When pitching to VCs, one of the most frequent errors founders make is incorrectly presenting their total addressable market, or TAM for short. Perhaps because this number is hypothetical and dependent on so many different factors, some founders do not give it the time it deserves.
But, the TAM slide is an excellent opportunity to both convince investors of the potential market for your product and also to prove that you are capable of providing an analytical and systematic way of reasoning through the problem. It’s an excellent opportunity to show off your insights about the market you are operating in and to touch on your product road map.
The biggest mistake we see with regard to TAM is when founders present a “top-down” estimate of market size. A top-down estimate is when a founder uses outside data to find the market size and then, usually somewhat arbitrarily, predicts that the startup will achieve a piece of that invariably massive pie.
Here’s why investors hate top-down TAM estimates:
The basis for top-down estimates is often opaque research reports from firms like Gartner.
Top-down estimates make the founder seem lazy, since it requires little more than a cursory Google search to find the market data.
Top-down TAM does not allow a nuanced inclusion of factors such as pricing and different pricing models.
Top-down approaches often don’t assume that a startup can change the actual size of the TAM.
The most famous example of why top-down estimates are irrelevant is the case of Uber. As Matt Pruess of Visible.VC writes, “Uber estimated their market size at $4B by using a top-down approach. By using existing market data, Uber dramatically undersized what the “cab and car services” market looked like, and what it would look like in the future. Using a bottom-up approach, Uber could have used their data set from their first market, San Francisco, which would have shown that the overall market was expanding, as current users were taking more rides in Ubers than they ever had in cabs.”
Investors want to see a bottom-up approach to calculate TAM. This number uses firsthand data about your company to form the hypothesis and reduces the risk of the data being wrong or taken out of context. Further, it shows that you are fully thinking through the size of your customer base and your pricing.
Here are 5 tips from Dreamit’s Steve Barsh on how to think about bottom-up TAM correctly:
Always think about this simple equation: (# of potential customers) x (price) = TAM
Make sure you convince the investor that you are talking about real customers. If you are selling to real estate brokerages, you would specify which size of brokerages you’re selling to (e.g. mid-market brokerages or ‘mom and pop brokerage’), instead of simply including the total number of real estate brokerage firms in the country.
Specify what geography your TAM estimate covers (e.g. US, EU, international, China)
De-risk your price assumption. If you’re already selling, you will have a good idea of the price of your product. If you are pre-revenue or selling to enterprise customers, the price question will be much harder to justify in the eyes of an investor. Be prepared to answer questions about how you found these numbers. “Just like your math teacher used to say, ‘You’ve got to show your work,” states Steve Barsh.
Use your product roadmap to speak about how you might increase TAM by taking the product up-market or into new verticals in the future. Going back to the real estate brokerage example, you might start off selling to individual residential brokerages, but your product roadmap includes an enterprise version. This would open up your TAM to much larger brokerages or potentially allow you to sell to both residential and commercial brokerages.
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By Charles LaCalle, Director of Sourcing & Marketing at Dreamit
Further Reading on TAM: