More often than not, Founders at the Pre-seed/Seed stage are expected to have clarity regarding the market size of their product/service.  This is the norm at the early stage as the potential of the startup is synonymous with the potential of the market the founders are targeting. In this article, we will discuss the importance of market sizing, how to size up your market, and common mistakes to avoid.

Why is Market Sizing Important for Early-Stage Startups?

Market sizing is crucial for making informed decisions, attracting investors, and developing a sustainable business model.

Resource Allocation: Early-stage startups often operate with limited resources and market sizing deliver insights into where those resources can be most effectively deployed.

Investor Confidence: Investors want to see that a startup has a clear understanding of its market. Demonstrating a well-researched and sizable market opportunity instils confidence in investors, making it more likely for them to fund the venture.

Raising Funds: Market sizing helps founders ascertain the quantum of funds they need to raise. The clarity achieved while following this process enables the founders to gauge market interest for their solution and the realistic amount of funds they can expect to raise.

Strategic Decision-Making: Accurate market sizing enables startups to make informed decisions about product development, pricing strategies, and market entry points. This reduces opportunity costs and makes companies nimbler.

How can founders size up their market?

An important, but often overlooked, precursor to ascertaining the market size is understanding the problem and the target customer. All early-stage entrepreneurs and startups must identify their target customer, which is the specific group of people or organizations that will benefit from their product or service and how well can the founders take care of their pain points. This insightful conversation between Sajith Pai (Blume Ventures) and Shubham Goel (Co-Founder of Affinity) shows the value that can be derived by working on first principles to identify and solve a problem for your target group.

Calculating market size accurately may be challenging at the early stage of a startup venture, but it's essential that we get as close as possible. Common methods for estimating market size for startups include the top-down approach and the bottom-up approach.

Top-Down Approach:

$ Market Size = $ Broad-Industry Market size X ICP customer set X % Market spend on category 

-        Define the specific market segment the startup is targeting, based on demographics, geography, industry, or other factors.

-        Industry Research: Begin with broad industry research to identify the total addressable market (TAM). Look for existing reports, industry publications, and market studies relevant to your startup's sector.

-        Segmentation: Narrow down the TAM into addressable market segments. Consider factors such as demographics, geography, and customer behavior to create meaningful segments. Estimate what percentage of the TAM is realistically serviceable by the startup, considering factors such as competition, regulatory requirements, and the startup's ability to serve the market.

Bottom-Up Approach:

$ Market Size = # of Customers X $ Revenue per customer annually

$ Revenue per customer annually = Transaction volume X Pricing

-        Founders can estimate the number of target customers through a first principles approach and corroborating the data from quality industry reports. Determine the penetration rate.

-        Customer Surveys: Conduct surveys or interviews with potential customers to gather insights into their needs, preferences, and willingness to pay. Use this data to estimate the number of potential customers in the target market.

-        B2B SaaS: Value-based pricing is the optimal approach to determine your customer willingness to pay. (eg. If your products increase your customer’s profits by $1M per year on a perpetual basis then you can charge a $100-300K per year subscription fee.)

When estimating market size for startups, it's important to avoid common mistakes to ensure a more accurate assessment. Some common mistakes to avoid include:

Relying Solely on Top-Down Numbers: Using only top-down numbers found on the internet can signal to investors that the founder didn't dedicate enough time to deeply understand the market. It's better to use a bottom-up approach, breaking the calculation down into the smallest components to understand the granularities of the business and the market it operates in.

Overlooking Future Demand: Estimating only the existing market demand and overlooking the hypothetical demand for the product in the future can limit the potential scale of the startup. It's important to estimate hypothetical demand for the product in 5-10 years, not just existing demand.

Bill Gurley's thoughts on valuing Uber shows the approach of second order thinking and is an important exercise for founders to better understand their service and its potential to create different markets as well.

Conclusion:

Market sizing is a dynamic process that evolves across the lifecycle of a startup. By employing a combination of top-down and bottom-up approaches, conducting thorough competitor analyses, founders can triangulate their market size with increased accuracy.  These processes in-turn aid decision making and strategy, enabling Early-stage founders to be positioned for success.