Market size is a lazy proxy for size of opportunity
Time and again I see $ market size used as a proxy for the size of an opportunity in a market. This is really lazy thinking.
Developing an educated guess at the size of an opportunity is very different to stating the size of a market. The size of a market is the total revenue of products sold in that market by all players. The size of an opportunity is a guess at the free cashflow the market leader can extract from that market at scale. When you think of it like that, it becomes clear that two equally sized markets can create totally different sizes of opportunity.
Variables that impact opportunity size
You can work all of the variables below from the top down and the bottom up. Top down will be driven by developing a deep understanding of the vertical you are investing in, what the current dynamics are and what are the historical behaviours. Bottom up will be driven by developing a deep understanding of how your new model and/or product might change customer behaviour based on understanding the need and any existing customers.
- Size of market:
at what price can you sell your product?
how many customers / users will buy your product?
how will that price develop over time?
2. Gross margin %:
what is the cost of your variable input prices (cost of sale and cost to serve)?
how will they develop over time?
3. % of market gained by likely winner:
force of network effects?
geographical and cultural barriers?
historical norms?
4. Marketing % of revenue to sustain market share:
what will be the cost of acquiring new customers?
how long will your customers stay with you, what is the cost of keeping them, re-activating them or replacing them?
Multiply these four variables together and you get to an estimate of the size of the opportunity that can be used to compare with other opportunities you are looking at. You also develop a much deeper working knowledge of the vertical you are considering operating in.
In venture, developing a level of conviction over the size of the opportunity is the only way to develop any level of conviction on valuation. Which is critical.
p.s. as an example of the difference between market size and market opportunity, the high end smartphone vs automotive market is an interesting and very current one. Ben Evans summarises it well in his post Ways to think about cars, quote “if Apple created a car business as big as BMW and Mercedes combined, that business would generate less profit than the iPhone.”
