Identifying Massive Markets: Learning from Don Valentine and Sequoia Capital

A massive market opportunity is a pre-requisite for a great venture capital investment. Just as competitive surfers must ride big waves in order to prove themselves the best, the great entrepreneurs ride large market waves in order to build massive companies. Peter Thiel argues that the best companies often begin by dominating niche markets. This may be true, but they inevitably identify and capitalize on multi billion-dollar market opportunities in order to become sustainable billion-dollar companies. Nelson Mandela once said, “There is no passion to be found playing small”. So it is with life, and also with entrepreneurship.

By extension, to be a great early-stage venture capital investor, a VC must identify new massive market opportunities that will produce the next wave of great startups. But not just identify them. Identify them before everyone else, and then select the best company out of the several startups that may be playing in a new market. Furthermore large markets are non-obvious in the beginning. Just ask the investors who passed on AirBNB because they believed no one would want to stay in a stranger’s home, or the investors who passed on Snap because they thought it was just a sexting app.

So how does a VC solve the challenge of identifying a large market? At 645 Ventures, we live by the saying that “greats study the greats”. Kobe Bryant mimicked Michael Jordan’s moves as he studied to become a basketball legend. Tom Brady studied his idol Joe Montana as he learned the quarterback position, eventually surpassing him to reach the most Super Bowl wins for a quarterback. And we love to study the great venture capital investors that have come before us, as we seek to build an exceptional venture firm that will stand the test of time.

When it comes to learning how to identify and capitalize on large markets, there is perhaps no better teacher than the legendary founder of Sequoia Capital, Don Valentine.[1] While the best VC’s will differ on whether team, the product, or market is the most important driver for an exceptional tech company, Valentine was firmly in the market camp, and there was perhaps no better VC when it came to identifying massive markets.

In the book “Done Deals: Venture Capitalists Tell Their Stories”, Valentine describes his approach to identifying massive markets by providing several compelling case studies. Valentine begins by saying “It’s better to invest in a company in a market with great demand than to invest in a company that has to create it.” While Valentine’s statement may at first seem obvious, he is arguing that large new markets are not created organically by a startup. The startup capitalizes on a market wave. It is the VC’s job to identify the best startup that is riding that wave.

We call Valentine’s approach the Sequential Market Identification model. In this model, Valentine uses proprietary domain knowledge to identify a first large new market. He then uses practical logic relating to the impacts of the first market to identify subsequent large markets that will evolve after it. In essence, Valentine systematically identifies the resulting markets whose growth will be driven by an initial market, either in the form of required supply inputs to that initial market, or alternatively due to new demand that is driven by the initial market. Valentine then determines the companies best positioned to capitalize on these shifts, and invests in them before anyone else. While this model has been applied by many great investors, not just Valentine, the scope of Valentine’s application and the size of the exits that resulted between the 1970’s and 1990’s is the most illustrative that we have seen.

Before founding Sequoia Capital, Don Valentine worked for seven years at Fairchild Semiconductor, a pioneering semiconductor company, and then co-founded National Semiconductor. When he founded Sequoia in 1972, he began with deep knowledge of the potential applications of microprocessors, and he scouted for companies that were leveraging the microprocessor in innovative ways. The first large company he invested in based on this initial proprietary knowledge was Apple.

Valentine states, “In 1977, we financed Apple… It was an era where knowing about microprocessors made the evolution of the PC obvious. Steve Jobs was an employee at Atari in its early days. So I had the advantage of all that knowledge before anybody else.” Sequoia invested $150,000 in Apple in 1978.

This was Valentine’s first application of the Sequential Market Identification Model: realizing that the growth of the chip industry and the potential of microprocessors would enable the PC revolution, and that companies building PCs would be poised for massive growth. Apple, of course, would go on to become the most valuable technology company of all-time. But this was just the first of multiple applications of the sequential model by Valentine.

The second was the identification of the market for computer memory and storage. Based on his understanding of the demand for personal computers, but realizing that computers were still limited in their ability to store data, Valentine knew that the new machines would need memory and storage in order to serve user needs. So he started looking around for memory companies.

Valentine writes, “It became very apparent that Apple needed a different memory system. So Sequoia financed a guy by the name of Jugi Tandon to go into a small five-inch disk drive business. That decision was clearly driven by an application need in the PC which required a solution that was faster, far more reliable, and had greater density than an audiocassette. So we financed Tandon. And it was a spectacular investment.” Tandon became a pioneering company in the PC disk drive industry.

By the late 1980’s, through its successful investments in the PC industry, Sequoia and Valentine identified the potential of the Internet, and the resulting need for Internet infrastructure to enable computers to communicate and leverage the potential of the web. Sequoia specifically began to explore Internet infrastructure investments in the areas of switching, routers, and Ethernet technology. That exploration yielded investments in both 3Com and Cisco. 3Com was eventually acquired by HP for $2.7 billion in 2009, not a bad outcome. Cisco, of course, has also grown to become one of the most valuable technology companies of all-time, with market cap of $204 billion today.

Valentine states, “In 1987 we started the internetworking industry with Cisco. We had previously invested in 3Com and other similar companies, so we understood the connection of the Internet, and all that it encompassed, probably better than most people. So we were looking for Cisco when they were looking for us. That is how we prefer to invest, in an anticipatory way.”

The identification of Ethernet and Internet infrastructure, specifically routers, were the third and fourth successful applications of the the Sequential Market Identification Model. We diagram the model below.

The Sequential Market Identification Model surely advantages VCs and firms that are already successful, because they have proprietary knowledge and information about new markets that are evolving via their successful portfolio companies. However, new VCs and new VC firms can also learn a lot from the model as well.

One basic way to apply the model is to ask the following two logical questions: 1) If an initial market gets large, which markets are likely to be created as a result of that initial market? And 2) Within those resulting markets, which companies are best positioned to capitalize on the shifts that will occur? Or, as Alec Baldwin asks the Matt Damon’s crooked cop in the movie Departed as they try to identify the motive behind a murder: “Cui Bono (Who Benefits)?”

Union Square Ventures and Fred Wilson are a good example of how to apply the Sequential Market Identification Model to blockchain and crypto-currency. USV made its first investment in blockchain in 2013, investing in CoinBase. In investing in CoinBase, USV defined crypto as a fundamentally new market, “an open and distributed Internet peer to peer protocol for transferring purchasing power.” USV further stated that CoinBase was a platform that solved three pain points: storing Bitcoin, accepting it as payment, and exchanging it into fiat currency.

Using its initial investment in CoinBase as a beachhead, and with the thesis that the blockchain would potentially transform many vertical industries, USV has sequentially invested in a range of companies across the Blockchain App Stack. The most recent example is an investment in Cryptokitties, with the thesis that blockchain will enable the growth of the digital collectibles industry.

At 645, we seek to learn from the greats of yesterday like Don Valentine, as well as the greats of today like Fred Wilson. We are currently applying the sequential market identification model to AR and VR, as an example. Believing that hardware technologies were required to enable the initial wave of AR/VR adoption, we first invested in the growing AR/VR hardware company MergeVR, whose Merge Cube product sold more than one million units.

Then, believing that content availability was critical to enable consumers to effectively utilize their headsets, we invested in Littlstar, a global network dedicated to putting viewers at the center of the best immersive experiences.

Now, believing that immersive experiences have the potential to transform consumer and enterprise behavior over the long term, we are now evaluating applications of immersive technology across vertical categories.

We will continue to apply the Sequential Market Identification Model as we grow our firm, believing that the best way to become a great VC firm is to stand on the shoulders of the giants who came before us.

[1] We recommend picking up a copy of the book “Done Deals: Venture Capitalists Tell Their Stories” by Udayan Gupta, and closely reading the chapter written by Valentine. We also recommend watching Valentine’s talk at Stanford GSB entitled “Target Big Markets”, which can be found on YouTube.