Is my market size big enough to raise venture capital funding?
I recently wrote a Linkedin post in which I shared a small study about market size by analyzing all the recent Y-Combinator demo day presentations. Given the high interest it got, I decided to do a short article to explain how venture capitalist analyze and assess market size. At this point, I want to clarify that not all businesses should go for vc money, and market size among other factors can help entrepreneurs decide this.
Y-combinator is the most famous accelerator worldwide, it started investing in 2005 and so far has backed over two thousand companies, their top investments include Airbnb, Doordash, Stripe, Instacart, Dropbox, and Rappi to name a few. The combined valuation of their portfolio companies is over US $300 billion and after demo day their companies have raised capital from main venture capital funds like Sequoia Capital and Andreessen Horowitz. All this track record beyond the numbers means they have probably seen it all and they know what is needed to create a successful company and what matters to investors.
After analyzing all the 319 presentation slides, I was able to find the following:
What the graphs above reflect is the importance of big market size, and this should not come as a surprise, as Andreessen Horowitz Partner Scott Kupor mentions in his book Secrets of San Hill Road, team, product, and market size are probably some of the most important elements venture funds look when evaluating a startup.
I get frequently asked: Is this a good market size? Is USD $1 billion the minimum required market size for a venture capital fund to invest? Is there a magic number VCs have? And I always answer no and it depends. VC funds do not look and analyze market size just for the sake of doing it or because it is the standard, they do this because depending on the market size among other factors, is their probability to get a good return.
The first advice I give to entrepreneurs to know if their business model has a market size that is suitable to raise venture capital funding is to put on the hat of the VC.
To put the VCs hat the first step is to briefly understand how they work (if you want to dig deeper, I highly recommend this article). To put it simply they raise capital from private investors, usually pension funds, endowments, insurance companies, and family offices, and promise to deliver above-market returns (to compensate for the high risk and illiquidity). If they can produce good returns, they are likely to raise a new fund every 3 to 5 years.
They produce returns by investing the capital they raised into several startups. In comparison to usual investing, they are not looking for all the investments to deliver average returns (2x-3x invested capital) but rather look that 10% to 20% of their investment become what is known as home runs or fund returners (>10x return on invested capital). One of the main reasons for this is that when you invest at an early-stage company the probability of failure is high and a high percentage of the portfolio companies either do not produce a return (1x investment) or go bankrupt. Because of this, they need that the times they are right compensates for the losses and allow outsized returns. If the market is small no matter how well a team executes the upside value will be caped and the VC manager will not be able to produce good returns and raise a new fund.
Now that we understand how a venture capital fund makes returns, we need to understand how they evaluate if a company has the potential to achieve the desired >10x return. The first step is to understand how startups get value, there are multiple valuation methods that include: discounted cash flows, precedent transactions, option pricing model, Dave Berkus, and many more, in this case, we are going to use multiples & vc method approach.
The first step is to calculate the annualized revenues (as in most cases due to their stage they have negative EBITDAs and net income), in startups because of the high growth it is common to annualize the last quarter revenues rather than taking the last twelve months (LTM). At the same time, you find comparable companies listed on worldwide stock exchanges (usually a good comparable is one that operates in the same industry, similar market, offer similar product, similar business model, has similar margins, and growth rates) and you take the average or mean of the companies you are able to find (you can also make additional adjustment for factors like liquidity or country risk), and then you multiply this value by the annualized revenue to arrive at what is known as enterprise value (to arrive at the equity value which is what VCs value you have to adjust for any debt and excess cash but in most cases startups don´t have this, and in the examples that will follow we will assume that no adjustment need to be made).
Example part 1:
XYZ fund is analyzing to invest in a Seed Round in an imaginary pet e-commerce company DogCatChow, that has Latin America as its target market. As a first step, they assume a valuation for the current round, the amount they want to invest, and the percent ownership that investment will give them.
- Median comparable adjusted revenue multiple: 2.5x
- Annualized revenues: USD $2,500,000
- Pre-Money valuation: USD $6,250,000
- XYZ Fund investment: USD $800,000
- Post-Money valuation: USD $7,050,000
- XYZ Fund percent ownership: 11.3%
After, the fund evaluates the financial model the company has (yes you MUST have a financial model) and makes the adjustments it sees are necessary. They estimate that in X number of years (usually 5) they expect to exit their investment and annualize the expected revenues of the company on the exit period.
For the case of DogCatChow let us assume they estimate to have annualized revenues of USD $350 million at the time of exit. But how can you know if those revenues are possible and make sense, and here is where market size comes in. Let’s say that after making deep research you find that the market size for pet care e-commerce in Latin America is USD $1,9 billion. It is worth pointing out that calculating market size can be more an art than science, I highly recommend reading this blog post about the topic. For simplicity, we will assume that the market has no annual growth (usually markets do grow and it is a factor that can make a company more attractive long term). After calculating the potential market size, you must find an assumption of a reasonable market share you could obtain, in this case, we will assume 25%. This means that the company could realistically have revenues of US $475 million (expected market share * market size) which means that the companies estimates are possible.
At this point, you may have realized that one of the most sensible variables is the market share assumptions, so how can you get a reasonable value, is 25% the used standard number, and the answer is no and it depends. There are businesses where there is a winner takes all market and you could have a >80% market share, or have a highly competitive business where you can have a 10% -15% market share. One of the best ways to calculate this, especially for markets like LATAM is to see for examples in more developed markets like the U.S where similar companies are already established, and research for their approximate market share and take it as a benchmark (but it is usually recommended to make some adjustments, for example, network effects could highly increase the potential market share).
Example Part 2
Continuing with our example, we will assume that with exit revenues of USD $350 million the company is expected to have a 15% EBITDA margin (to calculate exit value we are going to use the EBITDA multiple, but it is possible that at the time of exit the company is still not profitable and in that case, you would use again the revenue multiple).
- Expected EBITDA at exit: USD $52,500,000
- Adjusted EBITDA exit multiple: 10.8x
- Exit Value: USD $567,000,000
- XYZ Fund Value of investment: Fund ownership * exit value -> 11.3% * USD $567,000,000= USD $64,340,426
- XYZ Fund Return on invested capital: 80.4x
As we can see the fund can possibly make the desired >10x return, but assuming an 80.4x return will most likely be wrong, as to achieve the desired revenues the company must probably need additional funding which therefore will dilute XYZ Fund ownership in the company over the period before the exit.
Example Part 3
DogCatChow is expected to have 4 additional funding rounds before exit, based on XYZ Fund strategy they decided they will not make any follow-on investments.
- % XYZ expected ownership at the time of exit after dilution: 6.3%
- XYZ fund value of investment: 6.3% * USD $567,000,000 = USD $35,721,000
- XYZ Fund potential return on invested Capital: 44.7x
As we can see in the case of DogCatChow the market they were targeting was enough for venture funding. To see how this investment could affect the overall fund return, we will assume that XYZ Fund made in total 14 investments each of the same size (USD $800 thousand) which means the funds amount of money for investments is USD $11,2 million, we will assume that there is an additional USD $3,7 million for management and fees, making the total fund size of USD $14,9 million. Assuming that all other 13 investments returned 0 (usually not the case, but reflects the main point better), just the DogCatChow investment would return 2.4x the committed capital, proving the importance of big market size to produce outsize returns and compensate for the high failure rates.
Conclusions
Three of the main lessons that should come from this article are:
- To assess whether or not you have a big enough market size, you have to put on the investor's hat, and understand that venture capitalists are wrong more time than they are right. For these reasons they need that the times they are right, the market size is big enough so that their return is high enough to compensate for the bad investments and allow them to make outsize returns for their investors.
- There is no magic number when assessing the market size, a relatively small market might be good enough if it is a winner takes all market, or a competitive market with a small market share might be adequate if the market is large enough.
- Calculating market size is more an art than a science, in many cases, there are no benchmarks and you are creating a totally new market as it happened with Uber, having the vision to see the future and the potential market size is in my opinion one of the main variables that separate truly great managers and entrepreneurs.
Before finishing, I was showing the article to one Managing Partner, and he mentioned another approach some VCs take, which I think is worth mentioning. In some cases, some specialized VCs are not looking at a company whose solution has an obvious direct big market size in terms of revenue and users, but rather they value the technology for its add-on capabilities. In these cases, they are not looking to address the final users, but they rather have a thesis of being acquired by another company, which is going to need that technology to serve (or better or more efficiently) it’s customers. I think this approach is mostly used in the U.S as in Latam very few technologies of this type are being developed.
On a note of caution, a lot of simplifications were made in the examples shown to not overcomplicate things and keep focus on the main topic of market size. Things like growth of the market size over time, market share, valuation method, dilution, follow-on investments, and multiples selection among other factors, should be calculated carefully.
