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Investing in startups: understanding the real market opportunity
Markets, as described by enthusiastic entrepreneurs, feature big numbers designed to quicken your heart rate and loosen your purse strings.
While these figures may well be founded in truth, they are just a starting point for your analysis of what’s on offer.
As an investor your job is to accumulate both the startup’s evidence and your own research to make as accurate an assessment as possible. Of course, this is no exact science.
Even when you have put all the pieces of the market opportunity together, the collective picture you create will only ever be theoretical.
There is much to overcome before it is fully tapped into. Consumer habits must be changed, territories cracked and footholds gained.
But careful and thorough analysis of the market opportunity can help put you, as an investor, in good stead for strong returns, assuming the business plan is geared to succeed.
So what should you be considering when it comes to looking at a startup’s market?
How closely startups tie their projections to wider industry growth rates depends on their market proposition.
A new fintech product offers investors a route into a sector in the midst of rapid worldwide growth. Entrepreneurs in this space may point to surging global demand for online banking apps or cyber security solutions, for example.
A startup planning to disrupt a stagnant industry presents an entirely different market proposition. If it really is offering something new, real data from the wider industry may be less relevant. Investment pitches here may seek to provide evidence that customers in the industry demand a different approach.
Startup market estimations bound together by too many assumptions and ‘what ifs’ are a turn off for investors. Yet measuring potential markets with any real accuracy can be hugely challenging. There will always be some unknown qualities for the startup to contend with. Customer dynamics contain too many variables to ever be forecast with pinpoint precision. Add in the unpredictability of external socio-political and economic factors and the task of measuring prospective markets is even harder.
The challenging point for you as a potential investor is that some of the market measuring burden falls on your shoulders - unless, of course, you have absolute trust in everything the entrepreneur tells you, or you want to take an investment punt without mitigating risks.
The Total Addressable Market (TAM) is the moon-shot number. If everything fell perfectly into place, and every possible customer could be accessed without barriers, this is how big the market would be.
The TAM tends to be approached either from the top-down – starting with macroeconomic factors and working downwards – or from the bottom-up, starting locally and extrapolating across territories or regions. The closer and more accurately you focus in on the potential market, the smaller it gets.
Often from the TAM comes the SAM, the Serviceable Addressable Market. Then the most important number - the SOM (share of this market).
Here is an imaginary scenario for a new business management app for microbusinesses:
- TAM – the total number of microbusinesses in the UK
- SAM – the number of those businesses involved in non-office based trades (since the app is designed for use on the go, by people working out in the field)
- SOM – an amended version of the SAM, based on internal and external research and data, perhaps removing trades that do not require key functions of the app, for example
You’ve established that a lucrative market stands before the startup. Next comes the true test of the market opportunity – can it be viably accessed?
Reaching customers in a cost-effective way and provoking them to act is essential for the business model to function.
As an investor you need to see that the cash-flow, a robust plan of action and expertise to implement are all in place.
This is a crucial factor in determining the market share the startup could feasibly attain. Stagnant markets may be extremely crowded, with deep-rooted incumbents that will take great effort to challenge.
A rapidly expanding, relatively immature market, such as virtual reality products, meanwhile, may have plenty of space for a new offering to establish itself. The level of customer loyalty enjoyed by the competition should also be assessed.
How easily can customers be taken from competitors? Is the value of these customers more than the cost of prizing them away from competitors?
Where does the startup see its product or services sitting in the market? Is the combination – of price point, offering, quality and marketing – distinctive and appealing enough to make the desired impact? Does it have a unique selling point and/or IP that can be defended from replication?
Startups must be able to provide evidence that there is market demand for their product or service. Investors should look for any examples of customers using or interacting with the offering.
Beta testing – trialling prototypes or pre-released products on sample customers – may provide positive signs. Social media noise and media articles about the startup could also be a gauge of potential customer interest.
Market research findings and the level of interest at trade shows and exhibitions can also help. The only true test, however, is whether or not real customers will pay for the product and happily continue to do so for a prolonged period.
Less than a decade ago Britain was taken hold by an emerging trend in beauty treatments – the fish pedicure. Seemingly on every high street, customers wanted to pay for the privilege of fish nibbling at their feet. The service in the UK at least has rapidly declined in recent years, however, suggesting it was a mere fad or bubble market.
Such passing trends highlight the importance of forward-thinking when it comes to startup markets. Having an informed view on how the market could evolve in the coming years is vitally important if the startup is serious about long-term success.
Some major multinationals have the luxury of employing futurologists – professional soothsayers. This would be an extreme measure for a startup, but investors must have some evidence that there are many years of growth ahead in the market.
Also, there should be signs the business is prepared for changes in the market and is committed to continually developing to meet shifting customer demands.
Understanding the startup’s market
Just one of the areas you should investigate when investing into startups, it’s difficult to determine which of the ‘5 Ms’ is the most important, but without a real market opportunity - one that a startup can truly thrive and excel in - it’s going to be difficult to consider the startup as an investable company.
As with every type of investment, you need to be confident in the opportunity presented and every component within it. Achieved through extensive due diligence, advice and research, your findings should go a long way to helping ensure the startup investment opportunity is the right one for you.