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So if we can all agree that the team is the critical factor in company success, what else do we need to look at? We believe that market opportunity and product have a similar weighting in our company evaluation scale. For this article, I will give the nod to market opportunity and focus my questions to Christopher on what investors need to know when they evaluate a market.
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 niche 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?
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 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 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 that. 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. None of those bargain basement customers came back as repeat customers (and they all probably had really dirty houses that hadn’t been cleaned in a while.)
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...
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The market might be really fragmented with a ton of small players and it is waiting for a break-out leader,
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It might be old and calcified and totally ripe for disruption by a new entrant with a new edge, or
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It might be a really fast growing market 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, such as a cloud-based market-place, is badly needed. Typically, no one particular participant in the market 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 and trusted third party. Salesforce.com is an 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: if early stage investors need to be able to credibly model a 10X return at the outset of every investment because so many fail, and…
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They are only going to own part of the company, and
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The company is going to have way less than 100% market share, and
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The company is likely only going 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 they 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), and the early investors ended up putting $3M in ($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 because 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…
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Given the high risk of outright failure in this type of early stage investing,
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The near total lack of liquidity prior to exit,
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The amount of time it would take a start up to get 10% of a $100M market,
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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 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 is 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: Competition plays a big role in the addressable size of the market opportunity. How do you factor the competition into your overall evaluation of the market opportunity?
Many investors look at competition as if it is the boogey-man. Sometimes you will hear about diligence efforts called off because of the discovery of unknown competitors. But there is more often another element to that kind of story, such as a lack of founder honesty or market knowledge, because experienced investors will acknowledge that competition is not bad per se. In fact, I am fond of saying “if you show me an entrepreneur with no competition, I will show you a company with no market.” Even if it is just substitutes or alternatives, or other things competing for wallet share or a customer’s time, everybody has some competition. And that’s OK, because:
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Competitors help you bear the cost and workload of educating the market
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Their presence can legitimize and reduce the perceived risk of a new product category
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They can attract enabling services and technologies such as value-added resellers and partners and consultants with expertise
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They can attract analysts and an ecosystem around your product (such as Gartner or Forrester or other analysts recommending your product) and so on.
When competition becomes a problem it is usually when either: (i) competitors have a better value prop or a more differentiated solution (i.e. they outcompete you) or (ii) the market becomes so mature and so crowded that your product is commoditized and the market leaders lose pricing power and see their margins severely compressed by lower pricing and a greater need to spend on marketing to fight to hold share. (Though even businesses like that can make money - just ask Coke and Pepsi - but the days of hyper-growth coveted by early investors are gone and not likely to come back.)
What you have to do is figure out how differentiated and defensible the company’s value proposition is to customers and whether it will stay compelling over the longer term. If there is pull from customers, and you can get comfortable that it is a top buying priority for an identifiable population, you are looking at a solid market opportunity.
Q: Do impact investors think about competition the same way?
Yes, but only up to a point. If a need is being completely met by existing competitors, then there is little point in adding more investment to that market. In this sense impact investors are similar to traditional investors. However, in markets that are not saturated, impact investors may be slightly more tolerant of competition if there is still room for meaningful marginal impact.
Q: So let’s say you are comfortable that the market opportunity is large enough and the team has the right product, what else should an investor determine before they write a check?
The final area to look at when considering a market is the exit options it affords. The questions I like to find answers for include:
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What is the landscape of potential acquirers?
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Are there big competitors looking to compete by purchasing innovative new entrants?
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Are big companies trying to buy their way into the market?
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Is the market consolidating around some key players?
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And finally, who are the likely buyers, what aspects of the business will they want, what will they be prepared to pay, and what milestones are going to need to be achieved in order to get bought?
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