Every investor asks every entrepreneur, “How big is your market?” And almost every entrepreneur answers the question the wrong way …
“Our TAM is $256 billion!”
“The total XYZ Market is growing from $147.1 billion to $534.3 billion in the next five years, according to Research Company International. We only need to get 0.02 percent of that market to be a $100 million company!”
Investors don’t really want to hear some ridiculously large number you pulled off the internet that represents the total global spend in a broad market sector – of which you are going to target a tiny sliver. But that’s what most entrepreneurs claim as their TAM (Total Available Market).
Investors want to hear that you understand who your target customers are. Their defining characteristics, how many there are, how you are going to reach them, and how you are going to convert them to paying customers at a reasonable cost? Your success as a venture-backed company will not depend on whether or not the market for your product is big enough. Almost every market is big enough. (Even shrimp farming, nail salons, and pet wearables, believe it or not.) The challenge for entrepreneurs is not finding a market that is big enough; the challenge is figuring out how to reach and convert enough customers and deliver enough value to build a big business.
We have never seen a company fail because the market was too small.
Companies fail because they do not acquire enough customers. Just because a market is really big does not mean it is easier to acquire customers. In fact, the opposite is often true – it can be harder to acquire customers in a big, crowded market (like IoT, ridesharing, social networking). Savvy investors appreciate that it is often better to invest in a $0 billion market than in a $256 billion market. (On the other hand, it is generally true that there is a first-mover disadvantage, not a first-mover advantage.)
To be fair to the business school and pitch coaching community, the concept of Total Available Market is legitimate, but it’s just not very useful in the startup world. The concept of “Available Market” is too abstract, and so everyone takes the short cut and plugs in whatever numbers they can get off the internet. Startups have roughly zero market access, and so in reality they are starting from zero no matter how big the available market is. Plus, really great startups create their own market. So it doesn’t really matter if today’s TAM is $50 million or $500 billion.
In an earlier article, we explained why TAM is obsolete. [“Stop the Madness! No More TAMs“] In response, entrepreneurs asked, If TAM is obsolete, how should we answer the question when investors ask us, How big is your market?
The Wrong Way: “Top Down.” Most entrepreneurs take a top-down approach, which leads to unrealistic, irrelevant numbers. The worst form of top-down approach is to google “global apparel market size,” which will generate a modest estimate, “$1.5 trillion!” The alternative top-down approach is to say, “There are 250 million women in the developed world who spend an average of $250 a month on clothing, making our TAM $750 billion!” This is somewhat better, but still misleading.
The Right Way: “Bottom Up.” Identify your Target Customers and calculate your Market Opportunity based on your product offering, using a bottom-up approach, customer by customer, sale by sale.
Who is your target customer? What are the characteristics of the people who will buy and use your product or service? Your target customer cannot be “Millennials” or “SMEs” or “Travelers” or “Data Centers.” Those categories are much too broad and diverse. You have to segment the world into more specific categories that differentiate those in the category that are likely to need or want your product from those who don’t.
For example: You are focusing on women in North America age 21 to 35 who want smart, comfortable clothing they can wear in today’s more casual office environment. Get as granular as you can about the persona of your target customer. Do your homework. Get out and talk to prospects and experts, and figure out what percentage of millennial women this represents. How often do they buy clothes? How much will they pay?
Another example: SMEs in North America between $2 million and $20 million that spend at least $5,000 per month on marketing campaigns but can’t afford to hire an outside agency.
A different example: Maybe your market sizing is based on number of sites for which your solution is relevant (wastewater remediation) or number of high-end buildings that would benefit from your technology (electrochromic glass). Your solution will not be relevant or economic for every site or every building. Show that you understand the specific characteristics of a qualified prospective sale.
You want to show that you really understand the dynamics and the economics of the market, and you appreciate that not every participant in the market is a qualified prospect, and you cannot address all segments of the market at once.
Once you have tightly defined your targets, multiply the number of qualified prospects by the average price of your solution. You need to use your unit pricing to do the math, not the average customer spend in the current market. Just because your target customers are currently spending $120,000 a year on cybersecurity software does not mean that they will each spend $120,000 a year on your software.
The result is your Total Market Opportunity. You can call it your TAM, if you want, but technically it is closer to the definition of SAM (Serviceable Addressable Market) because you have honed your definition of qualified target customer down to the specific prospects you are going after.
So, from now on, when you are pitching your market size, show how you have calculated your Total Market Opportunity by clearly defining your target customers and using your unit pricing to come up with a dollar value. Show your work. Don’t just put up a number. Differentiate yourself from all the other lemmings using the TAM/SAM/SOM bubble slide by showing that you understand how to size a market from the bottom up.
Marry this analysis with your long-term financial projections model. Over the next five years, you need to build a marketing and sales engine that can acquire these customers one by one, and then onboard them, and then keep them happy, and then renew and upsell them. All this requires resources – people, money and time. Your sales ramp has to be realistic, not just in terms of revenue numbers, but also in terms of customer acquisition costs and time. Find examples of other successful companies whose sales ramp you want to emulate, and compare your costs and revenues to theirs. (You can find comparable company numbers by looking at S1 filings.)
By the fifth year of your projections, you should have a meaningful, but not delusional, percentage of your Total Market Opportunity. (Meaningful: 10 to 25 pct. Delusional: 80 to 90 pct.) If you only have 2 pct of your Total Market Opportunity, then you have not segmented your market precisely enough.
If you do this work, your business model and your financial projections will be much better grounded in reality. Delusional market sizing and financial projections will only get you in trouble. Disciplined market segmentation and customer targeting will significantly improve your chances of success, and will make you stand out in the eyes of investors.
Originallly published on LinkedIn