Every Company Needs a Good Map

Why would a Venture Capital firm like First Round Capital say something like this on their "Our Focus" page:

We love investing in technologies and business models that are able to shrink existing markets. If your company can take $5 of revenue from a competitor for every $1 you earn - let's talk!

Shrinkage in markets or other places is usually an undesirable thing, but it actually makes sense in appropriate and rather specific cases ...

In standard inventory terms, "shrinkage" means some amount of product disappears and is not paid for. This can be due to:
·    Theft
·    Deterioration
·    Expiration of time sensitive products.

Usually some amount of shrinkage is expected but not appreciated. Theft can be tracked and eliminated if the cost of this effort is less than the cost of the material lost. Deterioration and expiration can be reduced by several efforts among them improvements in handling methods and supply chain efficiencies. In plastics manufacturing, fixing a mold is usually put off until the value of the products that are defective exceeds the cost of repair.

In markets, it means that the total available market (TAM), the sum of all revenues or reality based potential revenues, decreases from such events or forces as:
·    Price competition
·    Diminishing customer base
·    Production cost changes

It may be difficult to image why a company would want to enter such a market and even more difficult to see why a VC would fund such a venture. There are some very good reasons to make a move such as this, but they are not for the faint of heart. Josh Kopelman explains his reasoning on his blog RedeyeVC as it relates to their recent investment in OpenAds and some of his previous ventures.

In a nutshell, the idea is that if you can destabilize a market by removing the profit margins for established players, you rewrite the rules of the game. Transformational changes (render existing skill and knowledge obsolete) can do this as well but that is not what Kopelman was getting at. He is saying that if you can bring the market price down so that the market size is $5 less for every $1 you make he wants your contact information.

Wal-Mart does something like this in every new town they enter. The cost of goods to the average person is reduced and competitors who cannot afford to cut prices that much are driven out. Big players from Fortune 500 to entire countries that subsidize production and sale of goods below cost, attempt to force competitors out using this strategy. The trouble lies in the aftermath when prices need to go back up or regulators discover the attempt to manipulate the market.

Josh is not suggesting anything illegal here. He is saying that if you can find a way to profitably make and sell a product for 20% of the existing price  and that product meets a need, he is interested. This is a more interesting situation. It is not easy to demonstrate equal value but you should be able to attract the price sensitive segment of the market.

With enough displaced market share and reduced profits you can force the bigger players to deal with you. They may try to squash you, acquire you, or flee to new markets. There are many examples of each response and Christensen covered a lot of this in "The Innovators Dilemma" as he discussed the issues the hard-drive market has experienced over the past few decades.

Lastly, it is important to note that this strategy is NOT usually successful if it is merely a temporary sale, subsidy, or false savings due to a change in packaging, quality, or substitution. The new product can be of a slightly lower value but it cannot simply be a cheap imitation. New potential has to be evident for the investment and opportunity to be worthwhile. If no future value is created then all that was done was to undercut the market with lasting consequences for everyone.

Gallo, of the wine family, used to say to the growing California wine industry, a rising tide lifts all boats. He meant that they all had to work together by producing quality products or they would a;; suffer from the same perception. To paraphrase then, if you just let water out of the lake, all boats are brought down.

If you have instances where you see a benefit to shrinking a market or if you disagree with my assesment I would like to hear from you.

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