There is no shortage of pitfalls in a typical VC pitch where an entrepreneur’s new business opportunity can unravel in the eyes of a venture investor. However, if I were to pick one area where management teams often tend to get caught in their own underwear it is when the subject of market penetration is first raised.
As any primer on raising venture capital will attest, targeting a sufficiently large market is a necessary but not sufficient requirement for most venture funds. Big markets provide the requisite upside a venture investor needs to feel comfortable that the new enterprise can carve out a sustainable business and defend that market position. Experienced investors know that many successful companies course-correct a number of times before they find the right market position, product and strategy for long-term success. As such, big markets are somewhat more forgiving; companies can muddle their way through, make mistakes in the early days, and still have a hope of building a significant business. Small markets rarely allow for that.
What big markets also offer investors is the potential for (relatively) bigger exits. As has become obvious across the venture landscape in recent years, the average fund sizes at many venture firms has increased, and larger fund sizes typically bring requirements for larger exits to effectively “move the needle” for that fund. Roughly speaking, billion dollar funds are going to need billion dollar exits. While this is not a hard and fast rule (and many of my friends at billion dollar funds would argue that they still want to see early stage deals with lower capital requirements and possibly smaller exit windows) the hurdle for a small deal at a big firm is pretty high. My suggestion is that if you are pitching a firm whose most recent fund is $500mm or larger and your company’s financial projections are for a business with a revenue profile in Year 5 of $50mm or less, you’re probably wasting everyone’s time. The partner you present to may love the business and its product or service but it will likely get nowhere at the Monday partner meeting when that partner presents your deal to his or her other partners. It would be best to focus on smaller funds or, even better, focus on a larger market opportunity.
Assuming you get over the ‘big enough market’ threshold as discussed above, here is one key piece of advice to entrepreneurs pitching professional venture investors: steer clear of statements such as “We just need (low single digit) percent of the market to build a really big business here folks!” These statements are fraught with peril and VCs will often visibly recoil when they hear a presenting company trot out such a naive comment. The reason for this resistance is that there is rarely support given by the entrepreneurs about how they arrived at that number or how the product or service can reasonably scale to that level.
The other trap that comments such as these set for a presenting management team is that it often makes the entrepreneurs appear to be focused on attaining low market penetration. That’s not an appealing goal for most VCs. The entrepreneurs make the mistake of thinking that by trotting out a number such as 6% the venture investors will consider the goal modest and, thus, achievable. Unfortunately, what the VC hears is that the founding team intends to work tirelessly (with the VC’s capital) to build the business and if everything goes according to plan (it never does), they will have 6% of the market in five years. No self-respecting venture investor is likely to be interested in a business that will have 6% penetration after five years of effort. If the team executes well and if after five years the company has only 6% market penetration, then something has gone terribly wrong.
What I advise start-ups to do when confronting the market size/market penetration question is to first define the market well and define what part of that market is truly addressable. This is commonly referred to as the TAM (total addressable market) number. If this is well-reasoned then it demonstrates to the investors that you have thought long and hard about your customer set, how to reach them, and why they are right for your product/service. Next, I would recommend that you emphasize that your goal is market leadership and that market leadership may not have a fixed percentage so early in the game. Markets can be fundamentally different – consolidated markets versus fragmented markets, new markets versus mature ones, and so on. What is considered success in those markets can vary widely depending on market structure and the behavior of market participants. Where the low market penetration percentage figures become important is to demonstrate that the business can achieve profitability fairly quickly. A business that requires, say, 20-30% market penetration to attain profitability is a tough sell. That hurdle demonstrates that you are probably in too small of a market segment, are not terribly capital efficient, or likely both. The best combination would be a big market, a large TAM number, a product or service that can scale quickly and cheaply, and a fast path to profitability with minimal market penetration and low capital requirements. Oh well, we can dream, can’t we?