August 8, 2023

#002: How to Size the Market for a Startup Idea

‍This is the second installment in Firstbase’s series on how to find and validate startup ideas. Read part one—How to Use Data to Find a Startup Idea—and subscribe to our newsletter to receive future editions of the series delivered straight to your inbox.

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One of the most important elements of developing a strong startup idea is accurately estimating the size of the market your company will serve. This metric is known as your Total Addressable Market (TAM). It will help you make crucial decisions about your go-to-market strategy, pricing structure, and how you capitalize your business.

The simplest way to think about TAM is as the theoretical maximum revenue for your business. It is calculated based on the number of customers in your market sector and the amount that each of those customers spend on your product. It sounds simple, but the devil is in the details.

The ride-hailing service Uber provides a canonical example of the challenges of calculating TAM and shows how even professional investors and financial analysts can be led astray by their assumptions about a market. In 2014, Aswath Damodaran, a professor of corporate finance and valuation at New York University, wrote a blog criticizing Uber’s recent valuation at $17B. We won’t go into the details here, but the post is worth a read in its entirety. Damodaran’s fundamental error was using a top-down approach—more on this below—to calculate Uber’s TAM. In 2014, he estimated that Uber’s TAM was about $100B globally and would grow to about $183B by 2024. Damodaran assumed that Uber would capture no more than 10% of that global market and that Uber would have trouble ever justifying its 2014 valuation.

But Bill Gurley, a general partner at Benchmark who invested in Uber, saw things differently. In a rebuttal to Damodaran’s post, Gurley did a bottom-up TAM analysis of Uber that accounted for the ways that Uber was expanding its addressable market. Damodaran had assumed that Uber’s TAM was equivalent to the global limo and taxi market, but Gurley had seen firsthand how Uber had expanded its market in San Francisco—where it launched—well beyond the city’s local taxi and limo market. Gurley realized that Uber isn’t just competing with taxi companies, it’s an alternative to car ownership. The market of car owners is much larger than the taxi market, and even using relatively conservative assumptions Gurley calculated Uber’s TAM to more somewhere between $450 billion and $1.4 trillion. Even if Uber captured far less than 10% of that market, it would grow well beyond Damodaran’s expectations and easily justify its valuation.

A decade on from this famous TAM debate, Uber is now a public company and we can see who had the better TAM estimate. At the time of writing, Uber’s market capitalization is $85B and the company did $32B in revenue last year. Uber’s revenues are nearly double what Damodaran estimated as a best case scenario in 2024 and underscore the profound challenges of accurately estimating a startup’s TAM.

Why Accurate TAM Estimates Matter for Your Startup

The Uber episode highlights why it is so critically important to accurately estimate the TAM for your startup idea. Any investor who used Damodaran’s TAM analysis wouldn’t have invested in Uber at such a “crazy” valuation, but this valuation only seemed crazy because it was based on inaccurate TAM assumptions. If you’re planning on raising capital to fund your startup, investors will want to see that your TAM is based on solid, data-backed assumptions. An accurate TAM analysis is also important even if you don’t plan on raising outside capital for your startup. It will help you make critical decisions for your business around your go-to-market motion and long term growth strategy. Let’s briefly consider how TAM affects each of these factors:

TAM informs your go-to-market motion. If your TAM turns out to be massive, this will reveal a very important fact: you are almost certain to face steep competition in your market. Rather than going toe-to-toe with all these competitors, you should consider narrowing the initial market segment you will target. Here you will face less competition and have the time to get a strong foothold. Then you can use this position of strength to expand your product offering to target the larger market. A secondary benefit of targeting a smaller initial TAM is that you will be able to capture a larger proportion of that market, which leads to better pricing power and lower sales and marketing costs.
TAM informs your growth strategy. Your product will only capture a portion of your customer’s spend. If you’re building scheduling software for restaurants, for example, your customers will also likely be paying for software tools to manage their business. Once you know the TAM for restaurant scheduling software, you can plot a growth strategy that involves layering in additional services, such as payroll or payments, into your core scheduling software. These additional tools will expand your TAM and give you insight into what your company needs to do to achieve sustainable growth. This will allow you to create a detailed product roadmap and measure your progress as your business grows.
TAM determines how you will capitalize your business. There are 3 main ways to fund your startup: you could bootstrap it using your personal savings or operating revenue, take on debt, or raise venture capital. An accurate TAM will help you determine which of the 3 choices is best for your business. Venture capitalists, for example, are in the business of grand slams. They invest in high-growth businesses that will return high multiples on their investment, and they use TAM as a way to gauge their expected ROI. If you’re seeking venture capital for your startup, you need to be able to show investors that you’re going after an opportunity large enough to justify their investment. As Don Valentine, the founder of Sequoia Capital, famously put it, “I like opportunities that are addressing markets so big that even the management team can’t get in its way.” A TAM that is too small for venture capital doesn’t mean it’s a bad business, but you will save yourself a lot of fruitless investor meetings if you know in advance that your market isn’t a venture-scale opportunity.

Common TAM Misconceptions

Before we dive into how to accurately calculate the TAM for your startup idea, it’s important that we clear up 3 common misconceptions about market sizing that will help you avoid a gross overestimation or underestimation of your startup’s market.

TAM is not a single “right” or “wrong” number. The truth is that your company’s TAM is always up for debate. To calculate this number, you must make reasonable assumptions about who constitutes a customer, how much those customers will spend, and how much it will cost to reach those customers. You should aim to back your assumptions with data collected from both primary and secondary sources. Even then, the assumptions that you make about your TAM may still be incorrect, but you will be able to make a strong case for how you arrived at your market size estimate. This will be especially important if you’re raising money from VCs.
TAM is not the same as the number of businesses in your market. Let’s say you are starting a software business that does payroll for barber shops. Looking at data from the market research firm IBISWorld, you’d see that there are 151,000 barber shops in the US, but not all of those barber shops will want or need your software. Some may be sole proprietors with no employees or others may be so large that they need a more comprehensive software platform to manage their business. To figure out how many of those 151,000 barbers may actually want your software, you need to create an ideal customer profile that precisely describes what types of barber shops will be buying your product. For example, perhaps your software is ideal for barbershops with 3-20 employees that have at least $100,000 in revenue annually. This more narrowly defined customer profile will only represent some fraction of the total number of businesses in the market.
TAM is not the size of a problem in your industry. In 2022, the National Retail Federation released a report that showed that shoplifting resulted in US retailers losing $100 billion that year. This is clearly a massive problem for retailers and it’s easy to imagine that many of those retailers would be willing to pay for a solution. But if you start an AI company that uses security camera footage to alert security guards about shoplifting incidents that doesn’t mean you have a $100 billion TAM. First, not every retailer employs security guards and others might not have security cameras. Second, your product can only offer a partial solution to the overall problem because no technology is perfectly accurate. Third, your customers may want to pay less than the problem costs them to solve it. If retailers are experiencing $100 billion in theft and they need to pay $100 billion to solve it, the hassle of implementing the solution won’t be worth it.

How to Calculate TAM

Earlier we defined TAM as the product of the number of customers in your market and the amount that each of those customers spend. But finding the right inputs for that simple calculation isn’t trivial.

There are two primary ways to calculate TAM: top-down and bottom-up. Generally speaking, a bottom-up TAM calculation will be more accurate and is what venture capitalists will want to see during a pitch. Top-down TAM calculations have a tendency to tell you the market size of your industry, rather than the addressable market of your business.

To calculate either your top-down or bottom-up TAM, you’ll first need to find your Serviceable Obtainable Market and your Serviceable Addressable Market .

1. Serviceable Addressable Market
TAM is calculated as the number of customers in your market multiplied by how much each of those customers spend. In an ideal world, your business would be able to serve all of those customers, but unfortunately that’s not the world we live in. The fact is that your business won’t ever be able to service all those customers. (Don’t take it personally—even Apple, the largest company in the world, only services about 23% of the global smartphone market.) Some of those customers will purchase your competitor’s product, others may not be able to afford your product, and still others may not even know about your product. Whatever is left over is your Serviceable Addressable Market (SAM).

To calculate SAM, you need to think about how your sales and marketing initiatives will affect your ability to reach customers in your TAM. This involves considering several factors, such as how you will differentiate your product from your competitors, how you will price the product, and how you will market your product to customers. For example, if your product is priced too high for 30% of the customers in your TAM, then you can’t really service those customers and they shouldn’t be included in your SAM. Alternatively, if your business starts by selling to customers in a limited geographic region, then customers outside that region will not be included in your SAM.

2. Serviceable Obtainable Market
Once you have calculated your SAM, it’s time to calculate your serviceable obtainable market (SOM). Just because you can theoretically service the customers you identified in your SAM doesn’t mean you can service them right now. Sales and marketing is expensive and not all of the customers that make up your SAM are equally valuable. This means that you will have to make a choice about what types of customers to target and when. To calculate this number, you need to understand how your business will do sales and marketing. Some businesses may rely on social media ads to land new customers, whereas others may require sales reps to do outbound calls. The cost of different S&M strategies can vary dramatically and SOM is the metric that describes the customers you can reach with your business’ available resources today. (If your business has a hardware component or is a service business, your SOM will also be constrained by factors such as manufacturing capacity and employee availability.)

TAM v. SAM v. SOM

Total Addressable Market: All the customers in your market

Serviceable Addressable Market: The customers in your market that could use your product today.

Serviceable Obtainable Market: The customers in your market that you want to target first.

Top-Down TAM

Top-down TAM is best thought of as the “back of the napkin” approach to TAM. It starts with TAM and works backwards to SOM.

The way to calculate TAM using a top-down approach is to use the data sources we described in part one of the Founder’s Guide to find the total annual spend for your market and the number of customers in that market. Multiply the total annual spend for your market by the percentage of businesses that could be your customers to get a rough idea of TAM. From here, you can calculate SAM and SOM based on assumptions about how many of those customers are addressable and obtainable.

Top-Down TAM Formula

TAM ($) = Market Size ($) * Segment of the market relevant to your company (%)

For example, data shows that a business’ average annual IT spend ranges from about 1.5% to 8% of company revenue depending on the industry. The average IT spend across all industries is 3.6%. Let’s say you’re creating a business that sells software to manufacturing companies. According to data from the National Institute of Standards and Technology, the annual revenue for the US manufacturing industry is around $2 trillion. (Not all IT is software, but to simplify our calculation we will assume that this only represents software spend.) So the annual software spend for the manufacturing industry is roughly $60 billion.

Now, your company isn’t going after all the software spend for the manufacturing industry. You’re only targeting a subset of the industry and your product will only capture a portion of the spend. There are 591,000 manufacturing companies in the US, but after analyzing the market you realize that your product is only suitable for manufacturing companies that are organized as sole proprietorships. According to IRS data, there are approximately 385,000 companies in the US that fit this criteria. That’s about 66% of the total manufacturing market. So when we plug these numbers into our formula, we get a TAM of $39 billion. From here, you can calculate SAM and SOM based on assumptions about how many of those customers are addressable/obtainable and multiply the TAM by the percentage of addressable/obtainable customers.

Bottom-Up TAM

Bottom-up TAM calculations work in reverse. Typically, the way to calculate bottom-up TAM is to start with how much your customers have historically paid for your product and multiply this by the number of serviceable obtainable customers, serviceable addressable customers, and total addressable customers.

Bottom-Up TAM Formula

TAM ($) = Total Customers (#) * Average Customer Spend ($)

There are a few alternative ways of doing this calculation if you haven’t sold any products yet. One is to look at the pricing of your competitor’s product and use that as the assumed customer spend. This can give you a rough estimate, but you run the risk of grossly over/underestimating your TAM because of unknown factors influencing your competitor’s business.

Another way to approach a bottom-up TAM calculation is to use publicly available data to estimate annual software spend. To return to our above example, we know there are 385,000 sole proprietor manufacturing companies and IRS data shows that their average revenue was $84,750. If we take the average all-industry software spend (3.6% of revenue), that means that these businesses will spend $3,000/year on software. You can use this ACV to calculate SAM and SOM based on assumptions about how many of those 385,000 customers are addressable and obtainable based on the unique characteristics of your business.

You’ve probably noticed that the estimated TAM for the manufacturing industry using the bottom up approach is vastly smaller than the top down approach. Assuming an ACV of $3,000 and 385,000 total addressable customers, the total TAM for the same business is just $1.1B when using the bottom-up approach. That’s almost 40 times smaller than the top-down estimated TAM.

What accounts for this disparity between TAM calculations? You’ll notice in the top-down example that we used the total number of manufacturing companies (591,000) and the total industry revenue ($2 trillion) as our starting points, and then multiplied that revenue by the percentage of manufacturing companies that are sole proprietorships. This calculation assumes that all the companies in our calculation are the average size across the entire industry, even though our business is focusing on manufacturing companies that are quite small. If you take the total manufacturing industry revenue and divide it by the total industry revenue, you’ll get an average revenue of around $3.4 million—a full two orders of magnitude larger than the average revenue of sole proprietor manufacturing companies according to the IRS.

The massive manufacturing companies severely warped our calculations in the top-down TAM calculation. The large manufacturing companies are likely spending millions of dollars on software annually compared to the $3,000 ACV we calculated using the bottom-up method. The skewed distribution of software spend is not accounted for with top-down TAM calculations. The top-down approach will often look more flattering to your business, but it may be wildly inaccurate. This is why VCs and founders prefer the bottom-up method—the $1.1B TAM is a much more realistic description of the true opportunity size for your business.

A Final Word on TAM

The different approaches to calculating TAM demonstrate why TAM is more of an art than a science. It involves making reasonable assumptions about your market that are backed by solid data. It’s easier said than done.

The way to avoid gross miscalculations of your TAM is to be explicit about the assumptions you’re making so you can be confident about using this market size estimate to make critical decisions about your business. A helpful starting place is to use the following checklist as you collect your data.

TAM Analysis Questions

Market Questions

How big is my market today?
What are realistic growth prospects for my market
Will my product meaningfully expand the number of customers participating in my market? If so, by how much?
Who are my competitors?
What are my competitors’ market shares?
Are there limits to my expansion (e.g., regulations)?
Where am I launching my product intuitively?

Customer Questions

Who are my customers?
How many customers are there?
Where are my customers located?
Are there customers who don’t use comparable products now?
How do I reach customers that aren’t using comparable products now to expand my TAM?
What are the primary characteristics of the customers I will target first?

The key to creating accurate TAM estimates that will validate your business idea is taking the time to understand your market and your customers.

Check out the previous installment in this series to learn about how to interview customers and find data to model your startup’s TAM. In the next edition, we’ll dive deep into how to find product-market fit for your startup.