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Market Sizing: Framing the Opportunity

Part 2 of 5 in the “Financial Modelling for Startups” Series

Maximilian Bruhn
Oct 26, 2020 · 10 min read

he market environment is a focal point of analysis for startup investors since it is a critical variable affecting the prospects of customer acquisition, margins, and, ultimately, reaching profitability. Large and rapidly growing markets promise an opportunity for high growth rates and moderate acquisition costs since switching costs are less relevant for new customers entering the market.

Framing the opportunity of your venture case means intentionally setting boundaries to clearly define your business’s target area and expressing the magnitude of the opportunity in numbers.

Implementing a well-designed market section in the financial model provides an opportunity to signal market expertise and strategic focus. That is, as long as your pitch deck includes a thorough analysis of your target market, a market sizing section in your model is not a must-have.

Displaying an understanding of the boundaries of the opportunity you are targeting provides a strong foundation when modelling the internal projections. Thus, if done correctly, a great market sizing section increases other projections’ credibility in the model.

Step 1: Identify your target market

Your target market definition should always reflect your product’s core value proposition and should be expressed as precisely as possible.

Founders often mistakenly look too widely for their market definition when sizing up the market in the second step. The focus on total market size stems from the common misconception that the attractiveness of venture cases for investors is in every case proportionally related to the size of the defined target market.

This point is partly true; investing in ventures targeting large markets is a clear preference for most investors. However, similar to other projections, the investor’s analysis always focuses on the underlying reasoning and not the magnitude of the numbers displayed.

A market size estimate does not equal current or future demand for your product and will remain a theoretical estimate in almost all cases. Beating a “magic” threshold of one or multiple billions while staying too vague is less valuable than going a level more in-depth in segmentation (demographic, geographical, behavioural, etc.). A smaller market that logically connects to your sales and marketing strategy makes a better impression in discussions as it illustrates strategic focus.

What matters way more to investors than a few more zeroes added to a total addressable market (TAM) projection, which sums up the money spent for a particular category of product or service to an overall figure, is seeing the possibility of quickly reaching product-market fit (PMF).

A loose definition of product-market fit is having a product tailored to the needs of a growing pool of potential customers that are aware of their problem and are actively looking for a solution.

Reaching PMF implies that the venture is ready for scaling since fewer resources have to go into testing hypotheses about customer needs and refining the product and can rather be systematically invested in growth, even if the former process in the best cases never entirely stops. Whether and how an objective measurement of product-market fit is possible is a hot topic for debate.

Precisely defining the market you want to target is, in every case, necessary and a step to repeat, and possibly refine, when preparing your projections for investor discussions.

Since the market environment is an external variable, it does not fit into one of the logical blocks previously defined. Instead, in your spreadsheet, add an extra sheet that contains the market definition and market sizing results.

Step 2: Use complementary methods for sizing estimates

The conventional way of presenting market size for a venture case is a multi-layered metric.

The natural starting point for estimating the business opportunity is the total addressable market (TAM). From TAM, you use derivations from statistics or other assumptions to arrive at the Serviceable Addressable Market (SAM). The SAM is the proportion of the market that is core or directly adjacent to the target customer base, and the Serviceable Obtainable Market (SOM), which is the short-term market share target.

In practical application, the methodologies widely used are either top-down or bottom-up. Since this series is concerned with the thinking process that should go into each step of building the model and critically examining your projections when preparing for discussions with potential investors, I will only briefly describe the process for each and outline a general suggestion for preparing this section.

Using both methods for market sizing and triangulating the results helps increase the confidence in your estimations. Even if both have the same goal of objectively measuring the business opportunity’s magnitude, they tend to arrive at fundamentally different results.

The top-down method starts with a broad market size estimate typically taken from a reputable and specialized entity such as a research institute or a consulting firm. It systematically segments the market either by using subjective assumptions or externally reported statistics.

This method is useful for getting a quick overview of the overall market and might also indicate expansion opportunities to pursue once a business has targeted its core market segment.

However, top-down views tend to overpromise total market size since the narrowing assumptions (often 3 to 4 segmentations) often fail to exclude non-addressable units from an extensive target market definition in the beginning.

In contrast, the bottom-up method takes limiting factors such as capacity restrictions into account by totalling the known variables of the target market (for example, by summing up product categories that solve the same problem).

Reaching higher-order segmentations from the ground up tends to result in smaller and more accurate figures. But it also takes way more time and specialized data that might be difficult to acquire.

For the market sizing section in your model, if possible, try to include both methods and triangulate the results in a reasonable way to get either a final figure or a range of values.

As with other projections, clearly outline the assumptions you use for the calculation and the triangulation and make them visible through consistent formatting.

Lastly, I would like to share some perspective regarding the typical procedure of using a top-down market sizing estimate to project revenues by applying the famous “1% market share assumption”.

One topic that will repeatedly come up in further sections is that successful fundraising for founders means finding the balance between showing a rational assessment of the case while simultaneously eliciting plenty of excitement in your investor about the future opportunity.

While a 1% market share in an enormous market might result in a fantastic figure of potential revenues, it does not mean anything if reasonable assumptions do not back the projection of achieving that market share.

I will give a few suggestions in later sections on making room for some fantasy into the model. However, especially for projecting short-term revenues, it is recommended that founders use bottom-up forecasting, meaning to rely on assumptions based on the business’s basic and proven fundamentals (i.e., unit economics and key performance metrics).

If, in the end, your only reasoning for going this route is that 1% market share is memorable or sounds small enough to be believable, project your revenues instead by extrapolating in a bottom-up way.

Step 3: Follow assumptions about market growth and trends back to its root causes, and when possible, supplement with primary research results

Combining both a target market definition tailored to your product and an adequately-derived market sizing estimate will significantly increase investors’ confidence that you will have a market to compete in. However, when framing the opportunity of your case, the current market’s status is only one part of the equation.

Ultimately, venture cases’ outsized opportunity comes from correctly anticipated future changes in markets rather than from their current state.

In this way, formulating the market section in your model and preparing to discuss the projections with investors should also include forecasts of market growth and a close examination of anticipated driving forces and trends.

While the earlier steps of organizing the model in blocks and preparing the market definition and initial sizing estimate both focused on demonstrating a structured and rational approach to your business case, projecting market growth and changes is the first opportunity for a founder to be bold and begin to bring the investors into a vision of the future via storytelling.

Integrating a market growth assumption into your model is done by adding a single line in your spreadsheet with a percentage figure and connecting it via a formula to the previously defined market size. The real work happens then outside the model once the investor more closely interrogates those assumptions.

In examining the market growth assumptions many founders tend to rely on a comprehensive market report initially used to quantify the total addressable market in Step 2 and copy the growth rate and drivers outlined for their market analysis.

Even if some investors readily accept this procedure, it may also cause common problems that can easily be avoided by following a few general suggestions.

First, a report covering a broad market will likely have a focus too wide to be suited for your target market definition from Step 1. Even if high-level drivers such as digitization or globalization will have a potential impact on your target market, this does not necessarily qualify those auxiliary markets as valid opportunities for your venture.

Second, expectations about market drivers and changes that are common knowledge are quite often hard to monetize.

Pursuing an entrepreneurial opportunity means deviating, at least to some extent, from the opinion that most current market participants have and believing you can exploit that difference with your business. If a large consulting firm or research institute has already published a report outlining precisely the drivers you are planning to use, your venture could likely have significant competition and thus look less attractive as a bet for investors.

Founders can avoid these problems by either replacing or supplementing the growth rates and high-level drivers, for instance, from an existing research report, with insights from primary research or feedback intentionally gathered from target customers themselves through surveys.

Key learnings from primary research are an excellent addition for your market section and overall case as it supports your venture’s differentiated approach.

Primary research enables founders to integrate a little bit of storytelling into the business case. Even if primary research from target customers is small in sample size and therefore limited in generalisability, interpreting these results on a broad scale can form a compelling narrative.

This kind of reasoning, in abstract terms, could look something like this:

“Reputable institution X has identified and forecasted a particular trend in a broad market that is a high-level representation of our target market. We have gathered primary research to confirm this trend with our relevant target customers and uncovered this trend’s root causes. These root causes will drive customer behavior in the future, and exploiting this trend is the big opportunity in this market.”

Market Sizing: Key Takeaways

Outlining the boundaries of the market opportunity is the first foundational part of every business case and should be thoroughly analyzed by founders before presenting their case to potential investors.

Fundraising is an exercise to compellingly use both rational assessment and talent in storytelling to increase the confidence of investors who are trying to form hypotheses about a business case. The first hypothesis that founders should try to support when building their model and discussing its projections is:

The founder has discovered and analyzed an opportunity in the market worth pursuing from a business perspective in terms of both size and driving trends.

The strength of this hypothesis depends upon how clearly you can define the opportunity (i.e., target market definition), estimate and argue for its magnitude (i.e., market sizing with complementary methods), and how well you tell a story about the future of the underlying market (i.e., identifying drivers and trends, preferably through primary research).

Step 1: Identify your target market

  • Identify your target market (logical reasoning beats absolute size)
  • Add your target market definition as an extra market sheet within your model

Step 2: Use complementary methods for sizing estimates

  • Triangulate your market estimates using complementary methods (top-down and bottom-up)
  • Clearly outline assumptions and segmentations used
  • If you choose to project your revenues by further narrowing down a top-down market projection, avoid simple assumptions like 1% market share

Step 3: Follow assumptions about market growth and trends back to its root causes, and when possible, supplement with primary research results

  • Project your market size growth over time, at the same horizon as your internal projections (3–5 years depending on the stage of the company, investor preference, etc.)
  • Add 2–3 bullet points about core market drivers as supplementary information either directly to your model or as a reference. When possible, also present results from primary research
  • Prepare a compelling narrative about future changes you expect to see in the market that you can discuss when asked about your projections, and make sure to dig deep into root causes for customer behaviour and avoid “common knowledge”

After presenting the market opportunity as the outline of your case, the next critical component of your overall business case and the model is to present a plan to monetize the opportunity compellingly.

Projecting a venture’s financial plan by referring to grounded assumptions in the form of core KPIs will be discussed in the next part of the series.

If you are a founder looking for an investment, I hope you find this article series helpful for your preparation.

Find the additional parts here:

Especially if you are working in the fields of FinTech, Blockchain or AI, I would love to hear about your company so feel free to connect with me on LinkedIn.

Similarly, if you are a VC Investor and have some feedback or additional notes on this topic, I would love to learn more about your views.

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Maximilian Bruhn

Written by

VC @ FinLab AG | FinLab EOS VC. Let’s connect on LinkedIN:

The Startup

Get smarter at building your thing. Follow to join The Startup’s +8 million monthly readers & +799K followers.

Maximilian Bruhn

Written by

VC @ FinLab AG | FinLab EOS VC. Let’s connect on LinkedIN:

The Startup

Get smarter at building your thing. Follow to join The Startup’s +8 million monthly readers & +799K followers.

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