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In this post, I show how the commonly held belief that a $1 billion market size is big enough for VCs is often misleading for founders. Rather than being tied to one number, I propose that founders should consider two key factors when trying to figure out whether a market is large enough to be attractive to investors: their margin profile and the likelihood of gaining significant market share. This post equips founders with the tools to know what big enough looks like so they are able to successfully argue that their market is just that, improving their fundraising chances. It also comes with a calculator that does all the hard work!
Founders are constantly told that a $1bn market size is the route to VC interest, however, this advice lacks nuance. The answer to “What is a big enough market size to be compelling?” is unfortunately “it depends”. Not knowing what big enough looks like is terrible for founders on the fundraising circuit as presenting investors with a market size that’s too small leads to instant rejections.
Two factors affect whether $Xbn is a large enough market for a venture scale outcome 1) the startups’ margin profile and 2) how plausible it is for the company to achieve significant market share. By the end of this post you should not only understand why, but also know how to figure out what big enough looks for your company. That way you will have a fair shake when pitching your startup to investors. To top it off I’m going to provide a handy calculator so you don't even need to do your own maths.
If you just want to get to the calculator skip here, but I would recommend reading the next section first.
To understand why some billion dollar markets are large enough and others aren't we first need to understand what underpins the advice to aim for them.
VCs don’t actually care about market size, they care about exit size (an exit is where a company is sold or publicly listed). For reasons outlined in countless articles, venture funds need a few of the companies they invest in to exit for $1bn or more for their funds to be successful. Funding this type of company is the sole reason venture funds exist, so every startup they look at is assessed for billion dollar outcome potential. Failing this test gets you a vague rejection email saying something like “too early”.
The advice that you need to present $1bn plus market sizes comes from this focus on billion dollar exits. This target symbolises a market large enough to support a company with the size of exit that VCs need for their economics to work. Behind this number is some basic maths and two core assumptions:
With these assumptions in tow, you can see how the $1bn market equals $1bn outcome heuristic became popular. The maths is pretty simple
Unfortunately, this rule of thumb loses all utility when these assumptions are incorrect. And they are incorrect often… In over 4 years working as an Venture Investor and in my time consulting startups on fundraising since then, I’ve seen many founders present market sizes that were too small to be interesting to a venture fund despite being well over a billion dollars. Given that market size is at least 50% a creative exercise 😉, I’m sure that these founders would have told a different story had they realised that they were coming up short.
Let’s explore when and why each of these assumptions fail so often.
If you want to skip to the calculator click here.
The reason why using a 10x revenue multiple is not a bulletproof way of valuing mature startups is the fact that it's an assumption which only really works for SaaS companies with a certain margin profile. Many businesses have far worse margins than the normative SaaS company thus valuing them by simply multiplying their revenue by 10x is a mistake.
To understand this we need to know a tiny bit of finance theory. In short, a company's valuation is based on the “present value of its future cash flows”. Cash flow is the money a business has left over after covering operating expenses. So the more cash flow (money left after costs) people believe a company will generate in the future, the higher it should be valued. The two key things are operational efficiency and growth. The problem is that this type of analysis is complicated so investors often use multiples as a shortcut.
When they use a revenue multiple to value a company, investors are basically saying to themselves that companies in the same industry can be expected to grow at similar rates and are likely to have comparable cost structures. They can be valued as if they are similar because they turn revenue into cash flow as efficiently as each other and revenue is expected to grow at the same pace. Thus if Ford has $10m revenue and is valued at $30m (aka 3x revenue), then another car company with $20m revenue should be worth 3x its revenue also.
In practice, sophisticated investors shy away from using revenue as the basis for valuation. This is because it compels investors to make assumptions about operational efficiency, which they can easily avoid. Instead, by subtracting costs from revenue to calculate EBIT, EBITDA and FCF, investors derive metrics which account for operational efficiency providing a better foundation for valuation. This allows investors to sidestep implicit assumptions about a company's operational efficiency compared to its peers.
Thus, investors are much more comfortable saying a company is worth 15 times its EBITDA because of how its competitors are valued than they are saying it’s worth 3 times its revenue using the same logic. By getting as close as possible to cash flow, the multiple only contains assumptions about future growth / decline.
If using revenue multiples to value a company is a dubious practice even within an industry, it is completely idiotic to use a revenue multiple from one industry to value companies in another. And this is where the cult of 10x is shooting founders in the foot.
The cult of 10x stems from the amazing gross margin profiles of software businesses. Gross margin represents the percentage of revenue that remains after subtracting the direct costs associated with producing the goods offered (raw materials, packaging, etc.). These expenses are called COGS (Costs of Good Sold). In the world of software where producing an additional item to sell doesn’t involve any labour or raw materials - COGS are typically lower than 30%. This means that software businesses have high potential to generate significant cash flows relative to their revenue, even after spending on other things like marketing and R&D. Because software companies historically have traded for around 10x their revenue on the public markets - VCs use this as a very quick way to figure out how much a startup will be worth at scale assuming they hit certain revenue targets.
However, for all the reasons outlined above, applying a 10x multiple to a company which doesn’t have software style margins yields perverse outcomes. To illustrate this, let’s take a supermarket business where COGS are 80% of revenue and compare it with a software business with the same annual sales but only 30% in COGS.
From the diagram you can see there is a massive $50m gap in how much cash is available to the company on the same amount of sales. Asserting that both the supermarket and software company should be valued at $1bn just because they have the same revenue is madness.
The second reason why $1bn market sizes are often too small to sustain venture scale outcomes is that some industries are just really hard to achieve high market share in. $1bn markets are only large enough if you assume that a company can get to $100m in revenue (i.e. 10%). If it’s only feasible for a company to get say 2% of the same market, ie. $20m in revenue, that results in something far smaller than the $1bn outcome investors are looking for.
10% is a fair assumption in a neutral scenario (although Pear VC are pretty convincing that 0.5 - 2% is much more realistic), however, the dynamics of your market can change people's biases. Some dynamics make the idea of a successful startup getting more than 10% of the market likely, while others make it unlikely that they’ll even get 1%.
To help with this I’ve listed some examples below of factors that affect how plausible achieving high market share is:
Negative factors
Positive factors
When thinking about what a big enough market size looks like, it’s imperative for founders to consider whether 10% share is actually reasonable and a lot of the time 10% doesn’t cut it.
Having spent this post explaining why not every $1bn market is created equal. I’m going to walk through how to actually calculate what a venture scale market looks like for your company. This involves two steps
We've demonstrated that using revenue multiples alone is an inadequate way to value companies because it disregards their cash flow characteristics. A superior approach would involve three steps:
1. Choosing a better metric
In an ideal world we would use EBIT, EBITDA or FCF, however, for a number of reasons, guessing what percentage of revenue these will represent once a business is mature is very difficult. Of all the metrics available to us, gross profit is our best bet. It has two benefits - it’s a much better proxy for cash flow than revenue as it includes a large chunk of a business’ cost structure, and it’s generally possible to figure out what a company’s gross margins will look like in the future (all you need to know is what raw ingredients and labour go directly into making the product being sold).
2. How much gross profit makes a billion dollar outcome
We can get a rough idea of how much gross profit corresponds to a billion dollar company by transforming the ubiquitous 10x revenue multiple into a gross profit multiple and the working backwards from $1bn. The normative software company is worth 10x its revenue and typically turns 70% of its revenue into gross profit. Taken together this means that these companies are worth ~14x their gross profit.
Using this number we can work backwards and calculate that a company would need $70m gross profit ($1bn ÷ 14x) to achieve our valuation target.
3. Figuring out how much revenue $70m in gross profit implies
Now that we know how much gross profit we need, all we need to do to figure out how much revenue this corresponds to is take the gross margin we expect our business to have in the long term and work backwards. Therefore if the startup is expected to have a 20% gross margin (i.e. spend 80% of its revenue on COGS) then it would need $350m in revenue ($70m ÷ 20%) to generate the required gross profit $70m whereas if margins were 10% it would need 700m instead.
To wrap things up we need to figure out how big the market needs to be to support the revenue we just calculated. To do this we simply divide the revenue target by the market share. Thus if we know a startup needs $350m in revenue to get a $1bn outcome and we believe that getting 5% market share is feasible then we would need at least a $7bn market ($350m ÷ 5%) for it to be big enough for a venture outcome. Contrastingly if we thought 20% was likely we would only need a $1.7bn market.
Having walked through all of the maths involved on this I’ve included a handy calculator that figures out how big is big enough for you based on three simple inputs.
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