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March 27, 2005

Commandment #9: Be Like Goldilocks

Any VC who doesn’t grill you on “the competition”, either in the initial meeting or during due diligence, fails the VC IQ test.  Understanding how to think about – and present -- the competition, therefore, is important to getting VC funding.  Here are some thoughts.

Competition is, what I call, a “Goldilocks” phenomenon.  You don’t want too much (no surprise here) and you don’t want too little (hmm, surprise?) – you want it just right.

It’s probably easy for entrepreneurs to understand why too much competition is a bad thing:

·        Competition for Funding.  By this, I don’t mean that there isn’t literally “enough” money to fund multiple startups in a single niche (on the contrary, one of the problems of the current early stage venture capital ecosystem is that there’s too much money chasing early stage deals). It’s more nuanced than that (and not as self-serving as it always sounds on first blush to entrepreneurs).  Several actual reasons:

o       because most top-tier VC firms don’t invest in companies that compete too closely (longer discussion in a future post), a startup that has numerous existing startup competitors actually may actually have a much shorter list of top-tier VC’s to approach;  given the odds of any particular VC firm funding any particular startup, this can have a dramatic adverse effect

o       Though apostasy to entrepreneurs, it’s actually quite hard to distinguish among startups going after the same space, if there are a lot of them.  When this occurs, every startup suffers from the “least common denominator” effect -- and inevitably seems less interesting; and

o       Many VC’s simply won’t fund the 4th or 5th company in a space.

·        Competition for Talent:  Pretty straightforward.  Commandment #8 asserts that “it’s all about the team”.  Where talent is concerned, two bad things happen when there are too many competitors:

o       talent gets spread too thin; and

o       good talent stays away because the space is too “crowded”.

·        Competition for “Market” Attention:  In a market with numerous competitors, any single startup will have a tough time gaining the attention of important consultants, analysts, pundits, columnists, reviewers, press, etc.  Partly, it’s the confusion (and the extra effort required to make sense of the competitive dynamic), and partly it’s the “least common denominator” problem mentioned above.

·        Customer Confusion:  Much the same thing.  Quite often, customers faced with numerous competing products or services find it too costly and confusing to differentiate.  Remember:  purchase decisions have costs.  When the costs are too high (because of confusion about what product or service is the best fit or value), it’s always bad news.  At best, the purchasing decision is delayed (as the competitors confuse the customer base by bashing each other).  At worst, the customer makes the “safe” choice and buys the product or service from the “most trusted” vendor – usually a large, established competitor with a vaporware or highly inferior product or service. 

·        Customer Leverage:  Smart customers also play off startups against each other to get the best deal.   Since the value of an early, marquee, reference customer is so important to a startup, the customer has all the leverage here.

·        IPO Opportunity:  For established companies, public markets don’t like markets with too many competitors because competition drives down margins and earnings.  For startups trying to go public, that’s also true, but another concern also comes into play.  To go public and achieve an efficient market for its stock, a startup needs coverage by sell-side analysts.  Even in the “good old days” when there were lots of analysts, it was not easy for startups going public to obtain broad analyst coverage (other than from the underwriters).  Nowadays, it’s much worse, given the dramatic decrease in the number of sell-side analysts.

·        M&A Opportunity:  In many markets (e.g., “core” enterprise ERP applications, or, increasingly, consumer internet businesses), the dominant players provide the main liquidity option through mergers and acquisitions.  While actual strategies differ, often the dominant players in a market will buy the 2nd or 3rd leading startup, rather than the leader.  Leaders often think they can go public as an alternative, and therefore demand a premium acquisition price.  Startups in the 2nd or 3rd position feel more vulnerable, and therefore feel pressure to sell for a lower price.  Once each of the dominant players has made an acquisition in a market, it’s often “game over” for the other competitors who remain independent, even the market leader.  Why?  Even for companies selling a technology-based product or service, the marketing, distribution and sales (or in consumer internet parlance, “customer acquisition”) muscle of a larger company is often more important than any particular technology.  A cheaper, inferior product or service in the hands of a powerful distribution system often defeats a better product or service being sold by a startup, even the (pre-acquisition) leader.  So, in a crowded market with dominant incumbents, if you’re not acquired, you’re toast.  Smart acquirers use this leverage to their advantage.  The more startups to play off against each other, the better.

[Quick sidebar

:  Having said all this, however, the history of venture capital is replete with instances where promising markets are imprudently (and even stupidly) over-funded.  VC’s (like entrepreneurs and other people) don’t always do the smart thing.]

Given all the bad things I just wrote about too much competition, one might assume (some entrepreneurs do) that “…if having a lot’s bad, then having none must be great…”.  This is wrong for a couple of reasons:

  • Though I’ve never seen it, I suppose that there may be cases, very rarely, in which a startup has a truly unique and original business idea – and therefore has no competition.  Most startups, however (no matter how innovative), do.  Given the inefficiencies in the information marketplace about startups, entrepreneurs may not know about all their competitors, but they’re almost always out there.   I know, from my entrepreneur friends, that this is painful for entrepreneurs to hear – and understandably so.  Because they’re human beings, and therefore subject to the same motivations (and foibles) as the rest of us, it’s hard for entrepreneurs to make the enormous sacrifices necessary for success if some little corner of their mind doesn’t think that they have a deep, fundamental insight into a market that no one else does.

  • Given this, if a startup asserts that they don’t have many (any) competitors, they hurt their case, no matter what.  Either:  (1) the VC won’t believe them, and will think that they simply haven’t done enough competitive due diligence (and are therefore not worth backing) or (2) the VC will believe them and conclude that, if there aren’t any competitors, it must not be that large or interesting a market.

So, if too much competition is bad and too little (or any) competition is bad, what’s the entrepreneur to do?

Couple of things:

  • Do your competitive due diligence.  By dint of their position in the deal flow, VC’s in the top-tier firms often know a lot about who the startup competitors are in a given market.  VC’s expect (and reasonably so) that good entrepreneurs, even though they’re usually not as deep in the deal flow, will be very well informed about their competitors, and to have thoughtful, balanced analyses of their strengths and weaknesses.

  • Don’t be Afraid to List Your Competitors:  From the VC’s perspective, it’s much more impressive to hear a thoughtful, careful, balanced analysis of a crowded competitive landscape, than it is to hear one that omits many of the competitors (the worst) or naively concludes that all the competitors are “losers” (for one reason or another).  VC’s will fund startups that have competitors.  Don’t be afraid to point them out.

In summary, as you develop your business ideas, and begin to think through your investment pitch to the VC’s, remember the following; it’ll help: 

  • Having too many competitors is always bad.  If you have too many, consider another startup idea, painful as that is.

  • Having too few competitors is usually bad.  If you have too few, consider whether the market’s that interesting.

  • Having some competitors is good.  It validates the market opportunity.  BUT,  know who the competiors are and understand their weaknesses AS WELL AS their strengths.  VC’s are most impressed by entrepreneurs who know who their competitors are and know a lot about them -- and have a healthy respect for them.

March 27, 2005 | Permalink

Comments

I don't know if it's something to do with Firefox, but the formatting of this post is all over the place. I've had this issue with Typepad's new WYSIWYG editor as well...

Posted by: Jeff | Mar 29, 2005 10:14:12 AM

Thanks for the post. My comment is on http://www.strategicboard.com/weblog/pivot/entry.php?id=139

Dudu

Posted by: Dudu Mimran | Apr 19, 2005 8:05:33 AM

Please discuss valuation. What is pre-money and post money. Should I give pre-emptive rights to angels? How does that impact my chances to attract a vc? What about preferred shares? Can you explain some of the common terms and how they impact the statements. Thank you

Posted by: tnaff | Oct 14, 2005 2:13:48 PM

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