Chapter 1: Understanding the 80/20 Principle

Many of you might be familiar with the Pareto Principle, commonly known as the 80/20 rule. This principle suggests that a mere 20% of efforts can yield 80% of the results. This concept extends beyond just productivity; it also applies to various aspects of life, such as consumption patterns, where 20% of individuals account for 80% of alcohol consumption.

But have you ever pondered the underlying reasons for this principle? I've found myself preoccupied with this question. For instance, if 20% of M&A professionals capture 80% of the value, what steps must I take to join that elite group?

The answer lies in asset accumulation. Wealthy individuals grow their fortunes by leveraging inexpensive capital against their existing assets to acquire additional assets. This same principle applies in the realm of fundraising, where a select 20% of entrepreneurs secure 80% of the available capital.

Through interactions with countless entrepreneurs, I've observed a common asset among those who succeed in fundraising.

In the tech equity financing space, you may have encountered statements like:

"I require funding to implement a winner-takes-all strategy and achieve a critical mass. Once that is reached, network effects will establish strong barriers for my startup."

This narrative—an equity story—consists of compelling reasons for investors to consider buying into your equity. Initially, these equity stories, often filled with buzzwords, resonated with me as I navigated this ecosystem as a novice.

However, through various challenging experiences that left me feeling foolish, I developed a skill for spotting insincere claims.

Now, I can effortlessly differentiate between two types of entrepreneurs:

• Those who merely regurgitate buzzwords superficially.
• Those whose equity narratives are grounded in well-developed mental models.

Let's illustrate this equity story within a fundraising context, where you, a SaaS founder, are engaging with a seasoned tech investor.

During the Q&A session, it’s likely you delivered an impressive pitch:

Tech Investor: "Thank you for your presentation. You've certainly used many key terms, indicating thorough preparation! However, one query remains: Are you genuinely operating in a winner-takes-all market?"

You (confidently): "Absolutely!"

You continue: "Historically, winner-takes-all dynamics have emerged in consumer markets, where the first player to establish a new behavior, such as Uber or DoorDash, emerges victorious. My SaaS solution is similarly focused on fostering new user habits. I possess compelling metrics that demonstrate high user engagement— the more frequently people utilize my product, the more habitual it becomes!"

Tech Investor: "That’s intriguing, but do you truly believe that adopting a growth-at-all-costs approach, akin to what is seen in consumer markets, is appropriate for your SaaS product?"

You (defensively): "My goal is to propagate this new habit across my total addressable market (TAM). My product is not only sticky, but it also benefits from inherent network effects. Just look at my retention statistics!"

You assert: "I’m ahead of my rivals, but I know they’re also courting investors like you. This is why it’s crucial for my product to achieve critical mass first. Once we hit that threshold, network effects will kick in, and my startup will dominate its category."

Tech Investor: "Should I interpret that to mean your product’s network effects guarantee that you are in a winner-takes-all market?"

You (taken aback): "What do you mean? Surely you recognize that most tech markets tend to culminate with one company seizing the majority of market share, largely due to network effects!"

Tech Investor: "If network effects were the sole determinant, why then do we have a multitude of CRMs, numerous enterprise messaging platforms, and various browsers and operating systems? Yet, we often see only one leading professional network or a single dominant video-sharing website?"

You (flustered): "Um… I think… I’m not sure…"

Awkward, right?

Merely relying on buzzwords gleaned from articles like this will not make your equity story memorable. While it's easy to adopt such terms, genuine understanding of your market structure and network effects requires effort and time.

However, this investment of effort pays off, equipping you to craft a distinctive and resilient equity narrative that withstands scrutiny during Q&A.

In the scenario I described, the equity story hinged on the false assumption that all network effects are the same. In reality, network effects vary significantly in type and strength. Each product experiences its network effects differently as they mature and evolve over time.

Instead of using the term "network effects" loosely, invest in a deep comprehension of these effects as a critical mental model.

This represents a vital mindset transformation that will allow you to reallocate your resources toward building robust fundraising assets. A solid equity story is a shared trait among all successful entrepreneurs I’ve encountered in the fundraising space.

This approach will provide you with a significant advantage, as venture capitalists are experts at crafting persuasive investment theses, which serve as their own form of equity story for limited partners. If they fail in this regard, their ability to secure capital diminishes.

It stands to reason that VCs are inclined to back entrepreneurs capable of constructing compelling equity narratives!

Begin your journey toward gaining an edge by accessing four curated resources that delve into mental models of network effects, along with a brief overview highlighting the benefits of each resource.

Chapter 2: The Importance of Understanding Network Effects