Any entrepreneur raising venture capital should be prepared to go through the exercise of sizing the market. Setting aside the recent micro-VC/super-angel boom, traditional VC funds like ours look to invest in companies chasing billion dollar annualized markets. We do so because selling into a big (and growing) market is the best way to produce the large absolute dollar returns required to return a venture fund several times over.
We sometimes throw terms like “addressable” and “total addressable” in front of “market size”; but, for my purposes:
Your market size is your average sales price (ASP) per unit multiplied by the maximum annual volume of product you can sell profitably in the geographic region and channel you’re targeting.
Obviously, it’s not always that easy to calculate. Cleantech entrepreneurs in demand-side management (DSM), for instance, often have trouble with this definition since both their price and volume are recursively related to their cost of customer acquisition (COCA), i.e. the cost of selling and implementing a single customer. In this post, I’ll discuss why this is and what entrepreneurs can do about it.
DSM is the monitoring and control of electrons “behind the meter” in buildings in order to produce new revenue sources, control energy costs, or provide some other ancillary benefit related to a facility or assets tied to that facility’s functionality. EnerNOC (NASDAQ:ENOC), for example, creates for its customers new revenue through demand response, cost savings through energy management, and ancillary benefits through monitoring HVAC systems and watching for impending breakdowns.
Energy management may be the simplest case. According to the landmark DOE CBECS study in 2003, a typical 15,000 square foot U.S. office building consumes 256,000 kWh per year of electricity. U.S. retail electricity prices are about $0.12/kWh, so such a building should spend $30,700 annually on electricity. An energy management solution which reduces electricity consumption by 16% would therefore create $4,912 of value per year.
So, how much would a facility manager pay for around $5,000 per year of additional cash flow? It depends on his required minimum payback period for capital investments. I’ve seen anything from 2-5 years, which would give a range of $10,000-$25,000 for the up-front maximum ASP of this product. As such, it’s tempting (especially if you know calculus) to calculate the market size as:
(# of 2-year customers) * $10,000 + (# of 3-year customers)* $15,000 + etc…
This equation, however, has at two crucial flaws:
- COCA is not the same for each of these customers. In reality, a 2-year customer may be more costly to acquire than a 5-year customer. His choice of a shorter minimum payback period may reflect his lack of faith in your technology, the complexity of his legacy building management systems, or just a small and inflexible capital budgeting process. In any case, sales and implementation costs may be high enough to make the 2-year customer unprofitable on a unit basis, which means he must be removed from the above equation for now.
- Even if COCA is the same, your ASP is fixed at the bottom in order to maintain attractive gross margins. For instance, if your cost of goods sold (COGS) on this product is $7,500 and you wish to maintain 50% gross margins, the 2-year customer would be unprofitable. Again, you would need to take those 2-year customers out of the above equation for now.
As a result, your market size depends both on the COCA of each particular customer set, as well as the minimum gross margin you want for your business. The key question is not, “How big is my market?”, but instead:
“Given my desired gross margins, how low can my COCA be for a large range of customers?”
As you lower your COCA, shorter payback period customers can be profitable for you to acquire. These additional customers add scale to your business, which further lowers your COCA due to increased operating leverage. Increased scale can also lower your COGS, which (holding gross margin constant) simultaneously lowers your ASP floor and opens up additional market segments.
These virtuous cycles are crucial for a DSM business. They allow you to march up the market “hill,” lowering your ASP profitably at each step, as shown below:
Entrepreneurs can also lower their COCA in ways other than simple scale. Here are a few suggestions:
- Sell once. Monetize often. Go after accounts that require one sales process to open up numerous individual customers. One example is selling to a VP of Operations or Facilities instead of individual facilities managers.
- Develop self-serve technology. Implementation cycles can kill DSM businesses, even after the sale is complete. Develop a product that a customer or channel partner can implement themselves, and you free up resources for additional customers. If they want you to hold their hand, make them pay for it explicitly, lest you set up the wrong expectations going forward.
- Remove the hardware barrier. Use cloud-based services and off-the-shelf hardware to the greatest extent possible. The less physical equipment needs to be altered, the lower the sales friction (and COCA) will be.
- Develop channel partners in markets that are harder to crack. If a market is large, but you don’t have the resources to focus on it today, engage a channel partner to help you go to market. The scale itself will be rewarding, even if you need to give value up to the channel.
In short, DSM companies should be on a constant quest to lower their unit cost basis in order to open up newer and larger segments of the market to profitable acquisition. Eventually, the market size numbers get very big and exciting, but they alone won’t convince a VC to give you money. Talk about the journey, not just the destination. Show how your costs get from Point A to B.