TAM is a dream- what if the entire world buys our solutions? But this thinking doesn’t sway investors. If chasing this high doesn’t lead to sustainable growth, what does?
“How big is this thing going to be?”
It’s the very first question every startup must face. And one that a lot of them skip out on.
They draw on ideas and business strategies, but the market size remains in question. Although it’s evident that they aren’t selling to the whole market, the markets they’re catering to are either too saturated, too microscopic, or don’t exist at all.
Existing data states that 70% of startups fail because they haven’t understood their market size. And this is why they’re missing out on a myriad of opportunities.
Your “amazing” product will fail to create an impact if you treat Total Addressable Market (TAM) as just a number in your pitch deck.
What exactly is Total Addressable Market (TAM)?
The generic definition of TAM is,
“A metric popularly leveraged by startups, entrepreneurs, and investors to evaluate the potential size of a market for a new product or service. It’s intended to represent the total potential demand for a product or service within a given market.”
Total Addressable Market is a mainstay in every startup’s pitch deck, presented as the potential revenue opportunity the company is pursuing. It’s the primary filter for investors, and demands that you present a hue, quantifiable market size that’s ripe for taking.
But investors aren’t swayed by this, given the current market conditions. What’s in large existing markets? It has become a blind spot- this is the main problem VCs now have with TAM.
Zeroing in Only on the Total Addressable Market Comes With Limitations.
Focusing on such massive markets is distracting businesses from actual opportunities- the creation of new markets.
Across this arena, TAM is negligible, barely attracting attention. It’s great for existing and well-defined markets, but for new or disruptive product categories, it’s a fluke.
The “top-down” approach to TAM analysis is taking the punch. It has come to be known as the unreliable pitch deck theater by the market.
What is the “Top-Down” TAM assessment approach?
The top-down approach starts at TAM- the total addressable market, i.e., the overall market size.
Then, they progressively narrow it down to the potential market size for the business or the eventual market share.
This comprises the target market segments for the business’s offerings out of the entire market (Serviceable Available Market, or SAM). And then you dive in even deeper, i.e., the percentage of market size that can be realistically obtained and serviced to (Serviceable Obtainable Market, or SOM).
- TAM = the whole 10-inch pizza.
- SAM = the slices you can eat.
- SOM = the slices you’ll actually end up eating.
The calculations are often subjective and presumptuous. These numbers are based on industry reports, various macroeconomic factors, and market research data.
This makes the traditional TAM calculation a significant hurdle for business leaders.
These numbers could end up over-inflated. Focusing on a chunk of the market doesn’t automatically generate more opportunities. And the glimpse into a company’s vast potential (or the upper limit) that TAM offers is misleading.
Limitations of the traditional “top-down” TAM analyses
The traditional TAM framework is inherently unsuitable for creating new markets. In recent times, it has driven investor skepticism and led to startups undermining their true potential. And investors might easily end up passing over the company, missing out on the company’s potential within new markets that could be created.
VCs now want believable numbers that align with your product strategy, GTM framework, and final objectives. Only focusing on TAM introduces too many limitations-
1. “For truly innovative products, the market is not a fixed entity to be captured, but a dynamic one to be created.” In simple terms? Disruptive offerings create their own demand (see Uber, Apple, and Microsoft).
2. TAM is often a farce, a large number on paper to make a company look good. Do the presented numbers actually link to the business’s analytical and real-world capabilities?
Imagine a client you’re working with asserts that their TAM is around $60 billion. They’re convinced. But the number is quite ambitious and should be credible. So, their SOM turns out to be $600 million. This 100x overenthusiasm can put a hitch in the client’s business strategies and growth planning.
3. Top-down TAM analysis put together by a third-party source reeks of laziness and lacks credibility. Just because everyone around the world uses phones doesn’t mean all of them will purchase an iPhone. It’s become a norm for third-party providers to tie up existing categories to reflect a large number. But what do those pre-packed figures really demonstrate?
4. The market is extremely heterogeneous- with distinct buying behaviors, needs, preferences, and myriad variations of the same offerings. TAM or the overall market size is a subjective number that represents the potential demand for a company’s offerings. But with the market fragmented and chopped into segments, this number doesn’t consider the challenges of penetrating these segments.
For a cloud solution, there might be individual as well as enterprise buyers. This demands majorly distinct sales, marketing, and distribution approaches.
5. TAM is too static a number for the dynamic market of the 21st century. The market transformation cycles have elevated from a 10-year-long pace to just 2-3 years. It’s due to the increased flow of information, tech disruptions, the adaptive nature of business models, and dynamic customer preferences. And these factors are what should impact TAM, but its rigidity doesn’t have the room to consider these fluctuations.
“I hear these TAMs – we are attacking a $30B TAM. OK, that’s great. But where did that number come from? The single largest company that exists in what you define as your category is a $2 billion company. So, where is the other $28B? Where are these numbers coming from? And then you have to unpack it- is it software? Is it software services or something else? They are packing it in so it looks gargantuan. But you look at every precedent company and nothing is over $2B.”
– Tony Kim, BlackRock‘s Head of Investments.
The problem here is that the analytical capabilities of the traditional TAM framework are lacking.
What’s the solution here?
You lean on alternative methodologies to calculate TAM- ones that dive into the specifics to gauge the accurate market size.
TAM Analysis: Alternative Approaches to the Top-Down
A. The Bottom-Up Framework
TAM analysis with a bottom-up approach is more granular and specific. And it’s data-driven, which is why it’s a market-favorite. This framework is also often used when industry reports and broader market data aren’t available, i.e, the market (third-party) data is limited.
So, you convert existing zero-party and first-party data to analyze your current market size and potential.
You leverage existing audience data, such as offering pricing and usage, to calculate the TAM.
It helps you put the customers first. Rather than relying on a third party’s data analysis, you conduct your own market research in the arena where you know you can play best.
The process?
- Define your ideal customer profile (ICP).
- Count how many companies actually fit into your ICP.
- Outline the average contract value (how much they’d pay you annually) for each account.
- Multiply to calculate your total potential revenue, or TAM.
Example:
You’re targeting businesses in Singapore with overall 200-500 employees for your HR and payroll tech.
- Number of companies in that range? – 10,000
- Average contract value? – $3000
- Your TAM? – 10,000*$3000 = $30 million.
All the calculations are based on actual customer and company data, and not assumptions.
With the bottom-up approach, you can negate the one dilemma that existed above- of pre-packed segments. And you can now explain to potential investors why you chose specific segments over others.
B. The Value Theory
Value theory asks, “What’s this worth?” i.e., highlights the economic value of your venture.
And mostly significant for startups with disruptive offerings.
You aren’t looking at existing markets. You are demonstrating your own worth to create a new segment driven by the value you offer. This means you’re solving an expansive market pain point that doesn’t have an established market size yet.
Value theory for TAM kickstarts investor discussions and offers market validation- what is the potential of your offering?
The process?
- Outline a particular business challenge.
- Measure how much this pain point can cost companies.
- Quantify your offering’s value creation, i.e., how much of that cost can you eliminate.
- Calculate the value of market share you can capture = total market value.
Example:
Data entry errors cost companies $750 per employee per year.
Your startup has developed a solution that can reduce the problem by 50%.
- Target => 5000 companies, each with 200 employees.
- What’s it costing a company? => $750*200 = $150k.
- Total cost of the problem for the market ⇒ $750*5000*200 = $750 million.
- How can your solution eradicate? ⇒ $750 million*0.50 = $375 million (Your TAM).
The Bottom Line- Adopt a Multi-Structural TAM Analysis Framework.
By changing the approach to TAM analysis, you aren’t eliminating the entire process but evolving it.
You must pivot to a TAM analysis framework that offers a more precise and accurate assessment of your company’s market potential. By solely sticking to the traditional method, you are limiting your understanding of your own company and its impact.
It can offer you high estimates and paint a sunny picture. But at the end of the day, it’s clouded by assumptions and doesn’t align with real-world market complexities.
A sustainable business model demands a change from this inflated TAM calculation.
Instead, opt for a multi-structural framework- one that considers diverse scenarios. And spotlights both the upsides and downsides of your market opportunities.
Alternative approaches help draw a realistic picture of a company’s market potential than depending on hearsay. Investors and founders alike can gauge its potential impact and ROI.
And highlight where you may stand in the market-
Will the market drive you, or will your offering end up driving the market?
