Is Competing In A Crowded Market Worth The Gamble?

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This XSeed blog was written by Venture Partner, Jeff Thermond, and originally appeared on Forbes.

One of the first things venture capitalists consider when they see a new pitch is, “How crowded is the market space in which the startup wants to compete?” If the investors express concern that the market is crowded, this should be a big warning sign to entrepreneurs. In my experience when entrepreneurs are asked how they are going to break out in a crowded market space, their answers often reflect only a partial appreciation of the dangers of competing in a crowded environment.

Because this is such an important issue, I wanted to call out the dangers I see in competing in over-crowded markets. For definitional purposes, I consider any market space with six or more different vendors making strong claims to sales prospects to be crowded. In a future article, I will talk about tactics one can employ if a company decides to go ahead and accept the increased risk of crowded markets.

These risks fall into two broad buckets: market risk and financial risk. The financial risks tend to flow as a consequence of the market risk, so I’ll cover the market risks first.

One of the biggest challenges in selling into a crowded space is the tendency for everyone’s marketing claims to be ratcheted up to a level where the claims are hard to believe. That just makes sense. If no one can hear you, the answer must be to shout louder, and to shout bolder claims than the last guy who shouted. As one example of many, the market for in-memory databases is one in which all vendors claim to be faster than the others, offering a single benchmark to support a very broad claim. Sales prospects in that market are very cynical about the breadth of these claims.

This perceived lack of credibility in marketing claims often causes buyers to ignore vendor claims altogether. When you consistently encounter prospects who tell you that “they’ve seen it all,” you know you are in this trap. Sales people hate this situation, and it makes lead generation, from which you need good yield to drive revenues, even lower yielding.

This leads to the next problem: a lengthening sales cycle, which oftentimes can more than double in crowded market spaces. After all, if there are almost a dozen vendors in a space versus two or three, simply winnowing down the list for a competitive bakeoff can take a long time for a customer. And if vendors’ claims border on hyperbole, the buyer will be required to take extra time to make sure that they are not getting fooled by the vendor. Not only does that push out revenue, it can put some projects at risk of being turned off by a new hot project from the C suite.

Finally, from a marketing point of view, there’s the enhanced difficulty in establishing yourself as a market leader. If everyone’s marketing messages are hyperbolic, who is to know which vendor is the best? That results in sales prospects defaulting to a Last Man Standing criterion which defers awarding the leadership mantle far down the road, often by years. This just reinforces buyer cynicism, buyer caution, and marketing claims that border on fraudulence.

As bad as all that sounds, I think the financial consequences of competing in a crowded space are far worse.

The first risk is that you have more competitors seeking funding from venture capitalists. The result of this is bad in two different ways. First of all, while having many competitors can lengthen your enterprise sales cycle, it will also likely lengthen your fundraising process. In particular, it could greatly elongate the time to close the company’s next financing round due to the extra due diligence required to survey the competitive landscape. If the space is really crowded, it may result in a majority of VC firms concluding there are no good investments to be had. Entrepreneurs aren’t the only ones who dislike markets where the leader only emerges after a matter of years. VCs dislike it just as much. Since raising money takes a lot of management’s time, a shorter fund raising cycle is a blessing to the executive team.

The other way increased competition for funding can hurt a company is in the economics of the term sheets you’re likely to get. If venture capitalists perceive undue risk in picking the eventual leader in a space, it will affect pre-money valuations negatively. It may also affect other terms that will hurt you upon an exit.

The next financial risk is in a firm’s pricing in a crowded market. When buyers have a lot of undifferentiated choices, the price they are willing to pay drops. In a world of software, this may not hurt your gross margin percentage as much as it does the total market size of the segment you serve. VCs are all about investing in companies that can show hyper growth and get to a large market size. If the structure of the market says prices are well below what a less crowded market would have supported, then the ceiling of what any given vendor can expect in sales gets lowered precipitously. That’s anything but a hyper growth story.

Of course, with conflicting and confusing marketing messages and longer sales cycles, it just stands to reason that a firm’s sales and marketing costs will be much higher than you will want, just as revenue is a lot lower than you want. That will increase the risk of your being able to attract future funding as well.

There is the risk that your financial reward when you exit will be a lot less than you hoped for when you started your company. Just as VCs are less willing to pay high valuations for companies in a crowded space, so are potential acquirers. I have been on one side or the other of a few billions of dollars worth of M&A activity, and the number of viable acquisition candidates was consistently one of the top two factors dictating the price we were willing to pay. And every VC knows this, which is why they always ask themselves how crowded the space is during a pitch. Since the majority of exits are M&A deals, and not IPOs, this risk is important to keep in mind.

I’ve called out seven different, but highly correlated, risks of competing in a crowded market space. In my experience, entrepreneurs are often not thoughtful enough about why they want to take this incremental risk on and what they are going to do to mitigate it. The intent of this article is to educate entrepreneurs on the full scale of these risks. In my next article, I’ll discuss tactics to break though the noise of crowded markets.