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As printed in Industry Scoop, November 5, 2002
Sizing the Market
By Todd Pietri, General Partner of Milestone Venture Partners
Venture capitalists spend a lot of time trying to estimate market size
when they evaluate a new investment opportunity. The exercise is more
than of academic interest. If the market is too small, the venture group
will pass. If the market size is on the low end of acceptable, the valuation
placed on the company will be lower than would be placed on a company,
all other things being equal, with a much larger opportunity. The math
behind market size analysis is straightforward. However, there is no formula
or objective set of criteria that will tell you if a market is big enough
for a venture capital investment. A venture capitalist’s perception
of a market opportunity is influenced by many subjective factors that
the entrepreneur can’t control or anticipate. The VC’s fund
size, investment strategy, past investment experience, and faith in management
all play a part. A good entrepreneur looking for money will do his best
to understand how these subjective factors govern a VC’s analytical
framework.
One should review the basics of market size analysis first. When an entrepreneur
submits a plan to our firm, I am not particularly interested in top down
numbers. Let’s use a hypothetical example throughout this article.
An early stage financial services software company, Derivatives Software,
Inc. (“DSI”), which automates derivatives trading, claims it
has a huge market because the notional value of outstanding derivatives
contracts is $X trillion. In addition, DSI tries to buttress the large
market size claim by citing comparably large numbers from Gartner and
Celent.
The reality is that the notional value of derivatives contracts and the
commissions generated thereon are of secondary concern to me as I evaluate
this market. Instead I want bottom up information. I want to know how
much revenue DSI and all of its competitors combined generated last year.
After all, this is the ACTUAL market size. For this example, let’s
say that the answer is $10 million and DSI has 20% of the market ($2 million
in revenue).
Is a $10 million market big enough to merit a venture capital investment?
The answer is ostensibly NO. The math simply doesn’t work. If the
venture investors invested $6 million at a $10 million post money valuation,
then the company would have to be worth $100 million in order to generate
a 10x return (assuming no further dilution). Even if the market was growing
at 45% per year and DSI captured 50% of the market in 5 years or $30 million
in revenue, DSI would have to sell at 3.3x revenue to meet the $100 million
bogey. However, VCs are loath to depend on optimistic market share projections,
industry growth rates and/or high exit multiples to generate the return
they seek.
Let’s modify our example and examine some of the nuances to which
I alluded above. Perhaps DSI tells us that only the top 10 investment
banks have purchased this type of technology thus far and that these early
adopters are likely to triple their number of seats. In addition, these
firms are paying annual recurring fees per seat. This is when the market
sizing exercise becomes more interesting and difficult, because the focus
of the analysis has shifted from actual market size to latent market size.
This is when we require a detailed bottom up market size analysis. We
would start by asking the following: how many brokerage firms exist? How
many trade derivatives? What percent of the firms that trade derivatives
can cost justify an investment in DSI’s technology? When we have
that answer to this last question we can start to split the universe into
small, medium and large prospects and test assumptions about the average
numbers of seats and the average selling price for each category. Lastly,
we have to make some assumptions about how fast the industry will adopt.
The best way to make rational assumptions is to look at what DSI has sold
to date, talk to their customers and prospects and ask industry experts.
Let’s assume that after our due diligence we can accept the following:
the market can grow to $75 million in 3 years; and DSI can grow from $2
million to $15 million (20% share) with 25% EBITDA margins over that time
frame. Is the market big enough now?
The answer depends on which firms are investing, how much capital the
company needs to meet their projections, the valuation the entrepreneurs
are willing to accept, the quality of the management team and the downside
risk. If the company needed $1.5 million to meet their projections and
was asking for a $2.5 million pre money valuation, the chances are pretty
good that a small fund or group of small funds would be interested in
the investment. This is because if you exit the investment at 2.5x sales
or 10x EBITDA (the recurring revenue model is quite valuable), you would
make almost 10x your investment.
The big funds wouldn’t want anything to do with the deal. When a
firm has $150 million or more to invest, it is not feasible to put out
money in small blocks (significantly less than 5% of committed capital).
Even some of the smaller funds would look at a $15 million company in
three years and yawn. This is because many VCs believe, based on past
experience, that if a company has under $20 million in sales, it is not
an IPO candidate and it won’t be able to attract the attention of
a significant acquirer, which will depress the exit multiple to 1x sales.
Even worse, you might not be able to sell the company at all if it is
too small.
The final decision to invest or not in a deal like this may depend on
downside risk and management talent. If the company is unlikely to run
out of money and go out of business and you know you could sell it to
a player in the space for something, your downside is protected. Furthermore,
if the management team has proven in the past they can develop add-on
products and have a credible plan to take advantage of identifiable opportunities
in adjacent markets, you might reason that the company will grow beyond
its base business (these opportunities will be heavily discounted though).
As you can see, market size analysis will always be as much art as science.
--
Reprinted from IndustryScoop, Vol. 120, November 5, 2002. 305 Madison
Ave., Suite 1166, New York, NY 10165, 212-717-0023
Todd Pietri is Co-Founder and General Partner of Milestone Venture
Partners, an early-stage venture firm located in New York City. The Fund
invests in enterprise information technology companies located in the
New York metropolitan area and focuses on enterprise software, information
services, and technology-based business services. For more information,
please contact Todd at 212-223-7400, email at ttp@milestonevp.com,
or write Milestone Venture Partners, 551 Madison Avenue, 7th Floor,
New York, NY 10022.
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