Once in a while, a seminal startup (let’s call them “category busters”) would appear to magically birth a whole new market category while engendering a legion of copycats and derivatives companies across multiple adjacent markets. The category busters often do so with some form of meteoric rise – some do so with incredible adoption metrics or; even better, revenue momentum, some are masters of hype and marketing, and others simply capture our imagination with “why didn’t I think of that” simplicity. We all have heard of these category busting companies. Today there are Airbnb (collaborative consumption), Dropbox (cloud storage), Gilt (flash sales), Groupon (daily deals), Shoedazzle (subscription e-commerce), and the latest, Pinterest (interest graph?). At one time it was Yahoo (portal), ebay (marketplaces), and amazon (e-commerce) and . . . webvan (local commerce) :) . The derivative companies, on the other hand, do not take on these rocketships directly; but instead, lifts some or all parts of the category busters’ strategy or product and apply it to a different market or segment of customers.

I struggle with understanding these paired siren songs – did these category busters fundamentally discover a new but permanent change in consumer behavior or business practice? Can the behavioral change they are exploiting spread beyond the user segment or market niche that they are attacking? Or. . . the behavior change is temporary, driven by passing external realities (such as the recession). Or . . . even worse, that the hype has become completely removed from the reality with no real traction beyond fund raising or PR and thus the derivative companies are just chasing ghosts. Even more frustrating, timing has a significant impact on the success of the derivative companies – retail e-commerce across every category eventually did take over the world – but only after going through a complete implosion in the dot-com era. Sometimes, the implosion is permanent. The cautionary tale is the tens of billions dollars of public and private capital that went into “b2b marketplaces” that all but completely disappear into thin air.

We meet with entrepreneurs all the time with derivative concepts of category busters – aka “Airbnb for blah” or “ShoeDazzle for X.” I constantly struggle with their long term potential, but here are some questions I always ask myself to somewhat insulate myself from the echo chamber. (wont know how successful I am till much later!)

1. What is the fundamental consumer behavior modification and what is the problem for the user/customer that the company is alleviating? Only when the “problem” is persistent and chronic can the consumer or enterprise behavior be permanent as well. Taking subscription e-commerce as an example – I want to know if it’s a recurring spend category where the friction of multiple transaction is a large part of the chronic pain. Furthermore that the product that is being offered is chronically “scarce” for whatever reason to the target segment.

2. Is the marketsize atleast comparable, or even better, larger than the original category buster? Call this one an ego issue for me. It’s hard enough to build a successful company. Market and product issue aside – the execution risk alone mean failure is the most likely outcome. In the off chance that I do get lucky, I really don’t want to square up on the ball and still only have it be a line drive single.

3. Is the life time value of customer just as attractive as the category buster? Using the subscription e-commerce business as an example again. Four variables drives your LTVC – average selling price, margin, frequency, and churn. Hitting 4 out of 4 as superior to the original company is a great start. Often it is almost impossible to measure and predict LTVC, BUT by breaking it down to underlying drivers, it is still possible to make intuitive guesses at the comparative attractiveness of these variables to the category buster.

4. Is the business model comparably attractive? This is a bit of a catch-all but many great category busters have some inherent innovation (by chance or design) to its business model (not just pricing model). As an example, the e-commerce business is by definition a low margin business – and as a result return on invested capital will be driven by things like inventory turnover and working capital efficiency. eBay & AirBnB hold no inventory. Amazon (in the beginning) & ShoeDazzle had negative or low working capital requirements. If there is value to be copied, it is in really understanding the cashflow statement and how that helps create a capital efficient yet easily scaling businesses.

5. What are the comparative user acquisition costs and channel strategies? If there is one common defining characteristic of category busting companies is that they often discovered a cheap and scalable source for customer or user acquisition before the rest of the bandwagon. These stories have become almost mythical folklores. Paypal exploited eBay. AirBNB exploited Craigslist. eBay exploited PR. Youtube exploited Myspace, ShoeDazzle exploited Twitter/Social/Celebrity Marketing. Zynga exploited Facebook / Facebook advertising. If there is one thing derivative businesses need to study faithfully is how to find similarily cheap acquisition strategies (of course the hard part is that often those opportunities have already been picked over and no longer cheap).

6. Are the category busters themselves having success (or have ambitions of) moving across adjacent markets? One of the things the entrepreneurs of the derivative companies need to really worry about is whether their market will be quickly encroached by the category buster. (Amazon moving from books to all of e-commerce is a great case study). And if so, understanding if the category buster has some sort of inherent advantage when it enters the market – are the customers similar, are the technology investment fungible, are their partner or distribution relationships the same – will help define the long term competitive picture.

There is no hard and fast rule in the technology industry that first movers are winners or that derivative copycats can never be bigger/greater companies. On the other hand, there are so many inherent risks and unknowns in starting a new venture that for many entrepreneurs chasing after an existing trend can falsely appear to be less daunting (copy product!) and more emotionally comforting (people are already doing it!). Same goes for people like VC’s, investors, and service providers – we are not immune. Dig in, understand the inherent customer value and the business model that the category buster has created and make sure to see the same dynamics exists in the targeted new market – this will help you adjust the playbook or even decide it’s a bad idea in the first place.

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