Great Entrepreneurs Pick Great Markets

It’s hard to underestimate the power of an attractive or unattractive market in driving outcomes for companies, including start-ups. As Andy Rachleff, one of the founders of the venture capital firm Benchmark has said “When a great team meets a lousy market, markets win.”

For entrepreneurs, then, the challenge is to find an opportunity in an attractive market.

A few weeks ago, I wrote about the three high-level decisions that guide my thinking as a seed stage venture capitalist. Is the market attractive? Is the founder great? And is there a strong fit between the two? This is overly simplified, but gives a little bit of a window into how I think about investment opportunities early in my evaluation process. On the flip side, entrepreneurs need to think about these questions when crafting their pitch to investors – founders need to explain why their market is attractive, why they and their team are A players, and why they are the right people to tackle the opportunity. In this post I’ll start first with the question of markets.

So, what makes a market attractive? Is it just one that is very big and growing fast?

No. There are some very big markets that are fundamentally unattractive, especially for start-up companies (for example – music).  There are also some markets that might be stagnating but present the perfect opportunity for startups to be disruptive (was anyone marveling at the growth of the eyeglass market before Warby Parker?) There is a lot more that goes into what makes a market attractive or not.

Crack open any strategy textbook and you’ll see Michael Porter’s Five Forces, a classic framework for understanding what makes markets attractive. With that in mind, here are a few particular points for start-ups to consider:

Mega Trends: Growth does tend to fuel great opportunities. But more important than the growth of a market are the big trends driving that growth and propelling companies and innovation forward. The key as an entrepreneur is to try to predict what these are before they are blindingly obvious and there are tons and tons of competitors in the space.

Some mega-trends are, well, mega. The platform shift to mobile computing is one of these. So was the shift from local to cloud computing. Companies in such spaces tend to benefit from wind at their back, even if that wind propels lots of companies forward.

Other mega-trends are a bit smaller and likely less publicized. The shift in advertising from direct sales to programmatic buying and selling of inventory is an example that unlocked a lot of opportunity for certain players.  Entrepreneurs who spotted this early and locked up dominant positions in different segments of this market have done well. Other companies didn’t connect the dots as well, and have suffered despite early impressive revenue growth.

Concentration: Entrepreneurs should pay particular attention to the degree of market fragmentation vs. market consolidation.  One isn’t necessarily better or worse than the other, but it does change the game in terms of how a new firm can compete.

Highly consolidated markets are ones where a small number of firms have significant market share. This makes it tough because these firms have tons of money, brand, and market leverage to compete.  Often, this exhibits itself through dominance in distribution.  In the college textbook market for example, a few firms utterly dominate.  The primary channel through which textbooks are sold is direct to professor, which requires a physical sales force that shows up at professors’ offices and pushes adoption of their product.  It’s extraordinarily hard for startups to compete at this same game, and most of the ones that have tried have lost.  This is why the prices of textbooks have increased at double the rate of inflation for decades, even as the content in the books has become more and more commoditized. This is also why in 2013, the only major company to exit in this space is Chegg, a rental company that has a direct to student go-to-market.  Any start-up in a highly concentrated market needs to have a novel go-to-market strategy initially to build brand and confidence in their product.

Moats: Market structure is often related to the ease or difficulty of competing in a market as a new entrant. And one of the main drivers of this is the existence (or lack thereof) of competitive moats.  As Warren Buffet has famously said, in business “I look for economic castles protected by unbreachable moats.”

These moats are conditions in the market of competition that significantly favor incumbents.  Network effects are a powerful moat (Ebay). Products with very high switching costs are another form of economic moats (enterprise software).  Access to massive amounts of free traffic is another form of economic moat (Tripadvisor).  The ability to drive costs down and service levels up to the point that no other competitor can exist economically is another powerful one (Amazon).

How will you create a moat to deter new entrants? Perhaps more urgently, if the incumbents in your market have a moat, what is your strategy to overcome it?

Market Creation:  Sometimes, I hear push back on this concept of finding attractive markets because some start-ups are in the business of creating great markets. Twitter is a notable example among many.  One could argue that a traditional market sizing analysis or Porter’s Five Forces analysis would have failed in analyzing that company.

I would argue that this is not really true. All companies are competing to fulfill some sort of customer need. Sometimes, the product a company offers is a direct replacement for something else that already exists.  In other cases (as in Twitter) it’s a completely different medium. But the “job to be done” is not new.  The desire for journalists and companies and celebrities and media to express themselves and build a following was not new. But Twitter has enabled it to a completely different degree, and lowered the bar for these individuals to develop a following.

Evan Williams himself has said this: “We often think…the internet enables you to do new things, but people just want to do the same things they’ve always done.”

One approach to this I really like is to think about the size of a problem, which helps you think more creatively about the ultimate scale of the market.  Seed investor Hunter Walk has said this well:

Billion dollar companies often create new markets by tapping into unmet demand. Billion dollar companies can start out looking like toys. It can be about levels of zoom – like on a Google Map. If you thought airbnb was just the size of the hostel market and not the hospitality market, you missed out. If you thought Uber was just the size of the black car market and not the transportation market, you missed out.

To summarize, when assessing the attractiveness of a market, entrepreneurs need to ask what’s changing (mega trends), how market structure (concentration) impacts how a start-up needs to compete, and what the barriers to entry are (and will be) for new entrants (moats).  If the market isn’t attractive, the startup is in for a very tough battle, even if everything else is in its favor.  If it is attractive, then the question is how equipped the team is to capitalize on the opportunity. That will be the subject of another post.

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