You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
In Evaluating Opportunities we discussed why you want to make sure the startup in question is targeting a large market. In performing due diligence, you may want to do a quick check on that market size calculation.
Let’s start by defining what we mean by market size. A common mistake entrepreneurs make is to use the value of the target industry they are selling into, rather than the value of the product or service they are selling. Using a fictitious example:
exampleA startup wants to sell an IoT tire pressure sensor that costs $10 and is compatible with 19” wheels. The total addressable market is not the value of cars sold, or even the value of wheels sold: it is the value of sensors sold.
Jared Sleeper at Matrix Partners has written a useful article about different ways to calculate the TAM (total addressable market), including “top-down” and “bottom-up”:
Top-down market sizing. The entrepreneur, and later the investor in due diligence, will Google around trying to find some research company or government estimate on market size for the product in question. This may or may not exist, and if the product in question does not exist, they, and later, you, will have to look for proxy markets. If there is no report on the tire pressure sensor market size, then you would need to find an analogous market size.
Bottom-up market sizing. This is more about estimating the number of likely customers, which forces the entrepreneur to go through a more useful exercise around product/market fit.
exampleContinuing with our example above, we would want to look at how many new cars are sold with 19-inch wheels, or perhaps how many existing cars on the road have 19-inch wheels. Right away you can see that this brings up clarifying questions about the market. Is this product meant to be a retrofit product for existing car owners? Is it a way for new car buyers to save on expensive options like factory tire pressure sensors? Is it going to be sold through tire dealerships, or car dealerships? Is the value proposition that it is cheaper than alternatives? In that case, you need to cut down your estimate of the market to those buyers who are price sensitive—Ford buyers versus BMW buyers, for example.
If there is a clear existing alternative for the startup’s product, like the tire pressure sensor, then you can check some of the numbers on car sales or tire sales with your own searches. It can be a little trickier if the product doesn’t yet exist. If electronic tire pressure sensors didn’t exist, you could think about who the target customer is. Early customers might be performance car owners and wealthy families who care about safety, such as luxury SUV buyers.
Every market sizing exercise will be different. Have the entrepreneur walk you through how they did it. Ideally their approach reflects some solid thinking about what existing products they are substituting (for Uber it was taxis), and the breadth of product/market fit for a new product category.
Ideally the target market should be growing; it is always easier to build a company in a growing market. Just being in a rapidly growing market will generate some sales even if the initial product is not dramatically superior to the competition. The company will also have more pricing power in a fast-growing market. In a slowly growing market, the startup will have to steal its customers from the competition.
Diligence on Customer Traction
Because traction is such a critical indicator of potential success, it is important to do diligence on the stated customer count and customer engagement and motivation.
examplePete once got excited about a company that claimed to have 85K customers. This was a consumer and small business product. After a few probing questions, it became clear that these “customers” were acquired when the company’s product was an add-on to a large ecosystem. These customers were on a free tier of the product, and the company determined that it could not monetize them, so it pivoted to a different value proposition. Entrepreneurs know how important customer traction is to investors, so the pressure to present numbers in a positive light can be extreme.
caution Early-stage companies may end up signing very unfavorable contracts to secure key deals or early customers that they need to move the business forward. If the company or its valuation is heavily dependent on a particular distribution contract or customer letter of intent (LOI), ask to see it.
You’re reading a preview of an online book. Buy it now for lifetime access to expert knowledge, including future updates.