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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.