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10% of infinity? Calculating your Total Addressable Market size

This article is written by Peri Kadaster

 

On a lazy morning scrolling the infinite scroll of Twitter, one tweet by a VC (whom I’ve never met) caught my eye:

“New trend in demo day pitches that I *love*: showing market size calculations.

Before: ‘Tooth brushes for cats are a $3b market!!!1! (sic)’

Today: ‘250m cats * vets prescribe tooth care for 40% of cats annually * car owner pays $30 for 4 toothbrushes/year = $3b market.’

Waaay better.”

(Source: Leo Polovets)

 

Why does TAM matter?

TAM – total addressable market size – is one of those necessary but not sufficient elements of an early stage business plan. A TAM is a rough articulation of “the size of the prize” – for startups and for their investors – that paints a picture of how big “big” can be for a truly successful product in that space.

I personally think of it also as a hygiene exercise for the entrepreneurs themselves; doing a thoughtful TAM calculation indicates whether the user is truly at the core of the business, of product development, of how they think about decisionmakers/gatekeepers etc.

 

What is the new “trend” cited above?

In Leo’s tweet, he illustrates a few important concepts: First, the importance of “showing your work”, by indicating the assumptions that go into a TAM number – rather than just showing the final answer.

On one hand, a TAM is a “shot in the dark” – much like other estimates or forecasts based on assumptions that are, themselves, estimates, the notion of precision is overrated. In that sense, I see the ultimate number not as relevant as an absolute, or in a vacuum, but rather as a relative measure and sanity check; e.g., is the number significantly larger than established market metrics (like number of active internet users worldwide – if the product requires internet).  

Ideally the entrepreneur has also done some sensitivity analysis, i.e., which of the assumptions have the biggest impact on the market size, and how susceptible to change or revision are those in particular? And can be ready to discuss those points with domain knowledge together with potential investors, employees, and more.

Second, Leo’s tweet also shows an important point on approach taken to a TAM. He shows a best practice example done by “bottom up” calculation – starting basic assumptions around the users and/or decision-makers for users about the product itself, based on current spend on complementary behavior.

Another approach is “top down” calculation – what I recall a VC investor describing to me as “% of country” approach. For example, if you find in a research report, or create an estimate, around how many people have cats who get dental care, and then apply that to a top-level market number (e.g., population of China, number of smartphone users). So if the estimate appears small – let’s say 1% – when applied to a substantially large number – like the population of China, which is 1.4 billion people – it can lead to some false conclusions (“we only need to get 1% of people to buy our product for 14 million customers!”). It doesn’t have inputs that can be easily tested and revised with data moving forward, but importantly it also doesn’t lead with the user and user need.

If it’s a great product, you don’t think of what percent of the population you “need to get” to use it – rather, you look at the personas who have the need for that product, and try to focus on and capture them. Have numbers you feel comfortable talking through.

 

How can I get comfortable with my TAM?

My third take from Leo’s tweet is that, candidly, I was a bit shocked that showing your assumptions in a basic equation was considered a “new trend.” I’ve done this and seen this in most business plans since I first dipped my toes into entrepreneurship well over a decade ago. (Also from my past life working in strategy, market sizing questions were often a week 1 exercise on many engagements – walking in with a single number simply was not an option!).

Some people may err on the side of too much complexity and false precision (think massive excel models), but at the end of the day highlighting not just the “what” but also the “why” of the TAM is part of the basic plumbing of any business plan.

I rarely look at people’s comments on Twitter, but I scrolled down to see Leo’s back-and-forth with his readers. One person noted that the emphasis on providing simple but stated inputs into a TAM is something that accelerator programs like Y Combinator actively coach companies to do. Another said it’s a great way to ensure that founders have spoken with customers about the problem space – how big it is, and how frequent it is.

***

It’s a delicate balance – painting a realistic picture based on data that may not exist yet, and promoting your potential market size without inflating it beyond belief. At the end of the day, it’s a high level estimate. It’s not a ‘blood oath’ that forces a company to adhere strictly to the borders or numbers therein, but it is a guide that centers on your users.

For founders, especially those who don’t come from consulting or finance backgrounds (where creating assumptions for market forecasts are an every day skill), this process can feel awkward. It may feel like a bit of art (getting at assumptions) parading as science (when you posit a number for the market size). The truth is, it’s both – calculating a total addressable market calculation requires both art and science; science in sticking to the fundamentals of how user segments and spend estimates build up, but art in creating estimates in those instances where “cold, hard data” may not exist. (you may smile when you see this take on Zappo’s, for example)

While I personally don’t consider a rough TAM calculation itself directly correlated to how attractive a startup is, I do consider the elements of the TAM, and how the entrepreneur thinks about them and questions them, one of many elements that does.  

 

12 September 2018

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