It’s been said over and over again that VC’s (and all investors) look to invest in great market segments.  I’ve also heard different folks say “you are better off backing a bad team in a great market than a great team in a bad market.” I believe Warren Buffet is credited for saying something like this, although I can’t quite find the quote.

Investors, entrepreneurs, and executives are all looking for great markets.  It’s always much much easier to be successful when the wind is at your back.  However, it’s not that obvious what makes a good market vs. a bad market.

At first, it seems obvious.  A great market is one that is really big and growing fast.  Simple enough, right?  Wrong – there are quite a few examples of big and growing markets that are actually quite challenging.  Also, some markets that are small or stagnant may actually be great places to start a new company.  Below are a couple tips that I’ve found helpful in figuring our how challenging or attractive a market really is (drawing heavily from Michael Porter’s famous Five Forces Analysis).

Tips for Evaluating Great Markets

1. Understand where power lies in your supply chain.  Do either your suppliers or customers hold unusually high bargaining power?  What would it take to become meaningful enough to level that balance?  Two classic examples of challenging value chains is the music and mobile industries.  In both cases, there are very big players that have significant bargaining power (ie: carriers and music labels) and can extract a disproportionate amount of the value created by other players in the market.

2. Know the difference between value creation and value capture.  Value creation is the difference between the cost of creating product and the willingness of customers to pay for that product.  I think some companies get into trouble because they mistake user engagement for willingness to pay.  Some companies also get into trouble because they assume that they can capture all the value that they create – which is not always the case.

3. High and low barriers to entry.  This is a double edged sword.  Low barriers to entry suggest that it’s an easy industry to enter, but it’s hard to extract a lot of value because someone else could enter and charge less.  On the flip side, high barriers to entry make it difficult to enter a market, but there the potential for greater value capture.  Both sorts of markets can be viable places to compete, which is why we invest in both types of companies at Spark.

4. Watch out for industries that have already been disrupted.  Often times, this disruption comes in the form of shrinking a market because a technological or business model innovation enables a company to deliver a comparable service for less.  Josh Koppelman talks about this a lot and the encyclopedia market is a classic example.  The problem is that companies will sometimes see a market getting disrupted, and jump on board because the market seems “hot”.  But usually, once a market has been shrunk by a couple leaders, a new entrant has a hard time piling on without doing something radically different.

5. It pays to create a market, but these rules still apply.  At Spark, we love investing in companies that are truly revolutionary and are creating new markets altogether.  But even in a new market – the tips above still apply and should have a major impact on product, business model, and pricing decisions. For a great article discussing some of these implications when establishing a new “two sided” market, check out a great paper by Tom Eisenmann at HBS.

This isn’t meant to be a catch all or a checklist.  But just some considerations beyond the “is it big and is it growing” analysis.  Would love to hear examples, counter examples, or other factors folks think are important.