What kind of soil you need to grow your roots: Sizing the Market

What kind of soil you need to grow your roots: Sizing the Market Valithea Advisory

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.

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?

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 validation 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.

As your company grows and reaches new milestones, all of these features will expand and will require new investments:

What kind of soil you need to grow your roots: Sizing the Market Valithea Advisory

 

The first step to take to take to build your financial projections, after the market analysis and validation, is therefore laying out the expansion strategy with realistic figures.

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.

What kind of soil you need to grow your roots: Sizing the Market Valithea AdvisoryYou 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. However, as you keep entering new markets as a startup, your growth in enhanced by the growth in the new markets. 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.

We start from calculating the Total Addressable Market (TAM). Depending on your sector, you can calculate this in terms of value, volume or number of customers. Value is the total spending per year in your target market, volume is the total number of products/ units sold per year in your target market, and number of customers relates to the number of people or companies carrying out a transaction in your target market every year.

Market value is generally the easier value to find, but not the most useful. Most new ventures will have different pricing models and marketing strategies, therefore by using volume, in many cases you will not be able to realistically project your financials. Value, however, is a great figure to use for those businesses that earn income on a project-basis, where every contract may have a very different price (B2B advertising income, for example may be difficult to project based on number of clients), or for transaction-fee businesses, where a certain percentage of an industry transaction value is earned.

Volume figures are recommended for those businesses where the number of products purchased on a per-client basis is difficult to determine. Calculating your projections based on the number of customers, is typically the most accurate option and helps greatly when measuring the company’s performance, particularly for B2C startups, as well as helping in the calculation of marketing and sales costs on a per-customer basis, which for some sectors is necessary.

There are some rules to remember when calculating the total market size:

  • Be as specific as possible; if you are in a niche sector, research its size or make some assumptions to reduce the market size to what is suitable to your specific company
  • Use values that are suitable to how your revenue will develop
  • For new disruptive startups, your market size may measurable but not straightforward, you can draw it from where your future customers will come from

You can repeat this exercise, and the following steps, according to your expansion strategy, using your first target market, second target market, and so on. The market can be defined in terms of countries, regions, different customer groups, different product users within the same industry, different industries or a combination thereof. Be focused by using only few expansion steps that are relevant to your business.

When you have a very disruptive business model, this may be a little harder to calculate, as there is little or no market data to draw from. In this case you can use data from different industries together or make estimates yourself based on macroeconomic data. In some cases, companies create new markets, or expand current markets: this, however, is not easy to do, therefore do not overestimate your ability to influence the market if you lack the resources to do that. In any case, even with scarce market data, market sizes have a limit that can be drawn with a simple and free market research on other industries. In too many cases these limits are disregarded, and it results in niche companies claiming the potential to become unicorns.

The Total Addressable Market will also grow. Typically, VCs and other investors are interested in markets growing at a higher rate than the economy, otherwise growth will be impaired. Most startups, and even more so disruptive sectors or new technologies, are easily growing at double digits at the time of the investment, as that leaves space for new incumbents. Slow-growth industries would be interesting for investors only when you are targeting the industry with new products or services. You will then need to apply a CAGR (Compound Annual Growth Rate) to your Total Addressable Market to measure how it grows, and recognise that double-digit growth rates will eventually slow down after a few years.

A Serviceable Addressable Market (SAM) instead indicates that portion of the market that can effectively be served and targeted, by further cutting down your target market size. Even though the entire target market buys a certain product, when you introduce an innovative product, you know that a portion of the market will not switch due to certain characteristics, demographics or habits, or you and your direct competitors may not be able to target them through typical marketing channels. Taking a clear-cut example of a developing country with lower internet penetration: your market for physical goods or offline services is of a certain size, but once you offer the same services on an internet platform or marketplace, you will not reach the entire user market for that product; only those who will be able to access or know how to use the platform have the potential to be your customers. The SAM and usage can also have a growth rate if the market is changing fast, and if you used a conservative CAGR for the larger TAM market: however, ensure that you are not counting the samee type of growth twice.

The Serviceable Obtainable Market (SOM) relates to that portion of the market that your company can effectively obtain as customers with your set marketing strategy. This is hard to determine, but there are ways to do it more effectively. If your SAM only includes the market that you and your direct competitors target, the SOM can be divided into the number of competitors in the market, accounting for market leaders when possible. This will not lead to very precise values, but still more precise than most methods in use. You can divide, let’s say a 2 million customers market by 4 competitors, which results in a 500k target market for your company. However, what if your competitive strengths differ? You can adjust it by how much your company’s competitive advantage can contribute to winning more or less customers. This exercise is very helpful in order to consider the company’s own strengths and competition, as many owners falsely believe that they can reach the entire market with only a slight competitive advantage.

What if your company has first-mover advantage? Regardless of the barriers to entry, if it’s a profitable market you’re very unlikely to remain the only competitor. Especially when it is easy to enter a new market, many founders believe that earning possibilities are endless, whereas low barriers to entry lead to too many companies entering new startup markets and leaving little earnings left, even when moving into the market later. You can also consider consolidation, or in slow-growing markets, decreasing competition, when suitable. Again, future competition is hard to predict, but do not underestimate the power of using simple logic. If you are knowledgeable about your market on how it developed in the past, it’s possible to roughly predict how competition can develop, and in any case, it’s always a factor worth considering. So, don’t forget that, especially in new markets, your competitors will increase every year: use a growth rate here as well.

The best way to realistically project the number of customers and growth for a startup will be to apply an initial low competitiveness, assuming for example that the average competitor is 5x more competitive on day 1, but that this competitiveness grows very fast to eve exceed competitors and their market share. Please set a maximum market penetration to ensure that your projection do not become unrealistic. By maintaining this market penetration, you company will still be growing through the market growth and the entry in new markets.

What happens after this? Many falsely project, due to the lack of better financial tools, that the SOM will be obtained on Day 1. You can set the Serviceable Obtainable Market as a time-bound target, between 5 and 10 years, or possibly the same length of your financial projections. Then you can build up your market reach to reach 100% during this time-frame.

As complicated as this may seem, one of the most incorrect variables to use for seed or early-stage startups is growth rate. Growth rates are important to analyse, but projecting them from 0 is pretty much impossible, or leads to many mistakes, for example taking over more than 100% of the market – we’ve all seen these financial plans. Defining your target market and building up to it is more correct, and you can still use different growth rates in different years to portray, usually, a slow market entry, a very fast growth for 2-3 years and then a fast growth more in line with your market, depending on your sector and stage.

Using these values results in the projected number of customers for the duration of the financial plan phase, for each of the target markets that you have used (or volume of products sold, or sales/ transaction volume, depending on the variables that you have used). You can then project retention and number of active customers.

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.