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Entrepreneurs, venture capitalists, and executives in established companies all find “hot” market segments that appear to have significant future growth potential appealing — for obvious reasons. However, new research finds that technology entrepreneurs and the investors who back them often do better if they identify winning strategies in markets that aren’t considered hot.
In an article in the March 2017 issue of the journal Administrative Science Quarterly, Elizabeth G. Pontikes, an associate professor of organizations and strategy at the University of Chicago Booth School of Business, and William P. Barnett, the Thomas M. Siebel Professor of Business Leadership, Strategy, and Organizations at Stanford Graduate School of Business, studied the effect of “herding” behavior on software entrepreneurs. The researchers found that, after positive events that affected perceptions of a market category — such as a number of startups in that category gaining financing from well-regarded venture capital firms — entrepreneurs had a greater tendency to flock to that market. The result was apparently less scrutiny by both entrepreneurs and investors of product-market fit before entering the now-hot market, because those startups were also more likely to leave the market category in later years.
In contrast, the researchers discovered that entrepreneurs who focused on not-so-hot market categories — whom the researchers dubbed “non-consensus entrepreneurs” — were likely to do better once they entered the market category, presumably because they faced greater scrutiny by stakeholders before making the move. As a result, those non-consensus entrepreneurs were less likely to enter the new market with a flawed plan. As Pontikes and Barnett write in their article, “The Non-Consensus Entrepreneur: Organizational Responses to Vital Events”:
“Non-consensus entrepreneurs, who resist entering faddish markets and may even enter those that are tainted, realize better long-term outcomes. They face high levels of scrutiny about how they will be able to succeed, both from people within the firm and outside parties, which functions as a high entry-selection threshold and strengthens the firm’s product-market fit. Non-consensus entrepreneurs therefore are more likely to thrive in the long run.”
What can companies do to avoid the sometimes deceptive appeal of hot markets? One option Pontikes and Barrett suggest is to develop a mechanism to counter the tendency to rush into a hot market without sufficient scrutiny — by, for example, appointing an executive to serve as a “devil’s advocate” who will evaluate proposals to enter faddish markets skeptically, with an eye toward fit between the company’s products and the market under consideration. “It may be wise,” Pontikes and Barnett write, “for industry participants to focus less on which market is hot and turn their attention toward the more nuanced — and perhaps more difficult — task of analyzing a firm’s product-market fit.”