Market size – or more accurately addressable margin opportunity – determines how valuable a company can be, and the size of the exit in turn determines how much a company should raise. Alex Iskold, MD of Techstars New York put it like this in a recent post:
Venture Capitalists are looking to deploy millions of dollars, and they are looking for multiple times return on that capital. That is why, in addition to founders, VCs focus heavily on the size of the market. If they don’t believe the market is large enough, they won’t invest.
There is nothing wrong with starting a business in a smaller market. You can still get capital, but not necessarily via VCs. Understanding the size of your market before going out to raise money is an important thing to do for every single business.
Simply put, if the exit is £100m and you want to keep £50m for yourself then the investors will get £50m, so if they are going to make 10x+ then the company can have raised a maximum of £5m.
Investors at every stage are doing this maths, and the exit size is a function of the market. That’s why investors with large funds obsess so much over market size. Investments in small or medium sized markets won’t move the needle for them.
A lot of entrepreneurs approach this subject the wrong way round. They figure out how much they want to raise and then they write a deck and writing the market becomes an exercise in selling the investor and justifying the amount of money they are seeking. When the market is genuinely huge that works fine, but often times it isn’t, and investors will walk away if they don’t feel it’s big enough for them to make a meaningful return. Worse, market size can be a difficult topic to give feedback on. If an entrepreneur has claimed the market is worth billions and the investor feels it is worth much less then feeding that back can invite confrontation, particularly if the founder has made a big play about the size of the opportunity. Good investors want to give feedback when they say ‘no’ to investments, but they say ‘no’ a lot and unless they have had meetings they will want to minimise the amount of time they spend giving it – and that means avoiding back and forth debate on questions like market size.
There are plenty of entrepreneurs who have used their sales skills to raise money this way even when the market is small, but that usually doesn’t work out so well in the medium term when the burn rate is high and everyone is disappointed because the market has limited growth.
It’s much better to have a firm view on the opportunity size and build the fundraising strategy from that.