Why startups exist (and also fail)
If someone were to ask me this question earlier, I would not have thought that the answer to both is along the same vector. But I think it is1
Let me give an example. Let’s say you like to have sauce with your food. There are enough such people like you, so it’s a big enough market. Some company figured this out initially and now there are enough sauce companies out there.
But you don’t like any sauce, you specifically want chipotle sauce. Again, not a very unique demand, many people like chipotle, so many such products out there.
But you don’t like any kind of chipotle, you want the right mix of spice and sweetness. Now we are entering into dicey territory - there are some products that fulfill this but you dont find anything completely satisfactory.
You take a leap of faith, thinking there might be similar people like you, who want this exact taste and ingredients, so you decide to start a company manufacturing this exact sauce.
You slog hard and refine your product to the exact taste and then launch. Your friends try it out and recommend to their friends. Months pass after the initial hype, but you dont see enough sales. You conclude there can be one of two reasons for low sales:
There are people who are interested but you are just not able to reach them
No one actually wants this
While the first one is to hard to prove conclusively (it’s the equivalent of saying that a particular sea has no corals - you can never look at each spot of the sea to say this for sure), you can still try different channels and then directionally conclude this.
It’s the second that kills startups the most.
But then you refine your taste and make the ingredients vegan-friendly. Now, with more people interested in vegan foods, you start seeing some traction.
What more, your sauce also is vegan-friendly, and , you start seeing an increase in sales. Meanwhile, the larger sauce companies still think that vegan (or the taste bucket) is not a big trend to go after, so they don't launch a new product along this lines.2
This is why startups exist - they serve a small (but ideally, growing) market that incumbents aren’t interested in.3
Why can’t startups serve a large market directly?
After all, most investors you know are talking about TAM to fund startups. That’s true, but the large market condition is of the end-state, not necessarily right now. At any point, there are actually very few large markets available where incumbents are not attacking. E.g. You cant say you are starting a sauce company, because a generic product that you put out there will be beaten by existing products who have tonnes of marketing, sales and operations machinery behind them. This often comes down to the product vs distribution debate. So naturally, you will have to make your market definition smaller.
Why are incumbents not interested in a market?
Like I mentioned above, they often think that the market is too small. The main job of anyone who’s running a large organisation is capital and resource allocation to the highest ROI projects. And a small market will not yield great ROI. There are sometimes other reasons as well - incumbents are slow to react, don’t have the innovation DNA left etc, but these are capability issues, not intent issues. Capability and agility issues plague very traditional organisations like General Motors, but not well-run orgs like Amazon / Stripe. So if you see these orgs not entering a market that they should be in, it’s most likely because the market is looking small to them right now.
E.g. Crypto has been around since 2009. There was sparse activity going on before that, but the last two years is when it really exploded and got attention of incumbents. Unsurprisingly, Stripe enabled crypto payments in 2021.
Did you notice the paradox here? Startups exist because they serve a small market but they get killed with a very small (= no) market.
Can you distinguish between small and very small market?
My answer is, not directly. Coming back to the coral example - it’s the equivalent of asking whether there are 10 corals in a sea vs 100? Tough to say. There is however one way to say this well - if while serving some users, more and more users keep coming to you. You can at least be sure that there is a larger market than you thought, and it’s enough (actually, more than enough) motivation to keep continuing. This will disappoint the control freaks reading this - I’m essentially saying that startup success is often by accident. This is however not empirically surprising - pick any startup that became big and you’ll find multiple accident points in their journey. E.g. HP refusing to buy Woz’s computer, IBM not licensing DOS, Yahoo rejecting Google’s proposal to be acquired.
So, to summarise, startups exist to serve an overlooked market. But if the market doesn’t exist, they fail.
This post has focused a lot on one axis - market, since that is usually the dominant reason. There are other reasons, most notably, team, as well that kill startups. More on that in a future post. One may argue that lack of capital kills startups the most, but that is a symptom of a deeper problem, not having a market of what you’re building.
Only an example. In the current state, it’s pretty clear that vegan is a big growing trend so incumbents are also investing. However, this was not the case 5 years back.
The definition of startup is loose here, ideally startups are special types of companies that can grow very fast. That is why the element of tech-based scale becomes important, which is not as valid for pure chipotle sauce companies.