Size Matters: How to Properly Calculate the Size of Your Market

"How big is your market?" It's a common question from investors, after all, it's one of the most important evaluation criteria for an investment. Unfortunately, it's also a question that most startups stumble over. The truth is, the question isn't as simple on the surface as it appears to be. Let's look at the different categories of market sizing and how you can use them to make your financial model.

Market Sizing: Navigating the Acronyms

When it comes to market sizing, there are three acronyms that most startups should be aware of:

1. TAM - Total Addressable Market

2. SAM - Serviceable Addressable Market

3. SOM - Serviceable Obtainable Market

As you move down the list, the dollar value will shrink as illustrated above. Let's demystify some of these terms, how to calculate them, and how to move from one to the other.

TAM

The Total Addressable Market (TAM) is the total revenue opportunity of a product or service if 100% of market share is achieved. You can think of this as the "size of the problem" but this is not the size of YOUR market. The TAM is what is potentially possible if a company could move into every market segment and all constraints are removed (competition, logistics, capacity, etc.) which is very unrealistic. Even though this is the biggest and most generous we will be talking about in this post, startups still make a lot of mistakes when it comes to TAM.

For example, let's say you have a US company that sells soccer cleats. It would be a huge mistake to go "Well there are about 7 Billion people with feet that could wear our cleats so the TAM is 7 Billion people multiplied by the price of our cleats". Your TAM would be the number of people that play soccer. Furthermore, if your company only made women's soccer cleats, then your TAM should be reduced again to the amount of women that play soccer. This example may seem silly on the surface, but I see startups make the mistake of overestimating their TAM all the time. This overestimation will certainly be discovered through your investors' due diligence and it will hurt your credibility. When looking at your TAM try to answer the question: "What business are you in?". If you are in the business of women's soccer cleats, then your TAM should be reflective of that.

SAM

The Serviceable Addressable Market (SAM) answers the question: "What part of the TAM can your product or service realistically reach?" From here, you add constraints to TAM such as Geography, Regulations, and Willingness to pay. Going back to women's soccer cleats example, if you don't have any international distribution capabilities, then your SAM will be restricted to the United States. Additionally, if you only sell high end, soccer cleats at $100 or more, then your SAM needs to be restricted to the portion of US women's soccer players that are willing to pay $100 or more for cleats. The SAM takes significant cuts at the TAM and gives investors a better sense of where your product or service fits.

SOM

The Serviceable Obtainable Market (SOM) is the portion of the SAM that your product or service can realistically sell to. To move from the SAM to the SOM, you need to add further constraints such as production capacity, marketing reach, and competition. Going back to the soccer cleats example, if there are 3 other equal competitors around you, then you need to only use 25% of your SAM to account for the other players. Let's add to the complexity and say you only have a marketing capacity reach people on the East Coast, then you need to cut down your SAM again to only account for those people. Now, let's say you only have the ability to produce 100 pairs of cleats per month. Your market has now shrunk from all women soccer players (your TAM) to 25% of women's soccer players, on the East Coast, willing to $100 or more for cleats (Your SOM). Those are two vastly different market sizes, but it is the second one that you need to build your financial model on. The SOM is what you are trying to sell an investor on as it gives them best and most realistic short term picture of the potential of your business.

Summary

Market Sizing is one of the most difficult and misunderstood concepts for startups. Remember that there are different market sizes: TAM, SAM, and SOM and each one adds further constraints to get to a more realistic picture of your business. Be realistic about the obstacles you may face (geography, competitors, etc.) and how that cuts down on what is actually available to you. Build your financial model based off the TAM, and you will look very silly in front of knowledgeable investors. On the other hand, thoughtful assumptions around the market and it's constraints will show investors you know what you are talking about and could go a long way toward getting a check.