103. Better than TAM SAM SOM 🚀 startup market sizing

Every early-stage investor wants to hear about your market opportunity. How big can you plausibly get if everything goes well?

That usually means sharing your TAM, SAM, and SOM. But what are they, how do you calculate them, and are they really the best way of showing your market potential?

This episode is part of our series on Fundraising. Check out the rest of the articles HERE.

Why focus on market size?

Angel Investors and Venture Capitalists focus on your market size because they need to know you have the potential for a gigantic exit. Their portfolio model depends on every investment having the potential to return the entire fund. You can read more about that in this article.

Investors want to see your potential to exit at a more than $1 billion valuation. You need to have something like $100 million ARR to achieve that.

That would be impossible if your total market opportunity is only $50 million.

If your market is $200 million, you could do it, but you must take at least half the market. That's possible, but ambitious. You will need to convince investors that you can get there.

If the market is huge, more than $20 billion, then any significant player would have the required valuation. However, it will be a very crowded and competitive landscape. You need to plan to thrive in that kind of environment.

TAM – SAM - SOM

Let's start by defining these terms. They are acronyms:

TAM: Total Addressable Market

The total market for the kind of solution you are creating. In reality, nobody gets 100% of the TAM. There are always parts of the market that you can't, or choose not to, serve.

SAM: Serviceable Addressable Market

The part of the TAM that could reasonably use your solution. Nothing absolutely prevents this population from using your solution, but they might not use it for various reasons.

SOM: Serviceable Obtainable Market

Those people in your SAM you can reasonably reach and who would likely want to use your solution. The SOM are your potential customers. They need the specific type of solution you are offering, can pay your price, can use it, and are in a location you can serve.

For example, non-English speakers might be in your TAM, but if your product is only in English, they will not be in your SOM. Why would they buy something they can't use?

Your SOM should connect to your financial forecast. It would make no sense to say your serviceable obtainable market is $500 million, then project year five revenues of $1 billion. You should not be able to sell to people you can't reach!

Market Sizing Mistakes

In the pitch decks I read, there are more mistakes in the Market Opportunity slide than anywhere.

The most common mistake is misunderstanding their market. Many founders will treat their industry as their market TAM. If they are in the automobile industry, they will show a multi-trillion-dollar TAM. But no company captures the whole industry. If this startup makes windshield wipers, then the TAM is for all the wipers sold annually worldwide. That's a much smaller number.

Another common error is counting money that just passes through your hands but you don't get to keep. Many businesses are built around handling transactions for third parties. Marketplaces and financial services are like that. I see founders using the total possible transaction volume as their TAM. But, in many cases, they just take a small commission on each transaction. They should be talking about how big that commission could get, not the total flow of funds, as their market opportunity.

Top-Down TAM-SAM-SOM Example

Watching Wile E. Coyote in some Roadrunner cartoons inspired me to found the Acme Clothing Company to make indestructible clothes.

I will need investors to help me build the company, so I need to develop some market size estimates.

Everyone needs clothes, and I make clothes, so let's take the global clothing market as my TAM. That would be $1.6 trillion.

However, I am not interested in dealing with export controls around high-tech products like this, so I will limit my SAM to the US market. That gives me a serviceable market of $600 million.

Not everyone needs indestructible clothes. It would be overkill for someone with a desk job. For my SOM, I will look at people with physically demanding jobs. I found a report that says 40% of workers fit that description, so my SOM is $144 billion.

This might feel somewhat arbitrary, and you wouldn't be wrong. Top-down calculations like this start with the biggest number possible, then slowly eliminate the parts you can't or won't support. Lots of things can get missed in that process. Two well-intentioned founders could come to very different values for their obtainable market.

Bottom-Up Market Sizing

With bottom-up calculations, you start with your likely customers.

How many people or companies fall into your target persona? How many of them can you reach? How much will they pay for your solution? Once you have that, your serviceable obtainable market is that number of people times your yearly expected revenue per person.

TAM, SAM, and SOM are annualized figures in dollars (at least in the US).

The calculation is easy with subscription solutions. The yearly subscription is the annual expected revenue. But what about products or separately purchased goods or services?

On average, people only buy cars every eight years. So, your market is not the number of car buyers times the cost of your vehicle but one-eighth of that.

As a masseuse, if your target clients get quarterly massages, then your market is the number of potential clients times the cost of your massage times four.

Finding the data you need to make these estimates may take a lot of work. You might need to look at industry reports, government statistics, customer interviews, competitor disclosures, etc.

Investors will probably push back on your numbers. Ensure you have the data to make a strong argument for your estimates. We all know this is not a perfect science, but you can't just pull them out of thin air, either.

When presenting your market size, highlight the dollar value. That is what matters to investors. You can show your work at a very high level, but keep any complex math or spreadsheets for due diligence or appendix slides. At most, you would show something like SOM: $1.2 B (12 m users @ $100 / year)

Something Better

You can probably see some of the problems with the TAM-SAM-SOM methodology.

The definitions are unclear, leading to wildly divergent estimations of the same market.

The process contains many judgment calls about what should fall within, or be excluded from, any of those categories.

And, as an investor, I only really care about the SOM. Why should I care how many people you CAN'T sell to? I just want to know who might reasonably use your solution. All the time you spend on the TAM and SAM is largely wasted.

Additionally, the TAM-SAM-SOM are only a snapshot of the market. They generally represent the total long-term potential for your business but say nothing about what you might achieve today or in three years.

As an early-stage startup, you are going after the lowest-hanging fruit. Your initial target market might be a very narrow demographic in your city. Your eventual plans might be to appeal to a wide range of people throughout the world. So, which is your market?

I suggest replacing TAM-SAM-SOM with a progression of target markets over time: Launch Market, Growth Market, and Total Market.

In each phase, you use a bottom-up calculation to show the potential of the market segment you are trying to reach at that time.

If you are focused on geographical expansion, you might initially target your local city, then the ten next most reachable large cities, and finally, all cities in developed western countries larger than one million people globally.

If you don't have a geographically restricted business, you might target based on age, income, profession, interests, hobbies, life events, or almost anything else. The key is to start with the people who are both easy to reach and have a substantial need for your solution, then expand that out to increasingly broad target audiences until you reach your largest possible market opportunity.

You might also be planning to expand your offerings over time. In the initial phase, you might just have one product. In the growth phase, you have three products, so your average value per customer is larger. When you reach your final stage, you might have ten products and a significantly higher average monthly revenue per customer.

Phased Growth Example

Let's revisit the Acme Clothing Company from a phased growth perspective.

I know that not everyone needs indestructible clothing, particularly not early on when my manufacturing costs will be extremely high.

Initially, I expect each outfit to cost $25k to produce, so I want to sell it at $50k. Only very well-funded buyers would be willing and able to pay that. After some research, I decide to target just the six thousand known superheroes around the world.

That gives me an initial market of $300 million.

Over the next two years, I expect the price to drop to $2,000 per suit, which is a price point many more people can afford. My best markets look to be the military and professional extreme sports practitioners. Research shows about 2 million of them could use my clothes.

That growth market could be as big as $10 billion.

In seven years, we expect to have the cost of our clothes down to $200 at which point they would be appropriate for anyone working in a hazardous environment and amateur extreme sports enthusiasts. I calculate that about 400 million people are in those categories, so the final total opportunity is $200 billion!

You may have spotted my mistake already. If those clothes are actually indestructible, nobody will need more than one suit. Those are total lifetime numbers but not annual numbers.

Doh! Obviously, completely indestructible clothes are not a good business model. Maybe I should introduce some planned obsolescence and make them only mostly indestructible.

Why is Phased Growth Better Than TAM-SAM-SOM?

As an investor, I like this approach because it provides more useful information. It not only shows me the maximum plausible market opportunity, it tells me how you plan to get there from here.

I know you need to start small and focused. This approach defines that focus.

It shows me how you segment your market and your high-level strategy for growth.

This structure also integrates well with your go-to-market strategy. They complement each other and make the whole story more comprehensible to your audience.

The final result is more believable when you show how you plan to go from your humble origins to becoming a global behemoth.

There are a lot of assumptions that go into building your market size estimates. You might want to look at our article on testing assumptions next.