Overview
It’s important for start-ups to candidly assess the size of the market and use the information to inform the plan of attack, including financial planning and financing strategy

Market size
Recently, I’ve been lucky to work a few entrepreneurs developing interesting technology and services that happen to be targeted at small or niche markets. Our early working sessions are often spent distilling the company’s focus, defining the market, identifying the competitors, painting the general ecosystem of partners/platforms/competitors, and sizing the market.

Most of these market turn out to be “small”, principally because the bar for a market to be “large” is set exceptionally high. To steer clear of relative terms, I define a large market as a market where a company can credibly build $100 – $200 million in revenue in 5-10 years with a realistic (20%) market share, or a market that can sustain several multi-billion dollar companies. This is generally consistent with definitions I hear from top tier venture investors.

Market size demands a lot of attention because top investors gravitate towards large markets where large companies can be built even if the company only delivers a fraction of its potential, where a large rising tide raises many ships. It deserves a high level of awareness, because even an innovative technology, superior product, expert team, and well-financed company can’t succeed in the absence of a real, growing, lucrative market. It’s a wave a start-up can ride but can’t influence (see Greg McAdoo’s of Sequoia describe these waves at Startup School 2008, starts at 4:46), and the valley is littered with innovative technologies than languished in the absence of a market.

Social networks are a good example of a large market – MySpace, Bebo, LinkedIn, Facebook have all surpassed $100 million in annual revenues; each have valuations approaching or exceeding $1 billion and I expect several more social networking companies to crest the $1 billion mark in the next couple of years.

Digital rights management in music is a good example of a small market. With $6 billion of digital music revenues projected in 2012, and DRM commanding one or two of percentage points (at most) per track sold, the entire market in 2012 will be $60 million, and a company owning 20 percent of this market would generate around $12 million in revenue and
be worth $30 – $50 million.

Entrepreneurs can be successful in large and small markets. Buried beneath the cover stories of the billion dollar exits, many entrepreneurs get wealthy on $10 – $20 million acquisitions that don’t seem worth writing about in Silicon Valley. But this doesn’t mean that market size doesn’t matter. On the contrary understanding the market size  will help inform a financing plan that maximizes the chance of success.

All things equal, a start-up working in a large market will have more access to less expensive capital than a start-up working in a smaller market. This means the start-up can afford to build a plan that will require more capital and may take the business longer to develop. Because the potential return is large, investors will often pay higher prices for their investment. A strong team and a strong product in a large market may have investors clamoring to buy 40% of the company for $5 million.

The same team and product in a smaller market may find investors who
want 40% of the company for $2 million to drive a reasonable return, and may find that top-tier investors and large funds are less interested because the smaller investment has less ability to impact the overall fund (see Venture funds are big at Y Combinator). This becomes even more important in subsequent rounds, when valuation are elevated. If the company in the small market has build a plan that requires $5 million, it will likely find that
capital extraordinarily expensive (selling the majority of the company to get it), or worse, may not find that capital at all.

The same principles apply to hiring. A senior executive joining a company in a large market may be happy with a 3% share that ultimately dilutes to 1%, because 1% of $1 billion = $10 million. That same executive is unlikely to be happy in a 3% share in the smaller market, where 1% translates to $500,000, and will probably seek a larger share. More often than not, top executives, like top investors, gravitate to larger markets.

Start-ups often intentionally (or delusionally) inflate their market size in an effort to appeal to top executives and top investors. The signals of delusion about market size:

• Talking about global markets instead of U.S. markets
• Adding incremental and vaguely defined revenue streams (“plus advertising”)
• Modeling unreasonably high prices or market share

These delusions can cause a lot of damage. If you build a plan that requires large amounts of capital in a small market, you are likely to have a difficult time raising the capital. On the same note, if you artificially inflate the size of the market, you are likely to have your competence or credibility questioned.

Bottom line:
It’s important for start-ups to candidly assess the size of the market and use the information to inform the plan of attack, including financial planning and financing strategy.

• Spend time upfront to define and size your market
• Be realistic, conservative in your estimates
• Use it to build a credible financial projections and budget
• Use it to develop your financing strategy

A final word
At this point, your market estimates and financial models have servied their purpose as a binary test to determine if the market is “big” or “small”, and you can discard them as a “source of truth.” They can and should be used to inform your financing strategy, but shouldn’t dictate how much money to raise, because there are more important factors in determining how much money to raise, and because your revenue forecast is wrong.