I was on a call with a pair of entrepreneurs last week and said something that seemed obvious to me, but was clearly news to them: “It’s not enough to have a market with strong volume, it needs to also have a big enough surplus.”
This team was trying to sell me on a market opportunity that had impressive aggregate transaction volume, as if it were self-evident that large markets are by definition attractive ones. My response was to ask about the unit economics of individual players in this market (which I knew to be marginal at best); to their credit, rather than bullshit me they admitted that they didn’t really know much about typical margins among their target customers, and would do more research and get back to me.
The fundamental error this team made — a common one among first-time founders — is starting with a top-down market size as opposed to a bottom-up unit economics analysis. Just because a market has billions of dollars of gross transaction volume doesn’t mean that it has billions of dollars of unallocated purchasing capacity sloshing around in it. There are very few markets — especially ones that have been around for a while — where competition hasn’t squeezed average operating margins to a nub. This is especially true in markets where barriers to entry are low — local services industries like bars and restaurants comes to mind — and new entrants pursue marginal economic strategies (e.g., heavy promotions and discounting) to capture attention and steal share.
This is why some investors (myself included) prefer to see entrepreneurs attack established industries with strong incumbents and high barriers to entry — including regulated industries like financial services and health care. Many entrepreneurs are scared away by the complexity and risk of enterprise-dominated and regulated industries, meaning there are fewer new entrants fighting for the same customers. And because they don’t experience the same competitive dynamics, these industries also tend to have fatter surpluses — in terms of high and stable operating margins — than those with a more level playing field.
One of my favorite Jeff Bezos quotes is: “Your margin is my opportunity“, a warning to competitors addicted to fat operating margins that he’s willing to attack them where it hurts — in the surplus they’ve come to depend on to run their business. If you’re looking for a productive place to start your next company, pay less attention to overall volume and more to the relative surplus that’s available for you to capture (or attack).
Creative Commons image at top sourced from DeviantArt
Aside from regulation/barriers to entry in a mature market, big margins could also be a “difficulty of problems” indicator in a less mature market. I would argue that solving a difficult, costly problem gives you a more sustainable market position (as well as being extremely gratifying). And nobody is better at solving difficult problems than risk-tolerant, intellectually-curious technologists!
Of course, the downside is that hard problems are hard.
Hi Chris! Is there a rough guideline for the TAM to margin ratio? I imagine with a large enough TAM, the margin can be on the smaller end (eg. payment gateways). Likewise on the other end, with a smaller TAM you’ll need large enough margins to offset that. Or as a startup should you just go after large margin / large TAM and not toe the line..?
Great question and no crisp answer – the nuance here (that didn’t make sense in the context of the post but is a real consideration for strong founders) is that there are opportunities that have small (or nonexistent) current TAM and unknowable margins, and those might be the most interesting opportunities of all. Think social networking in 2000, or ecommerce in 1995, or OTT messaging in 2010. Those may be the most exciting – and least well understood – of all opportunities, but it’s the rare founding team that can spot them + make them happen.
What are some of those that you think exist today? IoT? Drones?
Jason made a Slack app we use internally that has been incredibly useful. Feel like Slack apps could be next App Store.