Tag Archives: power laws

The 1% fallacy

Here is how to make a fortune writing software:

  1. Pick a large and established software market e.g. back-up, anti-virus or customer relationship management (CRM) software.
  2. Write a new product for that market.
  3. Get 1% of the market.
  4. Retire to your own island.

These markets are massive. The CRM market alone is estimated at around $18 billion per year. 1% of that is $180 million. How hard can it be to get one measly percent of a market? Ka-ching!

Except of course, it doesn’t work, unless you have massive amounts of funding or a brilliant idea that can completely disrupt the existing the market. Even then, you probably still need a fair amount of luck.

The competition in a large market, such as CRM software, is very tough. The top  companies have huge budgets and armies of developers and marketing people. Your chance of getting on the first few pages of Google results for a search term such as “CRM software” are as near to zero as makes no difference. And there are all sorts of network effects working in the favour of the established companies. For example, the biggest vendors will have an ecosystem of consultants, resellers, training courses, books, user forums and third party products that no new product can hope to match.

Then there are power laws which mean that you have to rank surprisingly high to get 1% of a market. The most famous power law is the Pareto 80/20 distribution. This is named after Italian economist Vilfredo Pareto, who observed that 80% of the land in Italy was owned by 20% of the population. Pareto distributions appear in all sorts of places. I have looked at various data for my own product and I have found the 80/20 distribution appears in my own data.  For example:

  • 77% of searches result from 20% of search phrases
  • 75% of sales come from 20% of email domains

If I could be bothered to crunch the numbers I expect I would find that  approximately 80% of support emails come from 20% of my customers and 80% of hits are on 20% of web pages. There is evidence that companies sizes are also distributed according to a Pareto type power law. Assuming a Pareto-type distribution, we can calculate what percentage of the market each company has according to their ranking using Zipf’s law :

Number of companies 1% rank
100 19
1,000 13
10,000 10
100,000 8

This table shows the rank you need in a market of given size to get 1% of the revenue of that market. For example, if there are a 1,000 companies in your market, you need to be ranked 13th to get 1% of the total sales.

How many companies are selling CRM solutions? I have no idea. Even in my little niche of seating plan software I have at least 10 direct competitors and well over 100 competitors with substantially overlapping functionality. I dread to think how many CRM products there are. At least a thousand I would have thought. What are your chances of coming from nothing to being the 13th biggest selling CRM solution? Also the conversion rates of customer visits to sales are typically around 1%. That means if you want to sell to 1% of a market and your main sales channel is your website, you need to get pretty much everyone in that market to at least visit your website. Good luck with that. Your best chance of getting a chunk of a big market is to create that market and grow with the market. But creating new markets is notoriously expensive and risky.

If you are a small software company, you have got a much better chance of getting a decent sized chunk of a small market, than 1% of a huge market. As a general rule of thumb, I would say pick a market for which you have got a decent chance of getting in the top ten Google results for important search terms (power laws again). You can even do this by going after a small segment of a big market. e.g. a CRM solution aimed at companies that trade on EBay. Or perhaps a CRM solution aimed at companies that trade on EBay in the Spanish-speaking market. You can always broaden your focus if you are successful in a small market.

Whatever you do, don’t stand in front of investors and pitch them the 1% fallacy. It makes you look an idiot. I should know, because I’ve done it.