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Perhaps the most important question confronting anyone thinking about creating a start-up, or marketing any product for that matter, is determining the size of the potential market.

There isn't an easy answer for this because, frankly, a "market" is not a thing, but an idea. You can't see a market, but you only have an idea that it exists. So, if you can't see something, but you want to measure it, how do you do this?

Well, there are actually several ways to approach this problem, and we'll consider one of these here and other methods in future tutorials.

Regardless of the approach, the first thing to consider is whether you want to determine the size of "primary demand" or "secondary demand".

Primary demand is the size of the market for a product category - like "virtual hard drives". Secondary demand is the size of the market for a particular brand - like xdrive.com or idrive.com. As you might imagine, secondary demand is more naturally associated with market share. You can read more about primary and secondary demand in our tutorial on firstmovers.

Since most companies we've dealt with tend to be interested in the demand for new technologies or services, our focus will be on primary demand - or the size of the market for a product category.

The first thing to note about almost all methods for estimating market size is that they are based on decomposing the larger "market size" problem into smaller problems, and building the results of these smaller problems into the market size. The best way to see this approach is in the familiar method of estimating market size as follows:

Market size = number of buyers in the market x
quantity purchased by an average buyer in the market per year x
price of an average unit

Notice how the total problem is broken down into its constituent elements (i.e., the number of buyers, the quantity per buyer, etc.) and aggregated up (through multiplication) to get the final result.

This is a common technique used by many companies, with the major differences being how they break the problem down and how they build in back up.

For example, an Internet service provider may think of the number of buyers at the level of a household - since a household buys the Internet service, not an individual. In contrast, an application service provider (ASP) selling to corporations would likely focus on the employees in the customer corporation who will use the service, not the corporation itself.

The art of breaking down a problem and building it up is also at the heart of the "chain ratio method". Similar to what we just described, but more focused on the size of the market in terms of number of customers, rather the dollars. Think of this method as trying to determine the "number of buyers in the market" in the simple equation above.

The chain ratio method can be used by either first breaking down the problem into smaller problems and then building up, or estimating (really almost guessing) the size of the total market and then doing some fine tuning. We'll focus here on latter approach of fine tuning a general broad estimate of the market by looking at the infamous cat problem.

Let's look at the question consulting firms like to ask potential employees to determine how they think. The question is: How many cats are there in the U.S.?

Here's how you answer this question. Notice how we'll approach this by fine tuning a broad estimate of the total market.

First, determine the unit of analysis. You could say the unit of analysis is a cat owner, but you would quickly see it makes more sense to think of the household as the unit of analysis.

Next, how many people are there in the U.S? Let's say 250million

Next, let's assume there are 5 people per household - - that means there are 250/5=50M households.

Next, about how many of the households have pets? Let's assume 1/5 - - that means there are about 10M households with pets.

Right, but what percentage of the pets are cats? Let's say 50% - - that means there are about 5M households with cats.

Now, let's fine tune this. Let's assume that of these 5M households have about 2.5M have 1 and 2.5M have 2 cats - - that would mean there are about 7.5M cats.

Throw in some strays (let's assume .5M stray cats), and you have about 8M cats!

You'll notice that we've used a lot of assumptions here. As in all business problems, there are assumptions and these are no different. Some of the assumptions you can verify with data (such as how many people per household). Some assumptions you can't verify, but for these you can do sensitivity analysis - - change the numbers and see how much of a change you have in the final result - to see if the assumption is really that critical or not.

Before you think this is just some interesting trick, consider how you could use this to determine the size of your own market. Follow the basic process as we just outlined.

Start with the universe of all possible buyers. Then systematically use percentages to fine tune the problem. The important thing is to do this in a logical manner, and clearly state you assumptions as you go along.

Remember, a venture capitalist - or anybody else, for that matter - won't know the actual percentages or numbers for the various elements of your problem. What they will know, however, is that you've thought through the problem correctly and logic holds. So focus on the logic and do the best you can at getting reasonable numbers.

When I was a Bell Labs (now Lucent Technologies) a number of years ago, my group was once asked if we could figure out the flow rate at the mouth of the Mississippi River in New Orleans. All we had was a piece of paper and our minds to complete this exercise.

We had help (thankfully) from someone who really understood this process of decomposing a problem into constituent elements. Given the nature of the problem, we started by estimating the answer to several small but more manageable problems, and then aggregating up.

Amazingly, by making estimates on such things as rainfall east of the Rocky Mountains, soaking rates in soil of Great Plains, and other such esoteric ideas, we were able to come very close to the actual flow rate. Did we get it exactly right? No. But we were able to get close and, more importantly, really understand what goes into the final answer.

This is as much as you can expect from any method of estimating market size. But when you think about it, that's really a lot!

Check out our other tutorial ( How to Size a Market - Part 2) on this important question.

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This is the fifth and last blog entry in our series on how to build a startup. Here's again an overview:

Section 1 - Business Models And Customer Development
Section 2 - Exploring Customer Segments And The Business Model Canvas
Section 3 - Building Customer Relationships
Section 4 - Exploring The MVP
Section 5 - Developing Your Revenue Model

Section 5 - Developing Your Revenue Model

Executive Summary

Very simply: how will your startup make money? And how does your revenue model integrate itself into your business model canvas and customer value proposition? This isn't limited to the pricing of your product or service - but rather the overall strategy and tactics related to collecting the revenue from the value your customers are getting from your product/service.

What Are My Revenue Streams?

A revenue stream is the strategy used by a company to generate cash from each customer segments - so if you have multiple customer segments, you may have multiple revenue streams.

A pricing model is the tactics you'll use to set the price in each of your customer segments. To determine the pricing, you need to understand the value they are willing to pay for. When you're first making your assumptions, you can guess what the pricing could be, but you'll quickly validate how much they are currently paying (and for what value), and how they are currently paying.

Common startup mistakes at this stage include thinking that your price is determined by the cost of manufacturing or producing the product or service or that your price should be lower than any other competitor's pricing.

Determine Your Revenue Model

There are a few types of revenue models you can use as an example for your revenue streams:

• Asset Sale - sale of the ownership right to a physical product (example: buying a car)
• Usage Fee - fee is proportional to the usage of service (example: mobile phone service or database hosting)
• Subscription Fee - fee for a continuous access to a service (example: SaaS products)
• Renting - fee for a temporary access to a good or service (example: renting a car)
• Licensing - fee for use of some Intellectual Property (example: software)
• Intermediation Fee - often found in marketplaces of various types, a fee for bringing together two or more parties involved in a transaction (example: online marketplace sites like Airbnb)
• Advertising - fee paid by brands and companies to get in front of potential customers (example: Google, Facebook)

Each revenue stream may different pricing tactics. Once you've figured out the revenue stream, there are two types of pricing: Fixed pricing and dynamic pricing.

Fixed pricing is based on 3 elements:

• the cost of production & a set markup
• value priced (based on customer segment or features)
• volume priced

Dynamic pricing is based on 3 elements:

• negotiation
• yield management (best example are seats on a plane closer to take off)
• real-time markets (auctions or marketplaces with time sensitive goods)

In an existing market you have to think about competition and how they'll shape your pricing. What are their costs? What are their products? What's their value? Make sure you take the time to research and understand them and use your pricing as a strategy for gaining more customers.

Another common startup mistake is to price from cost from day 1. This isn't a strategic way to price. You want to think about both your internal economics but also the value to customers - don't leave money on the table.

By getting out of the building and understanding your customer segment's pain and gains - you better understand the value your value proposition provides them.

Key Revenue Model And Market Questions

Keep these key questions in mind as you and your startup are choosing your revenue model and pricing tactics:

• What are my customers paying for?
• What capacity do my customers have to pay?
• How will you package your product? (not limited to the physical packaging, but what features will be included)

As for the market type, consider these critical questions:

• What's the market size and estimates of the market share?
• How many can your channel sell?
• How much will this channel cost?
• How many customer activations?
• How much will cost to acquire a new customer and what will be their lifetime value?

Outlook

Today micro Entrepreneurship is a real big trend. This trend is leading to the fact that many people are starting up their own business. But before you start up your own business, you should do your homework and get out of the building to validate your idea. By validate I mean check if customers want it and if you can make money with that idea. Otherwise you will end up like most companies in bankruptcy after two years.

So, if you out there want to become a founder and be successful you should make sure, that you get out of the building quick in order to build a functional business model and develop customers. Make sure you explore customer segments and pin a business model canvas to the wall in our office to constantly iterate with it. Build first customer relationships even if you don't have a product, just to validate your business. Then build a minimal viable product and test it until your customers are happy. Form this point, you only need to validate your revenue streams or pricing policy and the chance that you will be still alive after more than two years is going to be a real one. For sure there is no guarantee or what so ever but if you validate your business idea, the chance of surviving is for sure a better one and it will also open up your eyes with things you were not even thinking about initially.

We wish you guys good look and a lot of fun starting up your own business.