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Most VCs drink beer, but how much do they realise that their industry is increasingly resembling that of the beer industry?
Forgive me if I start a bit theoretical. The famed business strategist Michael Porter described a set of successful general strategies which firms employ to achieve a sustainable competitive advantage: differentiation strategy and cost leadership strategy for those firms with a broad market scope, and a segmentation strategy for those with a narrow market scope. In other words, for a company looking to compete across the entire marketplace in a specific industry, it must either develop a unique product offering (along the lines of brand, design, features) or more-efficiently produce the product to outcompete on price. The only other way for a firm to compete effectively is for it to narrow the scope of its offering so that it only appeals to a subsegment of the market consumers, but it does so because its specialisation appeals specifically to that narrow customer-set.
It’s intuitive to think that given economies of scale and the other benefits of size that relative market share (RMS) for a firm drives return on investment (i.e. the larger the corporation’s position in the market, the more profitable it is). However, in reality that only partially holds: “Empirical research on the profit impact of marketing strategy indicated that firms with a high market share were often quite profitable, but so were many firms with low market share. The least profitable firms were those with moderate market share.” The explanation for this occurrence goes to the strategy matrix outlined above – the most profitable firms utilise one of the three strategies to ensure a competitive advantage over time, and thus, sustained outsized profitability. Large firms win on differentiation or cost, and small ones win on focus; but those stuck in the middle get stuck.
The beer market in the 90’s a salient example of this theory playing out in action. The very top companies like Budweiser with the meaningful brands could command market share and profitability despite an average product (I’d challenge you to a blind taste test), but offered a premium brand (differentiation strategy) and value-pricing coupled with large-scale operations (cost leadership strategy) – the classic broad market approach. But during that decade, the microbrewery phenomenon emerged. All of these companies instead competed with a segmentation strategy – focusing in specific region coupled with concentration on a specific style or type of craft beer. A Red Hook IPA didn’t taste like a Sam Adams Lager or the Belgium-style ale at your local brewpub – all of which were very different than a Bud Light. Yet the two segments coexisted. The challenged firms were those caught in the middle, like a Genesee. It was not large enough produce more efficiently and price more cheaply, was not that much different a style, nor was it aimed at a certain subsegment audience.
As the venture capital space matures, I see a similar pattern emerging. In many ways, the beer market of the 90’s is like the venture market today. The elite top-tier firms have a sustainable competitive advantage with both entrepreneurs (and LPs alike) given brand, a vast network, and self-reinforcing success. These firms aim broadly – diverse along sector, geography, and stage lines. Perhaps a contrarian statement in this environment: but even though there’s been a dip in fund size due to broad economic factors and LP appetite, it wouldn’t surprise me if the truly top firms raise even larger funds over the coming decade. RMS and ROI will continue to correlate, driving these firms larger and broader.
Given that startups can fundamentally do more with less (along with many other factors), Micro VCs, like microbreweries, are currently emerging. They have a unique segmentation strategy – focused on a specific stage, industry concentrated, largely geographically-oriented, and often include additional differentiated “features” for entrepreneurs in their product. It’s actually quite the opposite of a bubble – I believe that we’ll actually see a proliferation of new Micro VCs which will each command a unique strategy and approach. Just like beer drinkers in the 90’s, the best entrepreneurs will have an increasing amount of real choice for their seed-stage funding options. And many of those offering them this product will be profitable doing it. (Though just like there are unprofitable microbreweries, there will certainly be unprofitable Micro VCs).
Similarly, like how larger brewers have attempted to launch products that compete with microbrews (think: Bud Light Golden Wheat), some large VCs have attempted to launch seed-stage programs – in both cases these initiatives have been met with mixed success. At the end of the day, it’s fundamentally difficult for a large player to attempt to compete with a focused one in a subsegment.
Note that Micro VC isn’t the only way to play a niche strategy in the venture business. Firms which are solely focused on an underserved geography or specialize in a specific type of technology application are also utilising a segmentation approach. The key is that they must systematically appeal to a specific entrepreneur-set to truly win competitive investment opportunities or uniquely recognise value which other firms cannot. Otherwise, they’re just smaller-sized (and much less profitable) versions of their bigger siblings.
(Of course, whenever drawing an analogy like this one, it’s intellectually honest to realise that the beer-VC comparison has limits to it. For example, much of the evolution of the U.S. beer market is due to other forces like distribution laws and global consolidation, neither of which have much to do with the venture industry.)
That being said, the lesson is clear. In both beer and venture, the most profitable firm approaches are to go big and broad, or to focus and specialize. As the venture market both matures and recovers from the past decade of overfunding & poor returns, the results of these strategies will play a sharper role. It’s no secret that there are currently challenged firms in the venture capital market, but I believe those firms look a lot like Genesee… caught in the middle and don’t really taste that great.
Cheers to your VC. I am currently drinking a microbrew.