Many of the companies we meet are founded by technologists — either young, dynamic founders with a computer science background or seasoned product managers or executives that see a better, different way of solving a problem.
When we meet them, they often have pitch decks structured using the business plan framework we shared many years ago. For the best pitches, it’s clear the founders have an intuitive understanding of the problem and how their product will be a novel solution loved by users. They’ve studied the competitive landscape and know why now is the right time to start the company. The product demo is great.
And then they bring up the Market slide.
The Market slide is often just a big number, confidently stated (where big varies from $1B to $1T+). If you probe, it’s clear that the number is a result of googling their company’s category plus the words “market size” (e.g., “video software market size”). Critical questions are often deflected.
The market you choose to serve is one of the most important factors for an early-stage startup. And for most technologists, it’s a blind spot. To help, we wanted to share one way of thinking about market.
The Market Formula
Market Size = (# of Customers) × (Revenue/Customer)
The simplest and most important way to think about market size is (a) how many potential customers are there and (b) what might each customer be worth to you.
For many of the companies I meet, I am constantly trying to triangulate these two variables as we talk.
One of my favorite questions for dissecting this comes from my partner Doug Leone. He will often ask:
Two questions, please — what % of the Fortune 2000 will ultimately buy this product? And how much will they be worth to you on average?
The reason this question is great is because for most enterprise-focused companies, the vast majority of their revenue will come from the Fortune 2000 (F2000). This question provides a very quick way to approximate market size.
If your answers are 20% and $500,000, that might seem like a great business (it is hard to get someone to pay $500,000/year for a product!), but 20% × 2000 × $500,000 = $200M. If most of your revenue is going to come from the top 2,000 companies and you are only serving 400 of them, you might be in a niche market.
On the other hand, if you have a broad, horizontal platform that serves the entire F2000 and you expect ACVs of $1M or more, then it’s easy to see your way to a $1B+ market (2000 × $1M = $2B).
If you are going to show a market size number, I would strongly encourage you to have thoughtful answers to these two questions: how many customers? and how much will they pay?
The Market Curve
Thinking about the number of customers and the revenue per customer is a tremendously clarifying way to think about a single company. It also provides a useful framework for unifying seemingly disparate categories:
Here, we have plotted the number of customers on the X-axis and the average revenue per customer on the Y-axis. The green line represents ~$2B in annual revenue (i.e., x × y = $2,000,000,000; my apologies to math purists who will point out that this is not entirely to scale).
I tend to think of the top-left corner here as classic enterprise sales businesses. At this part of the curve, you probably have tens or hundreds of customers, but they pay you a lot of money. For instance, Medallia went public last year. According to their Q2 2020 Earnings Deck, they have 839 customers and had $115.5M in quarterly revenue, suggesting ~$550k/customer/year in annualized revenue.
Where you are on the curve informs your sales strategy. If you have hundreds of high-value customers, you can afford to spend a lot on sales, implementation and customer success to make sure those customers remain happy.
As you move down the chart to Zoom, you’ll realize that “Enterprise” is a pretty broad range. According to Zoom’s Q2 Press Release, Zoom now has over 370,000 customers with more than 10 employees and $663.5M in quarterly revenue, suggesting ~$2.65B in ARR and ~$7,100 in annualized revenue/customer in that segment.
Zoom is unusual in that it now basically serves all markets, but it helps show the power of having a viral, bottoms-up product in the enterprise — they have almost three orders of magnitude more customers than a typical enterprise-focused vendor.
As you move down the curve, you hit the range of small and medium-sized businesses (SMBs). Yelp is a great example here. According to Yelp’s Q2 Earnings, they had 377,000 paying locations and $169M in net revenue, implying ~$1,800 annualized revenue/location.
One of the reasons it’s important to think about this curve is because it changes your sales strategy. If you have customers paying $500k/year, you can afford to have a dedicated account team per customer. If you’re earning $2,000/customer/year, you have to be much more efficient with how you sell to a new customer.
Another tough challenge in the SMB market is attrition. There are relatively few bankruptcies each year in the enterprise. The SMB market tends to have a much higher level of built-in attrition and tends to be more susceptible to macroeconomic shocks. E.g., in Q2 2019, Yelp reported 549,000 advertising locations and ~$247M in quarterly net revenue — their advertising base sadly shrunk by ~31% during the global pandemic.
You wouldn’t think that Peloton and Yelp are comparable businesses, but they looked surprisingly similar at the beginning of the year (they have since started to diverge). When Peloton went public last year, they reported 511,000 subscribers and $915M in FY2019 revenue (vs. Yelp’s ~549,000 advertising locations and ~$990M in annualized net revenue in Q2 2019).
Peloton has seen tremendous growth since the pandemic. In Peloton’s Q4 2020 Shareholder Letter, they reported $607.1M in quarterly revenue and ~1.1M Connected Fitness Subscriptions (suggesting ~$2,200 in annualized revenue/subscriber). These revenue numbers include hardware sales, which can be lumpy. Excluding hardware sales, they reported ~$121M in subscription revenue in the same quarter, suggesting ~$444 in annualized subscription revenue/subscriber.
Peloton and Yelp are obviously very different products with different customers and business models, but thinking about them along this curve helps to highlight some similarities.
Commerce & Marketplaces
As you continue moving further down the curve I tend to think about commerce and marketplace businesses. Typically, these are businesses that sell to millions or tens of millions of people, and they often make tens to hundreds of dollars per year in net revenue.
One public example here would be Grubhub. In Q2, Grubhub announced quarterly revenue of $459M and 27.5M active diners, suggesting quarterly revenue of ~$16.70/diner and annualized revenue of ~$67/diner.
Comparing Grubhub and Peloton, you see that Grubhub has about 30x more consumers and about 30x less revenue/consumer, leaving both with annualized revenue of ~$2B.
Lastly, we have mass-scale consumer apps. This is the part of the market where ARPUs are quite low but the number of users is massive.
Snap’s last earnings showed they had around 249 million customers and $679M in quarterly revenue, suggesting about $10.90 in annualized revenue/user. So again as you move from Grubhub to Snap, you have about 10x as many users but about 5-10x less revenue/user.
As you move even further down the curve, you get to the extreme outliers. According to their Q2 earnings, Facebook has 2.7 billion MAUs and their quarterly global average revenue per user (ARPU) is $7.05, which puts them at ~$28 in annualized global ARPU.
Most mass-scale consumer apps are, by necessity, free (and either monetized via ads or, increasingly, optional subscriptions). For these apps, the primary question I ask myself is “how big can this get?”
Some categories seem limited to tens of millions of users. While good, you likely need an ARPU of ~$100 for the market to “big enough.” On the flip side, if you have an app that can credibly reach >1B users if everything goes right, you only need a $1 ARPU to be at $1B in annual revenue.
Having a deep understanding of the market you are serving isn’t just important because potential investors will look for it. It’s critical because a great product is not sufficient for a great business — you need a great market, too.
For your market, the two key things to understand are (a) how many potential customers are there and (b) how much will each of them be worth to you if everything goes right. The better you really understand those details and can go deep on them, the more successful both your pitch and your business will be.