Evaluating Early Stage Companies: Part 2 - Market
The 5 M’s of evaluating early stage companies are Management, Market, Metrics, Moat, and Meaningful Impact.
Today, a shallow dive into Market…
TAM, SAM, SOM - A company should be able to estimate TAM, SAM and SOM for their business today and in 5 years. Don’t stop there…
Future Attainable Margin - In addition to TAM, SAM, and SOM, I like to focus on Future Attainable Margin (FAM), a concept borrowed from my friend’s at Cantos Ventures. The FAM forces us to focus (a) on the future (b) on the market dynamics and (c) on the business model and margin profile.
Future - For our purposes, I like to focus on 5 years out as the “future”, as companies typically need to have demonstrated product market fit by then and be in rapid growth mode in order to have raised successive funding. If a market is already really large, it’s easy. If the market is nascent, the questions I like to ask to build conviction around the future are:
Is rapid market growth already happening?
Is market growth dependent on the success of this company or other startups or are other exogenous factors driving the market growth?
What technical hurdles have to be overcome for the large market to evolve? If they exist, are they within the control of the company or outside their control?
Attainable - This speaks to the market dynamics and the potential market penetration a company can achieve. I look for markets that have high barriers to entry AND are undergoing change in a way that startups have an opportunity to unseat the incumbents. Some level of fragmentation is helpful, but I am weary of low barriers to entry if there is too much fragmentation. If there are a few dominant players in the market, I look for reasons why those companies won’t / can’t innovate or evolve - leaving room for the upstarts.
Margin - I look for companies with a path to strong gross margins - as good or better than the incumbents and established players, giving them room to move on price and/or invest the additional profit margin into building better products and increasing market penetration. A marketplace business may be playing in a massive market with billions in GMV potential, but if they can only take a 1% take rate and their platform costs a lot to run, the actual gross margin potential may be minimal.
Future Attainable Margin = Total Size of the Market in Next 5 Years x Penetration (based on market dynamics) x Gross Margin %.