Decoding VC Math: Why Market Size Matters More Than You Think
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TL;DR: Why VCs Care About Market Size and How It Shapes Investment Decisions
When it comes to venture capital, market size is not just a number — it’s a critical factor that can make or break investment decisions. But why is this so important? It all boils down to one fundamental goal: delivering returns to investors, known as Limited Partners (LPs). For top-performing VCs, this often means aiming to return 3–5X the capital invested by their LPs.
TL;DR: Why Early-Stage Founders Should Care About Market Size and How It Shapes Your Pitch
As an early-stage founder with a big idea and some initial traction, you might wonder why you should care about market size. The answer is simple: when a VC evaluates your startup, they’re not just looking at your product or team; they’re assessing whether your business can return a significant multiple of their investment. This could range from 10X the invested capital to being a “fund returner” or even a multiple fund returner. VCs operate in a power law business, where the majority of returns come from a small percentage of outliers, making market size a crucial part of their evaluation process.
The VC Math Behind Market Size
The basic formula VCs use to calculate returns is straightforward: ownership at exit x valuation at exit. For instance, if a VC is looking to return a $50M fund and owns 5% of a company at exit, that company needs to have a valuation of $1B at the time of exit. This is where market sizing becomes crucial. If your market is too small, it becomes challenging for the VC to envision an exit that meets their return expectations.
We recently had a conversation with a founder who pitched a total addressable market (TAM) of $225M (225K total customers at $1K LTV). Unfortunately, while we loved the company, this made it difficult for us to underwrite the investment because the market was simply too small to justify the required returns.
Deep Dive: Understanding Market Sizing
Market size is essentially the total revenue potential in a given market, based on the number of customers and historical sales trends. It represents the upper limit of your company’s revenue potential and is a key metric that investors use to gauge the potential ROI.
But how do you calculate market size? The approach can vary depending on the stage of investment. According to research from Pear VC, early-stage investors tend to prefer market sizing presented as TAM, SAM, and SOM, while later-stage investors focus more on recent revenue growth and future revenue estimates.
We’ll dive into an example next, but first, let’s break down the key components of market sizing.
- TAM (Total Addressable Market): The overall revenue opportunity available if your product or service achieved 100% market share.
- SAM (Serviceable Available Market): The portion of the TAM that is within your startup’s reach, considering its business model and geographical constraints.
- SOM (Serviceable Obtainable Market): The segment of the SAM that your startup can realistically capture in the short term, usually within three to five years.
Next, the two methods of market sizing.
- Top-Down: This approach starts with the TAM and works down to the SOM. It’s quicker but less accurate because it relies on estimates. It’s useful when data is sparse and you need to make quick assumptions.
- Bottom-Up: This approach starts with the SOM and works up to the TAM. It’s more time-consuming but generally more accurate because it involves using historical sales data and competitor pricing.
Example Scenario: Calculating Market Size and Fund Return Potential with a Bottom-Up Approach
Step 1: Define the SOM (Serviceable Obtainable Market)
Let’s say your startup has identified a Serviceable Obtainable Market (SOM) of $4B.
Step 2: Determine Potential Revenue
Assume your company can capture 5% of the SOM. This means:
Potential Revenue = 5% x SOM = 0.05 x $4 billion = $200 million
Step 3: Apply a Revenue Multiple to Estimate Valuation
If the industry standard is a 5x revenue multiple, your company’s potential valuation would be:
Valuation = $200 million x 5 = $1 billion
This valuation makes your startup a potential outlier return candidate! 🎉
Step 4: Calculate “Return the Fund” (RtF) Valuation
Now, let’s say a VC is managing a $100M fund and is aiming to “return the fund” (i.e., generate enough returns to repay their LPs). The VC might hold 20% ownership at the time of your company’s exit.
To return the fund, the required exit valuation is:
Step 5: Estimate Required Revenue for RtF Valuation
Using the same 5x revenue multiple, the revenue required to achieve this valuation would be:
Step 6: Assess Feasibility
Finally, the VC assesses whether your company can capture at least 2.5% of a $4 billion SOM to generate $100 million in revenue, which would support a $500 million valuation.
If your startup can realistically achieve this, a VC may consider your company capable of returning the fund, making it a viable investment candidate.
Summary
In this example:
- SOM is $4B.
- 5% SOM capture leads to $200M in revenue.
- 5x revenue multiple results in a $1B valuation.
- A VC looking to return the fund with $100M needs a $500M valuation, which equates to $100M in revenue.
- 2.5% SOM capture is required to achieve the RtF valuation.
Market sizing isn’t just about crunching numbers; it’s about understanding the bigger picture. Both founders and investors should continuously analyze market data and adjust their strategies to maximize returns. By aligning investment strategies with market potential, VCs and founders can set themselves up for success.
Learn more about the companies in our portfolio on our website. If you’re a founder innovating in commerce enablement, fintech, or the care economy, pitch us here!
