Reflecting on 20 years of investing, one investment professional recently remarked to us, “When I think about what we’ve gotten wrong in the past, the worst times have been when we believed we had a bigger market size than we really did. There’s just nothing you can do...the company just runs out of room for growth.”

Because of challenges like these, market sizing often makes it to the top of the CDD agenda.

Market sizing exercises are sometimes simple: models built in markets where public registration (or a rock-solid database) exists. In other cases, they require complex approaches building on original data. The complexity in these approaches – combined with the natural quantitative bent of investment professionals – means that the techniques themselves sometimes become the subjects of significant debate.

Having rigorous debates on these topics is rarely a bad thing, but it is vital that in the midst of the debate, we remember that no degree of savvy design can save a good market sizing approach from a bad market definition.

Here are a few questions we ask to make sure we are defining the market clearly before we size it:

• Are you sizing the current market (what is serviced today), or the addressable market (considering potential market growth), or both? In regulated product markets, these may be one and the same. In markets that are still in growth stages, however, sizing based on current usage may be missing a key question around headroom (and growth timing) in the market
• Should your market sizing be based on product specification or based on customer need? If there are several substitutes available to customers such as in many consumer goods, then sizing on need should be used so that those substitutes are considered. If you’re using the “TAM, SAM, SOM” approach (i.e., Total Addressable, Serviceable Addressable, and Serviceable Obtainable Markets), then the SAM or SOM may be used to filter down to specific product types, but the TAM should in most cases include the substitutes
• Is this a cyclical market? Anything touching European consumer wallets in 2016 is going to likely have very different dynamics in a bull market. There are two take-aways to consider in this example: first, that some markets should be sized with the possibility of significant upside; and second, that knowing how other businesses might perform in the face of a market slowdown is key. Remember that this can differ by segment: despite declining European consumer spend in our example, luxury goods have a distinctly different degree of cyclicality than mass and masstige products.

This is a partial list, but the point is that focusing on the definition (more than the technique) is critical to successful sizing. Having clear definitions that everyone on the deal team is aligned on is essential; poor definitions will often lead to a contentious investment committee debate – or worse – waking up post-close to a portfolio company with diminished headroom.

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