According to Jared Sleeper, VC at Matrix Partners, the total addressable market (TAM) slides are among the most frequently mis-executed. He also states “a more thoughtful TAM analysis and slide can improve a startup’s pitch as well as its business decisions.” This article describes the key attributes of an effective, rigorous TAM analysis, along with expected benefits and various uses.
We will walk through the architecture, process and analytical techniques to build a bottom-up TAM, an essential component of a meaningful total addressable market. A startup’s TAM fortress is further secured with air cover -- a credible means to ascertain market size from the top down. Rather than using the typical and usually flawed “Gartner/Forrester says there is a $10B market and we will get 10% share” approach … we will instead tackle top-down TAM using value theory. Value theory quantifies the total economic value created, then justifies the portion of that value captured through pricing.
Using an explicitly defined, segmented and justified bottom-up TAM supported by a top-down value theory TAM that quantifies product market fit, your startup can articulate a highly defensible TAM that could dramatically improve your chances of securing sufficient funding at fair terms or increasing acquisition value.
To qualify myself on this topic, I worked extensively with existing and new market TAM as head of product management for a fast growing $1B+ revenue multi-technology product line, and have helped various startups define their TAM as a growth consultant for the past 9 years. Recently, two clients I assisted with TAM analysis and presentation had favorable outcomes. Aktana received $21M in Series C funding, and PlanGrid was acquired by Autodesk.
TAM Definition and Visualization
What exactly is a TAM, and how can it be used? A total addressable market (TAM) represents the annual revenue potential for your company if all customers who are a “fit” for your product are acquired. Calculating customers that fit involves a mix of objective data layered with subjective assumptions. For example, if your only product is a $1000 outdoor cat gymnasium, your potential customer count analysis would begin with cat owners who also have outdoor space, but additional assumptions to reduce the number of target customers would be needed for a believable TAM.
The graphic below depicts a segmented TAM from a revenue perspective. Key concepts are the Total Market and Total Addressable Market (TAM) for each segment.
The graphic above is for a hypothetical company building a product worthy of purchase by 3 existing, distinct customer segments. Segments 1, 2, and 3 could represent SMB, Mid-Market & Enterprise, verticals, or geographies. Examples of verticals are healthcare, financial services and education, which could have compelling value propositions for vastly different product variants. A typical geographic segmentation is North America, EMEA (Europe, Middle East & Africa), and ROW (Rest of World) that includes Asia-Pacific and Latin America. The New TAM in yellow represents a market our company creates that is also fully addressable.
Segment 1 has the largest existing total market, but the second largest TAM component in this example. This is because Segment 2 has a much higher addressable percentage than Segment 1. The New TAM is a completely new market enabled by the existence of our company and product. Examples of new market creation are anonymized data monetization, an adjacent marketplace, or a new consumer variant of B2B software.
TAM Usage: Fundraising, Product, Marketing and Sales
A TAM analysis can be used a variety of different ways to strategically benefit a company. Fundraising is a typical driver for a rigorous TAM analysis. It can demonstrate a deep understanding of the market to be monetized, as well as the ability to capture that market with the right product and value proposition. Product market fit can be quantified in a skillful TAM analysis. Further, a thoughtful TAM analysis can demonstrate the business acumen and strategic vision of an executive team. If market conditions shift, investors gain confidence in the management team to adapt and seize opportunity.
TAM analysis can be extremely useful outside of the fundraising process. Product management can estimate the revenue impact of feature prioritization and future product roadmap. Marketing can include a credible global TAM size in marketing assets for multiple audiences. Allocation of marketing spend based on relative revenue opportunity is another use case. Sales can calculate segmented market share estimates, and prioritize sales efforts by geography, segment, and/or customer industry. A final example is convincing distribution partners to sign up before a company has gained traction.
Next we’ll dig in to specific techniques you can use to create a defensible TAM for your company.
Bottom-Up TAM Methodology and Architecture
Fundamentally a bottom-up TAM is the number of customers at 100% market penetration times the average price a customer will pay. But a bit more subtlety exists beneath the surface. Often a company addresses multiple customer segments with different attributes. The percentage of potential customers that belong in the TAM varies by segment, and what they will pay typically differs as well. Further, the components that drive TAM calculations can grow at different rates each year. A methodology and TAM model architecture that considers these details is shown in the graphic below.
A 5-year segmented bottom-up TAM is straightforward mathematically, and can be generated by the multiplication of 3 matrices represented in the graphic above:
Total Target Customers by Segment
Addressable % of Customers
Average Selling Price (ASP) by Segment
Total Target Customers by Segment multiplied by Addressable % of Customers yields Total Addressable Customers. Multiply by ASPs by Segment and voila, Total TAM.
Although the math is simple, the synthesis of credible hard data, comparable analysis and necessary assumptions deserves detailed explanation. A sample 5-year TAM will be used to illustrate the technique below.
Building the Components of a Fortified Bottom-Up TAM
A spreadsheet in Excel or Google Sheets is the right tool to construct your bottom-up TAM. I prefer a clean final results tab, shown below as “BetterSoft Bottom-up TAM”. All components of this results TAB will be illustrated in the example that follows for a fictitious B2B SaaS company we’ll call BetterSoft.
The heavy lifting to generate the necessary customer and ASP matrices occurs in the detailed calculation tabs, Total Target Customers, Addressable Customers and ASPs. Sample techniques for the detailed calculations will be discussed, but the development of these is unique to every business.
The art-science of TAM modeling is constructing a data tapestry from a basis of credible facts, weaving in relevant associated data via connecting logic, and constructing the remaining necessary assumptions to fill in the complete work. It is very useful to structure a limited number of key assumptions as model inputs. The resulting TAM model will usually vary substantially in response to these key inputs. Defensible conservatism is then possible by setting model inputs conservatively vs. comparable data. Let’s now move from theory to our case study.
BetterSoft is a hypothetical B2B SaaS company seeking Series B funding. BetterSoft just achieved $25M in ARR (Annual Recurring Revenue) by dominating a software category it created serving customers in an imaginary industry called OurVertical. BetterSoft was seed funded by a few well known investors, and received Series A funding 18 months ago after clearly demonstrating product market fit and accelerating customer acquisition. The CEO, executive team and board believe it is the right time to scale fast and solidify first mover advantage. A 5-year TAM analysis for 2019-2023 is considered an important component of the Series B pitch deck, as well as a strategic tool for product, marketing and sales.
The step-by-step process to build a credible bottom-up TAM is next.
Total Target Customers by Segment
A bottom-up TAM begins with counting customers that can potentially buy our product. Bill Aulet, Managing Director of the Center for MIT Entrepreneurship, calls this process “counting noses” in his best-selling startup methodology book Disciplined Entrepreneurship. For user-based pricing, actually counting noses is appropriate, in other cases counting companies is the right basis. BetterSoft sells annual software licenses at the company level, so our TAM analysis will count companies.
How do we go about counting companies that are in OurVertical? Sources of data to support a defensible TAM include the US Bureau of Labor Statistics, D&B Hoovers, Zoominfo, DiscoverOrg, McKinsey, Deloitte, industry associations, government statistics from countries of interest and the OECD.
It was decided in the cross-functional TAM kickoff meeting to segment customers by size, so the counting of customers includes classification into SMB, Mid-market and Enterprise. In addition, cloud service providers focused on OurVertical must be quantified. But this is easy in our example, as there are currently 7 well known companies that provide cloud services to OurVertical industry.
Zoominfo can be a great tool to segment companies by industry and revenues, as the user interface has industry check boxes and a revenue slider bar.
We’ll assume that we were able to use secondary data sources to reliably count companies in BetterSoft’s target industry according to defined segmentation variables for revenue and other appropriate characteristics. This is usually a non-trivial exercise for the person who has to actually do the work, but it’s simple theoretically.
With our 2019 segmented company counts in place, there is one more step to complete the target customer matrix -- annual growth. The growth rates of company counts for the next 4 years should be substantiated with defensible data. This is rarely the same source as the original counts. US Census historical growth rates are one source of credible data. Other sources are historical or forecast data for the target market, macroeconomic data, or another credible proxy.
Addressable % of Target Customers
The next step in building our TAM is the addressable percentages of target customers. Returning to the earlier example of an outdoor cat gymnasium product, cat ownership and available outdoor space are two necessary customer attributes for this product. According to Gallup there are 36,117,000 cat owning households in the US. Per the US Census, the level of detached homes has remained fairly consistent at around 60%. Ignoring cat distribution as a function of dwelling, and assuming that only single family homes have outdoor space, we can roughly estimate that there are 20 million cat owning households with outdoor space in the US. It would be ludicrous to claim a 20 million unit TAM for a $1000 outdoor cat gymnasium … as this yields a $20B TAM!
Hopefully this extreme example illustrates the importance of developing reasonable addressability percentages in a TAM analysis. Even 5% of cat owning households with outdoor space at a $1B TAM is still far from believable. A methodology that would be believable might include research into pet owners to see what percent spend $2000 or more a year on pet toys/supplies, then conduct a willingness to pay study for our product with high-spending cat owners.
You will find a counter example below, as BetterSoft considers all 7 cloud services providers currently focused on their vertical as 100% addressable. If your company made US state government software, 50 of 50 states could be reasonable.
Solid methodologies to develop addressable percentages include a detailed inspection of a sample of companies, simple multiplicative reduction (x% attribute A * y% attribute B * z% attribute C), or creating a data structure that includes all required attributes for qualifying companies.
Also, one highly detailed analysis of the % of addressable companies or “noses” can be extended to additional markets with justification of the relative difference. For example, the growth team at BetterSoft could have done a detailed analysis on 1000 of 4284 Enterprise target customers in 2019, yielding the 65% addressable result shown in the table below. It could be reasonable to use known qualitative and quantitative differences between Enterprise and Mid-market customers to justify a conservative 50% addressable level for Mid-market in 2019.
In practice, multiple reference datasets and analyses might be utilized in a spreadsheet tab dedicated to addressable customers. The final results for target customers and addressable percentage of customers can be clearly summarized for presentation as shown in the following tables:
ASPs by Segment
With segmented addressable customers counts in place for 2019-2023, an array of ASPs by segment and year will complete our bottom-up 5-year TAM. For a company that is pre-revenue, or just has a handful of early adopter customers, current pricing can be used to generate the table of ASPs. A typical product configuration and average discount for each segment will yield average ASPs for 2019. Ideally a pricing strategy has growth levers to justify ASP increases in subsequent years.
Our fictitious company, BetterSoft, has $25M in current ARR and 3 years of revenue history for all segments that is scrubbed and stored quarterly in the company central growth data repository. A 3+ year quarterly ASP dataset is ideal to construct a highly credible ASP forecast. With our 3 year dataset, 12 quarters of ASPs for each segment can be calculated. Time-based ASPs can then be used to calculate various annual growth rates like CAGR (compound annual growth rate) and YoY (year-over-year) growth in each quarter. Trends in quarterly YoY growth are telling, as they show the change in growth over time, and near term trends. A reasonable approach is to use the most recent completed quarter ASPs for the current year, then forecast annual ASP growth using conservative growth rates based on a combination of historical growth metrics.
The results of our carefully justified 5-year ASP forecast for Enterprise, Mid-market, SMB and OurVertical Cloud Service Providers are linked to the final TAM presentation tab. Since we have the matrix of customer counts, multiplying each customer count by the associated ASP yields our segmented TAM. BetterSoft 2019-2023 TAM is shown below, along with TAM growth rate and penetration calculations.
Overall annual TAM growth rate is a byproduct of this analysis, along with a 4-year CAGR. Further, company ARR can be used to calculate market penetration for the current year. Different organizations may be biased towards a smaller or larger total TAM, and it’s appropriate to involve the entire executive staff at some point in the process. Typically, the Head of Sales will have preference lower current year TAM which yields higher market penetration, while marketing and finance find a higher total TAM more beneficial for their organizational objectives.
Top Down Value Theory TAM
Value theory involves a justified approximation of collective buyer willingness to pay. The creation of customer value in a value theory TAM is a malleable concept that can be shaped in many ways, but a top-down approach with a rational quantitative structure will complement and support our bottom-up TAM nicely.
A top-down value theory TAM can be viewed as a macroeconomic ROI (return on investment) model. The ROI investment is our net pricing, and the return is quantified customer value. The analysis begins with quantification of customer value for the entire addressable market. An ROI model uses cash flows, and benefit is obtained by reducing expenses or increasing revenue. Total economic output or revenues for various industries can be obtained from research companies, management consultancy reports, government agencies and other sources. An addressable percentage of the total figures is usually appropriate, but key to creating an independent second analysis is to use a different approach to addressability from the bottom-up TAM.
Total savings can be calculated as a percentage of total overall addressable customer expenses and/or savings for a particular category of expenses. Annual reports of public companies can be a good source of expense percentages of overall revenue. Public company averages can be applied to private companies to gain a picture of the entire market. Clearly stated assumptions supported by comparable data wherever possible are the foundation of a credible analysis that ultimately calculates total industry savings.
A BetterSoft example of savings is as follows. Let’s assume that we have solid data that shows all global addressable customers in OurVertical spend a total of $10B in labor costs. Based on 5 detailed customer case studies, the average overall labor savings of BetterSoft customers was 15%. 15% of $10B is $1.5B in annual value creation for the total addressable market.
Value creation via revenue increase for the addressable market can also be calculated and supported with justified assumptions. There may be one driver of overall revenue increase, or multiple buckets of value with different math, assumptions and comparable data. Revenue increase is not a direct measure of value creation -- but marginal profit is. So calculated total revenue increase must be multiplied by industry gross margin % to calculate marginal profit. Software and cement companies have dramatically different gross margins, but the value for a particular industry can be effectively estimated using annual reports, or generally recognized profitability for a particular industry or proxy industry.
For example, if the global revenue generated by BetterSoft addressable customers is $100B annually, we can use that as a basis. Then, using an 80-page McKinsey report about the future of OurVertical, we might use hard numbers from that report and a few key assumptions to calculate that 20% of overall revenue can be affected by BetterSoft software, which yields $20B to influence. Next, our hypothetical company happens to have an A/B testing feature for customer acquisition and retention, and the collective, anonymized experiment data show that BetterSoft on average increases company revenues by 12.5% for that $20B of influenceable revenue. Our model does the math, and we have a total of $2.5B in theoretical additional annual revenue. If gross margins in OurVertical average 80%, we calculated $2.0B in value creation from revenue increase.
Using the general techniques described above, we can estimate total target market value creation for 2019-2023. But we are not done yet. If a salesperson knocked on your door selling a widget promising to save $1000 on electricity over the next five years, would you swipe your credit card for $1000 in the iPhone Square reader that emerges from the trenchcoat? Probably not. Exchanging a $20 bill for about 50x promised ROI would be more likely, perhaps to satisfy curiosity alone. The final assumption is the percentage of estimated value creation we expect to capture by pricing, and this is related to the value customers believe they will receive from your product. Quantitatively, a credible percentage of value captured by pricing is a function of ability to prove return on investment. Qualitatively, this can be viewed as product market fit.
BetterSoft annual value creation from our top-down value theory model is $1.5B in savings value creation plus $2.0B in value creation from additional revenue generation for total annual value creation of $3.5B. Since the BetterSoft ROI tool used by sales has been extraordinarily convincing for the CFOs of acquired customers, the TAM project executive sponsors are comfortable assuming that 25% of value creation can be monetized via pricing. $3.5B x 25% = $875M in top-down value theory TAM for 2019.
To summarize, the process above can be used to add a “Value Theory Top-down TAM” tab to our spreadsheet that quantifies total expected value creation in our addressable markets and the percentage of this value that can be captured by pricing. With the addition of annual growth assumptions, we can build a 5-year value theory top-down TAM.
Final Thoughts on TAM and Startup Funding
As we wrap up, our sample company BetterSoft now has a factually supported bottom-up TAM, and a thoughtfully reasoned value theory top-down TAM in one logically structured spreadsheet. Each of these TAM analyses have both tabular and graphical output. Naturally, they should be compared. Further, if our model is skillfully built, key assumption variables are structured as model inputs. Frequently, the top-down TAM will be more than the bottom-up TAM. But they should land in the same ballpark if we have done our homework and deeply understand the market space. In our BetterSoft examples, 2019 bottom-up TAM is $829M, and 2019 top-down value theory TAM is $875M.
Traditionally a funding pitch deck has a single TAM slide with an up-and-to-the-right chart. The best choice for one chart is likely the bottom-up TAM based on addressable customers and justified ASPs over time. A smart pitch deck could alternatively include both bottom-up and top-down TAM, even if the numbers aren't exactly the same. The transparency, thoroughness and rigor of your defensible bottom-up and top-down analysis together can be powerful. The TAM model itself can build credibility with investors by demonstrating a clear understanding of the market with quantification of a compelling value proposition, and the ability to test the sensitivity of key assumptions.
At this point we can definitely check the TAM slide box in our pitch deck, and present the 5-year results:
Your TAM slide talking points could include:
Methods used to quantify total customers, addressable customers and segmented ASP trends
Additional top-down value theory air cover based on product market fit
Resulting annual growth rates, CAGR and current market penetration
Your defensible TAM can be a pillar of strength to successfully fund the next wave of your company’s growth. I hope this article has offered useful concepts to strengthen a persuasive funding deck, inform product roadmaps, prioritize marketing investments, and/or hone sales focus.