Trees grow in size by first expanding their roots in the soil. Every specie of tree is different and it may need a different structure and acidity of the soil. Some need larger and deeper spaces to grow their roots to develop to their full potential, some need less. Different species grow at different speeds, have different lifespans and different resistance to external agents. If the soil is occupied by other trees, there might not be enough space for another one to spread its roots and they will compete for nutrition, water etc.
The same applies to startups. Before setting your ‘roots’, you need to know what kind of startup you are building, what it needs to grow and become profitable and the market (‘soil’) that is available to you and that your project needs to get started.
The market should be suitable to the venture that you’re planning. If your company can only be profitable at a certain size and your competitors have also grown to a certain size, you need a large enough market to grow. If you have a niche company that can become successful at a small scale, you only need a smaller market to do so. If the market is overcrowded, developing means taking up the space of other companies and success means winning over some of their customers. Some companies are built to be resistant to economic cycles, just like some companies can develop a business despite adverse market situations. These are things that you should know before ‘planting’ the roots of your company.
The way to start is to really define your market. Use numbers related to your specific business, not the larger industry, as the latter doesn’t tell you anything about your potential. You may as well be in an industry that is billions of dollars in size, but if you only target a niche group among the customers in that industry, or if you take transactions of 0.01% out of the revenues in that industry, the total industry size gives you the idea that possibilities and earnings for your company are infinite, whereas these are instead very limited. It all depends on how much revenue your specific market and companies with a similar business model earn.
How do you define your market? You may definite it in terms of number of customers, whether it is B2B, B2C, both or B2B2C: define who you are really targeting and keep it simple. You can also define it in terms of market value, or yearly spending in that market: this is usually useful to determine how much your market share can really grow in the long-term, and it’s useful for some B2B sectors where the number of customers or the spending per customer is difficult to determine (for example advertising).
However, having financial projections based on the number of customers that you can gain over time, also gives you information about your marketing expenses by measuring a Customer Acquisition Cost: you will easily see when your projections are off and when to adjust marketing spending or prices.
To define your market, start asking yourself: who is the product really for? Who is the decision-maker? Who are they influenced by? How are you going to approach them? The ability to approach them also defines whether they can be your market, for example if you target areas of low internet penetration you may only be able to target those who are exposed to online advertising.
How they use the product also defines your market and spending: how often is your service/product bought by the same customer? What is the retention rate, retention strategy or dependency on product add-ons? Can you sell new products to the same customers or do they belong to a different target group?
It’s not as easy as it sounds. You can break it down by defining:
- Total Addressable Market (TAM): Your actual target market. This will not be static and instead grow at a certain CAGR (Compound Annual Growth Rate, in size or value). Many startups typically target high-growth markets.
- Serviceable Available Market (SAM): The portion of the target market that you can address and realistically target
- Serviceable Obtainable Market (SOM): The portion of the market that can win as customers considering competition, the development of competition and how you compare to them.
I have seen quite a few financial plans that just assume that the entire Serviceable Obtainable Market can be reached on day 1, and from then on you can just apply a standard growth rate. That’s not the reality of startups. I think it’s best to consider SOM something that you can reach with your current business model, between 5 and 10 years from day 0, and then determine how fast you can reach that market. It’s often slow in year 1 and fast in year 2-3 for many tech startups. If you look further in the future, since the first few years may not tell much about a startup story, you can project how the growth curve slows down as the company matures. Surely not exciting for investors to even predict any slowdown, but that needs to be considered. Since many startups don’t sell before year 5, and many may sell after year 10, it’s an exercise worth doing to assess a realistic exit size, especially for markets in which we can observe these exit trends.
What problems are you solving for your customers? Why is now a good time? You will be asked these questions by investors many times as this often determines the success or failure of a startup, as well as how you validated your solution, with real-world examples, traction and partnerships further solidifying the reliability of your venture. Your possibilities are:
- Personal observation
- Market Research
- Industry experience and knowledge of industry practices
- Exact same product is successful abroad
- Superior solution to an existing business model and deep knowledge of customer needs
- Market validation
- Customer traction & positive feedback
- Existing partnerships
Validating your business model or idea also involves analysing competition. If you (in rare cases) don’t have any competitors, you probably have substitutes: what are your customers doing now to solve the problem and what would drive them to switch? Researching competing companies also gives you insights into how fast they developed, their market penetration, what prices they charge to compare to your revenue projections. If your projections are more positive, you’d be expected to motivate this through a competitive advantage.
The differentiation strategy can encompass one, or better, multiple elements: product/ technology, customer service, access to market/ resources, revenue model, marketing strategy, business model, etc. Is your competitive advantage sustainable and is it enough of a driver for customers to buy your product? Are your customers going to be using your product while at the same time using competitors’ products and what does this mean for your marketing strategy?
Also, what are the barriers to entry? Are your competitors being financed by VCs or quickly gaining traction? If they are, you may have a hard time competing by bootstrapping your company for too long.
It could seem early to think about your long-term strategy, but investors like large opportunities: the ability to scale efficiently at a low cost, having a pipeline of possible products. Can you expand geographically, to different markets, to different target groups or sell additional products to your current customer group? Do you have an effective expansion strategy connected to your pricing, R&D and marketing strategy? You would also want to ask yourself whether you want to expand, as if you want to stay local you might not be investor material. It could be worth analysing the Ansoff matrix to see where your future expansion can be placed.
Whichever type of expansion you choose, sales and marketing costs can grow in line with your expansion. Determining your marketing mix to win new customers (direct sales, advertising & other marketing activities, referrals, on-site shops, trade fairs, third-party companies) and the portion of customers originating from each activity also validates your business model. Additional questions that is worth asking yourself are: What channels are you going to use? What is the Customer Acquisition Cost in your sector? How much is this compared to the Customer Lifetime Value? Did you account for the differences among countries that you are planning to enter into?
There is a lot to research and validation work before a business model can be defined. Not all of these questions can be answered at first, but knowing that soon enough these metrics will be analysed helps you be prepared and take the right path. When in luck, or thanks to deep industry experience of the founders, the metrics of similar competitors are available and they can be used to validate or adapt the business model and therefore saving money.