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Series V

Who cares about market sizing? Part 2

“When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins. When a great team meets a great market, something special happens”- Andy Rachleff

Last week, we started a conversation about how important the current size of a market is (you can read that edition here), and why it is/might not be an important question to ask entrepreneurs.

This week, the other half of the team will make their case for market size estimates.

The argument for

Per the Pareto principle, we can assume that 80% of most VCs’ returns will come from 20% of their investments i.e. if a VC makes 10 investments, most of the financial upside will come from only 2 of them. This is popularly called the Babe Ruth effect, and as Peter Thiel notes:

“Actual [venture capital] returns are incredibly skewed. The more a VC understands this skew pattern, the better the VC. Bad VCs tend to think the dashed line is flat, i.e. that all companies are created equal, and some just fail, spin wheels, or grow. In reality, you get a power law distribution.”

How does this affect how we deploy capital? It means that we are often biased in favor of bets that have an uncapped upside; bets that could potentially return many multiples of the capital invested. The market does need to grow big(ger) at some point, to support the companies serving it, and the most straightforward way to make that assessment is the size and growth rate today.

Of course, these estimates can be flawed (and big paradigm shifts do turn the math on its head), but they are quantitative in ways the other proxies our colleagues suggested are not. That is, while we acknowledge that a market being large is not always proof that a particular entrepreneur will make meat of it, you cannot fit “Is this solution 10 times better than the alternative?” into a spreadsheet.

Secondly, market creation is often expensive and investing as our colleagues would have us, might lead us to back horseless carriages, not cars, or early approximations of what the future looks like, not the future itself. It’s okay to be early. Just don’t die.

Bonus: who wants to see what a smartwatch designed in 1983 looks like? Link.

In reality, the right approach is probably a mix of both. Venture Capital is both an art and a science, and we are as excited by the journey, as we are with the destination.

Victoria ascerta.

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