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The 1 Percent Fallacy

You've probably heard this one before: Your start-up needs only 1 percent of the market, and you're golden. If only that were so easy.
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In some tech start-up circles, you'll hear that there's something of a formula to making millions: Identify a huge and established software market, develop your own product for that market, aim for capturing a mere 1 percent of that market, and there you go. 

Take something like the online gambling market, which is currently about $34 billion in size, according to market analyst firm H2 Gambling Capital. Capturing 1 percent would mean annual revenue of $340 million. Pretty impressive.

The possibilities seem amazing, don't they?

Except it hardly ever works out that way, says U.K. software developer Andy Brice. In a recent blog post, he termed this concept the 1 percent fallacy. While the phrase may be new, the concept is old: it's called, making clichéd assumptions in your business plan.

The problem is that almost never do ventures get close to that mythical 1 percent level of business. Entrepreneurs frequently underestimate just how difficult the task can be. Brice actually undertakes a bit of a mathematical analysis that is worth reading. It comes down to historical observations that phenomena often fall into what is called a power law. The frequency with which something happens varies by some characteristic of the event brought to some constant power. Here's an example in a graph from Wikipedia:

power law

The portion to the left represents the popular choices, while the ones to the right are the so-called long tail. This is a stark representation of the Pareto 80-20 law. Brice does some calculations to show what market position would have to be to obtain at least 1 percent of a given market's position. If there are 10,000 companies in an industry, yours would have to be in the top 10. Even in a market of only 100 companies, given an often seen power law, you would have to be in the top 19.

This is why the 1 percent assumption is really the 1 percent fallacy. The larger the market, the smaller a chance you have of getting 1 percent of the revenue.

If only this were the only bad assumption that entrepreneurs made when planning businesses. Sadly, founders often have long lists of assumptions, including unwarranted certainty about what features will drive sales of a product (often based on talking to a handful of friends or acquaintances), taking for granted the level of attention from the press they will get for their start-up, or grossly underestimating costs, including the amount of cash that will be necessary to keep the new business afloat long enough to become successful.

Am I suggesting you give up? Not at all. The true genius of an entrepreneur is to see possibilities where others only envision failure, and then to work like hell to achieve your goals. But smart business means realism in your planning and assumptions. And it's tough to be realistic when you're wrapped in the soothing cotton wool of wishful thinking.

Last updated: Mar 12, 2013

ERIK SHERMAN | Columnist

Erik Sherman's work has appeared in such publications as The Wall Street Journal, The New York Times Magazine, and Fortune. He also blogs for CBS MoneyWatch.

The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.



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