A Framework to Prove Your Market Is 'Big Enough' to VCs! | VC Jobs
The Market Size Mistake By Shopify Founder & When The VCs Say No....
👋 Hey Sahil here! Welcome to this bi-weekly venture curator newsletter. Each week, I tackle questions about building products, startups, growth, and venture capital! In today’s newsletter, we dive into -
Deep Dive: A Framework To Prove Your Market Is “Big Enough” to VCs.
Quick Dive:
The Market Size Mistake By Tobi Lutke, the founder of Shopify.
How Do You Tell A Compelling Story About Your Company To Investors?
When The VCs Say “No”...
Hidden Trap Of Convertible Note and Liquidation Preference Multiples.
Major News: Microsoft Invests $1.5 Billion In AI Firm, Former SpaceX's Executives Launch VC Fund, Ramp's $150 Million Funding Round & Tesla Seeks Shareholder Approval for $56B Pay Package For Musk.
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TODAY’S DEEP DIVE
A Framework To Prove Your Market Is “Big Enough” to VCs.
The second most common reason why VCs pass on an investment is some version of “it’s not big enough.” For a VC to generate a great fund-level return, it typically need to invest in at least one company that has billions of dollars of enterprise value.
To do that, most VCs decide that each one of their investments needs to have the potential to exit at or above that amount, even if it’s very unlikely to be the reality for every single investment.
The problem is, that most really exciting companies seem “not big enough” to a lot of investors, especially really early on. These startups are often going after markets that don’t currently exist or seem like a niche opportunity (but in reality, are much bigger).
“So if you’re a founder choosing to take the VC path,
How Can You Counter Investors’ Objections About Market Size?”
Below are some different approaches. Keep in mind that some of these are left-brain sort of approaches and others are more right-brain.
Both are important and could be effective for different sorts of investors (and different sorts of founders). And if you gravitate towards one, keep in mind that investors who make team decisions will come at this question from multiple angles.
1. Top Down, But Brick By Brick
Most market sizes are top-down. “The market for marketing software is $XB dollars so it’s big enough to support some really big companies.” It’s the simplest way to think about market size, so most investors will gravitate that way, especially if you are building a company that is going after an EXISTING market.
One way to augment this is to essentially take the same approach but show brick-by-brick how your market opportunity may be bigger than it seems.
This means showing:
geographic expansion
pricing/upsell potential
market growth
very logical expansion into verticals or complementary products etc.
You will still need to be going after a pretty large core business for this to resonate in any way. But doing a build-up like this can be effective when a prospective investor does believe that the market is somewhat big but would love to see more upside to get fully comfortable.
2. Bottoms-Up Market Demand
The previous approach completely fails when you’re talking about markets that don’t quite exist yet or when an investor is not at least on the fence about market size.
Another approach is to do a bottoms-up analysis to demonstrate the scale of market demand for a service like yours. Start with the total number of potential end-users, and use reasonable estimates around customer demand, pricing, market share, etc.
The key things that you’ll be pushed on with this sort of analysis are -
a) how do you define the reasonable scope and segmentation of the potential customers,
b) how realistic your market share assumptions are, and
c) the fact that this is all conjecture.
One way to address d) is to include solid data points that lend credibility to your assumptions (like a reasonable estimate of how much customers already spend to solve a similar problem or some ROI analysis on your product/service that can be used to estimate reasonable pricing and the “no-brainer-ness” of what you are proposing).
Also, keep in mind the “vitamin vs. pain-killer” analogy.
Bottoms-up approaches tend to work better for “painkillers” than “vitamins,” even if the ROI of the vitamin seems to hold together.
3. Attaching To Mega-Trends
Being in lock-step with a broad mega-trend is another way that investors get over a seemingly small market. This means that the investor (consciously or not) believes that the mega-trend will either -
drive massive market growth or
drive the new company to have an unusually high market share.
A simple example of this was the shift from simple tools to advanced tech. Once investors believed this was happening, it became more reasonable to think that a new software product in a specific vertical might enjoy extremely rapid adoption and enough market share to build to $100M+ in revenue and $1B+ in enterprise value reasonably quickly.
Without this mega-trend, it’s harder to believe this because the pace of adoption may be too slow and it would be too difficult to dislodge existing players with a similar approach without being 10X better, faster, or cheaper.
4. Using Analogies
Using analogies can be tricky because they may not land. But if they do, I find that a lot of investors often get fixated on an analogy that can sufficiently build conviction. When doing this though, it’s important to not just list out similar companies or big exits in the space, but internalize what those analogies communicate.
For example, if there have been some large exits in a seemingly small market, this can be a blessing or a curse. Yes, those analogies exist, but how well do investors know the comp that you are citing? Was it a teeny business bought for purely strategic reasons?
Are there only one or two buyers who would pay that kind of premium? How many investors would take that bet?
Productivity software is in this category. One could point to companies like Evernote, Sunrise, Acompli, etc. as examples of companies with really nice exits or private market valuations. But looking at this another way, one could say, “Wow, outside of Microsoft, who will pay a premium?
The best companies only exited for at most a couple hundred million. Wow, doesn’t Evernote show that it’s tough to be a truly venture-scale, independent company in this category?”
I find that the best analogies are ones that tend to connect to one of two things. Either, it is tied to a mega-trend. For example, “Just like the shift to the cloud allowed for the rise of great companies in different categories, the shift to mobile computing in the enterprise will do the same. So this application that does X is the beginning of a mobile-first HR product that will be like Workday but for mobile.”
The second analogy is to connect yourself to a company with a similar ethos or founders with the same superpower. This is a lot harder to do and probably happens by inception more than through direct argument.
You would probably not say “We are just like the Airbnb founders, so you should believe we can make this work.” But I have heard investors who have gotten to know founders over some time say something like “Wow, these founders are unbelievably obsessed with design and user experience in a way I haven’t seen since (person X). Maybe they really can pull it off!”
5. Scope expansion
This is some version of “Today we are doing X, but that just puts us in a great position to do Y, which is obviously huge.” There are a couple of flavours of this.
The first is the bank shot. This is where X is actually not the foundation of a great sustainable business but could be a gateway to more. A lot of VCs have a hard time with bank shots unless you are already demonstrating some really remarkable traction. Usually, the right approach here is to focus on growth and scale as quickly and efficiently as possible when accomplishing X, and make most of your money doing Y down the road when you have a network effect, customer lock-in, or can provide a valuable service that no one else could provide without your scale.
The second version of this is when X is actually pretty decent. Maybe it won’t be “the next Facebook,” but it could certainly get you to a pretty attractive place. Usually, this works well when the underlying business is profitable and decently large without being too capital-intensive, which gives you more freedom to pursue the bigger opportunity as a next step.
This allows an investor to say to themselves, “I could reasonably get a 5–10X on the core business, and there is some small probability that this could actually be a 20X or more.” Usually, this means that the company is in a market that has decent prospects for future funding or M&A, such that if the business hits a double but not a home run, it still could be a good outcome.
6. Betting On The Future
One additional approach that most founders use quite successfully is what I’ll call “the future bet.” The approach here is to deflect discussions about current market size and focus the discussion on a single, simple bet about the future.
For example, this can be used in almost any rental or sharing economy company (clothing, transportation, equipment, etc). Even though most rental markets aren’t very large, the bet goes something like “Do you really believe that people are going to continue spending thousands of money on products that are not utilized 90+% of the time? Our bet is that consumers are rapidly moving away from ownership towards sharing and renting, and those multiple billions of dollars are going to shift towards the companies that get this right.
Two Final Thoughts and Reminders
First, don’t forget about what margins mean for market potential.
High-margin businesses like software or marketplaces (when revenue is correctly accounted for) can support 10X+ revenue multiples. So the bar for a large-scale opportunity is the potential to generate hundreds of millions of dollars in revenue to be worth billions of dollars down the road.
For low-margin businesses, the revenue bar for a larger-scale opportunity is higher. So when you are talking about how your business can build using a bottoms-up analysis or comparatives, make sure you keep this in mind.
Second, the landscape of potential acquirers plays into this discussion as well. Generally, don’t spend too much time talking about buyers and M&A opportunities. But when you are a company that may very well find that the market opportunity is not as big as one thought or hoped, it’s comforting to be in a category with a strong set of folks who would buy you for a reasonable amount.
Most investors don’t focus on downside protection. But psychologically, this could make a difference when one is on the fence because of market size or the risk associated with a bank shot/scope expansion strategy.
(Shared By Rob Go, Cofounder of NextView)
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QUICK DIVES
1. The Market Size Mistake
One of the most common reasons founders face rejection from investors is due to a small market size. Even Tobi Lutke, the founder of Shopify, has explained this. In the early days, many investors passed on Shopify because they believed the addressable market was too limited.
Lutke clarifies, "At the time, there were only about 40,000-50,000 online stores. Even if Shopify captured 50% of that market, it still wouldn’t be considered a venture-scale business."
When Tobi ran into the VC partner a few years ago, the partner asked Tobi what he missed (Shopify is valued at almost $100 billion today).
Tobi explained:
“You were correct, but what you didn’t realize was that Shopify was the solution to the very problem you identified. The reason there were only 40,000 online stores was because it was hard, expensive, and everyone who tried ran into all these brick walls of complexity, which Shopify, one after another, smoothed over and made simple to do.”
Tobi believes this is a common mistake:
“What a lot of free-market thinkers don’t understand is that between the demand and eventual supply lies friction. And I actually think that friction is probably the most potent force for shaping the planet that people just generally do not acknowledge… That was my theory when I turned my snowboard store into Shopify: there were a lot more people like me except there was too much friction which we needed to solve.
And Shopify has proven that every time we make the process simpler, there’s more consumption. At this point, we have a million merchants on Shopify, which is a mind-blowing number. So friction is a major component, and it’s something that software is uniquely good at reducing.”
You can watch the full video here Tobi Lütke The Creator of Shopify
2. How Do You Tell A Compelling Story About Your Company To Investors?
Every founder thinks they have an awesome team and technology; the question is, what will investors think? In fundraising, most founders are tempted to jump straight into PowerPoint to get started.
Don’t do it! Here’s the secret to a great pitch: "It’s not about the slides; it’s about the story."
So how do you tell a compelling story? - First, figure out which type of story you should be telling and make that narrative into a sandwich, emphasizing the key point at the beginning and again at the end. Next, use your problem and solution statements to emotionally and intellectually engage your audience, and be sure to adequately address all the expected areas in the deck.
With all that in mind, you’ll be ready to follow three simple steps to craft your winning deck.
Choose The Right Story To Tell
The first and most important thing to decide about your pitch is which story you should be telling. Fiction may have seven plot archetypes, but pitches tend to fall into one of four narratives, listed here in order of strength:
Traction. This is the story you want to be telling. Maybe your revenue or user base is growing really fast (> 20% month-over-month), or you’ve closed deals with major customers or partners. If you have traction that will impress investors, then tell a traction story.
Team. Maybe you don’t have wow-factor traction yet, but you and your cofounders are successful second-time founders or have a management team with impressive pedigree. In that case, tell a people story.
Technology. Or perhaps you don’t have strong traction but have created a technological breakthrough in an important field. Then you could tell a technology story.
Vision. This is the story of last resort. If you don’t have impressive traction, a highly regarded team, or a technological breakthrough, then you have to fall back on a vision story of how you want to change the world.
Be realistic in your self-analysis of what qualifies as “impressive.” Every founder thinks they have an awesome team and technology; the question is, what will investors think? If you’re not sure which story you should tell, then get some feedback from investors or other founders.
Make A Sandwich
To capture investors’ attention and help them remember you, open the pitch with your company’s single most impressive achievement to date, and then highlight that achievement again at the very end.
"Open the pitch with your company’s highest achievement." Read more here…
3. When The VCs Say “No”...
Many founders come across posts like 'Startup founder secures funding after pitching to 100 VCs' and feel motivated to pitch to as many investors as possible.
I agree that one "no" doesn’t mean anything—the VC could just be having a bad day. But If you meet with five or six or eight VCs and they all say no, it’s not a coincidence. There is something wrong with your plan.
Many founders are inspired by stories of startup founders securing funding after pitching to numerous VCs, but they often overlook the fact that these successful founders continuously refined their plans with each pitch.
Meeting with more VCs after a bunch have said no is probably a waste of time. Instead, retool your plan—which is what this post is about.
Remember VCs rarely actually say “no”—more often they say “maybe”, or “not right now”, or “my partners aren’t sure”, or “that’s interesting, let me think about it”.
They do that because they don’t want to invest in your company given the current facts, but they want to keep the door open. And that’s exactly what you want—you want to be able to go back to them with a new set of facts, change their minds, and get to “yes”.
The second thing to consider is the funding environment which influences more in fundraising. (But not in the founder's control...) so focus on retooling your plans...
I know this is hard — changing the facts of your plan and what you are trying to do, to make your company more fundable. But do it.
So how do you retool your plans? - Consider the onion theory of risk. Investors, look at the risk around an investment as if it’s an onion. Just like you peel an onion and remove each layer in turn, risk in a startup investment comes in layers that get peeled away—reduced—one by one.
Your challenge as an entrepreneur trying to raise venture capital is to keep peeling layers of risk off of your particular onion until the VCs say “yes”—until the risk in your startup is reduced to the point where investing in your startup doesn’t look terrifying and merely looks risky.
What are the layers of risk?
Founder Risk: Evaluate team dynamics; consider adding or replacing founders if needed.
Market Risk: Validate the market practically; seek paying customers or credible prospects.
Competition Risk: Ensure strong differentiation; avoid claiming no competition.
Financing Risk: Rethink and reduce future funding needs; optimize your financial plan.
Technology and Product Risks: Build and demonstrate your product; focus on progress.
Hiring Risk: Add crucial positions to the founding team if concerns arise.
Remember, the key is to make progress, build products, and continuously peel away risks to optimize chances of securing funds. Adapt, refine, and repeat until you hear that coveted "yes"!
4. Hidden Trap Of Convertible Note and Liquidation Preference Multiples
Young entrepreneurs often get screwed by their angel investors on convertible notes and I know I can’t convince you not to do it so I’d like to offer one simple bit of advice to help you avoid getting screwed.
When you do a convertible note with a cap that converts into the next round of funding, one of the unintended consequences is that if you’re successful and raise at a larger price than your cap the early angels often get “multiple liquidation preferences” on their dollars in.
Here’s how it works:
Let's say an angel invests $500,000 with a $5 million cap. That means they'll own at least 9% of your company if the conversion price exceeds the cap. If you raise funds at a lower price, their ownership goes up.
Now, with a regular 1x liquidation preference, they'd be entitled to $500,000 if you sell the company for less than $5 million. If you sell for more, they'd rather take their ownership percentage instead of that liquidation preference, which acts like a safety net.
Fast forward, You work your tail off for 18 months, securing a series of notes, and guess what? You're lucky enough to land $5M at $25M pre-money valuation. At this point, that early angel investor owns around 16.67% and probably still holds a 1x liquidation preference.
Now here's where the trickery starts: When the initial note converts, instead of snagging a $500,000 liquidation preference, they'd cash in a mind-boggling $2.5 million liquidation preference—a whopping 5x increase!
If a VC pulled this move in an early-stage deal, their reputation would suffer, making it hard for them to work with other VCs or entrepreneurs. In VC financings, this term is clear, but on convertible notes, it happens subtly, catching entrepreneurs off guard – a silent and painful setback.
So here’s what every entrepreneur should add immediately to any convertible note:
"If this note converts at a price higher than the cap that you have been given you agree that in the conversion of the note into equity you agree to allow your stock to be converted such that you will receive no more than a 1x non-participating liquidation preference plus any agreed interest."
Papering this when it converts is super easy if the angel has already consented to it and they are not being cheated at all. They get their full investment as a 1x liquidation preference. And please don’t let any angel try to convince you they deserve more for the early risk. The early risk is why they get a cheaper price.
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✍️Written By Sahil R | Venture Crew Team