In this Episode, Andy and Swati discuss how to understand the Market for a startup. Questions we discuss are: Why is an understanding of market potential relevant (and what is market potential anyway)? How should one estimate the market size? Does every startup really have to have a humungous market running into many billions of dollars?
Join us as we discuss these topics and more, that surround the key elements of startup evaluation – Market Size.
This is Propel(x) podcast, discussion on investing in all things startups. Startup investing is highly risky. Please listen carefully to the disclosures at the end of this podcast.
Andy Reed: This is Andy, and this is the Propel(x) podcast. I’m here with Swati Chaturvedi. Hi Swati
Swati Chaturvedi: Hi, Andy.
Andy Reed: And today we are about markets, specifically market sizing. I think it is one of the most important and probably.. kind of..most artistic thing that people do in early-stage valuation. So let’s go ahead and get started. Why does this matter?
Swati Chaturvedi: Yeah..so, market is very important. What does it mean to have a market? Is someone willing to buy this? If lots and lots of people are willing to buy it, then the company stands to make lots and lots of money. The more money that the company makes, eventually it can create more value, assuming the profit margin there all cans on. But it can create more value for its shareholders. Very often technology companies especially are sold at a multiple offer. So what a big investor or venture capitalist, in other words, would want to see is a very big market. So you can get sold for lots and lots of money and give those lots and lots of return. So market is relevant in that it translates directly into what kind of return you could get. But it doesn’t always have to be humongous..right..and we can discuss more of that, but that’s something that’s what I think is counter-intuitive.
Andy Reed: I do want to ask you to elaborate on something you said, which is lots of buyers. I think there are also counter facts or counterexamples where there are few buyers, but they spend lots of money.
Swati Chaturvedi: Yeah, lots of sales eventually. Its dollar value.
Andy Reed: I’m just saying we don’t need to push everyone to the Penn’s market where there are lots of sales. There are technology companies selling to big markets.
Swati Chaturvedi: Dollar value, absolutely.
Andy Reed: Okay, cool. So what should an investor be thinking about when they assess markets or the other way to do it is: How do you think about market risk?
Swati Chaturvedi: So we have to start by understanding who the customer is. In order to get to a market estimate, so our goal here is to confirm what the size of the market is and who the competition is so we can understand how much money this company is likely to make. To understand the size of the market, you actually have to understand the industry just a little bit, at least. So specifically you need to understand who is the customer. For example, a company comes along and says, I’m selling a software to hospitals to manage their operation. All right..who is the customer? Is it the hospital? Is it the chief procurement officer? Is it someone who’s lower down on the procurement chain? How much does your product cost? Those are relevant questions to ask because you want to understand the industry, you want to understand the buying dynamics, you want to understand the dollar sizes that are going to be transacted and over what timelines, because that does lead to estimating the specific market.
Andy Reed: So I actually heard you say a bunch of different things there: Who is the buyer? Is the purchaser the same person as the customer or the user? What’s the sales cycle? So thinking about how all the dynamics of payment works in that market. And then how close is the company to the customers or buyers? That’s a lot to get through. How would someone find out more about this information?
Swati Chaturvedi: Not every investor has to become an expert at every industry, obviously. And in the public markets, for example, you have the annual report, you can read it up and you can understand a little bit of the industry. So how does one learn this in the private market? Let’s say you have nothing to do with hospitals and you are, in fact, looking at a software that is sold into hospitals, how do you learn about this? Well, ask the startup. I think that that’s the logical place to start. And the reason I want to emphasize this is a lot of investors, early-stage investors, and in particular, angels who’ve not done this before are very reluctant to ask questions lest they be perceived as somehow intrusive. It is your right to ask these questions.
Andy Reed: It’s your money.
Swati Chaturvedi: It’s your money. Exactly. And it is the startup’s obligation, almost, to answer these questions, they’re asking you for money.
Andy Reed: In a way, it is important because it also demonstrates how well the startup actually knows the market. I mean, they should be able to sit with you and give you a high level of confidence that they know their path to sales. If they can’t answer those questions, I think it’s probably going to be pretty tricky for them to actually find their customer and generate revenue.
Swati Chaturvedi: Yes, no question. Any angel group, for example, will have the company pitch. They’ll have the company come and present in person, you’ll have the opportunity to meet the entrepreneur or at least see them from a distance, and if you’re lucky, you get to go up and ask these questions and potentially shake hands and so on and so forth. But that’s the opportunity to ask. There’s an in-person opportunity. And with platforms like Propel(x) and others, we host webinars and we encourage questions. Ask the question live and listen to the answer live at that time.
Andy Reed: I want to follow up actually on one thing you just said, which is with angel groups. So a big part of this kind of early-stage investing is also developing your network; learning how to quickly come up to speed on the salient factors of a different industry that you’re not a part of through the resources that are part of your network. So I definitely appreciate you plugging angel groups. So for markets, there’s a lot to talk about here. Can we just talk about how to size markets first?
Swati Chaturvedi: Sure. So this is something we discussed, right? Which is, we’re trying to understand how much dollars are spent by customers in this business every year. And you can size it top-down. You can size it bottom-up..
Andy Reed: What does that mean?
Swati Chaturvedi: So top-down is you start from a big number; macro number, for example, Andy, like we were talking about the size of the mattress market in the US, the context being Casper going public. But you can start with, okay there’s X number of households. Within that, each of them is probably going to need so many mattresses, and so when you drill down, some of them will be targets for direct-to-home delivery, and so you come with a number of mattresses that are potential to be sold times the price per mattress, you get to potential dollar value of the market. The other way to look at it is bottom-up; which is you have to start with the company itself. What is it selling? What is its process? How much the price is? What is its potential today? And then forecast it out into the future. So you do have to create a financial forecast to understand okay, this is the potential for the revenue for this company. Let’s say you forecast it down and you get to a revenue figure over the years, and let’s assume you’re capturing X percent or you believe you’re capturing X percent of the market. That’s how you get overall market size. So the top-down is really based on macro factors and you, and you get to the bottom of it and bottom-up is based on the company’s projections or company’s resources and methods of going to market and so on, and you come to the top.
Andy Reed: Yeah, I got a little bit lost in what you’re saying. But let me say how I think about it and you tell me what I’m missing here. So top-down is a macro approach. You’re probably going to start from something like an industry report, and you’re going to start on this year’s sales, right? So, in 2020—I’m making this up—a billion dollars of mattresses that were sold. And so typically, what I see people do is say, “Okay, well, 1% in this market or 2% of this market is this much. And if this company can hit 2% of this market, then that’s a big enough number for me based on what I think.” It’s kind of very back of the napkin approach. The other way, I think of it as more of a reflection of the assets of the company, I don’t mean like on a balance sheet perspective. I mean: What are the actual characteristics of that company? And so you had mentioned business model is a big one, channel is another one, team; all these things that you need to kind of suss out when you’re thinking about a company. Okay, now let’s multiply that out until we get to where I think this company is going to be. And if we stick with the mattress analogy or example, I think it’s an actually interesting reflection because there was a pretty big markdown on the IPO. So clearly people who were investing at kind of the middle stage of growth thought that…
Swati Chaturvedi: Just a minute. So people know we’re talking about the Casper IPO.
Andy Reed: Yeah. Casper had this markdown and clearly, people who invested in the middle thought that their bottom-up approach would result in a bigger multiple of sales than where they are today.
Swati Chaturvedi: Well, I would say that.. I wonder how many people actually did the bottom-up. One of the key things we need to be wary about in investing is all this hype that goes around startups. The startup is valued at 80 billion, another one is valued at a hundred billion, and another one is valued at a trillion. I mean, you have to have the revenues to justify these things, and because there are bubbles and there are cycles, so there are periods when companies are able to sell a higher valuation. Which is not justified by the revenue and honestly, investors have to put their money somewhere. So I’m very skeptical when people say, “Oh, I don’t know I did this analysis and I got proven wrong or something like that.” Well, I don’t know how good it was or how thorough it was.
Andy Reed: So the bottom-up approach you feel like since people are making their own decisions about it, there’s at least an aspect where it’s a little bit more. Not just a fireball in the ultimate sense, but it’s on you to figure out what you really think.
Swati Chaturvedi: I think you really need to ask the company. So you brought up this idea of business model and channel. That plays very much into market size, right? Because, to give the example of Casper, the fact that they are delivering to your home, it’s just a different business model. It targets a different type of customer, right? So, their market is not really the total market for mattresses in America. It is the market for people who want their mattresses delivered to their homes without sleeping on it in America. Most people want to try out the mattress and sleep on it. Here, it’s reversed. We’ll deliver the mattress and you can sleep on it and if you don’t like it, you can return the mattress. So it’s a different business model and that plays into the market estimate.
Andy Reed: So I do want to pause, I know in this conversation, we’ve touched on a lot of topics, but there is one that I think that we haven’t talked about yet, which is market timing, and especially with deep technology trends. So there’s a lot of things that we see in our company. And there’s an aspect of; when is this actually going to happen? And then there are macro factors that influence that. So if we took one example, which would be autonomous driving, I think you know..10 years ago, I can’t remember, some period of time ago, there was this hype that was like, “We’re all gonna be like caddied around by really cool robots that serve us drinks and we can just take naps and you know..all the things, right?
Swati Chaturvedi: I was hoping for it. Yes.
Andy Reed: But instead, we’re still driving the same vehicles that we drove eight years ago. Some of us at least. But more to the point, there’s some assisted driving technology, you see it in parking, but we’re not seeing widespread adoption of autonomous driving. And so a lot of this venture investing, or angel investing is trying to gauge the market, sorry, not market but technology adoption. So one question I have for you in thinking about markets is how do you think about markets that “do not exist” yet? So let’s stick with the Casper example, right? So when Casper was pitching seed deck, they had to convince people that there were other people that were in the market and there were a lot of these people enough to fund them. So if you were in the audience at that kind of angel group where they were pitched, how would you think about the bottom-up sizing of Casper’s market potential before they had demonstrated this market’s real?
Swati Chaturvedi: You wanted to see some traction and that is when that traction becomes important to understand. There are two things you want to see in a startup. Even if there isn’t a market, you need to demonstrate that there is some people who are willing to buy this, right? And then you have to persuade the angel investor that these ‘some people’ are representative sample, and that these will translate into much higher sales when you do more marketing around it, when you spread the word. On the flip side, the angel investor needs to see that there is some adoption, there are some sales already, and that’s actually very important, even if it is a drug company. You have to demonstrate that there are big companies that are interested in this drug. Examples that we see: We see people sharing screenshots of their email, where so-and-so person from Takeda said he was interested in collaborating with us in a joint development agreement. We’ve seen this in biofuels where so and so in Dow Chemicals said that we are interested in a joint development agreement, so you can demonstrate customer interest in many different ways. And the startup’s job is to demonstrate that traction, that eventually this will translate into sales and the angel investor’s job is to get a sense and develop their own sense of whether or not this existing small amount of traction will eventually translate into a big amount of traction. So traction is very important.
Andy Reed: I agree with you. But that doesn’t necessarily solve the market sizing for markets that don’t exist.
Swati Chaturvedi: Well, you have to have some understanding. You have to make up your mind about – let’s say a hundred people are buying a Casper mattress today and the potential for so many people exist, there are 150 million households let’s say in the US some 10% of them might be interested in now home delivery mattresses. Okay. So that gives us..there are 15 million potential households here. Out of that, they’ve demonstrated a hundred households in, let’s say, the New York area. Do I believe? It’s not a problem. It’s a question of judgment and belief and judgment always plays into investment. So that’s the difference between a bad investor and a good investor; the good investor had good judgment. And they’re able to envision and to visualize the future and say, is this going to be a thing where people get mattresses delivered? So just to reframe your sentence; how do I solve the problem when the market doesn’t exist? Well, that’s also your opportunity to demonstrate your power of visualizing the future and your judgment on that.
Andy Reed: Yeah, that makes sense. So I guess I have one last question. Which is just like..I mean..I see pitch decks all day and they say market size in them, right? And then you tell me to go chat with this person. So let’s assume that they’re directionally correct. Why not just take that and move on? Take the numbers the startup founders give you?
Swati Chaturvedi: Oh, because they are wildly off. I think it’s very good to be a skeptic when it comes to angel investing, especially. So the problem is that many startups haven’t really discovered their market, right? The flagship or the hallmark of a startup that has a market is that they have some customer traction. Whether they’ve demonstrated a hundred customers- that’s pretty good, a thousand customers — even better, but they have some traction. That is the hallmark of something that is starting to happen. Then you have to have judgment on whether it will grow or not grow and so on. But there are startups—let me give you this example, AI chip companies are all the rage these days, right? So, now there are AI chip companies, “Oh, we are developing this chip and it can be used in edge computing in autonomous vehicles, but by the way, it can also be used in IoT and it can be used in all kinds of blockchains scenarios.” So then your question is, okay, so you really haven’t nailed a market. You haven’t even started on that market yet. You don’t have a customer yet. One always has to have a beachhead market. You can always show the vision for how you’re going to make billions of dollars, but let’s have a beachhead market. And that’s where angel investors need to be skeptical of what they see in a pitch deck.
Andy Reed: So you’re really saying let’s have early customers.
Swati Chaturvedi: Yeah, let’s have early customers. That’s very important.
Andy Reed: I understand and extrapolate from there. I do want to go back. I noticed that that was my last question, but there’s something that caught my attention early in our conversation, which you said, I think, that you don’t need to have a huge market to have to basically continue in evaluating whether or not this is a good investment. My understanding is that you need to have like a $10 billion market.
Swati Chaturvedi: What? Haha..
Andy Reed: Maybe that’s a little bit of exaggeration, but I mean, you need to have a huge market to sell into, right? People say that all the time.
Swati Chaturvedi: That’s what we like to see, but that’s not entirely true market and competition go hand in hand, right? What is the point of having a $10 billion market, which also has 10 billion competitors? It’s not very valuable. On the other hand, if you had a half a billion, a $500 million market where you had no competition, you had unique technology, and you could capture 400 million of it all; there you go. That’s a winner for you.
Andy Reed: Zoom and Citrix.
Swati Chaturvedi: Yes. There you go.
Andy Reed: Not a lot of competition at that point in time in a video conferencing space and they did a great job of growing a company really quickly and getting to an exit that was kind of an amazing…
Swati Chaturvedi: For Zoom?
Andy Reed: Yeah, for Zoom.
Swati Chaturvedi: I mean, they had good competition, but they just executed a lot better, I think.
Andy Reed: Maybe that’s a big market, so it’s not exactly…
Swati Chaturvedi: Yeah. But there are casting technologies, for example; Specific materials, casting technologies in manufacturing. We had the example of a company the other day, which is 3D printing ceramics for a specific purpose. I don’t think that’s a humongous market but they are there aren’t that many 3D printing companies which are printing using that specific technology, using that specific material. And so it makes sense. So probably one or two out there, so maybe it makes sense for them.
Andy Reed: So it kind of goes back to what is the overall market, but most importantly, what is the overall market this company can reasonably capture given all the dynamics of the company?
Swati Chaturvedi: Yeah. Including competition.
Andy Reed: That’s a lot. Thanks, Swati. This is a fun conversation.
Swati Chaturvedi: Thank you, Andy. More to come.
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