When screening through startup pitch decks, one key factor investors usually look at is the size of the market where the business is operating. Let’s face it – building a great product that targets a small market is not what venture capitalists look for, neither should you as an entrepreneur. On the other hand, creating a service that through a stepwise G2M strategy can reach to a wider audience with market opportunity of $4B represents a lucrative opportunity that nobody would want to miss out. However, using market sizing as a tool for filtering investments can sometimes be deceiving for 2 main reasons.
1. It does not assume product cycle and CLV
Imagine you have 2 different products: a thermostat and a SaaS productivity tool. How often do you think you will charge for either of these? Well, for a thermostat a product cycle could be around 2 years, meaning that a single customer will buy a thermostat once every 2 years. Assume, he will no longer buy your thermostat, so CLV will be only the one-off fee for purchasing the product. For SaaS it is a different story as you will most likely charge him on a monthly basis with CLV equaling 48 times the monthly charge, i.e. you will keep him for 4 years. This means that if markets for thermostats and SaaS productivity tools were similarly big, revenue potential for the SaaS product is higher due to higher CLV. And for business without network effects, high revenues are the main contributor to high valuations.
2. Revenues are different from valuation
Reports about various market sizes you see on the Internet are based on the revenues of all players in that market. However, this does not give the full picture about returns on investment in that market as it does not include multiples (EBITDA, revenues) for making a rough valuation. For example, consider 2 markets – one with network effects and one without such but both equally big. A startup that operates in a market with network effects such as social messaging can get a much higher valuation than a startup, which could have much higher revenues, but operates in the market without network effects. Actually this is possible – Whatsapp got acquired by Facebook for almost $20B while having annual revenues of only $20M. And certainly Whatsapp has fewer revenues than many for example SaaS startups with lower valuations. To conclude, market sizing could be a deceiving tool, thus should always be used in collaboration with other important considerations when evaluating the attractiveness of an opportunity.