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Welcome to Nelson’s Newsletter, where founders learn the skills and knowledge they need to nail their next fundraise.
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After last week’s newsletter (Where do VCs get their money?), a helpful investor reached out with extra info about their fund:
They aim to deploy all their initial investments over the first 3-4 years. They rarely write a first check after year 4.
They allocate 70% of the fund to first checks and keep 30% in reserve for follow-on investments, though they know other funds that do 50-50.
If the fund is deployed over 4 years, they will gear up to raise another fund towards the middle of year 3, which is a lot earlier than I would’ve guessed.
(Thanks again for taking the time to message me. I’d like this newsletter to be as much a two-way street as possible!)
Why Markets Matter Most
This week, we’re talking about market size.
Market size is the single most important factor VCs will consider when deciding whether to invest in your startup.
Yep, that’s right. Your idea, expertise and the team you’ve built are all important, but markets matter most; more specifically, the size of the market you’re addressing.
And most founders don’t get just how big markets need to be to be profitable investments for VCs. Even the great Steves, Jobs and Wozniak of Apple, didn’t get it at first. From The Power Law:
Valentine went through the motions of asking what Apple was up to.
“What’s the market?” he asked Wozniak.
“A million,” said Wozniak.
“How do you know?”
“Well, there’s a million ham radio operators, and computers are more popular than ham radio.”
It took a lot of failed meetings and blunt feedback before Apple refined their pitch and began talking about a future in which every household had a computer.
But why is market size so important to VCs? Let’s dig into the numbers…
The economics of Venture Capital
As we saw last week, Limited Partners (LPs) give VCs capital in the hope they’ll generate returns that beat market indices like the S&P 500 by 5-8%.
For that to happen, VCs need their portfolio companies to return roughly three to four times the total fund size. Given that most of the startups they back will go to zero, they rely on a handful of their investments returning the entire fund several times over.
What does that look like in practice?
A $100 million fund would need to own 10% of a $3 billion company for a 3x return on the fund.
Many funds are far larger than $100 million, like a16z’s $2.2 billion Crypto Fund III. For a single company to return the fund, let alone generate any profit, a16z needs that company to be worth north of $22 billion (if they owned 10%).
How many $22 billion companies are created each year? Not many.
Now we can see why a profitable startup that generates $50 million in annual revenue might be a win for a founder but a failure for VCs like a16z who are hunting for multi-billion dollar exits.
As Scott Kupor, a GP at a16z, puts it:
“If VCs are wrong more often than they are right, and if success (or failure) as a VC is wholly a function of whether you get 10-20 percent of your investments to fall into the home run category, then the size of the winners is all that matters.”
What does this mean for founders?
Again, from Scott:
“you should be able to credibly convince yourself (and your potential VC partners) that the market opportunity is sufficiently large to be able to generate a profitable, high-growth, several-hundred-million-dollar-revenue business over a seven-to-ten-year period.”
If you can’t, then VC probably isn’t right for your startup.
If you think your market could be that large, then it’s your job as a founder to convince investors it is too.
But estimating market size can be tricky. Let’s see why.
Market sizing: more art than science
Sizing a market is easiest to do when your startup is a direct substitute for an existing incumbent. A ride-hailing startup in 2023 could look at Uber’s user numbers, number of rides and revenue across different geographies to get a feel for the size of their target market. But that assumes the market size will remain fixed. How will trends like self-driving cars, EVs, remote working or any number of unforeseen factors affect this?
What if your startup ends up increasing the total market size? That’s what happened with Uber, who increased both supply and demand by making it easier for anyone to become a driver and order a taxi. VCs that estimated Uber’s potential market size by comparing it to the existing taxi market at the time may have passed on the deal, believing it to be too small to make a good investment.
Airbnb is another great example. When hosts were mainly students needing extra cash, it would have been easy to dismiss it as a small market. Optimistic VCs may have decided to use the existing hotel market as a proxy for size, but even they would have missed that in making it easier for customers to book cheap and flexible housing and for hosts to offer up accommodation, Airbnb actually increased the total market for travel.
All this is to say market sizing is hard. It’s often more art than science, like many parts of early-stage investing.
The good news for founders is that VCs know this already.
Many founders get prickly when they’re asked follow-up questions about market size. Don’t. This is your opportunity to show VCs your logic and reasoning.
They don’t expect you to accurately gauge market size down to the user (they can’t do this either). It’s not just about the numbers, investors use questions to understand how you think. A discussion on market size is a litmus test of your analytical ability and long-term vision.
They want to validate whether you’ve done your research, whether your logic is internally consistent, and whether you’ve considered how current and future trends will change things. They want to know what assumptions you’re making and whether you know you’re making them. They want to know what has to be true in order for this to be a massive market worth investing in.
If you’ve done all this and can articulate it well, you should be in a good spot, even if VCs disagree with you on some of your minor points.
What founders need to remember
There’s a lot to learn about market sizing (and we’ve not even covered TAMs, SAMs and SOMs yet!), but if I was to boil it down to one thing founders should remember, it’s this:
It’s your job to show VCs that if your startup succeeds, it has the potential to return their total fund several times over.
Don’t expect them to automatically ‘get it’ because of the business they’re in. It’s on you to make them see your market’s potential, not just your startup’s.
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Speak soon,
Nelson
