Market Sizing

Whether you're deeply immersed in the startup ecosystem or just dipping your toes, you've likely encountered the term TAM. Despite its simplicity, TAM remains one of the most misunderstood concepts in entrepreneurship. In fact, many pre-seed and seed-stage startups often miscalculate their market size.

Market sizing is crucial for both investors and founders. For investors, TAM serves as a key metric to gauge the potential of a business within a specific market. Naturally, they are inclined to invest in companies targeting large TAMs. As a founder, assessing the market size before diving in is essential as with limited resources like time and funding, it's wise to focus on a market with greater potential.

In this article, we discuss the two methods for calculating TAM, how it is a function of your Go-To-Market strategy and the bigger picture of TAM.

Top-down vs Bottom-up analysis:

When calculating the Total Addressable Market (TAM) for a startup, there are two primary methodologies: the Top-down analysis and the Bottom-up analysis.

In a Top-down analysis, you begin with a broad figure derived from industry reports by firms like McKinsey or Goldman Sachs Research, and then refine this number downward. This method often results in an overestimated revenue projection, making it less favoured by investors. Conversely, the Bottom-up analysis is highly research-intensive and starts with specific data gathered from customer interviews and surveys at the ground level, then builds upward. This method yields a more accurate revenue estimate and is preferred by investors for its precision.

The concept of TAM varies between these methodologies. In a Top-down analysis, TAM is defined as the overall industry or sector revenue of the product you are selling from all players encompassing potential expansion into related markets. For example, if you’re selling untearable clothing, the TAM is equated to the global apparel market, estimated at $1.79 trillion. In a Bottom-up analysis, the TAM is a relatively conservative estimate of the revenue of strictly your product's target market. In this, the TAM is unique to each startup and heavily influenced by your Go-To-Market (GTM) strategy. Two startups in the same sector offering similar products might have different TAMs due to their distinct GTMs. For example, the same untearable clothing startup would have a TAM as (number of people in armies, sports etc) X price. This involves you identifying the target market for your startup and TAM is the size of this target market, much smaller than the overall industry or sector size.

Investors often inquire about YOUR TAM, seeking a personalized and realistic estimate of your startup’s potential revenue via Bottom-up Analysis.

Top-Down Analysis:

This method breaks down the market into three segments: TAM, SAM, and SOM. It starts with a large number from global industry reports for the total market (TAM) and narrows down to your projected revenue (SOM).

- Total Addressable Market (TAM) : The total revenue from all players in the market for a specific product.

- Serviceable Addressable Market (SAM): The total revenue from all the players in a segment of this total market. This market segment is mostly geographic.

- Serviceable Obtainable Market (SOM): The market share you aim to capture within this market segment with your Go-To-Market strategy (GTM). This involves the portion of customers which are most likely to buy your product and where your product-market fit is optimal. This reflects your startup's projected revenue in the initial stage.

For example, if you're selling untearable clothes, the TAM would be the global clothing market, estimated at $1.79 trillion (from global industrial reports). If your startup is based in Silicon Valley, the SAM could be the North American market, approximately 20% of the total, worth $360 billion annually (from regional industrial analysis reports). The SOM would then focus on specific customers in North America, such as armies, rugby and American football athletes, and physical laborers.

Bottom-up Analysis:

We read above that TAM in Bottom-up analysis is defined as the maximum potential revenue of your startup in the market you project to capture of your product. Realistically, you only capture a small market share of this target market of your product via your GTM and market penetration strategies. Let's understand this definition a little more in depth with some examples discussed below on where most startups go wrong.

1. Your TAM is not the size of the problem you are solving: Health-tech startups often state the size of the problem they are solving to lay emphasis on how big the market is. They often pitch "The opioid crisis is a 200 billion dollar problem" but the truth is that is the size of overall market while you might just be a platform for online diagnosis or a medicine synthesiser working on 2-3 specific opioid related diseases. So, your market is a very small portion of the overall market.
2. Your TAM is not the size of the sector you are in: Many times startups pitch "Cybersecurity is a 250 billion dollar market and we plan to get 1% of the market share using our market penetration strategies". Again, this is the Top-down analysis which is often considered wrong by investors and you should not confuse it with the Bottom-up analysis.
3. Accounting for value from other products: This is the primary reason why Top-down analysis results in wrong calculations and explains the above two points. Let us consider you have a startup of selling Ski-goggles to prevent snow from going into your eyes. The mistake startups make is pitching "The ski and snowboard industry has a TAM of 3.3 billion dollars". The problem is that number contains the combined TAM from markets of related products like the snowboards, the skiing clothes, the ski poles etc i.e. the whole skiing ecosystem whereas you just sell ski goggles.

Consider a company that sells unique cup holders for Toyota Innovas. They might claim, "Every year, $6 billion worth of Toyota Innovas are sold," to highlight their market size. However, this figure represents the total annual sales of Toyota Innovas, not their Total Addressable Market (TAM). The company only sells cup holders priced at around $10 each, while the cars themselves are worth significantly more. Therefore, the $6 billion figure represents the number of cars sold multiplied by the car's price. In contrast, the true TAM for the cup holders is the number of Innovas sold each year multiplied by $10, which is much smaller than $6 billion.

How to calculate TAM the correct way?

The TAM is calculated by a simple equation TAM=(number of potential customers)X(price). Both of the variables in multiplication need to be guesstimated and an error in either one inflates the TAM highly. The number of potential customers may be located globally or within India which would give the global TAM and the Indian TAM respectively. Pricing is your theoretical price of your product which you are selling which is simpler for startups post series A stage which usually have done some sales. But for an early stage startup, the pricing is based on testing the market via a prototype or a beta version of a product. Your price ideally should be lesser than the current market price to promote adoption.

The process of calculating the number of potential customers begins by identifying your target customer group and establishing an ideal customer profile. These are typically individuals for whom your unique value proposition (UVP) stands out and who exhibit the best product-market fit. With initial funding, you focus on this group first, as they are the most likely to purchase your product. Over time, you can expand your reach. E-commerce companies often start by targeting tier-1 cities before expanding to rural areas. For instance, OTT platforms initially target India-1 before broadening their scope to other market segments through horizontal integration. An example is Amazon Prime acquiring MX Player in India, which primarily serves audiences in India-2 and some of India-3. (Refer to the Indus Valley report pages 26-30 at the end of the article for definitions of India-1, India-2, and India-3.)

Understanding TAM calculation with an example: Let's explore the process of calculating TAM with an example. Suppose you run a cybersecurity SaaS company offering software that addresses all security issues a company might face.

But, are you planning to sell to all companies right away with your initial funding?

No, you will target the customer segment most likely to purchase your product. Who might that be?

Upon deeper consideration, financial institutions emerge as the prime candidates since they handle large sums of money and are highly susceptible to hacking.

However, not all financial institutions will buy your software. This category includes insurance companies, asset management companies (AMCs), non-banking financial companies (NBFCs), commercial banks, investment banks, and so on. You might determine that commercial banks and NBFCs are the most likely buyers.

But will all commercial banks and NBFCs be interested? This group ranges from smaller entities like AU Small Finance Bank to major players like SBI and HDFC.

You realize that banks without a dedicated security council or a Chief Information Security Officer (CISO) are the ones most likely to purchase your software.

But are targeting all of these banks globally. You might just start with the Indian branches of these banks first. There you have it—you've just identified your target market.

So, your number of potential customers is all Indian commercial banks and NBFCs who do not have a CISO which can be calculated with some research. Now, we come to pricing. You have to come up with pricing by testing a beta version with these banks and see how much they are willing to pay. You need to think of a revenue model for your company. Let us say the number is 5 Lakh Rupees per bank branch per month.

So, your TAM = (no. of Indian commercial bank/NBFC branches who do not have a CISO) X (5 Lakh Rupees) X 12.

This process is the core of calculating TAM for startups in any sector. For the social media companies, the equation looks like TAM = (number of users) X (cost of advertising) where cost of advertising may be in pay-per-click or CPT (cost-per-thousand) model. This way of calculating TAM also incorporates your Go-To-Market strategy and revenue model within it and that is why it is preferred by investors.

The Top-down approach gives you a snapshot of market dynamics in time. But the market is actually dynamic with time and markets may grow or shrink with time. So, investors prefer an alternate approach of launch market size, expansion market size and total market size in the long term.

The Bigger Picture:

Often times, even TAM does not give the full picture when investing and cannot be the sole criteria for investment. There are related parameters that go into play. Even professional VCs sometimes judge an investment opportunity wrongly because they miss out one of these following factors.

1. The sector they are in: VCs like to invest in startups with a potential valuation of 1 billion+ dollars. A common method of calculating the valuation of a startup is multiplying the revenue (which is TAM x market share) by the revenue multiple of a startup which is unique to the sector they are in. For example, a software business may become a SaaS startup or a consumer subscription business depending on the type of revenue model they employ but SaaS has a revenue multiple of 15x while consumer subscription businesses have a 3-5x multiple. So, it's better to become a SaaS company with the same revenue and TAM as that offers a better valuation
2. Scope of Adjacencies and Integration: The TAM and valuation are just numbers at a fixed point in time and does not indicate the scope of expansion into other revenue streams and integration. David Zse, an investment partner at Greylock famously pounded the table after an investment in Facebook at 500M dollar valuation. He thought the company will 3-5x but it turned out to 1500x at that valuation. This is because of Facebook employing horizontal integration and offering a vast amount of services (in the form of WhatsApp, Instagram etc) than just the original product. Similarly, Zomato has nowadays vertically integrated from just the food delivery business into the Hyperpure business, cloud kitchens and many more.
3. Market expansion with time: Some markets maybe small today but might expand in the future like the OTT industry in India is expanding because of increase in the per capita income of people and decreasing internet prices. So, investors also need to consider the CAGR of markets itself. Sometimes, the market expands upon the launch of product itself like it happened in the case of Uber. Aswath Damodaran, a prominent professor of Finance infamously predicted that Uber cannot cross a valuation of 17 billion dollars based upon his analysis. Uber currently has a valuation of 100 billion+ dollars. What happened at the launch was that Uber halved the ridesharing prices and made it a better customer experience. This resulted in people giving up their car ownerships and opt for Uber rides instead. So, Uber did not end up playing the 100 billion Taxi industry but also the car ownership industry worth 750 billion dollars.
4. Market Structure: The market structure is even more important than the market size. Often in unorganised and fragmented markets, there is a winner-takes-all type of situation which results in monopolies and duopolies in the market. This can drastically increase your market share than expected.
5. Luck: Sometimes some other factors play along for a company to do unexpectedly well. For example, some industries benefitted immensely during the pandemic like Healthcare and Ed-tech while others nearly wiped out like the restaurants, theatres etc.

Summary

• Never do your TAM top-down. Always do it Bottom-up. Do it after planning your GTM and revenue model.
• TAM = number of potential customers X your price. Do research to determine both variables.
• If your startup can dive into either of two sectors, say, SaaS or consumer subscription, always choose one after careful analysis as Valuation = TAM X market share X revenue multiple
• As an investor, try to predict scope of future expansion and integration.
• Analyse the market trends. Businesses with small TAMs today may have larger TAMs tomorrow.
• Analysing the market structure is equally important as the market size. Unorganised markets allow for larger market shares.