Total addressable market — The why, the what and the how for software SaaS.
The challenges of calculating your TAM
The total addressable market (TAM) is simply the price of your product multiplied by the number of potential customers. Then how come it can be so hard to calculate accurately? First let us consider the price. You have multiple products all at different price levels and potentially using different pricing models. You may have supporting services and add-ons or offer discounts for volume or buying bundles of products together.
You may charge for your product based on the number of users so straight away you need to know not only how many employees there are at a company, but what proportion of those employees have a need to use the product. Very large organisations will not expect to pay the same per user as smaller organisations — they will expect a volume discount of some sort.
So, we can see the pricing calculations can soon become complex. The same complexity can arise when identifying potential customers. Does your product serve a particular industry sector such as financial services or healthcare? If so, is the product equally relevant and valuable to all sub-sectors within this sector? Do you plan to make the product available in all countries — is this even feasible given language, timezone and general support considerations.
And of course, the market landscape is always changing with new economic factors, competitive entrants and the evolution of the product itself. These calculations soon become too complex to do manually or on a spreadsheet.
What is the TAM, SAM and SOM?
TAM stands for Total Addressable Market. The metric is a monetary value that represents the total possible revenue available if you were to sell all of your products to every customer who may be interested in purchasing them.
SAM stands for Serviceable Addressable Market. Again, this metric is a monetary value, is smaller than the TAM and represents the total possible revenue available if you were to sell all of your products to the customers that you consider are in your target market and can be serviced by your organization within the confines of your existing business model.
SOM stands for Serviceable Obtainable Market or is sometimes translated to Share of Market. SOM too is a monetary value, is smaller than the SAM and represents your estimated obtainable share of the SAM.
Example
Let’s say you have a company and it has one product, a web based application to help recruiters automatically filter CVs using artificial intelligence based on a set of criteria. To calculate the TAM, we need a pricing model. If the product is already live and in use by existing customers, we could use our historic sales figures to estimate the likely future revenue we may receive from certain types and sizes of customers. If the product is not yet live, we will need to create a pricing model based on market and competitor research.
The next step is to find the number of companies that may theoretically purchase our product. This will vary based on the type of product. In our example, the recruiter application, it could be used by recruitment firms across the world, of different sizes and specializing in recruiting different industries. But hang on a moment, perhaps our application is only available in the English language and only companies where users have a good internet connection, access to the web and a modern job market really qualify. We might do this top-level type of filtering now — even when calculating the TAM.
So let’s say we have 25,000 recruitment companies that qualify and we think our average selling price is going to be $5k per year. That’s a TAM of $125m. We can get a bit more sophisticated in calculating the TAM. Larger companies will pay more to serve more of their users. Different countries may have a different willingness to pay based on local economic factors and the same goes for different industries. We could bake all of those differences into our model to get a more accurate TAM calculation. But my advice is to start simple and then layer in that type of complexity as you go. Just make sure you document your assumptions and input when you present the numbers.
Now for the SAM. As mentioned before, this is the Serviceable Addressable Market. In practice this the component of the TAM that you are targeting with your current business model and product strategy. Going back to our example, perhaps we are a small UK based startup. We have decided our beach head market is going to be UK based small to mid sized firms with ,say, less than 200 employees. Our thesis is that these firms are unlikely to have full-time recruitment specialists and would be open to buying an application from a smaller software vendor. Of the 25,000 recruitment firms in our TAM, perhaps only 1,000 firms fit into this category. So our SAM becomes 1000 x $5k or $5m.
And finally the SOM, the share of the market or the serviceable obtainable market. It is not realistic to imagine that we will obtain every firm in our SAM, but we might predict with targeted marketing and a personal service we could capture 1% or 1 in every hundred firms. If we are successful, that would generate revenue of $50k. You can see the drastic reduction from $125m to $50k, but that’s ok — we are a start up and our first business goal may be to find 10 customers who are willing to pay $5k in our niche target market of UK SME firms with less than 200 employees.
Once we reach that first milestone, we are on our way to establishing product market fit and we can pull multiple levers to increase our TAM, SAM, SOM and ultimately our revenue. The important takeaway is we now have a baseline for the size of our initial market, the model can evolve, and how we choose to influence the TAM, SAM and SOM forms the basis of our future product strategy.
Why are these metrics important?
There are four reasons it is good to know the size of your market.
1. Investors will want to know
When the time comes to raise investment or perhaps even sell your company one of the many questions potential investors will ask is “How big is the market opportunity?” They want to make sure that the market is big enough to ensure they get a return on investment. If they are a private equity firm, they will also want to ensure that the market is big enough for the next buyer too. As an owner or founder, you need to have an answer ready for the market size question and a methodology and supporting data to back this up. The conversation is part of establishing yourself as a credible person to invest in.
2. Helps you prioritise development
In order to accurately size your market, you must first understand it. What size of customer will you sell to first? Where are they located and what do they do? Once you know the answer to these questions, you can prioritise the features for this particular market segment. Understanding the size of expansion markets can help you push back on developing complex features that do not provide sufficient return on investment — the complex language translation, the specialist dictionary of terms or the Enterprise level security features.
3. Provides new ideas and inspiration
Determining your market size is not just a case of multiplying a couple of numbers together. Instead you must dive deep into the true nature and value of your product and potential customers. Throughout this process you will challenge previously held assumptions and discover new areas that you had not previously considered.
Market sizing requires a disciplined approach that digs into how much your customers will actually pay, what gives you the right to win over the competition and the order in which you should act upon the opportunities in front of you. Many founders procrastinate in developing a market study, perhaps with a fear that the market may not be big enough. But the reality is that the exercise is almost always positive and will energise you and your team to accelerate and realise the full potential of your market.
4. The basis of your product strategy
Your TAM, SAM and SOM metrics and your ideas for increasing them forms the basis of your product strategy along with your “Right To Win” in the target markets you choose. These metrics should be understood by everyone involved in your product and reviewed regularly to ensure your strategy is working for you and your company.
