The Total Addressable Market Conundrum
So, it’s time to talk to investors. You’re preparing marketing materials and the subject of the total addressable market comes up. The TAM for short. Seems simple enough, right? Let’s figure out roughly how many companies are in your target market and multiply by your average revenue per customer aiming for the biggest number possible. Make a nice-looking pie chart or two and you’re finished. Well, it’s not quite that simple. Investors will apply a lot more scrutiny than that in looking at your market more granularly and so the conundrum facing founders in optimizing the positioning of their market size is how to best balance conveying a large (and growing) market with obtainable market share. Below we discuss the various ways investors will look at sizing your market.
TAM, SAM, SOM
You’ll hear investors toss around various acronyms when asking about your addressable market. Usually it’s TAM, SAM, and/or SOM…
TAM…or the Long-Term View…
TAM or the total addressable market is the most common one mentioned but is actually the least useful to investors. What is TAM exactly? This is the entire market you’re operating in no matter your product suite or ideal customer profile. This is the “shoot for the moon” number. For example, say you’re selling practice management software servicing large law firms in North America. The most aggressive approach could argue the TAM be thought of as 100% of law firms’ IT spend globally. This will be a very large number and one that is very long-term oriented. Could a practice management company eventually expand into martech for law firms or digital document management or e-signature etc.? Sure, but it would require lots of capital and as you are probably inferring the TAM is not how investors will think about their ability to monetize your market in the short or medium terms. The TAM certainly matters but think of it as setting the ceiling for your market vs. what is realistic today. For most companies, expanding across the entire TAM will require substantial investment across not only sales and marketing but also R&D and perhaps some M&A.
SAM…or the Medium-Term View…
This brings us to the next level down - the serviceable addressable market or the SAM. The SAM is usually thought of as what your market value looks like based upon your current product suite across 100% of potential customers. To return to the company example above, this could be thought of as the total practice management software spend across all law firms globally. Now you’re obviously not selling to every sized law firm across every geography today, but this at least gives investors a sense for what the market potential might look like with some more sales and marketing and modest R&D to retool for different customer profiles. Critically though the SAM is the market size based upon your current product suite only.
SOM…or the Short-Term View
The level below SAM is the SOM or the serviceable obtainable market. This is the size of the market based upon your company targeting only its current ideal customer profile with only its current suite of products. Returning to our practice management for law firms example, this would be the value of the practice management software market for large-sized law firms in North America only. Investors think of the SOM as what is obtainable without any outside investment or change in strategy. In other words, if this company just kept operating as is without any outside capital, new products or change in customer profile targeting then what is the size of the market they’d be operating in for the foreseeable future? If the TAM is the ceiling of your market size, then the SOM is the floor.
The Math
There are two primary ways to calculate each of TAM, SAM, and SOM. Top-down or bottoms up. We believe that generally speaking the TAM figure should be derived using a top-down approach while the SAM and SOM should be calculated using bottoms-up.
Top-Down
Top-down means using various industry reports such as IDC or Gartner to estimate market size. These firms do excellent research on TAM sizing at a high-level and so we usually recommend that our clients lean on the top-down approach for TAM unless they’re operating in a very niche industry. Take our example company above operating in the legal tech space. Gartner just put out a report last year sizing the global legal tech market to include the practice management segment. Because the TAM figure is the long-term, “pie in the sky” market size it would be a waste of time to arduously calculate a figure using a bottoms-up approach that will probably end up being within range of the Gartner figure anyway.
Bottoms-Up
This is the more granular approach and generally speaking what you should use for SAM and SOM. Bottoms-up means multiplying average revenue per customer times the number of potential addressable customers (SAM) or number of currently obtainable customers (SOM). Take our legal tech company for example…the SAM could be calculated by estimating the number of total law firms that are candidates for practice management software multiplied by the average revenue per customer. Estimating the total number of law firms that are candidates for practice management software is obviously more art than science, but you can imagine for our example company they’d need to segment the market by size to perhaps eliminate firms with <10 employees who wouldn’t have the need for sophisticated software. For the SOM they would need to separate out just large law firms operating in North America and multiply that number by their average revenue per customer. One could also make the argument that for the SAM the average revenue per customer should be reduced to account for the smaller / medium sized firms having lower ACVs.
Greenfield & Fragmentation
One common mistake we see founders make is focusing too much on presenting the largest possible market size numbers without thinking through greenfield and fragmentation. What is greenfield (sometimes also called “blue ocean”)? It’s just a finance buzzword meaning market share not currently captured by a SaaS competitor. Think SaaS competing against Excel or paper / pen. Investors love greenfield for obvious reasons. Very low customer acquisition cost. Faster sales motion. Fragmentation matters too though. A market that is 75% greenfield is not necessarily more attractive than a market that is 25% greenfield if in the former case the entirety of the remaining 25% is captured by one competitor vs. the latter where no single competitor is >1% market share. We always recommend that at a minimum we estimate greenfield and fragmentation for the SOM (and sometimes for the SAM as well). We can potentially justify our greenfield and market fragmentation estimates using our RFP data to illustrate which competitors we run into and how often we are trying to displace an entrenched solution vs. competing against in-house tools.
How to Optimize
Now that we have the basics out of the way…how do we optimize presenting the various figures?
Tie Current Product / Strategy Roadmap to SAM / SOM
Your SAM and SOM are obviously not static. Perhaps you’re hiring a sales team in a new geo next year. Or reconfiguring the product suite for a different customer profile. Or launching new product modules to expand into other adjacencies. While your current SAM / SOM calculations should not reflect these changes as they’re not yet initiated, we recommend to our clients that when beneficial we create additional SAM / SOM analysis that illustrates how the figures will increase over time parallel to various changes in the business.
Error on the Side of Conservatism
Investors will cut you some slack on your math not being exactly in-line with their own but if you’re caught embellishing some of your assumptions it ends up eroding some credibility across other facets of the business. One common example of being overly aggressive we see across founders is using next year’s estimated average revenue per customer based on a yet to be announced price increase to calculate the SOM. If the founder exaggerated the SOM figure who’s to say they wouldn’t exaggerate their forecast? Is this how the founder operates just generally? For these reasons we recommend to our clients to error on the side of conservatism vs. trying to squeeze every last dollar to maximize TAM/SAM/SOM size.
Think Intelligently About Average Revenue Per Customer
We see many founders simply take their average revenue per customer currently and use that as the multiplier for the SAM / SOM. This is usually not accurate for a few different reasons. For the SAM, you might plan on expanding to different customer size segments. What do the competitors charge? Probably a diffferent ACV vs. the segment you’re operating in now. For the SAM and/or SOM maybe you ran aggressive price promotions to capture early customers but have since phased them out…in that case taking the average might be understating your “run-rate” average revenue per customer. These are just a couple examples where you need to think more critically than just multiplying with the current figure.
Does Your Go-to-Market Data Reconcile with Your Market Analysis?
So you told investors that your market is 75% greenfield but then they dig into your go-to-market data and discover that >25% of the time your RFPs are attempting to displace an entrenched competitor. Not good. Make sure that whatever you tell investors about greenfield and/or market fragmentation roughly reconciles with your go-to-market data. This not only gives investors comfort in your analysis but also further bolsters your credibility across other aspects of what you’re conveying about your business and market.
Investors Will Trust…But Verify
You should know that during exclusivity most investors will employ their own 3rd party consultants to perform market analysis and so be prepared to bridge any material gaps between your analysis and theirs. You don’t want to end up in a position where an investor is leveraging market analysis that differs dramatically from yours to justify a re-trade.
Illustrating How Additional Primary Capital Expand Your SAM / SOM
It can be helpful to specify to investors exactly how primary capital would be deployed to expand your SAM / SOM such that they can get a better sense for the ROI. Perhaps you can enter new geographies or expand your ideal customer profile. Sizing these opportunities vis-a-vis the primary capital that would be deployed against them can be very helpful in not only verifying there will be immediate ROI but that you are thinking strategically vs. reactively.
