Why Every Startup Should Create Its Own New Category

Category leaders capture the majority of the available profit pool, and investors seek to find future category leaders. Peter Thiel’s ‘Zero to One’ book is about how to build companies that create new things and eventually become a monopoly. Investors also look for new categories because it is virtually impossible for a startup to unseat a current category leader.

But how to create a new category?

Founders should look for a net new problem and they should devise a net new solution. The only way to find this new problem is by talking to customers.

Category creation requires developing a concept and planting a story in people's brains. Customers may not understand that they have a problem and therefore may not have a budget. A new point of view replaces the current customer point of view. And customers may be puzzled because they haven't thought about it. In fact, there may not be any easily identifiable customers and the ultimate act of category creation results in a new role in a company. Box's Aaron Levy said 'you need to find a demographic and a customer that no other software company is paying attention to in a modern way, and your job is to make them be heroes.'  

The solution has to be not only better, but different and unique. Being different comes from proprietary insight and can be based on technology differentiation, network effects, or a structural competitive advantage. Peter Thiel asks founders one key question: ‘What important truth do very few people agree with you on?’

The existence of a band aided solution at the customer is a good sign that there is a category waiting to be productized. And a sufficiently large number of these cases is evidence that now is the perfect time for the category to be created.

Talking to existing channels is unlikely to generate new insights since they serve current solutions and address known problems and customers.Advisory firms such as Gartner and others will only validate new software categories when a category has become large enough for their own customers and competitors are emerging.

Qualtrics realized that their customers started to tweak the software and use it as a customer experience and employee experience solution; the original market research use case dropped to the third rank. CMO Kylan Lundeen said 'We realized we were not in the survey business, we were in the business of helping people manage the experience they provide to their most important stakeholders.' Qualtrics was acquired for $8 billion by SAP in 2018.

The best categories have no or few competitors. There is little noise and there are no preexisting notions and once a new category has been identified the work only starts. The new category needs to be positioned and an ecosystem around it has to be created. The message needs to be authentic at scale for the users and customers to evangelize it. Leadership of this movement has to extend beyond the company and include the competition.

Peter Thiel has said ‘... the single most powerful pattern I have noticed is that successful people find value in unexpected places, and they do this by thinking about business from first principles instead of formulas’.

2018 in Review - Category Kings Rule

A new year’s beginning is the customary yet arbitrary time to review last year’s market movements and portfolio developments. The main theme for decacorns, unicorns, and my own portfolio companies was category leadership; .

The undiminished power of that leadership in SaaS was again on display when Qualtrics decided to sell itself for $8 billion to SAP. Shopify, Veeva and Twilio are examples of these category leaders that have already reached or surpassed $10+ billion valuations and continue to go strong.

Picture credit: Forbes

Public markets and private tech startups

The longest bull market in history may be coming to an end. The DJII started at 25,461.70 and finished the year 5.8% lower at 23327.46 points; the Nasdaq Composite lost 4.6%. Cloud software stocks were still doing well though and massively outperformed the overall stock market where the Bessemer Nasdaq Emerging Cloud index rose by 37% from 621 to 851.

It pays to be a thunder lizard and create a new category. The plethora of tech IPOs continued and was led by some notable SaaS leaders such as Anaplan, Elastic, Docusign, Eventbrite, Pivotal, Zuora, and Dropbox. Even Domo made it out in time, although they raised a ton of red flags when they announced that they would have to IPO or go through a major restructuring.

SurveyMonkey debuted on September 26 and is trading at a market cap of $1.4 billion at the time of writing. Their IPO was soon  overshadowed by SAP’s announced $8 billion acquisition of Qualtrics on November 11. Also worthwhile mentioning is Plangrid’s $875 million sale to Autodesk. Plangrid was first introduced to the public at the Y Combinator day in March 2012 and raised a Series A not until 2015. I saw the team at the demo day and liked them, but did not pursue an investment in this vertical SaaS startup that set out to revolutionize workflows on construction sites.

Relayr was the only notable SaaS exit in Germany. Getting to a $300 million exit in five years is great by any measure, and growing into a full fledged unicorn in the IIoT space would have required a lot more capital to expand more aggressively and internationally.

Venture capital continued to flow freely according to PwC’s Q3 Moneytree report.  Late stage unicorn funding rounds drove up dollars invested in the U.S., but deal activity declined for the first time since Q4’17. In addition, seed-stage deals continued to decline, and early stage deals only increased very slightly and for the first time since Q4’17. The U.S. median seed stage deals cost $1.5m, down from the previous quarters but still very high based on historical figures. Historically, all these are signs that the funding market is a the end of the cycle.

Total investments in startups in Germany increased by 7% to reach 4.6 billion Euros, and the number of financing rounds increased by 21% to reach 615. European startups raised a median $1.2 million in Q3 for seed stage deals, less than in the U.S., but the money lasts a lot longer when taking into account the lower salaries compared to Silicon Valley.

The year started with Initial Coin Offerings (ICO) being all the rage, but the SEC quickly cooled buyer interest in the U.S. and subpoenaed 80 cryptocurrency firms in April. Global activity seemed to come to a complete halt shortly thereafter, tet Andreessen, USV and others invested $12 million in the inventors of the Cryptokiddies in March. Steem.it announced it had to lay off 70% of its employees in late November, and one of the more interesting experiments clearly is in deep trouble.

My portfolio

2018 began with 17 active investments and the value of the portfolio rose significantly due to the follow-on rounds in Wandelbots and in Kreatize.

There were 13 transactions in total: Two exits, two warrant deals, three bridges, three follow-on equity financings, and three new deals.

• Exits: Practice Fusion sold to Allscripts for $100 million in cash and Savvy was sold to Global English
  
• Follow-on financings: Truevault raised a venture venture round in August. Wandelbots continued to receive strong customer interest and raised €6 million from Paua Ventures and EQT in December. Kreatize changed their business model to provide a turnkey service for the sourcing of custom made parts and have been on a tear since January 2018. I participated in a bridge round in May, and in December they raised €5.5 million from Earlybird VC.

New investments

Some of my 2017 resolutions were continue to look for differentiated opportunities in enterprise SW in Europe - and in Germany in particular- , bet on contrarian outliers in Silicon Valley, and dive deeper into Blockchain and tokens. I did end up investing in two Germany based companies and in one enterprise SaaS company located in San Francisco.

• The AIPark team led by Julian and Johannes provides predictive parking information just based on data and without owning sensors.  Traditional parking is evolving as cities, drivers, and other stakeholders will need to rethink the curb as ride sharing services proliferate and self driving cars appear on the horizon. I helped the team sharpen their pitch and made introductions to VCs. As in most of my investments, I was the first money in, together with Atlantic Labs, Jens Lapinski and other angel investors. 
• I first talked Jan-Philipp from Hashplay in late 2017.They are building an AI powered business intelligence platform to translate operational data into digital twins and are garnering great interest from multiple verticals in a space which Gartner terms immersive analytics. The team is based in Hamburg and in San Francisco, with development resources in East Asia. 
• I got to know Oomnitza’s CEO Arthur when he raised an initial seed round in 2014. Oomnitza builds a connected, automated, and visualized Thing Management that tracks everything that makes a business run.  I was more than happy to join the bridge round in December.

I also deeply looked into two startups that planned to use tokens as an incentive mechanism for their respective market places. But the ICO market collapsed, and the collateral damage is that most token markets will likely remain frozen for a while. My other activities were concentrated on coaching and mentoring and helping fundraise some of my existing investments, and growing the deal pipeline of B2B SaaS startups  in Germany.

Observations and pontifications

The tech sector is continuing to go through seminal changes at every level of the tech stack and in every aspect of the business model.

• The Iaas market is growing in excess of 35% CAGR. Enterprises are finally moving their production environments to the cloud and to the multiple cloud providers. AWS and Azure are in the lead, with Google Cloud investing heavily to differentiate via AI and AliCloud staking their claim in China. These hyperscalers will to continue to move up the stack via acquisitions to better serve the needs of large enterprise customers and achieve customer lock-in.  
• Kubernetes fundamentally changes how complex SW is being developed. Again Google has disrupted the market with open sourcing their SW, and as a result, startups in the ecosystem are in the crosshairs of these hyperscalers. Heptio and CoreOs have already been acquired, and Docker and Mesosphere are going through massive changes to reposition themselves in this environment. 
• AI has matured from algorithms to the life cycle management of training models. But data and models are customer specific, and scaling these solutions creates challenges far more complex than for bread-and-butter SaaS solutions. In turn, this will lead to more activities in automating data labeling, model scaling and other areas which are not addressed by Tensorflow and other AI libraries.
• Tokens hold great promise in removing friction in marketplaces, and provide incentives for buyers and sellers. The market for security tokens crashed completely in 2018 and all tokens seem to be in the phase that Gartner calls the ‘trough of disillusionment’.
• IIoT customers understand the value delivered by SaaS ‘products’, but they are still expecting a full solution. On top of that, larger buyers in that segment are not yet used to paying recurring revenues. Industrial IoT (IIoT) startups need to be super disciplined about the engagement cycle from first contact to demo/proof of concept and then to pilot and to recurring revenue. Relimetrics and Amper have templated this approach and are preparing to reach escape velocity.

2019 outlook

Dark clouds? R.I.P. Good times? It pays to be prepared, although the VC guns are still loaded and there is plenty of money to go around.

The probability of a downturn becomes more imminent the longer the bull market continues. GM’s announcement of a significant streamlining of their operations notably implied an expected economic slowdown in 2019.

The time to get back into investing in Silicon Valley startups will be when seed stage and bridge valuations become more reasonable. In the meantime, lower valuations and great technical talent can be found in continental Europe. Celonis and Signavio are already category leaders in their respective segments, and Kreatize, Relimetrics and Wandelbots in my own portfolio hold great promise.