Most investors agree that the two most important factors in a decision to invest are the market size and the quality of the team. This chapter focuses on market size.
The most common ways to think about market size, and the estimates most institutional investors expect to see are:
- Total Available Market (TAM – pronounced as a word like “ham.”). Sometimes total addressable market The market value of the job to be done for all segments.
- Serviceable Addressable Market (SAM as in a person named “Sam.”) – sometimes also segmented addressable market, serviceable available market. The size of the market you could reasonably serve with your solution and business model in the medium term.
- Serviceable Obtainable Market (SOM, as in the nickname for a sommelier) – sometimes also share of market. essentially the market the company may credibly expect to obtain with available resources in the near term, say 24 or 36 months.
Some investors, advisors, and entrepreneurs (including me), prefer to define an additional category, the beachhead market. Getting a company up and running is really hard. Going after the biggest market segment is not necessarily the best strategy. Often the biggest market segment will demand aggressive pricing and thus significant cost efficiencies. Most start-ups won’t be equipped to tackle the biggest segments from the start. A beachhead market is one that provides the easiest access, allowing the fledgling business to get started, to develop a little traction, to build some scale, and to refine its products. The beachhead market is always a subset of the SAM. The desirable characteristics of a beachhead market are:
- The needs of the beachhead market are not being served well by competitors.
- You can access the customer using focused, efficient acquisition techniques as opposed to broad-based awareness campaigns.
- Specific customers are readily accessible for engagement in refining a solution.
- Your value proposition, even as a young company, is compelling.
- For goods and services requiring physical operations and logistics, the beachhead market is often geographically close to the start-up location.
The boundaries of these definitions are somewhat arbitrary, and so my primary recommendation is to be extremely clear about your definitions and careful with your assumptions. One of the biggest sources of delusion in entrepreneurs’ pitch decks is wildly unrealistic estimates of market sizes.
Top Down Estimates
There are two ways to think about market definition and sizing, top-down and bottom-up. With the top down approach, start with all economic activity on earth – that’s the maximum size of the market for “do everything.” Then, successively narrow the definition of the market until you get to the “market for the job that we aspire to do in society.” That’s your total available market (TAM). Then, further narrow to markets for which you can offer a value proposition in the medium term with your solution – the serviceable addressable market (SAM). Then, further narrow to the first market segment you will focus on and for which you offer a value proposition — the beachhead market. Each narrowing is a defined subset of a larger market.
For example, let’s revisit MakerStock (originally described in the handbook as “University Panel Supply”).
The GDP of the entire planet (c2023) is approximately USD 100 T.
The subset of that GDP representing the market for plastic, wood, and metals used in making things, and excluding construction, is approximately USD 6 T.
The subset of that market for plastic, wood, and metal panels (e.g., large sheets of material) used in making things is approximately USD 700 B.
The subset of that market comprised of specialty plywood (which excludes softwood plywood used in construction), medium-density fiberboard, and acrylic sheet is USD 44 B.
The US portion of that market is USD 5 B. (Now we are focusing geographically.)
The US market for these materials in which the customer’s ideal format is a less-than-full-sheet custom size with delivery by conventional ground freight is USD 500 mm. This is the subset of the market for which a cut-to-size supplier of materials would offer a value proposition. This particular focusing step is where you might sense we are pretty much guessing. There is no place to look up market sizes for the “cut to size” panel market, and we are left to doing some back-of-the-envelope calculations. For this reason, top-down estimates become a bit shaky as additional focusing assumptions are made. Still, USD 500 mm is a reasonable estimate of the TAM for MakerStock — the market is certainly smaller than USD 1 B and it’s more than USD 100 mm. The definition of your TAM is somewhat arbitrary. For instance, this estimate of TAM is for the US only, but might we reasonably consider serving customers in Europe, for example? Given that many different assumptions are possible, just be very clear about the focusing decisions that underly your estimate of TAM.
MakerStock’s TAM includes cabinet makers and raw materials for factories producing finished goods in relatively large quantities. MakerStock is unlikely to be competitive for these segments in the medium term. The company is likely to offer a stronger value proposition to customers that prefer custom sizes and that order a variety of different materials, both wood and plastic, for use in their fabrication processes, largely laser cutting. The US market for such materials for university maker labs, do-it-yourself individual makers, and small- and medium-sized businesses such as sign making shops is approximately USD 100 mm. This is a reasonable estimate of the SAM for MakerStock.
Now, how will MakerStock get started? Where will it focus initially? MakerStock will focus on university maker labs. It will focus on those labs that can be served by FedEx ground freight within three days of Scranton, Pennsylvania. The beachhead market is for pre-cut specialty plywood, medium-density fiberboard, and acrylic sheet for university maker labs located within the three-day ground shipping territory from Scranton, Pennsylvania. Top-down estimates are going to be very approximate for the beachhead market. To do a top-down estimate, we might gather some estimates (guesses?) of a few knowledgable people and average them and assume that 10 percent of the SAM is the beachhead market, delivering a market size of USD 10 mm. Bottom-up estimates are much better for tackling this estimate, the approach I will explain below.
With each successive focus on a subset of a larger market, we are making a decision about which narrower market will be more readily addressable by the new venture. Each narrowing reflects a belief which may or not be correct. For instance, commercial sign makers may be a better beachhead market than university maker labs. So, as with any problem solving activity, considering alternatives and testing beliefs will likely result in better outcomes.
For the top-down approach, conventional internet search and current AI tools are probably the best source of raw data. By using a variety of queries and triangulating on the result, you are likely to be able to make estimates that are well within one order of magnitude of the actual value.
TAM and SAM depend on the definition of your core business
Estimating TAM and SAM requires that you assume some boundaries for your core business. For instance, if I conceive of my panel supply business as providing panels of any type to any user of panels globally, my TAM is USD 700 B. But I really have to stretch my imagination to believe I can address the need for particle board panels purchased by the Chinese factories that make the best-selling IKEA Billy bookcase. Those factories are likely purchasing many full truckloads of those panels per week directly from the mill that makes them. The definition of available and addressable determines your TAM and SAM. I like to think of addressable customers as those customers who have a job to be done for which the core business could reasonably be competitive in delivering a solution. For MakerStock, that core business is sourcing sheet goods by the full truckload, breaking the bulk delivery into sheets, cutting sheets to custom sizes, and delivering pieces by conventional ground freight. The job to be done is to deliver an assortment of the right materials, at the right time, in the right sizes, all with minimal fuss. The serviceable addressable market is the size of the market for which that value proposition makes sense, a market not of USD 700 billion but rather about USD 100 million.
Bottom-Up “Counting Noses” Approach
The top-down approach is a useful way to put the business into a larger context, and to reveal possible additional market segments, and their sizes. However, the bottom up approach is usually more credible and less speculative. WIth the bottom-up approach, you start with a hypothesis about the beachhead market — the very first market you will tackle. You estimate the size of that market by creating an inventory of every potential customer in that market. This approach is called counting noses.
For example, the beachhead market for MakerStock is university maker labs located within the geographic region served by three-day ground shipping from Scranton, Pennsylvania, the initial location of the business. The business was located there because I as founder already had a facility and an available team member in that location, and because that location is a logistics hub, serving about one third of the US population within two days by conventional ground shipping. The geographic cut off reflects a belief that freight costs would be decisive in the value proposition to our customers.
Once that beachhead market is defined, counting noses is easy. First, there are about 5300 colleges and universities in the United States. Now, look up the ground delivery time map that FedEx provides. Identify those universities within the three-day shipping territory. That subset is about 2500 institutions. This set of 2500 potential customers can be identified and cataloged precisely and entered into a database. For each potential customer, say PennWest Edinboro University, an internet search can reveal whether or not it has a maker lab, and possibly unearth a name and contact information for the lab manager. In fact, an internet search for the PennWest Edinboro furniture design program yields a great description of the program, including photographs displaying specific details about the equipment and furniture in the shop. That search even produces a name of the program director, Karen Ernst, along with her contact information. We can now count Professor Ernst’s nose in our beachhead market. Doing a comprehensive search for all 2500 potential customers is probably not a good use of time until the business is actually launched, but doing that search for a sample of potential customers, say a hundred, produces an accurate estimate of how many labs would eventually be found in all 2500 universities. For this example, a preliminary search suggests that about 64 percent of these universities have at least one maker lab, a potential customer base of 1600 labs.
At this point, some assumptions are required about the average level of spending on speciality plywood, medium-density fiberboard, and acrylic by each lab. That estimate can be based on interviews with a sample of customers. By talking to about five potential customers, we found that the average spending seemed to be roughly proportional to the size of the university, with a university spending an average of about USD 4 on these materials per year per student enrolled. The labs serve an average of 1250 students each, so their average spending on materials is about USD 5000 per year. These figures lead to an estimate for the total size of the beachhead market of USD 8 million per year (i.e., 1600 labs at USD 5000 per year). This a pretty solid number. The real value might be USD 10 million or USD 6 million, but it’s not USD 50 million or USD 1 million.
Consider Adjacencies for a Bottom-Up Estimate of SAM
Once you have identified and characterized a promising beachhead market, now consider the immediately adjacent markets. The adjacencies might be geographic. So, after considering colleges and universities in the northeast, consider those in the mid-Atlantic region, or the mid-west. The adjacencies might be in the goods and services offered, for instance extension of the product line from wood and plastic to metals. The adjacencies might be in the types of target customers, for instance from colleges and universities to secondary schools, or to small and medium-sized businesses using laser cutters. These adjacencies taken together comprise your SAM, as estimated using the bottom-up approach. As a matter of good planning hygiene, consider how your bottom-up estimate of adjacent markets compares with your top-down estimate of your SAM. These two ways of getting to SAM should not deliver wildly different results.
Recall that SOM is the market you plan to actually serve within your planning horizon, usually 24 or 36 months. For my taste I prefer estimating SOM with a bottom-up, counting noses approach of the beachhead market integrated with some estimates of the rate of customer acquisition of the go-to-market system.
Recall that we estimated that there are 1600 potential customers in this beachhead market. I believe we can acquire an average of two new repeat customer per week with the likely sales and marketing resources we will have, net of churn. (See the chapter on go-to-market systems for how to think about this.) Thus, within three years, we will have approximately 300 university maker labs as repeat customers. We estimated earlier that each lab orders approximately USD 5000 in materials per year. Thus the recurring revenue for the customer base at year three will be approximately USD 1,500,000 per year, at which point we will have about 19 percent market share of the beachhead market of USD 8 million. Of course, even though we will focus on the beachhead market, we will unavoidably reel in some customers from adjacent markets, and likely will also sell to some do-it- yourselfers via the MakerStock website. It’s even possible that an adjacent market will prove to be a better fit for the company than the beachhead market we had originally envisioned. Still, the bottom-up nose counting along with some realistic modeling of the go-to-market system is a grounded approach to forecasting the scale of the business.
Fables Versus Realism
None of you readers are too excited about recurring annual revenue from the beachhead market of USD 1,500,000 after three years. Investors likely would not be too excited either. Yet, that’s actually an above-average outcome for a start-up in year three. I have invested in over 50 start-ups. About five of those have achieved recurring annual revenue of USD 1,500,000 by the end of year three.
Every founder faces many dilemmas. One of the most pressing is whether to spin a compelling fable in the pitch deck, which probably represents a 95th percentile outcome, or to provide a realistic forecast of what you believe to be a highly obtainable outcome. I believe the level of conservatism in the forecast depends on the audience. If you are planning to be a closely held, likely bootstrapped, company, then you should strive for hard, cold realism, even pessimism. That was my approach with MakerStock. I funded the business with my own money. I wanted to have a realistic sense of how the business would unfold and how much cash I would need to burn to get to positive cash flow. MakerStock actually did substantially better than the forecast, largely because do-it-yourselfer and small- and medium-sized business customers turned out to be fairly easy to acquire and serve alongside universities. That was a pleasant surprise easily accommodated as the business developed.
If, however, your audience is institutional investors, then they are highly conditioned to see forecasts at about the 95th percentile. My advice is to be excruciatingly clear about your assumptions and logic in estimating TAM and SAM. Those need to be highly credible. Then, the estimate of SOM should likely skew a bit optimistic, assuming that you have all the resources you need, including that investor’s capital, and that things go well. Your SOM is going to be discounted by institutional investors seeing your pitch, so you should account for that fact in your presentation. (Yes, I realize this is a pernicious cycle of optimistic forecasting and assuming discounting by the investor. I don’t see a clear way around it.)
Market Size Graphics
The most common way market sizes are shown in pitch decks is with nested circles, sometimes called an onion diagram, in which the area of the circle is proportional to the market size. Data graphic purists may prefer bar charts of some kind, but I think the nested circles work pretty well and you probably want to avoid bucking convention here. You can, of course, annotate this graphic heavily to support the numbers.
VC Factory Article on TAM, SAM, and SOM. Decent article from a venture capitalist’s perspective.https://thevcfactory.com/tam-sam-som/