Why Category Leaders Win

How Startups and VC are more similar than you might expect

We are obsessed with winners and winning. In some spheres of life, we marvel at Michael Jordan, and in others, at Uber and Airbnb. As a wise man once said — “if you ain’t first, you’re last”. In the startup world, in particular, this focus on the winner is probably merited, given that category winners capture a vast majority of the enterprise value of the startups in their sector.

Why this is this case is readily apparent in some business models, such as ones with network effects. Because a network’s value is largely driven by the number of nodes it encompasses, the most popular service will have an increasingly strong value proposition vs. its competitors (and against non-participation).

Though this mechanism is less readily apparent for a standard software business, being a category leader still brings many self-reinforcing effects to bear. To name a few:

  1. A larger pool of customers that can serve as references and referral sources, which can make it easier to attract the incremental customer
  2. More capital (both from investors and greater revenue generation) and resources to spend on marketing and product development, which can drive a more fully featured product and stronger market presence — thus reinforcing growth. More resources doesn’t always = better product, but can help under the right circumstances
  3. Higher caliber recruits (both executive team and beyond) who are attracted to join a winning team, which helps speed execution
  4. More organic PR, given the leader’s name will inevitably come up when people write about that market — providing more marketing leverage
  5. At scale, a leader’s product can become an interesting platform for others to develop on top of, developing an entire ecosystem of players that leverage their customer base and add functionality to the core product

Many of these forces are weaker than the inexorable pull of the network effect. After all, it’s hard to have a monopoly on all of the potentially relevant talent, and once your competitors reach a certain customer scale, they may be “good enough” from a ‘reference-ability’ standpoint. Early category leadership isn’t enough to guarantee success — ask the dozens of other search engines that came before Google. But leadership does seem to offers clear benefits that other players cannot reap as easily.

A classic example of category leadership / self-reinforcing effects = Amazon

My biggest learning of 2015 was just how much venture, like startups, exhibit many of these self-reinforcing effects. Take Sequoia as an example — a consensus top 5 venture fund. Sequoia’s track record spans for decades, and largely speaks for itself — they were early investors in WhatsApp, Apple, Airbnb, Cisco, Electronic Arts, Hubspot, Flextronics, Instagram, and many, many other massively successful companies. That track record, in turn, is shaped by many dynamics which tilt the scales in their favor:

  1. To start, their track record helps attract differentiated deal flow from many of the best entrepreneurs in the world, which leads to more great exits, reinforcing that record
  2. In addition, it helps build a robust set of corporate relationships, as corporations want to be abreast of interesting new technologies as customers, strategic partners, or potentially acquirers. These relationships prove hugely valuable in helping startups acquire customers, grow revenue, and ultimately achieve good exits, which again reinforces the track record
  3. The halo effect from that track record also helps them build relationships with experts in a given field, and with upstream investors who show them their best deals in the hopes of co-investing with them
  4. Down the road, the fund’s reputation makes it easier to recruit best in class talent as successors
  5. Moreover, because feedback loops in venture are so long (often 5+ years to know if something has succeeded), track records take a few cycles to establish in any significant manner — slowing the emergence of meaningful competitors

In venture, similar to the companies we invest in, it’s easier for the leaders to remain on top. Similar to the SaaS example above, these dynamics aren’t enough to guarantee success — investing is far more art than science — but they are likely enough to give top funds a continued edge.

One way to visualize the results of these effects

But, given the case I’ve laid out above, how do we account for the rise of A16Z, First Round, Emergence, Social + Capital, and others? Unsurprisingly, often in similar ways as startups.

In some cases, it’s taking advantage of broad, structural adjustments that create new categories, and building deep expertise in those areas (e.g., Emergence Capital in SaaS, USV in businesses with network effects). These category based strategies carry a lot of risk (cleantech, anyone?), but, as Emergence and others have shown, can work very well.

Others have succeeded by challenging the operating model of venture capital — A16Z, First Round, and Social + Capital are notable for the robustness of their platform services, including data science, marketing, product, recruiting, business development and others. Another angle on this is the rise of AngelList and syndicates.

Finally, many of these firms were started by individuals with the right backgrounds — being one of the creators of the modern internet browser, for instance, likely goes a long way in convincing an entrepreneur that you can help them navigate the trials and tribulations of building a business.

While there are many similarities, there are some meaningful differences in the dynamics of category leadership between VCs and startups. A few examples:

  • Early stage VC is a fairly local business — so funds outside of the valley have the opportunity to build their own power laws of sorts by doing well in their own geographies (similar to doing well in particular verticals / technologies)
  • Venture Capital is also largely a relationship business — because an entrepreneur and a VC are entering into a bond that lasts for years, their mutual compatibility is a wildcard that doesn’t always favor the category leading VC. Unlike buying and selling public stock, early stage fundraising is a person-to-person endeavor. In the best case, a VC can help accelerate the business and support entrepreneurs through the inevitable tough times. In the worst, the VC is difficult to deal with and is not committed to helping the company or the entrepreneur achieve a great outcome. The VC-entrepreneur relationship requires trust, empathy, belief, and many other intangibles that aren’t necessarily captured in a track record. Those human elements may rightfully drive an entrepreneur to work with the VC she best connects with, vs. the most prestigious one
  • Similar to building a company, making an investment in a company requires conviction to support a business whose viability is far from obvious. In fact, being an early stage investor often means supporting ideas that seem bad on the surface. While receiving the opportunity to evaluate these companies first is an advantage that category leaders have, there’s a leap between getting those opportunities and taking them that also allows for non-category leading firms to invest in iconic companies

Venture is a business that is wholly dependent on the success of startups, so it’s no surprise that the two are deeply linked. But I do think the self-reinforcing nature of VC is underappreciated, as well as the emergence of some of the newer venture platforms. Would love to hear any other thoughts or counter arguments — you can find me @ablordesays.