Estimating Your Market Size

estimating market sizeIt’s a necessary element of your business plan and pitch deck.  It’s a question you’ll get asked all the time by investor prospects.  And it’s something you’ll find yourself defending, even if much of the underlying data and assumptions didn’t come from you.  As the title of this blog article suggests, I’m talking about your market size.  But how do you go about estimating the size of your market and what should you do if the resulting estimate is way too big or way too small?  Read further for a few hints and tricks for conducting this important exercise.

Why is Your Market Size So Important?

Three are three reasons it is important to spend time analyzing and later clearly articulating your view of market size.

  1. The first reason is obvious and commonly understood.  The size of your market suggests the upper limit of how big you can grow your company (revenues) without adding more products or doing new things to increase the size of your market.
  2. The second reason is because investors want to see that you have thought through the various aspects of market size (explained below) and how you will address and attack them over time.
  3. The third reason is because it gives you a chance to educate prospective investors and business partners on the market from your point of view, especially if you have a fairly innovative product or one that requires a little evangelism to get others to understand.

How Big is Big Enough?

There is almost always a trade-off between market size and your reasonable market share over time.  For example, gaining 2% share of a $10B market derives the same revenue as 20% share of a $1B market or 80% share of a $250M market.  The answer in all cases is $200M.  But in the case of gaining 80% share you don’t have much room to grow unless the market itself is growing very rapidly.  And in the case of gaining 2% share, you are an extremely small, niche player.  But that can be great if the niche you serve is highly innovative, growing and is sought after by the large market share leaders.  In other words, it could lead to a very attractive acquisition.  Or it could give you an opportunity to expand into adjacent and synergistic parts of the market to continue your growth and strategic fit within the market.  Finally, if you later discover that your initial value proposition or business model is flawed, you will have room to pivot and still have a chance of succeeding.  Either way, with a very large market you have options.

As a general rule, larger markets are better than smaller ones and high growth markets or ones with potential to be disrupted with innovation are preferable over stagnant ones.  The key is to understand the dynamics of your market, how you fit into it and how you can best explain all of this to investors and important strategic partners.

Total Available Market (TAM)

At a conceptual level, TAM is simple.  How big would you be if you sold your offering to every single constituent in your broad market, even if they aren’t yet an ideal constituent?  Let’s look at some examples to be more clear:

  • Enterprises – Let’s assume you have a product that sells for $150,000 on average and is sold to large enterprises.  Perhaps your total available market is all organizations on the Fortune 5000, Forbes Global 2000 and the Fortune Largest Private Companies lists.  After eliminating overlap between the lists, let’s say there are 8,000 unique organizations.  Your TAM would be $1.2B ($150,000 x 8,000).
  • Consumers – Let’s assume you have a mobile app that sells for $4.99.  There are about 2 billion smartphones in use at the time of this writing, so your TAM would be $10B ($4.99 x 2B).
  • Market spend – Let’s assume you have a unique solution for the home healthcare market and you get 1% of the amount spent with home healthcare providers each time your solution is used.  People spend $350 billion globally on home healthcare (I’m totally making up the number), so your TAM would be $3.5B (1% of $350B)

I find that a lot of entrepreneurs mistakenly take an analysts report on how much is spent annually in a particular market and simple use that as their TAM.  That approach only works if your pricing method is attached to market spend and your product can replace everything in that market.

When estimating TAM, think broad but not too broad.  For example, notice above that when estimating for large enterprises I didn’t include all businesses of any size and for consumers I didn’t include every human being on the planet.  Also notice that one example uses the total amount spent within a market (called “market spend”) rather than a quantity metric like the number of businesses or number of consumers.  Market spend can be used to describe your market size as long as your revenue metric is attached to the total amount of spend in an industry, like my example above demonstrates.

Serviceable Market (SAM)

You might never grow to be able to address the total market, which means you can only service a subset of it.  This is your Serviceable Market (SAM).  Your SAM can grow over time as you expand geographically or implement new business models and sales channels.  Using the above examples, let’s imagine what the SAM might be.

  • Enterprises – You only have sales and support personnel in the US and the product is in English.  It’s also only currently useful for organizations with multiple, distributed data centers.  Of the 8,000 organizations in your TAM, only 3,000 meet this criteria.  So your SAM is $450M ($150,000 x 3,000).
  • Consumers – Your mobile app only works on Android phones and is currently only in English.  Of the 2B smartphone users, only 500M meet this criteria.  So your SAM is $2.5B ($4.99 x 500M).
  • Market Spend – You only have regulatory approval for your solution in the US where $50B is spent annually on home healthcare.  So your SAM is $500M (1% of $50B).

Target Market

Your target market is often smaller than the serviceable market.  This is because you know your solution appeals to a subset of the SAM.  For example, our enterprise solution above might resonate best with those in the financial services and insurance industries.  As a result, that company would implement messaging, pricing and a sales channel that is optimized for financial services and insurance providers.  The consumer solution might appeal primarily to females in the 25-39 year age range and with children.  You get the idea.  It’s yet another filter beyond the SAM that communicates where you are focusing at this point in time.

Messaging Your Market Size with Investors

You’ll want to be careful about accidental misunderstandings when communicating your market size to investors.  Some investors think of “market size” as the SAM and not the TAM.  So if you tell them the market size for your consumer solution is $10B (using the example above), they might think you’re crazy and out of touch with reality.  In fact, combining all three types of market size described in this blog article might result in a statement like this:  “As we launch our product next month to our initial target of US teenagers with Android smartphones, we will be serving a $250M market.  But as we add support for iOS and add the XYZ feature for college students later this year, we’ll be serving a $1B market.  And within three years we expect to have partnerships secured with three of the top 10 smartphone manufacturers globally, which further expands our market size to $5B.”

Other Considerations

  • For companies that sell a subscription-based offering (recurring), the market size will likely be expressed on annual terms – in other words, $825M per year.
  • For companies that monetize their offering by via embedded advertising from partners, the market sizing economics are much harder to calculate with simple methods like I’ve described here.  That’s because each situation is very different.  But the TAM/SAM fundamentals are still the same.  In other words, the TAM still assumes 100% of your constituent audience used your product.  But then you have to figure out how much advertising revenue you will earn for that totally penetrated audience (ie – advertisers will pay $0.10 per click and you project a 1.5% click rate for your daily active users, etc, etc).

Summary

Your market size is a very important aspect of your business plan and resulting conversations with investors.  What’s most important is that you’ve done your research and come up with reasonable models and assumptions to estimate your market sizes – TAM, SAM and target market.  If you get challenged, defend yourself using your methodology and assumptions.  If too often you are unsuccessful convincing the investor about your market size, then something is wrong with your assumptions and you should reevaluate.

Don’t forget to include attributes like market growth and opportunity for innovation and disruption when talking about your market.  These are often equally compelling, and sometimes more compelling, than just the raw size of the market.

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Author: Gordon Daugherty

Over the past 15 years Gordon has seen nearly 1,000 startup pitches, advised more than 200 entrepreneurs and been involved with raising over $45M in growth and venture capital. Throughout his 28 year career in high tech, serving twice as President and three times as CMO, Gordon has both an IPO and a $200M acquisition exit under his belt. Now his emphasis is purely focused on helping startups and early stage tech companies. Through his Shockwave Innovations advisory practice and as Managing Director for Austin’s Capital Factory startup accelerator, Gordon is an active angel investor, VC and startup advisor.

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