Does market size even matter?

Am I missing amazing opportunities through a misguided belief that I can analyse the future?

I was struck by a comment from Reed Hastings on his book tour for No Rules Rules:

“Typically, venture capitalists say that you want to go after the largest market possible. I’ve always thought that’s crazy because you can’t defend it …. I have always thought you want to go after the smallest market possible that can hold your 5- to 10-year growth ambitions.”

For reference, Netflix’s market cap at the time of writing is $212bn - suggestive of a decent sized market…

And Reed is right. Venture capitalists, myself included, have an obsessive focus on large market opportunities. It is a near canonical law in VC that they are a necessity. Indeed, Sequoia Capital, arguably the world’s best venture firm, built its investment approach on a focus on large market opportunities to the exclusion of much else.

The reason for this is that the returns from a venture fund portfolio invariably follow a power law distribution. To outperform their peers, venture funds need their best companies to deliver huge returns. The best company in a “good” fund will typically deliver ±20X cash on cash, with that multiple increasing to almost 70X in a “great” fund.

But I’m starting to wonder if we overestimate our ability to size a future market. I cut my teeth at The Boston Consulting Group and have always considered my ability to understand the structure, dynamics and scale of a market to be a key strength that I bring to the investment decision table.

Is that all bullshit?

At AirTree, we recently passed on a company that we liked on the basis that it would be unlikely to achieve a billion dollar outcome in its current market. Was this the right call? More specifically, how confident can we be in deeming this an unlikely outcome?

This question led me to go back through past investment papers I’ve written and analyses I’ve run. There is a company in our portfolio which is today worth ±$1.2bn, with real upside potential from there. When we invested 4 short years ago, I thought that, if all the stars aligned and you squinted really hard, it might get to $400m in 2022.

And it seems like I’m not the only “smart” investor to be so wildly off in my analysis as to render it a complete waste of time.

Vinay Iyengar @VinIyengar

Incredible to look back at Bessemer's original @Shopify investment memo. The very best case scenario was a $400m exit. Today, $SHOP has a market cap of ~$110b, 275X that amount!!! The sheer magnitude by which we often underestimate TAM for Internet businesses is astounding

You can find these kinds of errors all the way up the academic hierarchy. They don’t come much more credentialed in finance than NYU Stern’s Professor Aswath Damodaran. But even he famously whiffed by at least order of magnitude when he sized Uber’s addressable market at $100bn.

So what?

So am I wasting my time analysing market opportunities? Am I casually (and offensively!) labelling a swathe of companies as “lifestyle businesses” when in fact they have a far greater chance of achieving a huge outcome than I give them credit for?

I enjoyed Rory Sutherland’s quip that no sane person would have expected there was a market for Dyson. “Anyone who spends $700 on a vacuum cleaner probably employs a cleaner anyway and doesn’t do their vacuuming half the time. What the hell?” And yet James Dyson is worth $6.4bn…

Perhaps Reed Hastings is right. Perhaps all that matters for a sensible venture investment is that, today, there is a tractable path for the company to grow well for 5-10 years. Ideally, in the absence of stifling competition. And perhaps any further analysis on the size of the market is a total waste of time since we can’t even predict whether Donald Trump will still be President in 35 days’ time, let alone what the world will look like a decade hence.

Gosh, that would save me a lot of time and decision-making heartache if so.

What do you think? Which companies fit this mould and might make for surprisingly great venture investments?

---

Received unexpectedly? Just hit unsubscribe below and you’ll never hear from me again!