Posts Tagged: network effects

What type of market are you operating in?

When we look at investment opportunities, we need to consider the type of market that the potential investment is in. How much room is there for a market leader or leaders? Is it winner-takes-it-all or winner-takes-almost-all? Is there room for multiple potential winners?

Winner takes all

These markets are driven by network effects and only one company will win in the space. Examples of these winners include eBay (auctions), LinkedIn (professional networking), and YouTube (video). When these markets first emerged on the scene, there were dozens, if not hundreds, of companies vying for market share. Yet, only one dominant product survived.

Winner takes almost all

This market trend is happening across the enterprise where adoption is driven by end users, and not dictated from above by IT departments. In this case, a company or tool can emerge as a clear category leader, as word of mouth among satisfied users accelerates adoption across colleagues, departments, and companies. As a result, the tool can grab a large market share in a certain market segment or vertical. Think Mailchimp, Dropbox, Hightail or Unbounce for horizontal solutions or Clio, Jobber or Frontdesk for vertical products (disclosure some of those are portfolio companies). In particular, we see a winner takes almost all dynamic happening in vertical SaaS plays where word of mouth can quickly travel within one industry. For example, lawyers from different firms may work on the same case and spread exposure of favorite tools.

Multiple winners

When markets are not subject to network effects (or there’s minimal network effects/word of mouth), multiple winners can emerge. Today this type of market is mainly in commerce and enterprise IT.

The bottom line

As an entrepreneur, you need to understand what kind of market you are in order to create effective growth and fundraising strategies:

  • Growth strategy: Let’s say you end up being #2 in your market. While second place might be an enviable position for some, it’s essentially worthless in a winner-takes-all market. For this reason, you’ll need to be as aggressive as possible in the first few months after a category emerges to try to lock in the top spot before it’s too late. On the other hand, such an aggressive tactic doesn’t make sense in an e-commerce environment where there can be multiple winners. In this situation, you’re better off adopting a more conservative approach and ensuring you’ve reached product-market fit and nailed unit economics before accelerating.
  • Fundraising strategy: You’ll need to understand your market’s dynamics to know how much money to raise and how quickly. For example, in a winner-takes-all or winner-take-almost-all market, there’s a window to aggressively fundraise while the category is still open. However, once a category leader emerges, it will be hard to attract investors.

Of course, all of this is made even more complicated by the fact that it’s not always clear what the exact category is. For example, do Lyft, Sidecar, Hailo, and Uber all belong to the same transportation category or do they each define their own category? As an entrepreneur or investor, you’ll need to analyze the market and its current players to know how much room (if any) is left.

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Traction is the new IP

“Traction is the new IP” sums up perfectly how the technology space has evolved over the past decade due to the nature of the web. Barriers to entry are no longer created by patents or by tech differentiation alone, but by superior traction in the marketplace.

In today’s web landscape, word of mouth drives adoption and can lead to “winner takes all” (or almost all) in both B2C and B2B markets. Category leaders do very well, while the #2, 3, 4… players struggle to attract customers and financing.

This trend is particularly true in markets that are highly susceptible to network effects, such as online auctions and social networks. In these markets, we often see one major company emerge and take all of the value created in its respective category.

Even beyond auctions and social networks, the web tends to prefer the category leader. This is true in most SaaS categories, including enterprise applications. Consumerization of IT has accelerated the pace of software adoption in the enterprise, placing greater significance on market traction and momentum.

In the past, the adoption of an enterprise tool was primarily driven by the quality and aggressiveness of a sales force to win over more customers. The pace of adoption was kept in check by the limited size of the vendor sales force, as well as by gatekeepers (CIO/IT department) on the customer side.

However, now individual employees get the ball rolling by using a product. If that product proves useful, adoption ripples between colleagues, departments, and companies, without any discussions between a sales rep and IT department. Again, word of mouth can lead to a strong market leader, creating a significant barrier to entry for anyone else.

Know your market dynamics

If traction relative to your competitors defines the success of a company, it’s absolutely critical for any entrepreneur to understand the dynamics happening in his or her market. It’s also important to realize how little value investors therefore put on IP when investing in a company.

The same logic holds true for most acquiring companies. Let’s take my own portfolio as an example. To my knowledge, only 4 out of my 35 portfolio companies have filed for patents. Three of those have since been acquired and patents did not play a significant role in the acquisition process.

So, in this new market dynamic, should you go for patents?

If traction is the new IP, the question still remains if your startup should file a patent if you see an opportunity. Here are a few things to consider:

  • Treat a patent only as optional value: It can take up to 10 years to get your patent granted. Most startups have either been acquired by then or are in the deadpool.
  • Most investors and potential acquirers will not separately value patents unless they are granted (which again, can take up to 10 years).
  • If you want to file a patent and have limited financial resources, consider filing a provisional patent. This is a lower-cost first patent filing that at least gets the process going and gives you a year to test your idea before filing a full patent application.
  • Limit the exposure you give patent opportunities in your investor pitch – it sends the signal that you might be focusing on the wrong priorities.
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The only 2 ways to build a $100 million business

With tens of thousands of new start-ups being created every year, the potential of a company to truly scale and become a large, stand-alone business is more crucial than ever before. A great product is always the foundation but a clear distribution strategy becomes essential to cut through the noise.  So most early-stage VCs have started to evaluate investment opportunities with an imaginary benchmark in mind: can this company become a $100 million opportunity?

Generally speaking, there are two ways (and only two ways) to scale a business to hit that $100 million threshold:

  • Your business has a high Life Time Value (LTV) per user, giving you the freedom to spend a significant amount of money in customer acquisition. High LTV can usually be found in transactional or subscription businesses.
  • Your business has a high viral co-efficient (or perhaps even a network effect) that lets you amass users cheaply without worrying too much about the monetization per user or spending money on paid acquisition.

 

Route One: High LTV per user

The exact definition of a “high” user LTV depends on the specific vertical, so it’s typically better to analyze the ratio between Customer Acquisition Costs (CAC) and the Life Time Value of the customer. In my experience, having an LTV that’s three to four times greater than CAC makes a business (and potential investment) interesting.

The biggest driver for high LTV is repeat purchase behavior (in an e-commerce business) respectively a low churn rate (in a SaaS company). Companies that score highest in this criteria are typically:  E-commerce businesses that fulfill regular needs and offer a differentiated experience or SaaS businesses that help businesses or individuals manage core activities.

As a VC, the biggest challenge in evaluating LTV models is that metrics can dramatically change at scale. For example, Customer Acquisition Costs often increase once the more efficient marketing channels are maxed out and the company needs to find new users through less efficient means. In addition, churn tends to rise as a company grows. Early users of a product are often strong advocates and company ambassadors, while those users acquired through paid marketing channels down the road show far less loyalty.

Route Two: The Viral Effect

The other way to scale a business is through a strong viral and/or network effects that lets businesses grow to tens of even hundreds of millions of users. With this model, user acquisition is generally close to free, and monetization per user is often low (advertising-based or freemium businesses).

Many businesses built in the early days of the Facebook platform (like Zynga) benefitted from a huge viral co-efficient and scaled very rapidly. (As we all know, this is no longer the case as Facebook has essentially removed most of the free viral channels and businesses must now pay for most of their user acquisition via Facebook.)

Even more interesting are businesses that create network effects like marketplaces or social networks. Not only do they acquire lots of users for free due to viral effects but also create important barriers to entry and lock-in effects as the network grows over time.

Startup Purgatory: No Man’s Land

Unfortunately, many consumer internet startups find themselves stuck in the middle of these two strategies: they have a low monetization per user and limited viral effects. That unfortunate combination makes it rather difficult to reach the $100M mark.

As the consumer Internet space becomes more and more crowded, every startup founder needs to be thinking about these two ways to scale a business. Too often I have seen entrepreneurs believe that customers will automatically flock to their cool new service, completely underestimating how tough it is to cut through the noise and build an audience.

To build a standalone company and capture the attention of investors, you need a viable way to scale your business. The earlier you figure this out the better, since it may require you to build your product differently. While the $100 million mark may seem far away in those early days, it’s important to begin thinking about paths to reach this threshold from the start.

 

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