An investor, Sally, recently heard two pitches. The first was from A-Dot-Co, which will produce polka-dot jellybeans using a new patented process. The second was from BetterBean, will produce purple jellybeans using a trade secret method which improves existing manufacturing processes.
Having spent several years owning a candy company, Sally was interested in both opportunities.
Sally knows that the jellybean market is large and well established. With a few regional exceptions, she knows the annual market growth has been 3% for many years.
Accordingly, she was a bit surprised to see strong growth projections in the presentations from both A-Dot-Co and BetterBean. More diligence would be required.
Sally asked both companies to submit detailed materials in support of the projections they presented. She was particularly focused on the factors responsible for revenue growth. Since the market is large and established, Sally knew that growth for a new entrant must come from either expansion of the overall market or from switching behavior (customers switching from established providers to new providers). She was hopeful that the detailed support material for each revenue projection, would reflect management’s understanding of these market dynamics.
Sally received the following support detail from A-Dot-Co:
She knew from prior experience that the total candy market was very large and she was glad to see the jelly bean sub-market in excess of $2 billion. There would be plenty of upside for A-Dot-Co. She was also glad to see that in year 5, the founder did not expect to exceed 1.0% of the market. Any larger share percentage would require major resources and additional funding rounds.
However, before investing, Sally still needed more information on the detail behind the market share projections. She scheduled a follow-up call.
On the call, A-Dot-Co was very enthusiastic. It went like this:
Sally: “Thank you for your revenue detail. I have some follow up questions. How do you expect to land nearly $2 million in revenue in the first 2 years?”
Founder: “A-Dot-Co is well positioned to achieve our revenue goals. We have a seasoned team who formed many candy company startups in the past.”
Sally: “That’s great. But how do you intend to land $600K of sales in year 1?”
Founder: “My team has deep knowledge about the jelly bean market. We only need a mere 0.03% of the market to land the projected $600K! Surely there are enough polka-dot jelly bean eaters out there to achieve this projection!”
A-Dot-Co’s founder fell into The Big Little Trap.
The Big Little Trap occurs when a founder believes his future projections are achievable because the market is so big and the market share percentage is so little. Specifically, that the sales goal will be very easy to accomplish because the market goal is such a small percentage, such as 0.03% with A-Dot-Co. (“It’s so small that anyone can reach it…as easy as falling off a log!”) In fact, the Trap victim might further say that the percentage is so tiny, that it may take only a few customers to reach it, and “…clearly the market has more than just a few customers!”
The response to an enthusiastic Trap victim: “I’m glad you’re excited. Name the customers!”
BetterBean submitted the following detail to Sally:
As before, Sally was glad to see confirmation of the jelly bean market. (They must have used the same market study). But she was even happier to see customer detail behind the revenue projection.
The detail reveals several important items:
- BetterBean knows his target customers and may already have relationships established with them.
- Knowing BetterBean’s target customers should lead to a more efficient operation by helping the company prioritize the company’s limited time with its important customers over less strategic prospects.
- BetterBean has applied the 80/20 rule—at least 80% of the revenue is derived from specific, identified customers. The remaining revenue will come from other customers, currently unknown. Forecasting is an inexact science and to communicate over-precision in the detail implies the founder may be taking his projections too seriously. BetterBean has not been overly precise.
- When—not if—BetterBean misses its projections, the detail will provide insight as to why the projections were missed. The “why” is more important for fixing future revenue projections.
- BetterBean is more transparent than A-Dot-Co. Specifically, BetterBean’s founder has shared his target customer list, perhaps with the hope that Sally may have contacts to be leveraged at those customer accounts. Conversely, A-Dot-Co has shared no customer detail, suggesting that its founder may not know who his customers will be. This is concerning if true.
Sally rejected the opportunity with A-Dot-Co. It fell into The Big Little Trap—and didn’t even realize it. The lack of transparency did not generate confidence in the company’s management team.
Sally proceeded with further diligence on BetterBean.
The Big Little Trap grabs victims all the time. Like Sally, an investor should consider the market size, but only in the context of the startup’s upside potential. As she observed, there’s, “…plenty of upside for A-Dot-Co.” However, market share is not the justification of year-to-year or month-to-month revenue goals. Market share is best seen as a byproduct of sales efforts.
The jellybean example is fictitious, but the Trap is very real. Watch for The Big Little Trap at your next pitch session. See if the founder falls into it!
About the Author
Scott M. Anderson is a principal at Anderson Financial Services, LLC and has been performing cash projections for decades as an investment banker, a workout specialist, and recently, as an advisor to investors and startups. He can be reached at email@example.com
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This article appeared in NEWS FROM HEARTLAND
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