Sizing Your Market

market sizing

If you aspire to build a company that is scalable, then the size of your market is a very important element of your business plan. That’s because it suggests the upper limit of how big you can grow without adding more products or taking other actions that increase the size of your market.

The act of sizing your market is valuable for more reasons than simply deriving a magic number. The research you conduct, the theories you form, and the competitors you identify provide a broader picture than size alone. With this, you are better able to describe the opportunity you are pursuing to prospective investors and business partners. In fact, the more innovative your solution or business model, the more evangelistic your description of the market will be. That’s because you see the market through the lens of your vision and associated business plan, which means you’ll need to assume the role of evangelist and educator.

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 $10 billion market will derive the same revenue as 20% share of a $1 billion market or 80% share of a $250 million market. The answer in all cases is $200 million but with very different implications.

Gaining 80% share of the smaller market means you don’t have much room to grow further, unless the market itself is growing very rapidly. Gaining 2% share of the big market means you are an extreme, 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 exit. It also leaves you room to continue growing to 5% or 10% market share to become an even bigger company. Alternatively, the starting niche position could give you an opportunity to expand into adjacent and synergistic segments of the market to continue your growth and strategic fit within the market.

The final reason why large markets are a big advantage is optionality.  If you later discover that your initial value proposition or business model is flawed, you should have room to pivot and still have a chance of succeeding. Flexibility is a startup superpower, but it only helps if there is room to maneuver.

Total Available Market (TAM)

Market sizing almost always starts with assessing the total available market (TAM). That’s because it reflects 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. Since this means gaining 100% share of the broad market, it is impossible to achieve and is only used in a theoretical and comparative context.

TAMLet’s size the TAM for DoggieDrone, a silly startup case study I used in volume 1 of my book Startup Success. DoggieDrone is a dog-walking drone that sells for $500 each. With some research, the DoggieDrone founders estimate there are 150 million families globally that have one or more pet dogs. With this information alone, the founders size the TAM at $75 billion (150 million households buy one DoggieDrone for $500 each). The most revenue DoggieDrone could ever produce is $75 billion.

When estimating TAM, think broad but not too broad. For example, notice that the DoggieDrone founders didn’t include families with cats or other domesticated animals, even though they could possibly be customers of the product. In fact, $75 billion is such a huge TAM that pushing it higher might only serve to discredit the analysis. A business plan that involves a TAM in the low billions of dollars is typically fine.

If DoggieDrone were instead rented as a monthly service for $10 per month, the TAM would be expressed as annual recurring revenue of $18 billion per year (150 million * $10 * 12 months).

Serviceable Market (SAM)

There are always limitations that prevent any startup from being able to serve the total available market. Because of this, the subset they are actually able to serve at any given point in time is referred to as the serviceable market (SAM).

The SAM is derived by applying one or more filters to the TAM. The filters represent the current limitations that exist. For examples of the most common filters, see the list below:

  • Geographic
  • Language
  • Company size
  • Buyer or user demographic
  • Platforms (browsers, operating systems, etc)
  • Industry verticals

In the case of DoggieDrone, the founders realize they only have retail distribution capabilities in the US and current laws only permit the use of a dog-walking drone in 20 states. Additionally, the first version of the product only supports dogs up to 25 pounds. Because of these limitations, DoggieDrone’s SAM is represented by 18 million households. The SAM is $9 billion (18 million * $500).

A company’s SAM certainly can grow over time as the limitations are removed by product enhancements, partnerships, or numerous actions that are pursued for continued growth. In the case of DoggieDrone, as more US states allow dog-walking drones, their SAM will increase. Same for when they release the second model of the product that can handle dogs between 25 – 50 pounds. It is typical for a company’s SAM to change somewhat regularly while their TAM might never change, or only slightly.

Target Market

Even though a company’s SAM is derived by applying various limiting filters, it is often the case that an even smaller subset gets the focus of marketing awareness and customer acquisition efforts. This hyper-focus is applied to what is called the target market, sometimes also referred to as a beachhead.

DoggieDrone’s target market might be upper middle class and high-income families, due to their disposable income and ability to spend $500 on something that is more of a nice-to-have item. Or, better yet, maybe they should first establish a beachhead with the elderly, aging-at-home, population. They gain important psychological and even health-related benefits from having a pet dog, but might not have the physical ability to regularly walk one. DoggieDrone to the rescue.

See the graphic below for a visual representation of how the three markets fit with each other.  Although SAM is smaller than TAM and the target market is smaller than the SAM, the relative ratios vary widely by company.

market sizingWhat About Market Spend?

You noticed that the prior-mentioned explanations and examples did not calculate the market size based on the amount that is spent in a given market. In other words, DoggieDrone’s market was not sized based on the total transaction volume of pet accessories and supplies. I’m sure that number is extremely large, but it doesn’t have anything to do with how big DoggieDrone could possibly be if they sold a drone to every reasonable customer. Instead, it’s just an interesting factoid that could become a part of the company’s business narrative, but not directly involved in determining their TAM or SAM.

Online Marketplaces

Online marketplaces earn most, sometimes all, of their revenue by processing transactions between demand side constituents and supply side service providers. A very important metric for them is gross merchandise value (GMV). It is basically the total transaction volume processed by their marketplace, which is different than the revenue they receive from those same transactions. Marketplace startups might want to perform the TAM and SAM calculations for both revenue and GMV.

Challenges

Some business models make it much harder to calculate the market size. A good example is monetizing a product based on embedded advertising from partners. It might be possible to quantify the total universe of possible users. But estimates of average daily usage, click rates, and advertising fees cause a compounding multiplication of assumptions. The company has no choice but to do just that if they want some sense of their market size.

Startups that monetize by selling data that is derived from product usage have an even more difficult challenge with market sizing. Same for those that earn their revenue via affiliate marketing. Lots of nested assumptions are required.

In the early days before your product is launched and customers are happily paying for it, assumptions will likely be needed in order to size your market. Even DoggieDrone made an assumption that $500 is a price that people will pay for their product. No problem, just add these assumptions to the long list that makes up your initial business plan so that you can make sure to validate them as soon as practical. (see related article titled “Your Initial Business Plan is a Huge List of Assumptions“)

Size isn’t everything

As a general rule, larger markets are better than smaller ones. But the size of your market doesn’t tell the whole story about how helpful your chosen market will be towards growing a great business over time.

Markets experiencing high rates of growth or high levels of disruptive innovation can be extremely attractive. Same thing for markets that are highly fragmented versus dominated by three big behemoths. That’s because fragmented markets are more easily available for entry by a startup.

The key is to understand both the size and the dynamics of your market, how you fit into it, and then figuring out how to best explain all of that to investors and important strategic partners.

Case Study Example

Watch this video clip for an example of market sizing for our case study company DoggieDrone.

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 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.”

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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