Source: Tien Anh Nguyen, OpenView Partners
As venture capital investors, we have to carry out this analysis on every single prospect that we look at, and we deploy a full range of analysis. Sometimes it’s simply a back-of-the-envelop calculation in simple cases, but sometimes it involves going into excruciating details.
In our diligence, we study our prospect companies’ market extremely carefully, and try to validate any quantitative model with feedback and inputs from market participants and experts. But we never make a decision on a single number that we consider represents the market size.
The reasons for this are simple:
1) Technology Is Always in Flux
The nature of technology is that it is always evolving, and so the market for a technology is always new and evolving. There will always be new markets that arise because of new technologies or new ways of utilizing existing technologies. The numerical market size does not tell you whether the market represents a groundbreaking development or whether it is simply a segmentation of an existing mature market.
2) There Is a Difference Between Potential Total Market and Targetable Market
We conduct market sizing to understand how big a company can grow if it focuses solely on that market, which is a proxy for potential returns on the investment. But this is often not the case, especially in venture capital, where the investment horizon is long and companies are expected to grow, evolve, and adjust to changing markets and opportunities.
Therefore, it is not clear whether a single number represents that size of the targetable market as opposed to the potential total market (targetable market segments are segments that your product and services can address right now, without major product enhancement or addition.)
3) Some Markets Are More Sensitive to Outside Factors than Others
As we have learned through the most recent economic crisis, addressable market size does not help measure or take into account how sensitive the market value is to macroeconomic trends or business cycles. Therefore it leaves out major question marks as to the potential shrinkage or loss of market demand in a global recession.
For example, a smaller but “recession-proof” target market might have better “expected” value than a market that can be extremely large or extremely small depending on business cycles.
4) The Question of Value
Lastly, market size has to be consistent with the economic value created and captured by the company’s product and technology — that is, ultimately, the company should be worth the value that its technology/product is generating for its customers. But what “value” exactly means is typically not fully settled for many early-stage companies. The pricing model of the product might undergo major changes, dramatically increasing or eliminating market size. Likewise, the value of a network of users might grow in geometric terms or might result in declining marginal gains.
The bottom line is that boiling down a market opportunity to one single number really isn’t realistic or productive.
But the good news is, most VCs understand that, too. So when you see a big market size number in a pitch deck or presentation, or if someone asks you to generate a big market size estimate, take it with a grain of salt and look for the hidden factors such as growth, maturity, economic value, and addressability.
About Scale Finance
Scale Finance LLC (www.scalefinance.com) provides contract CFO services, Controller solutions, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, business valuations, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance LLC has offices throughout the southeast including Charlotte, Raleigh/Durham, Greensboro, Wilmington, Washington D.C. and South Florida with a team of more than 30 professionals serving more than 100 companies throughout the region.