From the March 2010 issue of Investment Advisor • Subscribe!

Venture Populist: The "First-Mover Advantage" Myth

Why followers can be better venture bets

The conventional wisdom of venture investing is populated with a myriad of musty and meaningless maxims that do little to develop due diligence deft. The list of such utter untruths include little tarradiddles such as the importance of a start-up to draft a comprehensive business plan when seeking financing (wrong), or the existence of a clearly defined exit strategy (also wrong).

The often cited notion that entrepreneurs have material amounts of their personal cash invested as "skin-in-the-game" is another feckless formula for evaluating venture opportunities. My only private investment write-off in the last 10 years was the result of backing a proven entrepreneur with a prior high-multiple liquidity event who put $12 million of his own money behind a good idea that proved beyond his ability to execute.

Many bankable opportunities come from entrepreneurs that lack the personal wealth to back their great ideas. Sweat equity, career opportunity costs, material equity upside, and personal sacrifice are generally sufficient substitutes for a founder's funds.

One of the more sophomoric shibboleths among venture investment evaluation criteria is the fictitious "first-mover advantage" (FMA). The na?ve notion, which garnered its groupies during the dot.com delirium, suggests that the first entrant to a market space can fend off the followers and dominate the market for a material period of time. Fueled by VC funding and visions of carried interests, blind faith to this "first-to-market" fallacy financed many blowouts and busts.

For every Amazon where the FMA proved sustainable, there are dozens of examples where the market pioneer gave ground to a later entrant. Admittedly, there are a few instances where the first mover held considerable market share (and developed material enterprise value) for a material period, such as Henry Ford's Model T domination of the market for years until giving ground to Chevrolet.

Mouse No. 2 Gets the Cheese

My own experiences concur with the broader history of venture. I had a hand in the development of a multibillion-dollar alternative strategies asset management firm that picked off the AUM of pioneer firms by developing cheaper, more transparent, and more liquid investment vehicles. The pioneers spent vast sums on educating the marketplace. We simply piggybacked and poached the pioneers' early-adopter clients on the way to assuming a dominant market position.

In most cases, you are better off backing the entrepreneurs that are building the second coming of the next big thing--the slower but wiser entrepreneur for me.

Viola, Erwise, and Midas, the first browsers, gave way to Mosaic, which in turn gave way to Netscape. Chux, the first disposable diaper from J&J, gave way to P&G's Pampers. Micro Instrumentation & Telemetry Systems pioneered personal computing with Altair, which later gave way to Apple, which hardly dominates the personal computer market today.

Microsoft succeeded not by being first. Digital Research developed the first desktop operating system. In fact, Softy purchased the original DOS program from Seattle Computer Company for $50K. It's easy to forget today, but back in the day Mr. Gates's expertise was in marketing, not innovation.

Visicalc, the first desktop spreadsheet program, gave way to Lotus 1-2-3, which in turn gave way to Excel. Boeing did not pioneer the commercial jet, Disney the theme park, Starbucks gourmet coffee, or Wal-Mart discount retailing. They were not first--they were better.

Why Later Is Better

Proponents of the FMA argue that the first entrant achieves name recognition and economies of scale, locks in early customers, and develops brand loyalty, consequently building barriers to entry.

But with the exception of truly proprietary intellectural property or geographic advantages in brick and mortar or service industries, I don't find those "advantages" to be sustainable by fiat. Better will always end up beating out first.

In the 1996 study, "First to Market, First to Fail?," Gerard Tellis and Peter Golder demonstrated that pioneers are rarely rewarded for their efforts. Rather, they found that another class of firms labeled early leaders (second- and third-comers) enjoyed "a minimal failure rate, an average market share almost three times that of market pioneers, and a high rate of market leadership."

The first mover pays a huge cost in R&D and marketing and advertising to educate and entice early adopters. The later comers have the benefit of case study, market intel, and the opportunity to sell relative value...often referred to as "free-rider effects," where late movers may be able to take a free ride on a pioneering firm's investments in R&D, consumer education, and infrastructure development. These "imitation costs" are more affordable than "innovation costs" that often cause the pioneer to crash and burn.

When evaluating private ventures, it is best to eschew first-to-market business models in favor of better, faster, or cheaper followers.


Jeff Joseph is a financier, entrepreneur, CEO of Prescient Advisors, and the author of the blog at www.venturepopulist.com. Send Jeff comments, questions, and column suggestions at joseph@4prescient.com.
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