PS#095: An Intro to Market Sizing (Part 1)
In the last issue, we finished our series on Employee Stock Ownership Plans (“ESOP”).
Throughout the series, we walked through an overview of ESOP, its impact over the life of a startup, and how investors leverage ESOP to align incentives.
Today, we’ll be starting a new series. We’re going to discuss market sizing and my approach to estimating the potential revenue opportunity for a startup.
In this series, we’ll cover…
Purpose of this analysis
Timing in the diligence process
My 4-step guide for market sizing
Let’s kick things off.
Purpose of this analysis.
At the end of the day, as investors, our job is to find and fund startups that have the potential to build massive businesses ($50M+ in revenue) in a relatively short period of time (5-10 years).
In order for these startups to succeed, there needs to be a current or future market that is able to support this type of company.
To help determine if this is possible, investors will use a process called market sizing.
In this effort, investors will estimate the revenue potential of a market and how much of this market the startup can capture.
More specifically, this process will give investors insights into the…
Revenue generating potential of a business in the near & long term
Competitive dynamics of the business and what is required for success
Level of risk involved in taking a product/startup from early to more mature stages
Potential return of the investment and the possible exit strategies (i.e., M&A, IPO, etc.)
All of this information helps an investor determine if this investment has the potential to achieve venture-like returns. If the investor doesn’t believe there is a substantial market opportunity (either today or tomorrow), they will likely pass on the investment.
Timing in the diligence process.
It’s also important to understand when to start this analysis within the broader investment process.
Market sizing falls into the preliminary diligence stage of the investment process.
Preliminary diligence is where we decide whether we want to commit 100+ hours in full diligence for this opportunity. We might have been excited after our initial evaluation, but will now need to decide if this opportunity is worth dedicating significant time and resources.
To make this decision, we’re often focused on “deal killers”, specifically those associated with market and people risk(s). We do this for two reasons…
These risks can often be understood with less engagement from the startup
Red flags in these areas are often enough to kill a deal immediately
Let’s look at these two points from the perspective of market sizing.
First, if we know (1) what the startup does, (2) how it’s priced, and (3) who it sells to, which are all things we should collect in our initial discussion, we can calculate the potential market opportunity for this company.
Second, we often want to be doing this analysis independently (or at least alongside the information provided by the startup) so that we can come to our own conclusions. It’s important for us to have an understanding of this market from a first principles perspective.
Finally, we always want to be cognizant of our reputation. If we request a whole bunch of information, requiring a lot of time/effort from the startup, only to pass shortly afterwards for something like market size… It won’t come across well. We’ll look like we were wasting the founder’s time with these requests.
My 4-step guide for market sizing.
Alright, with an understanding of its purpose and the timing in our investment process, let’s outline the steps involved in properly sizing a market for a venture investment.
My 4-step guide to market sizing is as follows…
Define the target customer
Perform top’s down analysis
Perform bottom’s up analysis
Review potential growth opportunities
In the next issue, I’m going to go into the details of this 4-step guide. Stay tuned.
But before we go, it’s important to understand that estimating the size of a market is a mix of art and science. Markets change all the time – new ones are born, old ones disappear, some shrink, some grow.
Our job as investors is to review all the potential eventualities and scenarios (or at least the ones we can imagine) to best understand a given market.
With this process I’ve defined above, we review markets from multiple angles, forcing us to consider as many of those different eventualities and scenarios as possible.
