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Yesterday, I wrote about aligning a market and the product development cycle. Essential to understanding a market is market segmentation.

To succeed, startups have to pick one of two major market segments to serve. There is a smaller, premium, highly profitable market segment, the head, and a larger, economy, less profitable segment, the tail. At first blush, this kind of segmentation seem rudimentary. But it’s everywhere. It’s true for airlines, for cars and even mobile game makers, 4% of whom generate 72% of in-app revenues. No where is this distinction more apparent than the mobile handset market.

US smart phone penetration has grown to 30% in just a few years driven by Google’s Android and Apple’s iOS. Google approached the market with a tail strategy: open, free software designed to win share. Apple entered the market with a head strategy: premium hardware and software at premium price points. Each has been successful with their respective strategies.

Interestingly, iOS’s share is constant over the past 18 months, meaning Apple phone sales are growing as fast as the market. Said another way, the premium market segment is a fixed fraction of the total market, roughly 25% of the smart phone market or 8% of the total US phone market (which coincidentally is about Apple’s share of the US PC market).

Android, on the other hand, is growing much faster than iOS and about twice as fast as the overall smart phone market. Meanwhile, RIM is ceding share as quickly as Android is winning it.

Price drives these market dynamics. Apple’s average selling price (ASP) is $640 – a premium price for a premium product.

Android’s principal handset makers, Motorola, Samsung, LG and others have an ASP of $100 to $200, a fitting strategy for the tail. Meanwhile, RIM is caught in no man’s land – an older product at a mid-tier price point. No wonder they are losing share. (I’m ignoring carrier subsidies for simplicity).

These lessons can be applied equally well to startups. Few startups will choose a premium path because startups strengths typically align with the needs of the tail.

A startup has two advantages: development speed and small marginal cost to serve a customer, thanks to the cloud.

For most startups, starting with the tail and moving up into the head is the right initial strategy. Tomorrow, I’ll write about the application of this strategy to freemium SaaS companies.

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