Does the winner take it all?
Over the next few months I’m going to be sharing some thoughts on different market characteristics and business models that are often associated with venture scale returns. First up is ye old ‘winner takes most/all’ dynamic.
It’s often said that there is no such thing as an original thought, and nowhere is that more true than VC opinion pieces. A regularly repeated trope of VC is that you want to invest/build in sectors which have ‘winner takes all’ potential.
What does this mean?
Market share in its simplest form should be viewed as an outcome of sustained competitive advantage. Studying market share is useful as it provides an insight into both the stability and the concentration within an industry. Porter’s Five Forces is arguably the seminal treatise for understanding and identifying market competition and its drivers. However, like many academic texts, it’s not entirely survived the test of time, with technological progress, globalisation, and changing regulatory aims all challenging its utility.
As investors, one of the many difficulties tends to lie in the judgement required to assess the size and dynamics of the market. For instance; even if a total addressable market (TAM) is defined, how many companies at scale can be accommodated? Or judging the minimum efficient scale which is required to compete with the incumbents.
Drivers of market concentration
Winner takes all dynamics have always existed but historically the dynamic was most evident in industries which either had significant government regulation or where significant M&A activity had led to consolidation. The US defence industry is a prime example. Since the 1990s, the defence sector has contracted from 51 to just 5 aerospace and defence contractors.
The more interesting question is whether tech enabled services and products lead to extreme market concentration. A company has market power when it can set the price of its good or service above the marginal cost (i.e. a ‘mark up’). Economists use a ‘mark up’ to measure this market power. The recent decade has seen a huge increase in markup changes within different industries. In other words we’re seeing more and more ‘superstar’ firms, to borrow from the academic discourse.
If we dive into the academic research, there’s also clear industry concentration of these superstar firms. Roughly 40% are in technology, ~20% are in manufacturing and 13% are in healthcare.
It’s not hard to theorise as to why this is the case. Tech enables faster innovation cycles — as software has near zero marginal cost, so the company with the most revenue can invest into a superior product and service, begetting more revenue. We have seen this throughout numerous hype cycles in recent years. Entrepreneurs quickly gravitate towards a new market, which sees a frenzy of activity, before market dominance is achieved and competitors retreat.
Why does it matter in venture?
For quite a few reasons, but for the sake of brevity;
- It leads to pricing power and value capture — as alluded to above market power means the price of the good or service can be set above the marginal cost. In a competitive market the price trends towards the marginal cost, which can diminish shareholder value.
- It creates more attractive exit opportunities — as recent history has shown us, it means you can extract high(er) multiples in an M&A exit because acquirers really only have one asset to fight over.
- It leads to platform opportunities — as complementary integration partners will want to access the largest potential pool of customers and will only want to integrate with 1–3 platforms.
Does the winner become the loser?
I’d like to think my writing is always timely, but this piece is more timely than most with two seismic shifts underway that look set to see a restructuring of market dynamics;
The impact of AI on market dominance — While expectations of progress rarely actualise to the heady heights which we quite expect, it is fair to say that we’re on the precipice of huge productivity gains for software engineers. Moreover, it’s somewhat lazy to think that AI is of more benefit for the incumbents, and that it will only serve to make big companies even bigger. The more interesting assertion is that AI actually makes risk/reward far more interesting for the challengers. For instance, new large language model (LLM) based search features provide ample incentive and opportunity to challenge Google’s dominance in search [with currently 13x market share compared to its closest competitor, Bing].
Antitrust has a broad church of support — industry regulation can both giveth and taketh away. Antitrust is a spectre for most big tech companies, particularly now given that both the DOJ and FTC are of the view that antitrust issues can still be apparent even if a product is free [see Dina Srinivasan’s work for more detail on this]. Moreover, it was widely reported last month that the DOJ is likely to file a suit blocking Figma’s acquisition, and it’s also facing scrutiny from the European Union. Indeed, the initial euphoria from a 50x ARR multiple now looks to be incredibly short lived.
Final thoughts
Of course, there will always be exceptions which prove the rule, or more accurately, aspects which make the rule hard to assess. For instance, the CRM market is vast and there are many ways you can segment it. So in this regard, for Salesforce to have an estimated market share of 24% is very high and they remain the indisputable ‘winner’ in the industry.
I’ve refrained from spending too much time on how investors evaluate ‘winner takes all’, but if there’s sufficient interest, I’ll write on that separately. Nonetheless, hopefully this article goes some way to explaining why funds are often alert to new entrants and are focused on businesses who are able to achieve market share gains through network effects, and organic growth more broadly.
