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Entering An Existing Market? Read This First

January 2, 2012

If you are thinking about entering a market with an improved product/service, how much thought have you given to how you will differentiate and how you will price?  Over the Holidays we had the opportunity to read this piece that does a great job at distilling the concepts of  Deflationary Pricing and Distruptive Market Entry into a quick and informative read.    Coming from an entreprenuer-turned-successful VC, it not only offers lessons from an operating perspective, but insights on how this particular VC thinks about assessing a startup’s business model economics.

When you think about the great achievement of the Internet in aiding content, commerce & communication they include:

  • Large scales of connected people & information never seen before in humanity
  • Unprecedented transparency of information
  • Open standards that make it easier to plug into other products & services, creating a global bazaar
  • Socially connected individuals and platforms that enable faster roll-outs of successful products
  • Payment ready consumers (Amazon, iTunes, PayPal) and businesses (Google AdWords, Square)

So which types of businesses become super successful given this environment?

Ones that offer amazing value (low relative margins) at high volumes that makes it nearly impossible for high-cost incumbents to compete. That’s what I mean by deflationary economics.

It is a classic case of the Innovator’s Dilemma in practice.  If you’re a startup and you haven’t read my summary of Clay Christensen’s seminal work please do.

It’s the single most influential piece of work in determining my investment philosophy and how I think about markets.  In a recent panel discussion I participated in with Fred Wilson he said the same.

Why Deflationary Business Win

In the simplest form, new startups have a product that is INFERIOR to that offered by the competition but at a dramatically lower price with the seller opting for a very thin margin on their product.

Initially their only customers are people who can get by on the reduced functionality or perhaps don’t have the money to spend on the expensive product.

Often it turns out that the market is greatly expanded by having a lower price point new entrant. And over time the new entrant attracts enough business that, as depicted in the graph above, the quality of the product slowly increases over time.

The new entrant keeps margins low but suddenly has a lot of profits due to large volumes of business.

How does the incumbent respond? Not by dropping price & quality – they don’t have an advantage there. Instead they spend more money trying to innovate on product quality and call attention to the weaknesses of the new entrants product quality.

Often major customers defect en masse to the new entrant as they realize that the huge price premium is not justified by the product differentials.

Read on to learn more about why you may be thinking about pricing too high… even if you are closing business!

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