How VCs Assess a Market Size / Opportunity
I and a number of my colleagues have spent time writing posts on what we look for in an investment opportunity. It’s probably the most frequent question we get from entrepreneurs and expansion-stage company management teams. Since I’ve already opined on how VCs assess investment opportunities in broad strokes, I thought I’d take the time to explain how we evaluate one of the more nuanced, but critically important aspects of an investment opportunity: market size.
Typically, I’ll start with a rough top-down analysis to get a quick sense of the scale of the opportunity. This can generally be gleaned from research reports from firms such as Gartner, Frost & Sullivan, Forrester, Ibis World, etc. While the accuracy of theses “market sizes” can vary wildly, they help give context/act as a sanity check for the most important part of our work, which is the “bottom-up” analysis.
Getting to an approximate “bottom-up” analysis can be done relatively simply if you have the appropriate facts or are willing to make the appropriate assumptions.
As an example, let’s say I was trying to figure out the overall market size for an imaginary company, LearnStuff.com, which sells software to higher education institutions for use by their students. An incredibly simple (but probably not sufficiently accurate) way to do this would be to find a figure for the total number of higher education institutions in the US and multiply that number by an assumed average sale price per institution. That figure is approximately 6,700, of which approximately 4,500 are degree granting. We might assume that only degree granting institutions have a need for LearnStuff.com’s solution so we’ll stick with a market of 4,500 institutions. If I then assume that, on average, LearnStuff.Com is charging $100k per institution per year, we would arrive at a market size of $450 million. Though this is helpful in understanding the market size in a “quick and dirty” fashion, it’s probably not completely accurate.
A more sophisticated approach to understanding the total market would be to evaluate the market based on LearnStuff.com’s different revenue streams (software and services/support) quantified by the number of FTE (full-time enrollments) at the underlying institutions (since most consumers of enterprise software make purchase decisions based on number of “seats” as opposed to writing checks for nebulously described services for a non-specific number of people).
If we first assume that LearnStuff.com charges $30 per FTE plus a 15% support charge, we get a blended total cost per FTE of $34.50. If we then multiply that number by the 18 million students we assume attend the 4,500 institutions in LearnStuff.com’s core market, we arrive at a total market size of roughly $621 million.
I then might try to figure out the actual addressable market and would make assumptions about the revenue dollars that LearnStuff.com could compete for (taking into account whether this was a highly competitive market), and what % they would win in competitive situations. For example, I might have reason to believe that only 40% of the market, or $249 million of revenue, was actually up for grabs to a new market entrant. Based on the information that the LearnStuff.com management team has provided to me during diligence, I know that they win 1 out of 3 contracts they bid on, so I feel comfortable making the assumption that they can take 33.3%, or $83 million of the available revenue in the market.
You can see how what appeared to be a $621 million market was quickly reduced to an $83 million opportunity in the eyes of an investor. I’m more inclined to get excited about a company whose initial investor presentation has put serious thought into their target market segment and actual addressable market, even if it’s sub $100 million. Nothing will draw more scrutiny from an investor than the magic $1 billion addressable market size!