One of the most critical aspects of investment diligence is developing a thorough understanding of the market, its growth dynamics and the competitive intensity. If you misjudge whether the market can support the company’s growth objectives, almost nothing else matters. Even a great team can’t succeed in a bad market.

In our experience, when investors misjudge a market, they typically believe it is bigger and more attractive than it really is. This is usually due to making one or more of these common errors:

  1. Overestimating the market size
  2. Leveraging ‘experts’ to understand purchase dynamics
  3. Letting the company select the customers

Overestimating the market size

While investors value companies with a large addressable market for good reasons, the truth is that most B2B tech companies succeed by winning a large share of a unique segment of the market, and then expanding into additional segments over time.

While the overall market may be large, the total addressable market (TAM), the segment in which the company truly thrives, can be much, much smaller. In analyzing the $4B market for mid-market HR software, we found that the target company was a great fit in the $250M segment of White Collar employers with 50 to 250 employees. Given market and competitive dynamics, exceeding a 15% penetration of that segment appeared highly unlikely.  Therefore, getting to $50M in revenue and still having attractive growth prospects for the next buyer, would require the company to get beyond its core. It wasn’t a show-stopper, but it did cause the investor to rethink how they were approaching the investment.

Best practice in market sizing is to develop a bottom-up analysis, which involves a) developing deep insight into market dynamics and segmentation generated through extensive interviews with customers and potential customers, b) identifying the number of prospects in the company’s target segments and c) applying realistic pricing to the identified prospects.

Leveraging ‘experts’ to understand purchase dynamics

We are all familiar with expert networks, and they are a godsend. There is nothing like talking to industry experts to get the lay of the land in a new market and to understand the big picture forces driving it. However, experts are a terrible way of understanding the competitive and purchasing dynamics of the target’s solution. Experts do not make buying decisions. They are not at the frontlines looking for new solutions and evaluating vendors. When an investor needs to understand purchase decisions and alternatives, best practice is to talk to buyers. It’s that simple. Unless you talk to buyers of the solution in mind, you cannot truly grasp:

  • What are the drivers that lead customers to buy new solutions or replace existing solutions?
  • Who are the competitors and what are alternatives that customers are evaluating?
  • How and why do they choose certain vendors and not others?
  • How satisfied they are with their current vendor or solution?

Talking to buyers and decision makers is critical to understanding the true investment opportunity.

Talking to selected customers

This is my favorite topic, and probably the most common mistake. Bankers and target companies will typically offer up the most loyal and satisfied customers for investors to interview. It is the path of least resistance for most investors and a way to begin a positive relationship. It is also important for keeping the potential deal confidential. It makes sense. However, what we often find is a significant discrepancy between the feedback gathered from this short list to the overall customer base. Best practice is to review the whole customer list and pick a representative sample by size, tenure, industry, product set. In a typical scenario we will find that the short list, given by the company, will generate an NPS score that can be 50 points higher than a random customer sample.

There is no company in the world where all customers are satisfied. A low NPS score or satisfaction rate is not necessarily bad for an investor. The key to the investment decision is whether the causes of dissatisfaction are addressable with an investment or focus which the investor can bring.

If you would like to learn how Topline Strategy can help you avoid the pitfalls of market diligence contact us at