Venture Capital Due Diligence: The Market Test

This is part of GoingVC’s Research Series on Venture Capital Due Diligence

Introduction | The Screening Process | The Market Test | The Scorecard

The Management Test | The Management Team

Product KPIs | Building Product Moats

Accounting 101 | Financial Valuation

Technical Due Diligence

The Market Test

The market test asks whether or not the venture’s addressable market, also commonly referred to as TAM (Total Addressable Market), is large enough to warrant a venture investment. Included in the addressable market test is the existing (and potentially new) competitors in the space. This is a critical component of the screening process because there exist several large markets (online retail) that may be dominated by one incumbent (Amazon), making the barriers to entry more significant than when viewed based purely on market size. Let’s look at how VC’s and entrepreneurs can underwrite the addressable market — it is both a science and an art.

We will dive deeper into the market in terms of competition, growth strategy, and exit opportunities when we discuss the business due diligence, but for now we’ll develop a simple test to ensure the market is large enough to warrant VC investment. There are two considerations: first, can the market support the type of hyper-growth necessary and can that growth be sustained for a long enough period? Combined, these paint a picture of the velocity within the market, and higher is better, meaning the company can grow faster than it spends. Situations to avoid are those where the company has to grow slowly and burn lots of cash to acquire customers or maximizes at a very underwhelming market share. Let’s see how VCs can estimate these market sizes and likelihood of solid velocity potential.

New vs Old Markets

First, is the company delivering products and solutions in an existing market or are they creating a new category? Is the existing market highly fragmented (meaning there is opportunity to become the dominant player)? How quickly are the most successful companies growing and is there continued opportunity for disruption? How adequately are potential competitors solving the same problems (are they at all?). How easy will it be for potential customers to adopt new technology? Is the product a marginal improvement over existing solutions or 10x better?

The above graphic is an overly-simplistic representation between the risk and reward when companies develop a combination of new products or create new markets. For companies that are offering new solutions to existing markets, at least one of the following must be true:

1. There is real product differentiation: The product is at least 10x better than existing solutions through either the user experience, total functionality, or something else.
2. There is perceived product differentiation: The product benefits from the strength of the brand (i.e. Microsoft may have an easier path to launching a new productivity tool than an unknown company).
3. There are networks effects: There is added value as more users join and use the product or platform (social media platforms and other two-sided marketplaces such as eBay) and/or value is created by interactions among users.

For those creating entire new categories, the challenges are a bit harder. How easily are the people within the target market identified? We will discuss the segmentation of users in the marketing due diligence section in more detail, but if the founders cannot in a single phrase identify their core users, the market may not exist. Furthermore, how painful is the problem and is the product one where people will not be able to live without having? How likely are potential users to actually adopt and begin using the product. Let’s look at electric scooters as an example. Across the US, many cities are running pilot programs to test the adoption of electric scooters by weighing the trade-offs between things such as safety and clutter and environmental benefits. When personas need to change — in this case the idea of getting comfortable riding a scooter in a city versus driving or public transportation — it can be an uphill battle. It often requires investing lots of time, resources, and capital to do so, and often require lots of trial and error before the user base adjusts and adopts. This is known as the Tough Tomato Principal and stitched together brilliantly by Jackie DiMonte of Hyde Park Venture Partners (tweet here):

These exercises are often more challenging to identify than it appears. Netflix is an example of a company that started by entering an existing market, rental movies, but eventually carved out an entire category of on-demand, stand-alone, cable alternatives (which quickly attracted competitors such as Hulu, Amazon Prime, and HBO Go, to name a few). The trade-offs of being the first or second into a market are beyond the scope of this exercise but are worthy topics for continued research. Another example is the iPhone, which completely revolutionized the mobile phone industry by not just it’s hardware, but through the eventual adoption of a more open-sourced environment for third-party app developers, creating an entire new marketplace for mobile app development.

Top-Down versus Bottom-Up Size Estimates

There are two ways to go about estimating the size of the market. The ‘Top Down’ approach is generally used for existing markets where the largest competitors, price points, and customers are more easily defined. Starting with the overall market size, you then whittle down to the likely market share the venture may be able to grab.

For a hypothetical Real Estate venture focused on technology for residential real estate agents, a Top-Down approach would start by leveraging data from places such as Google, IDC, and Forrester to source a potential market size. A quick web search reveals that in 2017 the industry took in $75B in commissions — a substantial market size to say the least. This, however, is the total market size, which differs from the targeted market by the company, the aforementioned TAM. This is where getting more accurate data can be challenging using Top-Down methods. In comes the Bottom-Up approach.

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The Bottom-Up approach does just the opposite of Top-Down: start with the venture and determine the path towards the minimum required market size and the necessary steps and achievements necessary to get there.

Continuing with Real Estate, a quick Google search informs you there are approximately two million licensed real estate agents in the country. If you estimate the product will sell for, on average, $1,000/agent/year, the overall market size is therefore $2B. Alternatively, you could note there were 5.34M homes sold in 2018 per the National Association of Realtors and back into a total commission figure based on an average 5% commission rate applied to the average home sale price to guesstimate a market size based on commissions.

What, however, is the total addressable market size? That of course depends on the segment of the entire market the company intends to target. If the products are best suited for agents working at independent boutiques, that, according to NAR Statistics, will drop the potential customers by 46%! Further whittling this down to specific region focuses, for example, shrinks the TAM further.

Which figure is the best to use between overall market size and TAM? In most cases, it’s TAM, as it represents the likely more accurate depiction of the capacity for the venture. However, as previously mentioned, it may be using data for an existing market, ignoring new possibilities that could expand the potential market size. If the Real Estate product is a platform that would also be valuable to ancillary roles such as mortgage brokers and attorneys, title companies, and others, the market size can grow quickly.

Again, these exercises are not about precision and do not represent the revenue potential of the company (that takes further analysis down the road) but asks if the market can sustain a large enough company to warrant institutional investments. A good benchmark is a minimum of $500M-$1B in overall market size and a minimum of $100M in addressable market size.

Plotting Opportunities

For those who prefer visuals, we can plot markets and competitors along the X and Y axis to better understand the market and value propositions (more to come on this later). As an example, we can simultaneously look at two companies: Uber and Opendoor by the shared value prop they deliver (enhanced consumer experience) but develop market sizes differently based on the frequency of use.

Both companies are disrupting traditional means of transacting in their respective markets. Opendoor by displacing services more traditionally offered by real estate agents by acting as a cash buyer for home sellers and of course Uber over traditional taxi cabs. In terms of risk, this is not to be confused with danger, but rather the magnitude of error when wrong. When deciding between a Yellow Cab and an Uber (or driving yourself, public transportation, etc.), you may get a buggy app experience, an extended wait, drivers who do not know their way around town, or get dropped off in the wrong spot. These risks to the consumer are lower than that of buying or selling your home, where there are larger financial risks in play. While both these companies offer improved technology and more fluid consumer experience, the methods of developing a market size may differ given the frequency of transactions among the company’s respective users. People buy a home on average once every five to seven years whereas people often take an Uber more than once a day. Depending on how you develop the market size, the frequency of use of the product may matter quite a bit.

A Top-Down approach is likely a more appropriate means for determining the market size for Opendoor, who can look at the total value of homes sold in a year and in a particular market and begin to subset those by side (i.e. sales to other individuals facilitated by an agent) and estimate a percentage of those sales and their equivalent value they can capture. The Arizona Regional MLS website contains statistics that show an average of 7,000 home sales per month (84,000/year) and an average price of about $390,000 — a total annual value in the market of $33B. Backing into Opendoor’s fee structure of an estimated 6% per sale nets a total market size of about $2B (ignoring for now their profit on the eventual sale). Given almost no firms achieve more than 20% of any single market, and most achieve figures closer to 1–3%, Opendoor can estimate it’s TAM in a single market to be between $59M and $390M. Expanding this to other markets quickly increases the TAM to a substantial figure.

On the flip side, a Bottom-Up approach may lend itself more naturally to Uber, which might be done by starting with an estimated number of people per day who hail a taxi, an average fare, an estimate of Uber’s take, and the aggregating that annually. This of course ignores potential multipliers like the amount of people who would be more willing to use Uber given the ease of use than a taxi. This is why when estimating market sizes for new markets or massive disruptors, starting Top-Down with an existing market may be secondary to Bottom-Up.

Next Up

Does the venture pass the market test? Great! Next we’ll take a look at our screening scorecard to help develop a short investment thesis.