Market Size Calculations: A Founder’s Guide
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Understanding market size is crucial for founders as they develop their startups. While many entrepreneurs are adept at tackling significant challenges, they often falter when discussing market size with potential investors. This uncertainty can be a warning sign for any new venture.
Without a defined market, a business faces an uncertain future. Grasping the potential size and dynamics of the market is fundamental in the early phases of a business, influencing everything from your strategic goals to product development and investor pitches.
Consider the early days of Facebook (now Meta). Initially, the social media landscape was largely untested, and the platform had to demonstrate that there was a viable audience for its services. The following slide from their early presentations illustrates their market research efforts:
This compelling data helped Facebook gain investors' confidence, particularly in accessing the college student demographic, paving the way for its later success.
So, how did Facebook derive its numbers? Founders can adopt similar methods through three key acronyms: TAM, SAM, and SOM.
Definitions of TAM, SAM, and SOM
TAM = Total Addressable Market This refers to the maximum revenue opportunity available to a company if it captured 100% of the market share without any competition.
SAM = Serviceable Addressable Market This represents the portion of the TAM that can realistically be served by a company’s offerings.
SOM = Serviceable Obtainable Market This reflects the actual market share currently served by the company’s products and services.
These terms are interconnected and are typically visualized as a series of concentric circles.
To begin, we should first focus on calculating TAM.
Total Addressable Market (TAM)
TAM serves as the ideal scenario number, indicating the highest possible revenue a business could achieve if every potential customer became a paying one. While helpful for understanding a business's scale, it is not a feasible target, as it assumes no competition exists.
Calculating TAM
There are several approaches to determine TAM:
Top-Down Approach This method starts with a broad market and narrows it down to your specific segment, often leveraging industry reports.
- Identify the total market size from credible sources like Gartner or Forrester.
- Segment this data to align with your target market.
- Apply relevant percentages for the portion you can realistically serve.
For instance, if the software market is valued at $100 billion, and small businesses account for 20% of it, your TAM would be $20 billion.
Bottom-Up Approach This approach calculates TAM based on previous sales and pricing structures.
- Multiply the total number of potential customers by the annual contract value (ACV).
For example, if your medical software costs $1,000 per year and there are 1,352 hospitals in your target area, your TAM would be $1.35 million.
Value Theory Approach This subjective approach is useful for innovative entrepreneurs who may not yet be selling a product, focusing on what customers would pay based on the value offered.
Continuing with the medical software example, if your product offers unique cloud access, you would want to include the additional revenue potential for that feature in your TAM calculation.
Serviceable Addressable Market (SAM)
Moving on to SAM, we become more realistic about market potential. SAM acknowledges that no product can serve the entire market.
Calculating SAM
To calculate SAM, you continue using the bottom-up approach while refining your target market.
For example, if your software is more suited to public hospitals, you would base your SAM on the number of public hospitals in your area, leading to a SAM calculation of $695,000 if your ACV remains at $1,000.
Serviceable Obtainable Market (SOM)
Finally, SOM indicates the actual share of the market that your products currently serve, becoming essential for assessing future growth.
Calculating SOM
To calculate SOM, you need to establish your market share based on previous sales and the current SAM.
Assuming last year you sold $400,000 worth of software in a market where the SAM is $715,000, your market share is approximately 56%. If you retain this percentage, your SOM for the current year would be around $400,000.
Note: While SOM starts at zero until your product is in the market, you can create hypothetical scenarios to estimate market share when seeking investment.
Importance of TAM, SAM, and SOM for Startups
- Attracting Investors: A well-defined TAM can capture investor interest, especially if it's seen as neither too high nor too low.
- Growth Potential: A larger TAM showcases opportunities for market expansion.
- Market Positioning: Understanding the gaps between TAM, SAM, and SOM can highlight customer acquisition challenges.
- Funding Opportunities: A limited TAM may restrict funding unless accompanied by growth strategies.
- Strategic Development: These metrics help identify underserved market segments for quick gains.
Tips for Creating an Effective Market Size Slide
- Use a Bottom-Up Approach: This indicates thorough research rather than superficial number gathering.
- Avoid Inflated Numbers: Focus on your core audience to maintain credibility.
- Clarify Geography: Ensure your TAM reflects your intended market, particularly if not global.
- Prepare for Pricing Questions: Have defensible assumptions about average selling prices ready for scrutiny.
- Illustrate Future Growth: Show how your product roadmap may enhance your TAM over time, similar to Facebook's evolution from college students to a broader demographic.
In conclusion, investing effort into a well-crafted market size slide can significantly enhance your appeal to potential investors.
For additional tools and resources, consider checking out StartupStash. Zendesk is also offering $75,000 in credits and perks for startups—apply now!