Market Sizing Analysis – A Critical Tool for VC Discussions

25th May 2011
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Soumitra Sharma, IDG Ventures India

Ah! Total Addressable Market (TAM) – the usual suspect in all business plan presentations. The slide where larger is never enough. The slide which should force VCs to hand out the cheque immediately, considering the number of billion dollar pies that are apparently out there, ready to be eaten. Surprisingly, it is also the slide which more often than not, is considered as a space filler in the presentation deck.

It is the slide which usually turns VCs off during meetings and which, if an entrepreneur survey is done, would probably figure right at the bottom of b-plan priority list. I don’t plan to touch on how market sizing should be done – entrepreneurs are smart enough to do that and there are enough public resources out there to guide them. Instead, it would be worthwhile to try and understand how market sizing analysis can be used as a critical strategic tool in discussions with VCs, instead of acting as just another piece of data.

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First things first – market sizing is extremely critical both from an entrepreneur’s as well as a VC’s perspective.  For entrepreneurs, this is one of the first things that needs to be done while building a business plan. Even the most promising and disruptive products/ services can fall flat if the founding team doesn’t have a grip on its target market dynamics. For VCs, unless the addressable market is large enough, growing and ready to pay, the returns will just not be there. But wait a second – how does “market sizing” equate to “market dynamics”? I always thought TAM was a number that was supposed to be calculated back-of-the-envelope, or picked out of a consulting/ research report and quoted (along with some graphs, again out of the same sources!) without much context?

It’s important to understand that a good market sizing exercise is about answering certain key questions that clearly open up the market panorama. These are the same questions that a VC is looking to answer while probing the entrepreneur during discussions. Let’s look at them one by one:

What does the venture do “best”, and more importantly, “better” than others? – this is what defines a venture’s real addressable market. Realistically, the venture can hope to capture significant market share only in segments where it has a sustainable differentiation and competitive advantage. If you have developed a new kind of ERP software, the multi-billion dollar market catered to by the likes of Oracle and SAP might not necessarily be YOUR addressable market. However, if your ERP does a better job at catering to specific needs of say the auto sector, then THAT is your realistically addressable market because that’s where you are better than Oracle or SAP.

Who will pay for the venture’s offerings, and are there enough such players ready to pay? – the venture might be passionate about an area, product or service, but for investors, the primary concern is monetization.  The part of value chain that pays for the venture’s offering deserves all attention. Analyzing its characteristics, behavior, needs and idiosyncrasies will ultimately decide the commercial potential of any value proposition. In addition, more the number of potential payers better are the venture’s market prospects.

How much are potential customers currently paying for similar offerings/ needs? – knowledge of prevailing pricing points, models and mechanisms is crucial, especially in established market segments. This helps the venture better understand potential pricing inertia and comfort levels among target customer base. This analysis should ideally, also reflect the presence of deep pocketed clients.

How much value is the venture delivering to customers, and how much will they be potentially ready to pay for its offerings? – For a young company, pricing is a spectrum with 3 distinct inflection points – “will pay” (what you can charge as a startup with relatively new and untested offerings), “could pay” (what customers are currently paying for similar but tested offerings), and “should pay” (what the customer ideally should pay, in proportion to the value being delivered by your offering). Ventures need to be extremely clear about which parts of the spectrum are suited for various points of the offering lifecycle.

Quantification of value delivered to customers, be it tangible or intangible, is critical. Is your offering saving them $100 or $20? Because that will impact how much they are ready to pay you. Also, are you serving a real indispensable business/ commercial need for them, or is it a dispensable “lifestyle choice”? Answers to these questions, tied in with the earlier discussed point of prevailing pricing mechanisms, will decide whether the venture will be constrained by cost-plus type of competitive pricing, or can it actually charge value pricing proportionate to the value it delivers.

Does the economics work out in the target customer base? – A venture’s realistically addressable market will be the one where it can achieve the most efficient customer acquisition costs. The same sales and marketing outlay can get you one $10mn contract from a player like GE, or $100k individual contracts from 10 small players. Which is better? Unless customer level economics work out for the venture, both in B2B and B2C plays, the segment can’t be realistically included in TAM.

How much value or “wallet share” is the venture capturing out of the client’s budget? – High potential ventures usually tend to capture a large portion of the client’s wallet. If the customer is budgeting $100 for accounting software, will it be ready to pay $60-70 for your product, or does your offering only deliver value worth $10-20? This serves as an excellent proxy for the offering’s value, need and criticality in the chain. Ultimately, from a scalability perspective, the venture needs to be well positioned to capture large “wallet share” in its addressable market segment.

Who is the venture’s REAL competition? – Ventures need to be extremely careful and cover all bases while defining competition in the TAM analysis. Apart from obvious competitors, substitutes, alternatives and even blatant “need-discarding/ bypassing” is a potential threat. For Coke and Pepsi, more than each other, their competition is with the homemade lassi, nimbu pani, juices and even drinking water. This is the level of granularity that needs to be achieved while looking at competition. Once this question is addressed, other aspects such as what do they offer, how much are they charging, how much can I charge, are our markets overlapping, where do I fit in the competitive landscape, how will they react etc., can then be analyzed.

The best TAM analysis answers all the above 7 questions, either implicitly as part of b-plan workings, or explicitly as information items. Either way, these questions are always going through a VC’s mind while he/she is looking at the TAM slide. An entrepreneur who has already thought of these issues, and who has included them in analysis and calculations, comes across as focused, and as someone who has done his/ her homework with demonstrated market understanding and rigor. It also positions entrepreneurs well to answer pointed questions that VCs will subsequently throw at them, and handle granular market slicing and analysis that VCs will typically do on the spot. Finally, this provides comfort to VCs about the business plan projections being based on realistic and reliable business driver assumptions, instead of plain math.

Ultimately, the equation is simple. Revenue is equal to Price times Quantity. Leave aside fundraising; it’s important for entrepreneurs to understand all underlying drivers behind this equation purely from a business strategy and growth perspective. Rest assured, an insightful TAM analysis will also definitely help them do well in VC discussions.

Disclaimer

The views and opinions expressed in this column are strictly personal, and not those of any organization/institution the author is or has been a part of, nor is made in any official capacity of such organization/institution, unless explicitly stated otherwise. None of the information, views and opinions in the column should be construed as business or legal advice.

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