If you have read the classic The Innovator’s Dilemma, you will realize that the reason why established companies can’t innovate quickly isn’t because they are stupid or blind, but because they are efficient and optimized to make their current business more profitable.
Clay Christensen studied companies that were well run and found that they miss great innovations because those areas are initially too small to impact their core business. Paradoxically, the best run companies are often the most effective at building their core business and thus less flexible to pursue new areas of innovation.
Investing in startups has a similarly paradoxical nature. No one wants to make bad investments, but optimizing for the characteristics that make most established companies work well is exactly the wrong way to invest in startups.
Here are a few pairs of myths and realities of investing in startups.
- Let’s talk about the team. Everyone wants a great team.
Myth: look for a team who has great experience and has “done it before”.
Reality: look for a team who is able to learn and grow the fastest.
In well established companies and industries, leaders need to have significant prior experience to work with a more experienced team. They benefit from industry relationships built up over the years. But in a startup, the crucial factor is speed. No matter how much experience someone has, doing something new will create new problems that requires rapid responses. Speed and experience are not mutually exclusive, but sometimes having experience creates a sense of “we already know how to do this”. In reality, there will always be many unforeseen challenges so look for the team that is willing to experiment and learn the fastest.
2. People all want to invest in a killer new product or service.
Myth: look for products with better and more features.
Reality: look for products that are different and are hacked together quickly but gaining traction with a small core group of “addicts”.
Rarely does a better product win over the incumbent choice. Usually the product has to be meaningfully different than existing solutions. Big companies can compete with a slightly better products with massive marketing — why do you think you see so many car, fast food, and financial services ads. Those are mature industries with incremental product improvements that rely on mass distribution. As a startup, you need to rely primarily on organic product growth by building something unique and loved by a core group of users. How do you build something different? Focus on a rapidly emerging market segment, which brings us to the next idea.
3. Everyone wants to invest in companies that operate and grow in a huge markets.
Myth: invest in gigantic markets.
Reality: invest in small markets that are growing dynamically — the Internet in 1990s.
Great startups can only be built in rapidly growing markets. In large, but stagnant markets, the major players are already competing and beating each other over market share. It would be the opposite of smart and strategic for a startup to jump in. In 1994, when Jeff Bezos founded Amazon, the Internet grew at a rate of 2,300% off of a meaningful base. Over the next two decades, not only did that growth allow for Amazon to blossom, but it created almost all of the most significant companies of this generation. The emergence of a new market create a vacuum of customer needs for a company to fill and is the white space that startups can work to fill.
4. We all want to invest in companies that have strong and predictably business models.
Myth: look for companies that have revenue and/or profit.
Reality: look for companies that are focused on building huge protective moats around technology and network but aren’t monetizing yet.
Ultimately companies need a healthy financial model but their long term success is determined by two forms of competitive advantage. One form is a technology advantage — a startup can win with the best technology that gets transformed into the best product. The other is a network advantage — a startup uses network effects to create a positive cycle where each new person that joins the network creates more value for everyone in that network (Facebook, Airbnb, Lyft). Sacrificing short term revenue and/or profit to build long term competitive moats can be taken to an extreme, but only focusing on financials without intently creating long term advantages is dangerous.
The Investor’s Dilemma
As with the innovator’s dilemma, there is also the investor’s dilemma of trying to check all the standard boxes for what makes for a great large corporation.
Paradoxically, those boxes are not the ones that make for the best startups to invest in. It requires discipline and contrarian thinking to get past the investor’s dilemma and find the most valuable growth companies of the future.
