Does It Really Matter How Big The Market Is?
There is something that I have heard pretty frequently since I started my venture capital journey: look for companies that are playing in big markets, because those are the ones with the most potential. I have had conversations with co-investors and co-workers about this very topic, and the general consensus seems to be that yes, the bigger the market, the better. And while it is very difficult to disagree with what seems like such an obvious opinion, I wanted to do some digging and analysis to see how true this principle really was.
“This Market is MASSIVE”
I don’t think that I have heard a startup pitch yet where the founder / CEO doesn’t say something along the lines of “this market is massive” and then continue to walk the crowd through why the market is so gargantuan. A lot of times, it is pretty easy to follow along with the mental math that a pitch walks you through – 600 million people do this same thing every day, and they already pay $200 per year for this service, so the market is at least $12 billion (wonky example, but you get the point). However, there are plenty of times where a pitch’s calculations make no sense and the venture capitalist is too distracted trying to figure those numbers out to grasp the rest of the presentation.
The mental gymnastics that a founder performs are some of the reasons it is essential that a venture investor does some of their own research into the market’s size. It is a habit of some of the best investors out there to thoroughly validate the claims made by a startup. I frequently hear the phrase “trust, but verify” by some of my colleagues and I completely agree. But the riddle that should be solved for is not whether you can get the exact same market size number that the pitching company provided, but rather, whether you agree with the market sizing logic and the math that follows.
Market sizing is a delicate art, not an exact science. There are a lot of methods that can be utilized, such as building from the ground up or looking from a very high level view and drilling down. But at the end of the day, the market size that you come up with is just a prediction. And like most predictions, the only thing guaranteed about this one is that it is wrong.
Building from the ground up seems the most logical approach. Take the amount someone is willing to pay for a service multiplied by the total number of people or businesses who are potential customers and arrive at the market size in dollar form (this is a simplified explanation). The problems become apparent once you dig into these numbers. How do you really know what the broad market is going to pay for the service? It is totally possible the the price point the product has now is way off - that has happened plenty of times in startup history. Also, how do you know all of the potential customers? There are way to many variables at play for this number to be rock solid.
The same can be said about the top-down approach. Take an existing market and claim that a product is going to acquire a certain percentage/share of said market (again, simplified explanation). The issues here are much more obvious. There is no clear way of determining how that captured market share percentage is discovered. Most of the time this is done by an extremely rough estimation
Although it might seem like it is a crap-shoot determining the market size of a startup, the point that I am trying to make is that it’s not the final number that matters so much as the logic used to arrive at that number. Just like with most machine learning programs on the market today, this is a “garbage in, garbage out” methodology. The better your research and formula, the better your understanding of the market size.
Tiny Markets Are The Only Markets That Matter
But even if your methodology is rigorously tested and you thoroughly vet the correct market indicators to determine the general size of the existing market, you still might be in some trouble. Investors are trying to hit a moving target. What should be focused on is not what the market size is today, but what the market size will be in a couple of years, when the invested company reaches maturity (or at least early profitable adolescence). This poses a significant problem because who knows what is going to happen in the future. Like I already detailed, predictions are only guaranteed to be wrong.
If you look at some of the biggest winners regarding venture capital in the past couple of years (facebook, Uber, Snap, SpaceX, etc), I would wager that there were a lot of skeptics in the investor community when reviewing the market sizing slides in those companies’ pitch decks. For example, in 2011, when Uber was just getting started, it was viewed as a replacement for premium black cars and limos. That market was only worth ~$2 billion. If you included taxicabs into that figure as well, the market would have been worth approximately $100 billion. Today, Uber is preparing for an IPO at a reported $120 billion valuation. The market since 2011 has changed significantly and I would argue that is mostly due to the introduction of Uber.
There are stories like this all over the place in the startup world. Markets change drastically because that’s exactly what startups are trying to do - change the way a market operates. A startup probably wouldn’t be worth the investment if all it did was unseat the incumbent product/service provider by doing the same thing. Venture capital money really gets put to good use when a startup essentially creates a market from scratch, the way much of the social media giants did.
One way to better understand what the size of the market will be is to try and figure out if the Company being assessed has a good roadmap in place for the product and their business plan. If that roadmap makes sense and doesn’t rely on some absurd miracle (like a brand new technology being invented that isn’t even close to being discovered), then it’s entirely possible that the market conditions are in place for disruption and high market growth. Sometimes all a market needs is a nudge in the right direction. As long as that nudge doesn’t need to be massive, then a market has potential to be massive.