The number 2 more frequent reason why VC’s pass on an investment opportunity is some version of “it’s not big enough“. For a VC to generate a great fund-level return, they need to invest in companies that have billions of dollars of enterprise value. In order to do that, most VC’s decide that each one of their investments need to at least have the potential to have an exit of that size, even if it’s very unlikely to be the case for any single investment.
Here’s the thing, most really exciting companies seemed “not big enough” to a lot of investors, especially really early on. Chances are, your company will run into this objection when you speak to investors. The reason is that a lot of startups are going after markets that don’t currently exist. The other interesting thing is that when a fund does invest in something that seems small to many, those funds are often the ones that are most aggressive and upside focused. Somehow, they just saw the potential before others did.
What are some strategies to address this? Below are some different approaches. Keep in mind though, some of these are left-brain sort of approaches. But others are more right-brain. Both are important and could be effective for different sorts of investors (and different sorts of founders). If you gravitate towards one, keep in mind that investors that make team decisions will come at this question from multiple angles.
1. Top down, but brick by brick.
Most market sizes are top-down. “The market for marketing software is $XB dollars so it’s big enough to support some really big companies.” It’s the simplest way to think about market size, so most investors will gravitate that way, especially if you are building a company that is going after an EXISTING market. One way to augment this is to essentially take the same approach, but show brick-by-brick how your market opportunity may be bigger than it seems. This means showing:
– geographic expansion
– pricing/upsell potential
– market growth
– very logical expansion into verticals or complimentary products
You will still need to be going after a pretty large core business for this to resonate in any way. But doing a build up like this can be effective when a prospective investor does believe that the market is somewhat big, but would love to see more upside to get fully comfortable.
2. Bottoms Up
The last approach pretty much completely fails in new markets that don’t quite exist and when an investor is not at least on the fence about market size. Another approach is to do a bottoms up analysis. Start with the total number of potential end-users, and use reasonable estimates around customer demand, pricing, market share, etc. The key things that you’ll be pushed on with this sort of an analysis is a) how you are defining the reasonable scope and segmentation of the potential customers, b) how realistic your market share assumptions are, and c) the fact that this is really all conjecture.
One way to address c) is to include solid data-points that lend credibility to your assumptions, like a reasonable estimate of how much customers already spend to solve a similar problem, or some ROI analysis on your product/service that can be used to estimate reasonable pricing and the “no-brainer-ness” of what you are proposing. Also keep in mind the “vitamin vs. pain-killer” analogy. Bottoms-up approaches tend to work better for “pain-killers” than “vitamins”, even if the ROI of the vitamin seems to hold together.
3. Attach yourself to mega-trends
Being in lock-step with a broad mega-trend is another way that investors get over a seemingly small market. This means that the investor (consciously or not) believes that the mega-trend will either a) drive massive market growth or b) drive the new company to have unusually high market share.
A simple example of this was the shift of enterprise software to the cloud. Once investors believed this was happening, it became more reasonable to think that a new software product in a specific vertical might enjoy extremely rapid adoption and enough market share to build to $100M+ in revenue and $1B+ in enterprise value reasonably quickly. Without this mega-trend, it’s harder to believe this because the pace of adoption may be too slow and it would be too difficult to dislodge existing players with a similar approach without being 10X better, faster, or cheaper.
Another example is iot. Historically, investors have hated the idea of investing in consumer electronic products. But because there is a strong mega-trend here, there is more suspension of disbelief around the “Nest for…” many other product categories.
4. Analogies and Comps
Using analogies can be tricky because they may not land. But if they do, I find that a lot of investors often get fixated on an analogy and that can sufficiently build conviction. When doing this though, it’s important to not just list out similar companies or big exits in the space, but internalize what those analogies communicate.
For example, if there have been some large exits in a seemingly small market, this can be a blessing or a curse. Yes, those analogies exist, but does the investor know that company that was acquired? Was it actually a really teeny business bought for pure strategic reasons? Is there actually only one or two buyers who would pay that kind of premium? How many investors would take that bet? Productivity software is in this category. One could point to companies like Evernote, Sunrise, Accompli, etc as examples of companies here that have had really nice exits or private market valuations. But looking at this another way, one could say “wow, outside of MSFT, who will pay a premium? The best companies only exited for at most a couple hundred million? Wow, doesn’t Evernote show that it’s really tough to be independent since there are so few others and some folks think their business is way behind their last private valuation?”
I find actually that the best analogies are ones that tend to connect to one of two things. Either, it ties to a mega-trend. “Just like the shift to the cloud allowed for the rise of great companies in different categories, the shift to mobile computing in the enterprise will do the same. So this application that does X is the beginning of a mobile-first HR product that will be like Workday but for mobile.”
The second analogy is to connect yourself to a company with a similar ethos or founders with the same super-power. This is a lot harder to do, and probably isn’t something that happens very directly. You would probably not say “we are just like the AirBnB founders are are awesome at design, so you should believe we can make this work”. But over the course of getting to know a founder and seeing their work, an investor may say “wow, these founders are unbelievably obsessed with design and user experience in a way I haven’t seen since (person X), maybe they really can pull it off!”
5. Scope expansion
This is some version of “today we are doing X, but that just puts us in a great position to do Y which is obviously huge.” There are a couple flavors of this.
The first is the bank-shot. This is where X is actually not the foundation of a great sustainable business, but could be a gateway to more. A lot of VC’s have a hard time with bank-shots, unless there is already some really demonstrable traction. Usually, the right approach here is to focus on growth and scale as quickly and efficiently as possible when accomplishing X, and make most of your money doing Y down the road when you have a network effect, customer lock-in, or can provide a valuable service that no one else could provide without your scale.
– The second version of this is when X is actually pretty decent. Maybe it won’t be the next Facebook, but it could certainly get you to a pretty attractive place. Usually, this works well when the underlying business could be profitable and decently large without being too capital intensive, which gives you more freedom to pursue the bigger opportunity as a next step. This allows an investor to say to themselves “I could reasonably get a 5-10X on the core business, and there is some small probability that this could actually be a 20X or more. Usually, this means that the company is in a market that has decent prospects for future funding or M&A, such that if the business hits a double but not a home run, it still could be a good outcome.
Two Quick Things Not to Forget About
First, don’t forget about what margins mean for market potential. High-margin businesses like software or marketplaces (when revenue is correctly accounted for) have 10X+ revenue multiples. So the bar for a large scale opportunity is the potential to generate hundreds of millions of dollars in revenue to be worth billions of dollars down the road. For low-margin businesses, the revenue bar for a larger scale opportunity is higher. So when you are talking about how your business can build using a bottoms up analysis or comps, make sure you keep this in mind.
Second, the number and interests of the acquirers plays into this somewhat. Generally, I don’t recommend founders spend too much time talking about buyers and M&A opportunity, and we don’t obsess over it much here at NextView. But when you are a company that may very well find that the market opportunity is not as big as one thought or hoped, it’s comforting to be in a category with a strong set of folks who would buy you for a reasonable amount. Most investors don’t really focus on downside protection, but psychologically, this could make a difference when one is on the fence because of market size or the risk associated with a bank shot / scope-expansion strategy.
It’s been an interesting few weeks in the startup world. The chatter around Zirtual quickly moved on to the market correction and general nervousness all around.
During this time, I happened to catch the second half of Back To The Future II on TV (yes, I still watch normal TV now and then). This made me think of an analogy that Angus Davis shared at an Angel Investing event a few years back. Angus is the founder of our portfolio company Swipely, and was the co-founder of TellMe Networks.
Angus’ analogy is that running an early stage startup can be compared to driving Doc Brown’s Delorean in Back to the Future. The Delorean can only travel through time if it reaches 88mph, but inevitably, there is a cliff or a brick wall or some other obstruction ahead. Can the car get to 88mph with the limited runway? Unclear, but the only chance is to drive full-speed ahead and try to make it work.
This isn’t always the right approach for a startup, but often, it’s exactly what a company should do. If a company has product/market fit and is confident about its unit economics, it’s quite rational to spend against aggressive growth and raise capital to support that growth. This is even more rational for a company that has network effects or increasing returns to scale.
For an early stage company, this strategy can be pretty scary because raising capital may not be easy. Lots of people will say no, and early stage fundraising is a search for true believers, not convincing skeptics. When a fundraise looks potentially challenging, it could make sense to course correct or start working towards plan B. But usually, going back to the future doesn’t have a great plan B, so it’s reasonable to make the bet that the best thing to do is to just keep running as fast and hard as you can towards the brick wall.
There are two ways that this doesn’t work out. The most obvious is that you don’t actually have a functioning time machine. To me, this is the equivalent of not really having product/market fit in a space where a meaningful company can be built. It’s not easy to achieve this, and the explosion of companies and unicorn valuations in recent years masks the fact that this is very very hard to do. Raising too much money too quickly might mask this too, but doing so just means that you get to drive a very nice car very fast right into a brick wall.
The second way this doesn’t work out is that you don’t drive fast enough to go back to the future. If you have PMF, you need to show growth and acceleration, otherwise, you may hit a brick wall. Following this analogy, I think that a bad macroeconomic environment or challenging capital markets is the equivalent to trying to achieve this speed while driving uphill or against the wind. It doesn’t make the challenge impossible, but it does make it more difficult and may require more time to get to the same speed.
I tend to think that being too conservative can really hurt too. We often talk about how some companies are “slow motion train wrecks”. The wall isn’t right around the corner, but you kind of see the writing on the wall way before the inevitable collision happens. Startups kind of needs to run hard and fast towards their goals, and I don’t think the lesson from Zirtual is that founders should take their feet of the accelerator. It’s more a reminder that the risk of failure is very real, so you better know that you really have a time machine.
Being cash-flow breakeven is like having a vehicle with brakes and a steering wheel. It gives you the option of veering off course, maybe giving yourself more space to build speed or finding a nice hill to drive down to get the velocity you need. It’s an awesome thing to have and is more valuable the tougher the market environment gets. But cruising around at 40MPH doesn’t get you where you ultimately might want to go as a startup. You’ll still need to hit 88MPH at some point to go back in time.
Gotta run, so I just have one last thing to say:
The problem that Scratch is solving is something that is quite near and dear to my heart. Since I’ve worked in the consumer internet space, I’ve been interested in the problem of product discovery. How do you select from the vast choice presented by the internet? How do you find the right thing in subjective, taste-driven categories? How do you shop for people when you don’t know exactly what they would want? And how do you do this all in a way that is fun, and doesn’t take forever?
This was something I thought about a lot at Ebay (12+ years ago). The beauty of Ebay was the vast selection of all sorts of products. But this selection was also the reason discovery was so difficult. Fast forward to day, and everyone buys online in a myriad of ways, and the paradox of choice has exploded exponentially.
Scratch is looking to solve this problem. It allows consumers to more efficiently find the right items in a broad range of categories through the help of curators and data driven personalization. The result is that you buy better products much more quickly through a natural, conversational process.
Already, I’ve used the service to buy plants for our office, birthday gifts, furniture and accessories for my home office, apparel, and backpacks for the NextView team. And this is just in the last few weeks!
The company is led by Matt Zisow, who we first got to know through his time at our portfolio company Custommade. He is building an amazing early team with world class operators from Tripadvisor, Wayfair, and others. We are excited to be making this investment alongside Bessemer, Red Swan, and Matt Salzberg. The compay is currently in a private beta, but is letting in new members in waves. Click here to join the waitlist, and I’ll do what I can to get you in as soon as possible ☺
I’m starting to get really interested in voice as a major computing interface. Prior to my Apple Watch, I rarely ever used Siri. But I find I’ve been using voice more and more, and my experiences with the Echo and the rise of more apps that utilize a conversational interface make me pretty excited about this new communication medium. A couple thoughts/questions.
Interface: Voice is a funny interface. It’s super flexible in some ways, but really limited in others. It’s potentially insanely convenient, but also really clunky. I think that there are two shifts that usher in the more mainstream adoption of voice as an interface (in addition to improvements in the actual language processing and AI). The first is convenience and speed. I think that consumer adoption of new interfaces like these exhibit sort of a convenience tipping point. 20% more convenient drives next to zero usage, but perhaps 50% more convenient drives massive adoption. I’m experiencing this with my watch. The delta between pulling out my phone to make a request, and making a request on my watch (and then have the request fulfilled more naturally on my watch) is getting me over the hump. Navigation is a great example of this, and is even getting to me to occasionally switch off of Google Maps to enjoy this benefit. I haven’t actually made a complete switch yet, but I can see it happening if the mapping software were better.
The second trend is that we are going to see new use cases for voice-input that will be more narrow and forgiving but way more convenient. Messaging apps and pseudo-human-powered services are making me think about this. Part of the frustration of voice is the unpredictability of it. Does it actually understand what I’m saying? How many mistakes until I totally give up on the medium? You could see voice being integrated in more constrained environments, like in a narrow app with a messaging interface where the meaning behind a response could be easier to parse. Or, if there is actually a human on the other end, that parsing may not actually need to occur. Using voice as an input to specific instructions to an Uber driver or a Taskrabbit seems like a potential no-brainer. Finally, the nice thing about Apple, Amazon, and others moving into this area is that they are training us to use semi-natural language to communicate with machines, shedding the massive negative bias that anyone who has ever dealt with voice prompts why trying to call an airline CS number can attest to.
Social: One question I have is how voice plays into messaging and social services. I’m curious how often the voice input is used in major messaging services with different demographics. I actually suspect that it’s surprisingly low, even though it’s pretty widely featured (one of only three main options on Line, Whatsapp, etc). I’m curious whether this is because voice actually doesn’t work well, or if it’s just that those apps are built so much around text that it’s unnatural to use. Or maybe I’m wrong and the use of voice is increasing on these services (if anyone knows, please tell me). I’m curious to see what types of voice-native social networks might emerge in the coming years and whether one really will exist that is reasonably separate from video, text, or photos. One big impediment to voice is that it’s super awkward as the recipient in many cases. But maybe there will be a social dynamic that is unlocked by that constraint as well.
Age: I’m curious how impressions of voice as an interface is different between different age groups. I actually think that my age group is probably going to be most negative. We find other input mechanisms too natural, and have too much of a distaste from early speech-based interfaces that we find no need for it. My kids find our Amazon Echo absolutely magical. I haven’t seen them as excited about a piece of technology since they learned how to make Netflix work on my iphone I’d love feedback here, especially from readers of a younger demographic.
I have mostly questions and no answers at this point. But it’s an area I’m getting pretty excited about.
When an investor “does work” on a potential investment, it usually means engaging in some form of due diligence.
One of my favorite VC sayings is from an investor that has said that “due diligence is something VC’s do very studiously when they want to kill a deal”.
I’ve often quoted this, half joking, half in truth. Especially in the early stages of investing, it’s super easy to do due diligence to the point where a “no” is obvious. There is always some major flaw in every company, and doing some cursory due diligence usually uncovers this. Too much due diligence creates conservatism which is poison to venture capital.
But as I mentioned in my last post, I’m trying to think more deeply about this these days. We talked about this as a team recently, and the opposite idea emerged. The point of “doing work” as a VC isn’t due diligence. Even the phrase “due diligence” seems to connote a CYA mentality around the work. Uncover all the bad stuff so you don’t make a stupid mistake.
But I’m realizing that being diligent as a VC is quite different. It’s about truth seeking. Or, put differently, identifying changes in markets, technologies, user behavior, etc before it’s obvious to everyone else. But this takes work. Gut alone won’t get you there, because these developments are non-obvious.
The idea of “doing work” to make you more open-minded, not less. Something best done studiously to see opportunities that others miss. There is a place for some due diligence. But more so, I think truth seeking is what “doing work” as a VC is all about.