This article is the eighth in an ongoing series on Due Diligence. To learn more about performing due diligence quickly and effectively, download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.
Market Opportunity is an important metric for estimating the long-term potential for an early stage company. Typically, we invest in companies that are going after market sizes of at least $100M. At that size, a market is large enough to support a $25M+ company. Many early stage companies are opening up new markets, so determining overall market size is not easy. We recommend attacking this problem from several angles.
It is important when looking at market opportunity to do your best to gauge how much customers are willing to pay for the product, since this will be a key driver of top line revenues. Don’t rely solely on information from the company. Rather, you and your team should try to develop your own assessment of the market opportunity. Talking to potential partners of the company who are already in the market can provide useful information. This is information you will use to assess whether this is a lifestyle company or one that has a likely exit.
As an active angel investor, Christopher looks at hundreds of companies every year. Some are tackling big problems in huge markets. Others are going after undiscovered challenges in specialized or emerging markets. At first blush, most investors would choose the former investment opportunity over the latter. But you will have to dig a bit deeper to understand whether you’ve made the right choice. So let’s see what Christopher’s years of experience have done for his market sleuthing skills.
Q: Christopher, what characteristics do you think make for an interesting, investable market opportunity for startup companies?
In a perfect world, I am looking for a market that is worth going after and offers an opportunity to build non-linear growth - very steep growth curves. By “worth going after” I basically mean big enough and durable enough over the long term (i.e. product needs which are not just a fad). By “opportunity to … grow,” I am talking about market conditions which are going to allow companies to accrete value to the entity much faster than they spend the entity’s resources (cash/equity). In an established market, that means growing faster than the overall market growth and thereby taking market share. In a new market, that means educating and acquiring customers for much less than the lifetime value of those customers.
Brand new markets are very tough to estimate in size. Your best estimate can be wildly off on both the downside or the upside. Startups routinely overestimate their markets. Even the CEO of IBM once said the worldwide market opportunity for computers was only 5 machines. In evaluating the new market opportunity, you look for genuine pull from customers and you watch out for false demand from unsustainable marketing practices.
HomeJoy is a great example of the kind of trouble you can get into with delusional thinking. They raised tens of millions of dollars in venture capital and were using it to offer their $100 cleaning services through bargain sites, like Groupon, for $19. Predictably none of those bargain-hunting customers came back as repeat customers (and who knows if they had really dirty houses that hadn’t been cleaned in a while.) Spending $100 to acquire a crappy $19 customer who does not stick around is roughly equivalent to picking up a spade and digging your own grave.
With established markets you are looking for places where the market and the solutions on offer are kind of “stuck” in one way or another. These are the opportunities you can pounce on. For example, the market might be:
Really fragmented with a ton of small players, and waiting for a break-out leader.
Old and calcified and totally ripe for disruption by a new entrant with a new edge.
Really fast growing where customers are starting to flock and can be picked off before they settle on a competitor.
One favorite situation of mine is an industry where a technical innovation or solution is sorely needed. Typically, no one particular industry participant is going to build the solution. If they did, they would not recoup the expenses because they would build it to suit their needs only and they wouldn’t want to give it to their competitors, even if they could. Third parties can come into a market like this with a new and better way of doing it, and solve critical problems for everybody in the industry as a neutral third party. Salesforce.com is but one example of that.
One final observation is that whatever the market, the investor syndicate must include active investors with deep experience in some aspect of the market. Maybe they have worked with these same customers in another context, or they have deep expertise with the technology, or they have built a very similar business in an adjacent space. Ideally you would have all three in the group.
Q: Is the evaluation of market characteristics different for impact investors?
There are similarities, but the overall goal is different. With impact investors the focus is not on conditions which will maximize growth, so much as on conditions which allow the company to maximize impact. As a result, it is less of a question of acquiring customers than accessing the underserved you are trying to reach. So size remains a factor, but it is much more about the interplay of the solution, the impact, and the access. You must find a market in which you can have the desired impact in the most efficient way and in alignment with your goals.
Q: Is there a minimum size to a potential market below which you won’t invest? If so, why won’t you invest?
Well, it is hard for early stage equity investors to make the numbers work with a market less than $100M in total size. It is basic arithmetic. Here is why: early stage investors need to be able to credibly model a 10X return at the outset of every investment, since so many companies fail. If, …
They are only going to own part of the company, and
The company is going to have way less than 100% market share, and
The company is likely to be acquired for a revenue or EBITDA multiple of less than 10X...
Then the arithmetic won’t work for much less than a $100M market.
Let’s look at a couple examples. Let’s say a company ends up with 5% of a billion dollar market, and the early investors put in a total of $4M in early rounds and end up holding about 12% of the company after dilution from later rounds. And let’s give the company a good but reasonable revenue multiple from a buyer of, say, 7X. In that scenario, the company is worth 7 times $50M revenue (5% of a $1B market) or a total exit valuation of $350M. In that scenario, the early stage investors end up with $42M for their 12% of the $350M, which is a solid 10X return.
If you run that same model with a much smaller market and no adjustments, it is a terrible result: for example let’s say a company ends up with 5% of a $100M dollar market, and the early investors put in a total of $4M in early rounds and ended up holding about 12% of the company after dilution from later rounds. And let’s give the company the same revenue multiple from a buyer of 7X. In that scenario, the company is worth 7 times $5M in revenue or a total valuation of $35M on the company. In that scenario, the early stage investors end up with $4.2M for their 12%, which is a break-even 1X return.
What is really interesting is that if you re-run the scenario with some reasonable adjustments to reflect a lighter capitalization due to a smaller market, and a higher attainable market share percentage, you still don’t get a great result. Even if you stipulate that the investors end up owning two times as much of the market share and you stipulate that they raise significantly less money, you are still looking at half of the desired model return.
For the sake of completeness, here’s how those smaller company, smaller market numbers look. The company ends up with 10% of a $100M market (twice the market share in percentage terms of the previous example), and the early investors ended up putting in $3M ($1M less in early equity), and they end up owning 20% of the company (twice as much of the company because they were diluted less since the company raised less money). The company gets acquired for the same 7X revenue (which is probably overly generous for a market this size, if you could even find a strategic buyer for a $10M run-rate company). So they are bought for 7 times $10M or $70M, and the investors get $14M of that for their 20%. Given that they put $3M in, that is a 4.6X return.
One can play with the numbers and assumptions a bit…
Given the high risk of outright failure in this type of early stage investing
The near total lack of liquidity prior to exit
The amount of time it would take a startup to get 10% of a $100M market
The time it would take to find a buyer willing to pay 7X for the company
A 1.0X - 4.6X range of best-case return is much less attractive than going after a bigger market. So the $100M market probably represents the absolute floor in market size, absent of special circumstances.
Q: Do minimum market size considerations apply in the same way to impact investors?
An impact investor cannot achieve their desired impact if the market space they are playing in is too small. Many impact investors can work in smaller markets than traditional investors because they may be willing to accept concessionary returns or longer timelines. But, they can’t have the desired impact if the market is too small. They need to find a market that allows them to put capital to work to have maximum impact on the greatest number of customers or beneficiaries. Smaller market means smaller impact.
Q: One of my pet peeves with investor presentations occurs when an entrepreneur states they are going after the $400B XYZ market, when in reality they are going after a small segment of this huge market. How do you go about determining the real size of the addressable market for a startup?
It all comes back to customer buying priorities. You can talk all you want about how big your potential addressable market is, but at the end of the day, your true market consists exclusively of those people for whom your solution is a top buying priority, plus any additional customers you can profitably convince to make it a top buying priority. As I said in my Q&A on the importance of due diligence, it is very easy and very tempting to confuse early adopter excitement with true market pull. It has been said that “anybody can get the first 10% of a market,” and Geoffrey Moore’s Crossing the Chasm stands for that proposition.
The key to growing a company is finding a big enough market of willing buyers who can be accessed in an affordable way (relative to their lifetime value). The product may be good, and there may be lots of people who might buy it, but unfortunately a company’s true market is limited to those customers for whom that purchase addresses a top pain point and a top buying priority (See our piece on Oxygen, Aspirin & Jewelry). Often a marginal improvement on a marginal cost is not enough to drive buying behavior in all but the earliest of adopters. So the key is to recognize when you are looking at what is sometimes called false traction and do some further digging. There is no substitute for talking to real customers and prospects before making an investment in these situations.
Q: When evaluating an impact investment, how do impact investors determine the scale of the impact?
The due diligence process that determines market opportunity with an impact investment begins with a series of conversations held with key stakeholders. These stakeholders include:
Customers (e.g. individuals, businesses),
The local community (e.g. residents, farmers, family members),
Government (e.g. regulators, federal/local agencies, labor unions, NGOs), and
Externalities such as the environment (e.g. regulators, NGOs)
During your conversations with the stakeholders, it’s important for you to focus on three key questions. First, how important is the company’s proposed impact to the stakeholders? Second, is there demonstrated evidence of the effectiveness of the impact? And finally, is impact a primary business mission or merely a side effect? Once you have verified the impact, quantifying it is just a matter of looking at the number of stakeholders affected.
Q: A colleague of mine at one of my prior startup companies had a favorite expression. “More companies die of overeating than starvation.” What do you think he meant by this?
This can mean one of two things, and sometimes both! The first form of startup gluttony is losing focus, and the second is pouring resources into unproven hunches before there is enough basis for doing so. For start-ups, focus and prioritization are everything, and it is critical to spend resources wisely and in a targeted way. Companies overeat by taking too much on, losing focus on what is important, and hiring and taking on the costs of trying to scale before there is a solid basis for doing so. From a diligence perspective the key is to review and agree on the strategic plan, the use of proceeds, and the milestones to be achieved before raising the next round and ramping up the spend.
Q: One of the popular buzz phrases for VCs these days, is “Product / Market Fit”. What do they mean by this and what should you look for during due diligence?
Product / Market Fit is a very simple concept which refers to the moment when you have a product that meets the needs of a large market segment. It is often used in conjunction with the term “minimum viable product” because, during your search for fit, you are generally trying to build as little unwanted product as possible. So you create what you think will be the minimum viable product for a target market and test and iterate until you suddenly see pull. Your pipeline of leads begins to grow, your cost of sales begins to drop, your sales cycle begins to shorten and your average revenue per customer starts to grow. That is when you know you have product / market fit and you can begin pouring on the gas in search of accelerated growth.
From a diligence perspective, determining product / market fit is tricky because there are very few data points. So it’s as if you are trying to read tea leaves. It can take months of experimentation to find product / market fit, and so it is often necessary to raise money before the company has found it. There is a tendency to want to believe, at face value, the positive story the founders have spun based on a couple good months in a row. But you need to dig deeper to really understand what you are looking at. You may still invest prior to product / market fit, but you need to recognize what you are doing, size the round modestly, and establish a cost-effective path to find it.
Want to learn more about performing due diligence quickly and effectively? Download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.