Few entrepreneurs and investors can resist the temptation to follow the herd into a new, "hot" market, even when they understand that it is rarely the path to riches.
New research from the University of Chicago Booth School of Business finds that entrepreneurs who resist pressure to follow the consensus are most likely to stay in a market, receive funding and ultimately go public, according to a paper published in the Administrative Science Quarterly.
In "The Non-consensus Entrepreneur: Organizational Responses to Vital Events," Chicago Booth Associate Professor of Organizations and Strategy Elizabeth G. Pontikes and Stanford University's William P. Barnett find that entrepreneurs who follow the prevailing beliefs in a market are less viable, while non-consensus entrepreneurs prosper.
"Startups and investors face constant pressure to follow the consensus, and that pressure is hard to overcome" said Pontikes. "When we talked to individual entrepreneurs and venture capitalists directly, they said they know intellectually that they shouldn't follow the crowd, but they still do it."
The researchers studied startups in the software industry over a period of 13 years. The data contained 4,566 organizations in 456 different market categories from 1990 to 2002.
The researchers assembled data on software organizations, their market categories, when they received venture capital funding and when they had an initial public offering. They also interviewed investors, board members and executives in the software industry about the decision-making process for entering a new market.
The study found that both firms and venture capitalists engaged in herding behavior by entering markets that received venture capital funding. On average, software entrepreneurs enter market categories every other year, and the top 30 percent enter market categories yearly.
Those firms and venture capitalists following the consensus suffered in the long term. They put too much emphasis on the viability of a "hot" market and overlooked whether their product had a good fit for the market. Entrepreneurs who entered "untouchable" markets -- those tainted by bankruptcies -- applied more scrutiny to product-market fit and, in turn, fared better.
The study has implications for entrepreneurs and investors across industries. Firms would do well to institute processes that force executives and decision makers to carefully examine whether their products are suited to compete in a market before entering, Pontikes said. This formal process can offset tendencies to overweight the potential of hot markets and to gloss over questions around product-market fit.
"Although non-consensus behavior may seem like foolishness at the time, it turns out to be a wise alternative -- if the organization can weather the heightened scrutiny," the researchers write. "Consensus entrepreneurs can readily garner support to enter a hot market, but as a result are less viable."
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