Why Market Size Matters

And How To Think About It

Sep 11, 2023

Why Market Size Matters (And How To Think About It) - newsletter exclusive article
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1. Why Market Size Matters (And How To Think About It)

When we make venture capital investments we are trying to generate the highest return possible on each one. That means sifting through every opportunity and figuring out which ones you think will generate the best return.

Almost every early-stage venture opportunity is currently unprofitable. That means there is no intrinsic value in the business, you are just buying an option on what it could become. The bigger, the better.

It’s not quite that simple. There is a probability distribution attached to the outcomes. At its core, you want ones where the chances of good and more importantly great outcomes are at their highest.

It also matters what price you invest at. If you invest in identically distributed outcomes and one has a higher price, you are better off in the lower valuation opportunity.

It also matters how much capital they will need to achieve the upside. The more capital required, the more you will be diluted and the bigger the outcome you need to generate the same return on investment.

To summarise, you want the opportunities with the highest chance of the biggest outcomes normalised by valuation and capital required.

At a high level, it is that simple. In practice, it is not.

All things being equal, it is clear the bigger the market opportunity, the better the payoff, the more likely you should be to invest, and the higher valuation you can afford to pay to invest in the opportunity.

But market size changes!

You often hear people say they missed a big opportunity after they passed because of market size. The business either became much bigger than they thought or it pivoted into a bigger market. They use this to justify ignoring market size when making investment decisions.

But there are clearly businesses where the market size is much too small for a venture outcome and either market size matters or it doesn’t.

If you have a boundary where below is too small and above is too high you still care about market size. And even in this case, it’s crazy to have a line. If it matters, it’s obvious that it shouldn’t just be a boundary. Tiny differences can turn a yes into a no and in practice that can’t be how it works. Bigger has to be better.

When a business’s market becomes much bigger or smaller than you thought, that can’t be avoided. But this just points to paying attention to founder strength, the most important thing, and to thinking about market size differently.

Founder strength

Founder strength matters because the bigger the market the more likely strong founders are to take full advantage of that market.

Founder strength matters because strong founders are more likely to notice and take advantage of adjacent opportunities which substantially increase the market size.

Founder strength matters because strong founders are much more likely to pivot, if that is the correct thing to do, into bigger markets with a better chance of successful outcomes.

How to think differently

Market size is not what you are told it is. Do your own analysis. That’s not as simple as just figuring out the current market size.

Great businesses will either solve a problem in an entirely new way or at a wildly different price point or solve a problem that’s never been solved before.

You have to figure out how important the problem is, how well this solution solves the problem and how big the market could be with the new solution. This is very, very rarely the current market size.

The most important factor in early-stage investing is founder strength because they will maximise both your chance of success and the size of the outcome if you are successful.

This can blind you to the fact that the starting market size is important. If it is too small probably the founder isn’t so good. They ought to realise this. And a large starting size gives the founders the best chance of winning. If this market is big, adjacent markets may also be.

The bigger the better

Don’t be fooled by outcomes where the market size started small. The bigger the starting point the better.

That’s why all my new investments this year aren’t just opportunities where if everything went right they could return 100x, they are in very strong founders whose startups could be 1000x opportunities or more. Then, even if everything doesn’t go perfectly, you still have the chance of a huge outcome.