How To Think About TAM
One of the things that VCs will tell you is that we love big markets, and the way we measure market size is usually called TAM, which stands for Total Addressable Market. I’ve seen so many entrepreneurs get tripped up on this in pitch meetings, that I want to lay out how I think about TAM as an investor, how I suggest entrepreneurs figure out the appropriate TAM, and how to think about different TAMs that have different traits.
The key word in “total addressable market” is the middle word “addressable.” If your business plan is to sell bottled water in front of amusement parks, you can’t use the total size of the bottled water market as your TAM, because a lot of bottled water is sold in other places (grocery, drugstore, gas station, etc) and your business plan doesn’t have a way to reach those customers. This is the most common mistake entrepreneurs make — inflating their TAM.
Why Is TAM Important?
There are a lot of small TAMs in the world. The total market for used sewing machine parts is small, but it’s a market. To build a big company, you need to be in a big market. But that doesn’t always mean your market is big now. Every market that exists, even the biggest ones, were small at one point. Part of understanding TAM is understanding whether you are playing in an existing large market, or a smaller market that is growing. Either way, the point is that you can build bigger companies in bigger markets, which is why TAM is important.
What Is Your TAM?
You should calculate your TAM in pieces, since as your company grows larger you may have the ability to expand TAM. Start by focusing on the market that you can sell into over the next 2–3 years. This includes everyone who is a possible buyer of your product but qualified by the point that you have to be able to reach them through your existing marketing methods. If you aren’t marketing internationally, for example, then you can’t use international demand in your TAM calculation.
In more established markets, you can find reports that will quantify TAM for you. In earlier markets, or markets you are re-segmenting (pulling off a targeted part of an existing market with a focused product) there are two ways to calculate initial TAM — bottoms up or tops down.
In a bottoms up scenario, you can figure out TAM by looking at end user numbers. Say you have a novel CRM add-on and your initial target is Salesforce users in the financial industry. You can calculate a TAM by finding the total number of Salesforce users in the world, subtracting those that aren’t in the finance industry, and multiplying by your target sales price. If you can’t find the number of Salesforce users in the finance industry, use a proxy like the percentage of the labor force that is in finance. If you don’t know your sales price yet, use a proxy of a similar tool sold to a similar buyer. If a similar tool doesn’t exist, use the hourly wage of the buyer and the amount of time you save them.
The second way to calculate TAM is top down. Here you start with some industry level metric and draw parallels to your own TAM. If you are launching a new faster hard drive, instead of doing the bottoms up tally of how many hard drives are sold per year, you can just look at the overall spend on hard drives — and then adjust it by the percent of the market that cares about hard drive speed. What percentage is that? If you are the expert on the market, you should tell us, the investors, and justify your analysis. If you don’t know, you could do a small survey of a few thousand people and try to get a least a ballpark gauge.
What Do You Do If Your TAM Is Small?
There are two ways to deal with this. First, you could expand to adjacent TAMs horizontally or vertically over time. This is difficult to do, as in most markets you will get bogged down just serving your core TAM, so if you plan to expand TAM in the early days of the company this way, you need a really convincing explanation of why you can do it.
The second method is you can grow TAM. When you launch something brand new, you often have to evangelize and educate the market about it. If your product doesn’t have a natural virality, then you need ads or content marketing or partnerships to educate your customer base. These are all hard and expensive. But if the product is good enough, and particularly if the market position is defensible once acquired, then it may be worth it.
Avoiding the “1%” TAM mistake
Entrepreneurs often make a classic mistake about small percentages of large numbers. Say they are building a new messaging app, and they have a few customers paying $5/month for it, and the market is worldwide. The entrepreneur may say “we are going to launch in China soon, and there are 1 Billion people in China — if we just get 1% of the market we make a hundred bazillion dollars.”
The idea here is that somehow 1% of the market is easy to get. It’s not. Anyone who has ever run a company will tell you that getting customers is hard. Getting 1% of most markets is hard. Don’t assume that just because there are so many people in your market, some will just find and buy your product. Selling is work. Always.
How do you get around this? You need to have a plan for how you penetrate your TAM, and it needs to be believable. For the record, while many of your early users will come from “word of mouth” and that’s great, it is very unlikely that will scale. But that’s better for another post.
Summary
TAM is a very important thing to look at when starting any company. And it is one of the areas I see entrepreneurs get tripped up very often. Be realistic about TAM and how you can influence it, and you will have a much better chance of raising money.
