Figuring out the size of a new venture’s market opportunity is what I call an evergreen blog subject. It keeps raising its ugly head, and for good reason, as it’s one of three main investment criteria – the others being the management team and the product and its secret sauce. See The worst slide in everyone’s deck.
However, as Tom Taulli in his Forbes article Pitching A VC: How To Size The Market Opportunity notes, “This focus on a large market opportunity has become even more important in recent years, as the the funds have gotten much larger.” As these funds grow, to as much as $1.5 billion or in the extreme case of The Vision Fund, to $100 billion, individual partners at their firm much each put more money to work, as there is an upward bound on the number of boards of directors they can sit on. Given VCs aim for a 10x return on their investment, with every larger investments they must get even larger returns, thus startups must target ever larger markets to generate those returns. My rule of thumb is that a vc won’t be interested in a market smaller than $1 billion. (They aim to build a company with $100 million in sales which could sell for 3x+ or go public at 10x+ valuation.)
So how is a founder to calculate the size and value of the market they are targeting? Kara Sweeney Egan of Emergence, a vc firm that has invested in Salesforce.com and Veeva Systems. Market research firms like IDC, Forrester and Gartner publish analysis on various tech markets from which you can come up with the TAM (Total Addressable Market). For example, a quick Google search shows that the CRM category comes to nearly $40 billion (the estimate is from Gartner). However, in my experience its not so simple. Very few of the startups I mentor or the companies I founded fit into neat, established categories like CRM. And today where AI-driven startups are attacking niches it is even less likely that you’ll find your answer to the top down question in the reports from a market research firm.
What then? You need to take a bottoms-up approach. How many potential users are there and given a product price what does you total market equate to? Mr. Taulli uses the example of CPAs in the market. According to the U.S. Labor department there are 660,000 CPAs in the US. So at a product price of $1,000 that equates to what he terms TOM (Total Obtainable Market) of $660 million. (The term I’m familiar with is TAM, Total Addressable Market, not TOM.) I encourage my mentees to use a bottoms up approach as by focusing on the number of customers they can also derive other important financial metrics such as the cost of customer acquisition (CCA), which is very important in deriving gross margin (GM). Of course, assuming you will get 100% of any market is foolish, first of all there are going to be competitors with existing market shares plus customers who are happy with a home-brew, legacy or even manual solution to their problem.
Another important point with which I totally agree is that a large market is necessary but not sufficient. What investors want to see is a megatrend that will enable the adoption of new products – the rising tide that lifts your venture’s boat.
So it’s not just familiarity with the numbers that are important, it’s a deep understanding of the dynamics of the market you are targeting. “A well thought-out view of the the market can help build excitement about your company, demonstrate your industry expertise, and highlight your key insights into your customers,” said Kara Sweeney Egan.