Venture Populist

The common and conventional wisdom of venture investing is populated with a myriad of musty and meaningless maxims that do little to develop due diligence deft. The list of utter untruths include little tarradiddles such as the purported prerequisite that a start-up must draft a comprehensive business plan when seeking financing (wrong), or that there must a clearly defined exit strategy (also wrong).

The often cited notion that the entrepreneurs have material amounts of their personal cash invested as “skin-in-the-game” is another feckless formula for evaluating venture opportunities. It’s bunk. My only private investment write-off in the last ten years was the result of backing a proven entrepreneur with a prior high-multiple liquidity event who put $12 million of his own money behind a good idea that proved to be beyond his ability to execute. An expensive lesson, but…school me once (shame on me).

The majority of the most compelling private investment opportunities originated from entrepreneurs that lacked the personal wealth to back their great idea. Sweat equity, career opportunity costs, an equity positon providing material upside incentive and personal sacrifice are generally sufficient substitutes for a founder’s flesh.

One of the more sophomoric shibboleths among venture investment evaluation criteria is the fictitious “first-mover advantage” (FMA). The naïve notion, which garnered its groupies during the dot-com delirium, suggests that the first entrant to a market space can fend off the followers and dominate the market for a material period of time. Fueled by VC funding and visions of carried interests, blind faith to this “first-to-market” fallacy financed many blow-outs and busts.

Fact is, for every Amazon where the FMA proved sustainable, there are dozens of examples where the market pioneer gave ground to a later entrant. There are only a few instances where the first mover held considerable market share (and developed material enterprise value) for a material period…such as Henry Ford’s Model T dominated the market for years until giving ground to Chevrolet.

The second mouse gets the cheese

My own experiences concur with this more accurate history of venture. I had a hand in the development of a multi-billion alternative strategies asset management firm that picked off the AUM of the first-to-market pioneer firms by developing cheaper, more transparent and more liquid investment vehicles. The pioneers spent vast sums on educating the marketplace. We simply piggybacked and poached the pioneer’s early adopter clients on the way to assuming a dominant market position.

In most cases, you are better off backing the entrepreneurs that are building the second coming of the next big thing. The slower but wiser entrepreneur for me.

Viola, Erwise and Midas, the first browsers, gave way to Mosaic, which in turn, gave way to Netscape. Chux, the first disposable diaper from J&J gave way to P&G’s Pampers. Micro Instrumentation & Telemetry Systems pioneered personal computing with Altair, which later gave way to Apple who hardly dominates the personal computer market today.

Microsoft succeeded not by being first. Digital Research developed the first desktop operating system. In fact, Softy purchased the original DOS program from Seattle Computer works for $50K. Easy to forget today, but back in the day Gates expertise was marketing, not innovating.

Visacalc, the first desktop spreadsheet program, gave way to Lotus 1-2-3 which in turn gave way to Excel.  Boeing did not pioneer the commercial jet, Disney did not introduce the theme park, Starbucks was not the first gourmet coffee shop and Wal-Mart was not the pioneer of discount retailing. They were not first—they were better.

Proponents of the FMA argue that the first entrant achieves name recognition, achieves economies of scale, locks in early customers due to consumer habits or high switching costs and develops brand loyalty…consequently building barriers to entry.

But, with the exception of truly proprietary IP or geographic advantages in brick and mortar or service industries, I don’t find those “advantages” to be sustainable by virtue of fiat. Better will always end up beating out first.

The empirical research bears this out. In the 1996 study, “First to Market, First to Fail?”, Gerard Tellis and Peter Golder demonstrated that pioneers are rarely rewarded for their efforts. Rather, they found that another class of firms labeled early leaders (the category of second and third-comers) enjoyed “a minimal failure rate, an average market share almost three times that of market pioneers and a high rate of market leadership.”

Thats because the first-mover pays a huge cost in R&D, marketing and advertising to educate and entice early adopter customers or clients. The later comers have the benefit of case study, market intel and the opportunity to sell relative value…often referred to as the “free-rider effects”, where late movers may be able to free-ride on a pioneering firms investments in R&D, consumer education and infrastructure development. These “imitation costs” are more vastly affordable than the “innovation costs” that often cause the pioneer to crash and burn.

When evaluating pre-revenue ventures, I find it best to eschew first-to-market business models in favor of the better, faster or cheaper followers. Look to who’s next. It’s easy to be sucked in by the intuitive appeal of the FMA, but I have already been schooled…I won’t get fooled again.

Album:   Who’s Next, The Who, 1971

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