Why Most Investors Get Market Size Wrong Over And Over Again

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A shorter version of this piece originally appeared in Forbes.

In the mid-17th century, the average Chinese farmer knew the exact size of his market. China had been cultivating staples like rice and buckwheat for thousands of years, honing planting, harvesting, and distribution down to a precise science. So when European traders showed up with an exotic new tuber from South America they called the “potato,” many established farmers probably expected that the new crop would take over some fraction of the existing market for rice.

Those farmers would have been dead wrong. China’s rice supply was constrained by the country’s relatively limited amount of fresh water, and the Chinese population was hungry—literally and figuratively—for more food than it could provide. Since potatoes use 30% less water than rice, they could be grown in arid highlands previously thought unsuitable for cultivation. As journalist Charles C. Mann describes in his 2011 book 1493: Uncovering the New World Columbus Created, millions of people migrated up mountainsides, clearing forests to make way for potatoes. The influx of additional food helped drive a sudden population boom; some scholars believe China’s population as much as doubled in the years between the introduction of the potato and the end of the 18th century.

The history of Chinese potatoes illustrates an important characteristic of innovative products and the companies that create them: the majority of their growth comes not from stealing share from existing markets, but from unlocking new ones. Companies like Uber, Snap, and Airbnb have succeeded by doing the equivalent of turning forested hillsides into productive potato farmland, using technology to tap into new markets incumbents didn’t even know were there.

Unfortunately, when determining the size of a potential investment opportunity, too many investors still look at the size of the metaphorical rice paddy. Though they’re often discussed in investment meetings, indicators like total addressable market (TAM), which measures the size of a target market that already exists today, aren’t a great predictor of the full potential of an innovative company.

In existing markets, incumbents have established sales channels, high brand recognition, and massive scale that enables price advantages. Today’s most innovative companies actually wreak havoc on those existing markets, deflating prices and very often revenues. Their real growth is to be found elsewhere—in entirely new, wide-open markets that they unlock. These upstart companies rapidly acquire dominant or even monopolistic market share in their new spaces, achieving pricing power and other competitive advantages even before they have competitors. If investors want to spot the next Google or Facebook, they need to look not at markets that already exist, but the new markets that a product or service has the potential to create.

Look forward to potential markets, not back at pre-existing ones

Take Airbnb, for instance. 10 years ago, when the founders were raising their seed round, it looked like a niche service with little potential to scale. It was true some people were seeking temporary housing on sites like Craigslist and Couchsurfing.com, but they were mostly broke college students and twentysomethings—a tiny and not very profitable sliver of the hospitality market. There was little indication the service would appeal to anyone else. Even Couchsurfing.com featured only 630,000 listings worldwide, according to Airbnb’s own pitch deck. Why would anyone opt to stay in a stranger’s home if they could afford a nice, comfortable, private hotel room?

This sort of thinking about Airbnb’s potential led many investors to make what we at Alpha Edison consider a Type II error. In an investment context, a Type II error occurs when an investor passes on a company that goes on to be successful. Type II errors generally receive less attention than Type I errors (which occur when an investor invests in a company that fails) but they’re actually more financially damaging. Losing a few million dollars on an unsuccessful company may feel bad, but it’s dwarfed by the monetary cost of missing out on the next Uber, Snap, or Airbnb. If more of Airbnb’s potential investors had understood why new markets are important and how they’re unlocked, they might have been able to avoid that costly Type II mistake.

New markets are unlocked one of two ways. First, they can enable new purchasers, bringing new people into the market who didn’t participate before. This often happens when a company democratizes a product or service that was previously accessible only to the rich, e.g. Uber making luxury black car service available to anyone with a smartphone. Alternatively, new markets can be unlocked when companies create new purchasing occasions, so that people go from buying a product or service two times a year to buying it monthly. Very successful companies like Airbnb usually do a combination of both.

Yes, the market for couchsurfing in 2007 was small, but if investors looked closely they could have seen that what Airbnb was offering wasn’t really couchsurfing. It was an innovative new service poised to enable new purchasers, create new consuming occasions, and unlock a new market thanks to a few key drivers that are common to most innovative companies today.

  • Technology enablers. Mobile, payments, data, GPS, cloud. All of these technologies were relatively new in 2007, and Airbnb was able to pull them together to create a service that’s very different from traditional couchsurfing. Airbnb’s convenient mobile app, efficient search algorithm, and secure online payment process reduced friction that had been inherent in the process of finding and booking temporary housing. For people who already used Craigslist and Couchsurfing.com, this might have been enough to create new consuming occasions.
  • Trust. More importantly to its eventual scale, though, Airbnb used those same tech building blocks to create systems that fostered trust—that elusive quality that’s so key to the sharing economy. Trust is what makes customers comfortable riding in a stranger’s car, letting a stranger walk their dog, or sleeping in a stranger’s house. By tying users’ Facebook profiles to their Airbnb accounts and providing professional-quality photos of each room, Airbnb made sure hosts, guests, and the rooms themselves were who they presented themselves as. Joining Airbnb as a host or guest meant joining a community of people who could depend on mutual trust in a way that had been impossible before. These sorts of trust systems have enormous network effects, driving rapid adoption of the service by first-time consumers.
  • Business model innovation. With scale comes cascading waves of much bigger change. Airbnb reorganized supply in the broader hospitality market by giving people a way to monetize their unused spare rooms and empty houses as rentable spaces. It also created a trust system that unlocked latent demand for a safe alternative to expensive, impersonal hotels.
  • Behavior change. As the impact of these drivers rippled outward, Airbnb’s success brought about behavior changes in the broader population. Millennials’ desire for authenticity ——key to the success of everything from LaCroix sparkling water to “voluntourism” trips—added fuel to the fire here. Staying in a complete stranger’s primary residence is a bit awkward, yes, but it also lets guests immerse themselves in the everyday life of the city they’re visiting, yielding a more local, unique experience.

But it wasn’t just Millennials who have changed their behavior in the face of Airbnb’s reorganization of the market. In a report released earlier this year, Airbnb said that Millennials account for only 60% of guests on Airbnb, and that people over 65 are the fastest-growing host demographic. The fact was, as more and more people joined Airbnb’s community of mutually trusting strangers, forgoing a hotel room to stay in a stranger’s home seemed like a less odd idea to their family and friends of all ages.

The combined impact of these drivers and the new market they unlocked is clear. As of August 2017, the total number of rooms available on Airbnb hit 4 million—more than the top five hotel groups in the world combined.

Pore over other tech success stories, and you’ll see this pattern of unlocking new markets again and again.  The new entrants quickly gain a monopoly, and keep it as the market expands.

  • Apple’s invention of the iPhone in 2007 didn’t just steal market share in the cell phone industry—it unlocked a new market for a new product. Technically, “smartphones” had been around since the 1990s, but they were staid, corporate products like the Blackberry, mostly used by business professionals for work. Similar to the market for couchsurfing, the market for smartphones appeared to be vanishingly small: in 2007, only 17 million smartphones were sold worldwide out of 1.15 billion mobile devices. However, the iPhone’s user-friendly design and mainstream appeal unlocked a new market of smartphone users who used phones to communicate with friends, play games, and listen to music. Three years later, year-over-year growth in smartphone unit shipments was close to 80%. By 2016 smartphone sales totaled 1.5 billion units compared to only 396 million for feature phones.  Though Apple has never had a monopoly position in the smartphone market—its share has been around 15-25% for almost a decade—its reputation for innovation and position at the high end of the market has earned it a disproportionately large share of smartphone profits.
  • When Google AdWords launched in 2000, only a little over half of US households had computers, according to a US Census report; most local businesses advertised in the yellow pages. However, AdWords’ low price, convenience, and trackability created new consuming occasions for local advertising, unlocking a new market that quickly ballooned. The entire US yellow pages industry took in only $13 billion in ad revenue in 2000; by 2010 AdWords and Google’s ad network AdSense were raking in almost double that much—$28 billion a year. Google still retains its dominant market share today: it will take 77.8% of all US search ad revenues in 2017, bolstered by its dominance in mobile search over competitors like Microsoft, Amazon, and Yelp.
  • International phone calls used to be expensive and rare, but in 2003 Skype’s free VoIP service changed all that. Now it was possible to call friends and family in another country for a casual chat without paying through the nose for long distance. By 2011, cross-border Skype traffic was growing 48% year-over-year, almost four times the long-run industry average of 13%. By 2013, one-third of all international voice traffic was over Skype.
  • WhatsApp, now part of Facebook, similarly enabled a free, global texting platform whose user base quickly outgrew that of costly old-school SMS. On New Year’s Eve 2016, WhatsApp processed a record 63 billion messages in a day, more than three times the volume of messages sent on an average day through SMS. And that’s not including the messaging traffic for other popular OTT chat platforms like WeChat, Line, Facebook Messenger, iMessage, and Viber. According to a December 2016 report, WeChat’s 768 million daily logged-in active users send an average of 74 messages per day, which puts that platform at around 57 billion messages per day, on a par with WhatsApp’s total.

But the rapid expansion of the user base is only one part of the picture. The entry of innovative new players to the market triggers price deflation, causing the original TAM to shrink. In many cases, once they’ve established a user base, startups will then pivot their platform and audience to attack TAM directly and deal a death blow to already weakened incumbents. (See: Skype’s rollout of SkypeOut for calling landlines and cell phones, for instance.) But startups usually also take market share from incumbents organically as more and more consumers change their behavior to adopt the new product or service.

This puts incumbents in a tough place. Initially they can escape price competition on the low end by fleeing upmarket, but eventually even that small customer group will be eroded (for example, luxury vacation rentals through Airbnb and elsewhere now compete with the most upscale hotels). And, as many new apps—even those with millions of daily active users—don’t always generate steady revenue at first, the overall size of the combined market in terms of revenues may also decrease.

For example, in 1999, four years before the advent of Skype, US telcos saw more than $20 billion in revenue from international calls made from the US, according to the FCC. In 2014, by contrast, international call providers including VoIP services billed US customers only $3.7 billion. That’s more than an 80% decrease. UK communications regulator Ofcom estimates that SMS generated £708 million in revenues for UK telecoms in 2016, down more than 70% from 2010, one year after the founding of WhatsApp and a year before the launch of iMessage. We’ve already pointed out how the invention of a mass-market smartphone deflated sales of feature phones worldwide.

TAM presumes that markets are in relative stasis, and that markets in the future will look more or less like markets that come before. But we know now that change, when it comes, is neither incremental nor small. Why do we keep insisting otherwise at pitch meetings?

Time travel by asking the right questions

It’s impossible to predict the future, of course. But looking back, it’s easy to see some ways that perceptive investors could have reasonably forecasted the success of companies like Google, Airbnb, and Uber—if they’d asked the right questions during those companies’ respective pitch meetings.

A starting point always in a time of accelerating technology changes is: “How could this business model attract new consumers and/or create new consuming occasions, and therefore create a new market?” Take AdWords, for instance. In 2000, it was easy to see that Americans would eventually spend nearly as much time browsing the internet as they did watching TV. According to the same US Census report mentioned above, of those adults with access to the internet at home in 2000, about 53% used it to check the news, weather, or sports—previously the province of newspapers and TV. The internet was also already loosening the yellow pages’ stranglehold on local search: in 2001, 27% of Americans searched the web instead of the yellow pages to look for products and services, up from 17% three years earlier, according to Ad Age.

Equally clear was the fact that compared to print advertising, AdWords was both more trackable and cheaper. According to CRM Associates, the average Yellow Pages ad brings in 80 calls annually for about $10 per call; meanwhile the average cost per click (CPC) in the early years of AdWords hovered below 50 cents. The low price helped to create new consuming occasions for local advertising: since it cost nothing to set up an ad, and the advertiser paid only when the ad worked (by generating clicks), small businesses were able to iterate and optimize their ads without wasting budget. An underperforming ad could simply be removed, and that part of the ad budget reinvested in an ad that was generating ROI.

In other words, Google AdWords’ success would have been easy to predict for any investor sensitive to the ways that technology enablers can create new consuming occasions and incite behavior change, unlocking new markets that expand rapidly.

The same basic concept applies today. With technology transforming society at such a rapid pace, opportunities to innovate appear before companies pop up to take advantage of them.

Great entrepreneurs are driven by their conviction of the way things should be. They identify real problems in the world and build companies to solve them, changing the world—or at least a small corner of it—in the process. In a lot of ways TAM is the opposite of this approach. It only deals with the way things are now, as if that were how they were always going to be. In short, it’s a massive failure of imagination. If they want to harness the full power of latent demand, investors need to grow beyond that failure and learn to think like entrepreneurs, envisioning the world as it could be.

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