Trick question: which is a better business plan:

  1. Targeting 1% of a $100B market
  2. Aiming to take 30% of a $1B market

If you answered #1, you’ll have a hard time attracting investors.

Simple math says #1 is worth $1 billion while #2 is only $300 million. But building a startup is not a math problem, and nothing is ever simple.

As a startup investor, I see hundreds of pitch decks. The ones that show the company aiming to take a tiny sliver of a huge market do not get funded.

There are 3 reasons why targeting a small sliver of a huge market is a bad business plan.

First, every investor has it drilled into their head a maxim of Business 101: the leader in any market can make huge margins. There’s room for a second player to do reasonably well, too. Think Coke and Pepsi. Android and iPhone. Nike and Adidas.

After the market leader and a follower, the business is tough for the rest. Player #3 might break even. Everyone else loses money.

Whether this maxim holds true in every market doesn’t matter. Investors believe it’s true. Nobody wants to invest in Player #25, no matter how enormous the market.

Second, the conventional wisdom about profitability being highly correlated to market position isn’t just myth. The market leader has so many advantages that they’re nearly impossible to compete with head-on.

Imagine I invent a new, better tasting cola and decide to take on Coke. Right, good luck with that.

The engineer in me says that if I invent a better mousetrap, or a tastier cola, customers will flock to me in a kind of divine revelation. The engineer in me is a clueless dreamer who doesn’t understand the challenges of building a business.

I can’t match Coke on price because their volumes are a million times larger. They have volume deals with all their suppliers and control over their highly optimized factories.

Instead, I have to compete with a higher-priced, better tasting product. That’s tough, too. Coke has billions to spend on advertising to convince the world their product is better. Or cooler. Or more refreshing.

The grocery stores are already stocked to the rafters with a dozen different flavors of Coke. The last thing they want is yet another cola.

All I’ve got is me and my website, and maybe if I work hard, I can convince the local gourmet shop to give me a tiny tasting table for a couple hours.

Through word of mouth and expert use of social media, I might be able to eke out a few sales. The Coke executives in Atlanta are hardly quaking in their boots.

In the end, here’s the problem: to compete head-on with Coke, I have to spend as much as them on advertising and distribution, and probably twice as much on production. With a tiny sales volume, it’s a foolproof recipe for losing money.

In other words, with the same costs, the market leader with the biggest volume is highly profitable and #2 can do okay. Everyone else (except a store brand) struggles to keep the production lines running.

Third, the goal of a venture-based startup is to get acquired (or grow big enough to go public in an IPO). Wil Coke acquire my business to get their sticky hands on my secret formula? Ha! Will Nestle buy my business to take on Coke in a battle of Godzilla vs. Mothra? Double ha! If they can’t acquire the market leader, they might acquire #2 or #3. Everyone else is too small to bother with.

Taking on Coke with a better cola is a bad idea. Does that mean I should pack up my tasting table and head home to drink beer? Nope.

Instead of taking on Coke directly, I need to find a market niche that they’re not dominating. How about if I make a persimmons and yuzu-infused zero calorie bubbly water instead?

Ah, now I have something different. I don’t need to claim to be better than Coke but to have something different that consumers want. That’s much easier.

Back at that tasting table advertising my healthy, zero calorie drink, I now have a line of people excited to try my soda instead of blank stares of shoppers walking past.

Distributors are excited, too. They like to have something new and different in their catalog. Retailers are willing to try it on their shelves, maybe even feature it on an end cap.

If it’s successful, Coke will come calling to acquire the company, not for the secret formula which their chemists could easily copy but for my trendy brand.

Instead of being a rounding error in the $400 billion carbonated drinks market, I’m a significant player in the $30 billion sparkling water market. I can legitimately aspire to be the market leader in the $13 billion flavored water market. And I own the new market for Asian-fruit flavors water.

You can argue this is just semantics — I’ve defined my market to be a smaller niche. But it goes beyond semantics to how I advertise the product to consumers and reach out to retailers. My product is not another carbonated drink but a new entry in the flavored water space.

Yes, the carbonated drinks market is 30x larger, but the flavored water market is growing quicker and appeals to a younger audience. That’s an easier sale to both retailers and investors.

The big numbers of the carbonated drinks market appears to be a larger opportunity. But in reality, it’s not because realistically I’m not going to take significant market share from Coke, Pepsi, and other established players.

As an investor, I’m far more interested in putting money into a startup that intends to become a market leader of a niche. A company targeting a tiny share of a large market is almost an automatic pass because the business model doesn’t work.

When I examine the TAM/SAM/SOM of a startup, I’m not impressed by big market sizes. The only numbers I care about are the SOM and the market share. The SOM tells me the company’s revenues when it reaches market saturation. The market share tells me how profitable the company is likely to become when it reaches scale.

The only reason I to look at the TAM and SAM is to see how the company is defining itself and how it calculates the SOM.

So how tightly should I define my market? Am I the market leader for zero-calorie, persimmons-infused carbonated water made in California by a left-handed person over 50? That’s clearly absurd.

How about the market for persimmons-infused water? No, because I’m a direct competitor for blackberry-infused water, strawberry-infused water, and any other infusion.

Both retailers and consumers see the distinct category as zero-calorie, flavored carbonated water, so that’s my niche. However, if it’s CBD-infused, that’s a completely different category appealing to a different consumer.

So, define your market as the tightest niche in which the product competes directly. Then show investors how you’ll dominate the niche. That’s a plan for success.