Building a sector leading company
Importance of Leadership:
- Clear leader in nascent market
- Standout leader in growing market
- Not: One of a crowd
In nascent technology sectors, companies can typically be grouped into one of three patterns.
The first applies to very early markets, typically characterized by only a few (i.e. 3-4) companies, one of which is already a clear leader. The second is a growing market that is already actively being invested in and where a clear "pecking order" of leadership has been established. The third is by far the most common pattern -- one in which there are already a meaningful number of competitors, but no pattern of leadership has developed. The charts below reflect these three patterns:
When making earlier stage investments, this is the pattern we look for -- a relatively small number of companies have discovered the opportunity and a clear leader has emerged within that small group. Here leadership is shown as market share, but these younger companies have often not yet completed their product, so we focus on leadership in terms of product differentiation, market insightfulness and, most of all, strength of CEO and team.
At the growth equity stage, we are typically investing into a market where a fairly sizable group of companies has developed, each recognizing the now obvious market potential. Over time, virtually all markets resemble the chart above, with one clear market leader and then a fairly rapid dropoff in market share amongst another 5-10 competitors. Here too, history strongly suggests that investing in the leader will outperform the seemingly greater bargain of investing in some of the also rans.
The one important distinction is that a market often morphs over time, particularly as new products become available that were not taken into consideration in the initial market analysis. In those instances, it is important to understand where the market is going and to choose the leader that reflects the "real" market as it develops over time.
Unfortunately, most markets that venture and growth equity investors invest in look more like the chart immediately above and not the two preceeding charts. These are markets we characerize as "presently uninvestable" because we do not believe that risk equity investors get rewarded during the time that it takes a market that looks like this to progress toward one that looks like the prior chart. We also believe that if you invested in the leading company in the top chart and your industry segment starts looking like the third chart, that follow-on investments become much more questionable.
By definition, properly defining markets and properly characterizing the factors that make a company the leader in that market segment are critically important skills for us to have as investors. But the better our entrepreneurs do at defining their markets and establishing themselves as the leader in that market, they better they tend to perform.