One of the most important things that investors (and good entrepreneurs) consider when investing in or starting a business is market size. Even so, my experience has been that the vast majority of entrepreneurs calculate market size incorrectly.
I will focus here on what is generally referred to as the Total Addressable Market (TAM) for a business. While other measures (SAM and SOM) are important, they are often particularly hard to define for an early-stage company, which is the focus on this post and of my current investment activity. Simply put, market size (TAM) is the product of the expected unit price for the new product (Unit Price) and the total number of units the market would buy per year assuming 100% market penetration (Potential Units). In an equation:
TAM = Unit Price X Potential Units
The equation is obviously simple. The difficulty for a nascent company is estimating the Unit Price and number of Potential Units. With regard to price, competitive offerings are often a reasonable rough guide, but it’s obviously important to keep in mind any plan to offer the new product at a significantly lower price than existing solutions. Indeed, new products are often significantly cheaper than alternatives offered by incumbents (witness Skype) though not always. As for Potential Units, look for an estimate of the total population of potential buyers of the product, together with an understanding of the units a single buyer might purchase in a year. An enterprise SaaS license is something that a business buys only one of in a year, while a U.S. consumer would, on average, buy tens if not hundreds of bottles of water. When estimating the Potential Units, be sure to include only buyer population(s) that could reasonably considered addressable. For example, adults should not be counted when estimating the Potential Unit sales for children’s shoes.
Many entrepreneurs jump right to the Serviceable Addressable Market (SAM) when attempting to calculate TAM. They do this by estimating a potential steady-state market penetration for their product (usually expressed simply as a % of the market they think their product might ultimately capture). While SAM is important, appplying such a penetration estimate when calculating TAM is incorrect. As previously noted, SAM is also typically less relevant at the early stages of a company’s life; this is because estimating steady-state penetration is often an arbitrary exercise for a new product.
This form of market size estimation is a “bottoms-up” analysis; it starts with unit-level metrics and builds up. The other common mistake entrepreneurs make is to focus on market sizes calculated using “top-down” analyses. This kind of estimate often manifests as a reference to a research report; “the mobile content market is $8B and growing 28% per year.” (Note I completely made up those numbers for this example.) That approach is, generally, irrelevant to the task of determining the potential for a new business. The statistics quoted almost never address only the population of potential buyers for the new company’s product(s). And even if they do focus on the specific, relevant population, these estimates are based on the unit prices of solutions already in market; prices which, as I noted earlier, are relevant but not deterministic when estimating market size for a novel product. Very often, a truly revolutionary product will dramatically shrink a market because its price point is so much lower than that of incumbents’ (again, consider Skype).
No one expects a new business to capture its entire TAM, or even for a TAM estimate to be within 25% of the actual market size five years from the time of its calculation. This is still an important measure, though, as it provides the entrepreneur and would-be investors with an order-of-magnitude estimate of the size of the field on which the business will play. A new business will evolve a great deal as it grows; a large market will increase the likelihood that it will ultimately find a customer base (within its market) that will enable it to become substantial. For this reason, most venture capital and angel investors look for a TAM in the billions of dollars (many will not invest in a business with a TAM of less than $1B or even $10B). Entrepreneurs with the grandest ambitions often observe a similar bar.
