapters). The financial statements will not explicitly reveal loyalty effect dynamics. They will show up as high margin and return on capital eventually but it won’t be so obvious why.

The Chick-fil-A Case Study: This math explains why Chick-fil-A dominates despite spending virtually nothing on advertising. While McDonald’s spends over $2 billion annually on ads (roughly 8% of net sales), Chick-fil-A spends that money elsewhere.

In 2023, the average Chick-fil-A generated $9.4 million in revenue per store (non-mall locations), while McDonald’s averaged about $4 million. That’s more than double the revenue per store, while being closed on Sundays. The highest-performing Chick-fil-A made $19 million—more than a Cheesecake Factory, Outback Steakhouse, and Cracker Barrel combined.

That 8% savings on advertising can go toward:

• Better ingredients (their chicken costs more but tastes better)

• Higher employee wages (leading to better service)

• Better store locations

• Higher profit margin

This creates a powerful feedback loop: better product → more loyal customers → less need for advertising → even better product → even more loyal customers.

Why This Doesn’t Show Up in Financial Statements: Here’s the problem—you could look at two restaurant chains’ financial statements and see one with 15% operating margins and another with 10% margins. First level thinking might suggest the 15% margin company is more profitable. But what if the 15% margin company achieves that by skimping on ingredients and service, driving customers away? And what if the 10% margin company is investing that 5% difference in customer satisfaction that doubles their customer lifetime value? In 10 years, the 10% margin business might get to 20% margins while the 15% margin business stays flat or goes down if these are direct competitors. The financial statements won’t tell you this. They’ll just show you today’s margins, not tomorrow’s customer base. Having this new lens through which you can look at business models will be a game changer.

Why This Advantage Compounds: Once you have a base of loyal customers doing your marketing for free, every dollar your competitors spend on advertising just widens your cost advantage. They’re paying for customers while yours come free through referrals. Over time, this gap becomes nearly impossible to close through traditional competition.

Rule #3: The Best Businesses Sell More Things to the Same Customers

Once you solve one problem really well for a customer, you earn the right to solve other problems for them too. The mathematics of this strategy reveal why it’s one of the most powerful business advantages in the world.

The Customer Acquisition Math: Let’s use hypothetical numbers to illustrate the concept: Assume it costs $400 to acquire a customer through advertising, retail stores, and sales costs. In most industries, that customer would buy one product and you’d hope to recover your $400 investment plus some profit.

But lets see what happens when the business can sell more products and services:

Single Product Company (Hypothetical):

· Acquisition cost: $400

· Customer buys one product: $200 profit over 3 years

· Total return: $200 profit - $400 cost = -$200 loss

Multi-Product Ecosystem (Hypothetical):

· Same acquisition cost: $400

· Customer buys product #1: $200 profit

· Same customer buys product #2: $150 profit

· Same customer buys product #3: $300 profit

· Same customer buys product #4: $400 profit

· Same customer subscribes to services: $200 profit

· Total return: $1,250 profit - $400 cost = $850 profit

The same $400 investment generates over 4x the return when spread across multiple products. Because the business has more products to “cross-sell,” it can spend more on customer acquisition (or ideally it is also a “Loyalty Leader” and has zero customer acquisition costs also).

Why This Creates Unfair Competition: Companies selling single products must recover their entire customer acquisition cost from one purchase. Businesses like Apple and Amazon can spread that same cost across five purchases from the same customer.

This means Apple and Amazon can:

• Spend more on acquiring each customer (outbid competitors for prime retail space)

• Invest more in product development (better R&D budgets per customer)

• Accept lower margins on individual products (make it up on volume per customer)

The Hidden Financial Statement Problem: Look at the return on invested capital (ROIC) for two companies. Company A shows 25% ROIC selling one product with fat margins. Company B shows 15% ROIC but sells five products to the same customer. Which is the better business? The financial statements suggest Company A, but Company B might be building a customer ecosystem that will dominate in five years. The lower ROIC today might reflect investments in customer relationships that will pay off massively tomorrow. But you’d never know this from just reading the numbers without understanding the fundamental question: What problem does this business solve for customers.

The Amazon Example: Jeff Bezos understood this principle deeply. As he famously said, “There are many ways to center a business. You can be competitor focused, you can be product focused, you can be technology focused, you can be business model focused, and there are more. But in my view, obsessive customer focus is by far the most protective of Day 1 vitality.”

Amazon started by acquiring customers for book purchases. But once they had those customers, they could sell them:

• More books (same category expansion)

• Electronics, clothes, home goods (adjacent categories)

• Prime memberships (subscription revenue)

Each additional product or service leverages the same customer base without additional acquisition costs. This is why Bezos was willing to operate at near-zero profit for years—he was building trusting relationships with customers, not quarterly earnings.

The Compounding Effect: As customers buy more products from the same company, switching becomes more expensive. An iPhone user who also owns AirPods, an iPad, and uses iCloud has hundreds of dollars and hours invested in Apple’s ecosystem. Switching to Samsung means replacing everything and learning new systems. This “switching cost” makes customers stickier over time, reducing the need to re-acquire them through advertising. Meanwhile, competitors still have to spend $400 to acquire each new customer for their single products. This is one of the strategies businesses can use to defend themselves, which we will talk about in another post.

Why Most Companies Can’t Copy This: This strategy only works if you solve the first customer problem extremely well. Customers won’t trust you with adjacent problems unless you’ve proven yourself with the core problem. That’s why companies can’t just decide to become “ecosystems.” The customer relationship must be earned through exceptional execution on the primary problem before you can expand to secondary problems.

Smart Money in Action: Three Case Studies

Case Study 1: Costco - “Prices are too high and grocery shopping is boring”

Most people think Costco is just a warehouse store that sells stuff in bulk. Second level thinking goes deeper: Costco solves the problem that retail prices are artificially inflated by inefficiencies that customers shouldn’t have to pay for.

The Customer Problem: Traditional retailers pile on costs that get passed to customers—expensive store displays, endless product variety requiring complex inventory management, heavy advertising budgets, complicated pricing games where some items subsidize others. Customers end up paying for a lot of services they don’t actually want.

Costco’s Solution from First Principles:

• Limited selection - 4,000 stock keeping units instead of Walmart’s 100,000+ eliminates massive inventory management costs

• No frills warehouse format - products stay on pallets, eliminating expensive shelf stocking labor

• No advertising budget - while competitors spend 5-8% of revenue on ads, Costco spends virtually nothing

• Volume purchasing power - buying massive quantities directly from manufacturers

• Membership fee model - consistent markup instead of pricing games

The Genius of Costco’s 14% Rule: Here’s a detail that reveals why some companies succeed while others fail: Costco has a strict rule that no product can be marked up more than 14% over cost (15% for their private label, Kirkland). This isn’t just about being nice to customers—it’s about organizational behavior and incentive alignment.

Think about what happens at a typical retailer. A store manager is under pressure to hit quarterly numbers. They see an opportunity: that hot Christmas toy everyone wants? Mark it up. Those batteries people desperately need during a power outage? Mark it up. Short-term profits soar, the manager gets their bonus, and customers feel exploited. The business erodes over time.

Costco’s 14% cap prevents this entirely. A store manager literally cannot juice the numbers by gouging customers on high-demand items. The only way to increase profits is to sell more volume or reduce costs—both of which benefit customers. This simple rule aligns every employee’s incentives with long-term customer satisfaction rather than short-term profit extraction. Costco employees, all the way from the store to procurement to the C-suite, are engrained with a mindset to wring out costs from the system and pass them onto the customer through lower prices.

Compare this to Blockbuster, where store managers were actually incentivized to generate late fees. The employee behavior that maximized profits also maximized customer frustration—a recipe for disaster. As Fredrich Reichheld says, a business must align incentives between 3 key stakeholders: (1) customers, (2) shareholders, and (3) employees.

Costco has a 93% annual membership renewal rate in the US. That’s higher retention than most software companies. When customers voluntarily pay $65-130 annually just for the right to shop somewhere, you’re solving a real problem. A 93% retention rate implies that the average Costco member stays for about 10 years. Compare that to typical retailers where customers might visit sporadically across many different stores. Costco’s customer lifetime value is enormous because of this loyalty.

Case Study 2: Spotify - “Music access and discovery is too complicated and expensive”

Before 2008, if you wanted to hear a specific song, you had several bad options:

• Buy the entire $15-20 album for one song

• Use piracy (illegal, time-consuming, low quality)

• Hope your song played on the radio when you wanted to listen to it

The Customer Problem: Music access was fragmented, expensive, and riddled with friction. Discovery was limited to mainstream media, radio, or word-of-mouth. Building a music collection required significant time and money investment.

Spotify’s Solution: Instead of selling individual songs or albums, Spotify sells access to virtually all music ever recorded for a monthly fee. They solved multiple problems simultaneously:

• Access: Any song, instantly, anywhere

• Discovery: AI-powered recommendations introduced users to a significant portion of their listening

• Convenience: No downloading, syncing, or storage management

• Cost: $10-15/month for unlimited access vs. $15-20 per album

The Industry Math: Spotify didn’t just create a new business— they saved an entire industry. Global music revenue was in free fall from 2001-2014, declining from piracy. Streaming revenue through platforms like Spotify reversed this trend.

Value Proposition Math: Average US listener spends 16 hours per week listening to music online. At $15/month for Spotify Premium, that’s roughly $0.23 per hour of entertainment. Compare that to:

• Movies: ~$7.50 per hour ($15 ticket for 2-hour movie)

• Cable TV: ~$2-3 per hour

• Books: ~$1-2 per hour

The value delivered per dollar spent is exceptional, explaining why 300+ million people pay for music streaming globally.

Case Study 3: Basic Fit - “Gym memberships cost too much for what most people actually use”

Traditional gyms in Europe charge €40-50+ per month and included amenities most members never used - pools, saunas, daycare, extensive classes, and personal training pushes.

The Customer Problem: 85%+ of Europeans don’t belong to any gym. High prices and intimidating environments kept “couch potatoes” away. Existing members paid for amenities they didn’t want or use.

Basic Fit’s Strategy: Instead of competing for existing gym members, Basic Fit went after the 85% who weren’t members anywhere. They eliminated expensive amenities and focused on what most people actually want: basic equipment that works, clean facilities, convenient locations. Basic Fit removed inefficient costs from the business model and passed the savings onto customers through lower prices, similar strategy to Costco.

The Cost Structure Math: From industry expert interviews, here’s how Basic Fit achieved 50% lower prices:

• Independent gym break-even cost: ~€30/month

• Basic Fit membership price: €10-15/month

Basic Fit’s advantages:

• Scale discounts on equipment from manufacturers

• No pools/saunas - eliminates massive infrastructure and maintenance costs

• Technology-enabled operations - automated monitoring reduces labor costs

• Higher utilization - more members per square foot because they target people who just want to work out, not socialize

Market Expansion vs. Market Share: From 2011-2019 in the US (similar model), Planet Fitness captured 11.1 million of the 12.8 million new gym memberships. Instead of stealing customers from competitors, they expanded the entire market by solving the problem for people who had never joined a gym. Similar dynamics are playing out in Europe.

The Loyalty Spiral: Why Good Gets Better

When companies truly solve customer problems, they trigger a “loyalty spiral”— a feedback loop where success breeds more success:

Employee Loyalty Drives Customer Loyalty: Companies with loyal customers tend to have loyal employees. Why? Because it’s energizing to work for a business where customers genuinely appreciate what you do. At Costco, 90% of employees stay at least one year, and those who make it past year one typically stay for over a decade. This creates institutional knowledge that’s nearly impossible for competitors to replicate.

Customer Loyalty Drives Innovation: When customers stick around, companies can invest in long-term improvements rather than short-term customer acquisition. Amazon spent years losing money on Prime because they made a bet that loyal customers would eventually make it profitable. Companies constantly churning through customers can’t afford such investments.

Loyal Customers Become Quality Control: Long-term customers provide better feedback because they understand your business deeply and want you to succeed. They’ll tell you about problems before they become crises. New customers, by contrast, often just leave without explanation when something goes wrong.

The Defection Audit: Learning from Failure

The most successful companies have a systematic process for learning from customers who leave. Frederick Reichheld documented how smart companies conduct “defection audits”—senior executives personally interview significant customers who defect to understand exactly where their value proposition failed.

The math here is striking: companies that systematically study their failures and adapt accordingly can reduce customer defection rates by 5 - 10 percentage points, which translates to 25 - 50% increases in per-customer value over time.

Yet most companies don’t even track customer retention, let alone study why customers leave. We measure what’s easy (quarterly sales) not what matters (customer lifetime value).

The Three Customer Segments That Matter

Not all customers are created equal when evaluating how well a business solves problems. Second level thinkers look for companies that understand these three segments:

Loyalists (20% of customers, 80% of value): These customers have found their solution and stick with it. They spend more, refer others, and provide predictable cash flows. Companies that lose loyalists are in serious trouble because these customers represent disproportionate lifetime value.

Switchers (60% of customers, 20% of value): These customers bounce between providers based on price, convenience, or temporary dissatisfaction. They’re expensive to serve because they require constant re-acquisition efforts. Companies that focus too much on switchers often destroy their economics.

Non-customers (Everyone else): These are people who aren’t using any solution to their problem, often because existing options don’t work for them. This is where the biggest growth opportunities hide— Basic Fit found a business by serving the 85% who didn’t belong to any gym.

The Value Creation vs. Value Capture Balance

Here’s where most companies get the economics wrong: they optimize for value capture (extracting money from customers) rather than value creation (solving problems exceptionally well). The most durable businesses create far more customer value than the price they charge.

Value Creation Companies:

• Focus on solving customer problems better over time

• Reinvest efficiency gains into customer value

• Build loyalty through superior problem-solving

• Examples: Costco, Amazon, Spotify

Value Capture Companies:

• Focus on extracting maximum short-term profit

• Keep efficiency gains as margin expansion

• Build dependency through switching costs or contracts

• Examples: Traditional cable companies, many banks

The counterintuitive truth: companies that focus on value creation often capture more value in the long run because they build sustainable competitive advantages that allow for premium pricing and market expansion.

The Financial Statement Trap: A value capture company might show spectacular margins—30%, 40%, even 50%. A value creation company might operate at 5% margins or even lose money. Looking at the financial statements, you’d think the high-margin company is superior. But what if those high margins come from squeezing customers who are desperately looking for alternatives? And what if those low margins reflect massive reinvestment in customer value that will create an unassailable moat?

This is why starting with customer problems, not financial statements, is so critical. The financials show you what happened. The customer problem shows you what will happen.

When Customer Problems Evolve

The most dangerous moment for any company is when the customer problem evolves but the company’s solution doesn’t. This is how giants fall:

Blockbuster’s Problem Evolution:

· 1990s Problem: “I want to rent movies conveniently”

· 2000s Problem: “I want entertainment on demand without leaving home”

· 2010s Problem: “I want unlimited entertainment access for a predictable monthly cost”

Blockbuster kept solving the 1990s problem while customers moved on. Netflix evolved with the problem, ultimately moving from mail-order DVDs to streaming to content creation.

The Early Warning Signs: Second level thinkers watch for these signals that customer problems are evolving:

• Customer acquisition becomes more expensive

• Increased customer complaints

• New competitors unburdened by legacy costs taking market share

The Network Effects of Problem Solving

Some customer problems create network effects, meaning the solution gets better as more people use it:

Data Network Effects (Spotify): More users lead to better recommendation algorithms lead to better discovery for all users

Marketplace Network Effects (Amazon): More customers attract more sellers which leads to better selection and prices which attracts even more customers

Learning Network Effects (Costco): More members leads to more purchasing power which leads to better prices which attracts more members

Companies with network effects in their problem-solving approach often become nearly impossible to displace because competitors face a “cold start” problem - they can’t provide the same value without the same network size.

Framework for Evaluating Customer Problems

When analyzing any business, second level thinkers ask these deeper questions:

1. Problem Intensity: How painful is this problem? (Higher pain leads to higher willingness to pay)

2. Problem Frequency: How often do customers face this problem? (Higher frequency leads to higher lifetime value)

3. Solution Satisfaction: How well does this company solve it compared to alternatives? (Better solutions leads to higher retention)

4. Problem Evolution: How might this problem change over time? (Stable problems leads to predictable businesses)

5. Network Potential: Does solving it for one customer make the solution better for others? (Network effects leads to sustainable advantages)

6. Value Distribution: How much of the value created goes to customers vs. the company? (Balanced distribution leads to sustainable model)

The companies that score highest on these dimensions often become are positioned to thrive for the long-run.

What These Case Studies Teach Us

All three companies succeeded by asking the same fundamental question: “What problem are we really solving?”

• Costco realized they weren’t in the “retail store” business - they were in the “eliminate unnecessary costs” business

• Spotify understood they weren’t in the “music sales” business - they were in the “instant music access” business

• Basic Fit saw they weren’t in the “gym” business - they were in the “remove barriers to fitness” business

Each found ways to solve customer problems more efficiently than existing solutions, then passed the cost savings to customers while building sustainable competitive advantages.

Companies that deeply understand customer problems can evolve and expand. Companies that only understand their products get disrupted by someone who understands the problem better.

The Litmus Test For Your Thinking

Before you invest in any company, ask yourself these questions:

1. Can I clearly explain what problems this business’s products and services solve to a fifth grader?

2. How painful is this problem for customers?

3. What other ways could this problem be solved?

4. Is this company’s solution significantly better than alternatives?

If you can’t answer these questions clearly, you don’t understand the business well enough to invest in it. And if you don’t understand why customers choose this company over alternatives, you can’t predict whether they’ll keep choosing it in the future.

Why Most Investors Skip This Step

This question seems too simple, so many investors rush past it to get to the “sophisticated” analysis—financial ratios, technical charts, price targets. That’s first level thinking behavior. Second level thinkers know that everything else—the financials, the competitive position, the growth prospects—flows from how well a company solves customer problems. If you get this foundation wrong, all your sophisticated analysis is built on quicksand.

Businesses are simply groups of people that get paid to solve problems for customers.

Much love,

Akshay