How to estimate Market size? TAM, SAM, SOM
If you ever read through the startup pitch deck, you should have seen the slide dedicated to TAM, SAM, SOM. What do these acronyms mean and why are they useful for investors when assessing an investment opportunity? These abbreviations give us an idea of the market size for the project. It is important for the investor to understand how large the target market size is and the respective slice that the startup is aimed at occupying on this market. However, understanding the size of the market is equally important for the founders. Oftentimes, the founders of early-stage startups mistakenly present huge target market size in their pitch deck without justifying the numbers with some thorough research behind it. As a result, they fail because that market niche turns out to be much smaller than initially expected. So how to understand which market the project will occupy, how to calculate it better? What are bottom-up and top-down approaches? After roughly estimating the market, the founder can decide whether he should go to a venture investor or not. Maybe it’s easier and better to take a loan. If the market is small, it is possible to build a good business there, but no one can’t build a large, growing company in this market. That doesn’t fit the strategy of a venture investor. We still aim for the 10x return and if the whole market is 10x for investments, how can the investor return the money and also earn?
Bottom-up and Top-down approaches
Let’s start with bottom-up and top-down market sizing approaches.
These two approaches are very different. We at Leta Capital prefer Bottom-up approach. It’s more accurate, but at the same time, it’s more difficult to calculate the market size via this approach.
Top-down approach.
A top-down analysis is calculated by determining the total market, then estimating your share of that market. A typical top-down analysis might go something like this: “Hmm… I will be selling a widget everyone can use, and since there are 300,000 people in my area, even if I only manage to land 5 percent of that market I’ll make 15,000 sales.” Sound a little optimistic? That’s how a top-down analysis usually goes; it’s like the stereotypical, “2 percent of a $1 billion market is $20 million!” sales forecast presented in hundreds of pitch meetings every year.
Bottom-up approach.
A bottom-up analysis is calculated by estimating potential sales in order to determine a total sales figure. A bottom-up analysis evaluates where products can be sold and whom. For example, you decided to set up a Dog walking service in Moscow. In this case, you have to find the population of dogs in Moscow. Try to find the most accurate statistics from trusted sources. For instance, in Moscow, there are 600k dogs. Let’s assume that only 8% of them walk on any given day. If your average check is $20, you will get to a maximum revenue per day of $960,000 = 600,000*8%*$20. Annual revenue of $960k*365 = $350,4M.
While it takes a lot more effort, the result is usually much more accurate.
TAM, SAM, SOM
- TAM or Total Available Market is the total market demand for a product or service.
- SAM or Serviceable Available Market is the segment of the TAM targeted by your products and services which is within your geographical reach.
- SOM or Serviceable Obtainable Market is the portion of SAM that you can capture.
TAM (Total Addressable Market)
Total addressable market or TAM refers to the total market demand for a product or service. It’s the maximum amount of revenue a business can possibly generate by selling their product or service in a specific market. TAM is most useful for businesses to objectively estimate a specific market’s potential for growth.
According to MIT’s Global Startup Labs program, the best way to calculate total addressable market is by running a bottom-up analysis of an industry. A bottom-up analysis involves counting the total number of customers in a market (which you can do by adding up the amount of customers each company in this market has) and multiplying that number by the average annual revenue of each customer in this market.
TAM shows how many customers in the core market are in need of your goods or services, given all potential customers who can’t afford your product or service.
SAM (Serviceable Addressable Market)
Unless you’re a monopoly, you most likely can’t capture the total addressable market for your product or service. Even if you only have one competitor, it would still be extremely difficult to convince an entire market to only buy your product or service.
SAM is the part of the total addressable market that can be actually reached. It means that this shows the volume of customers who are ready to buy goods or services in the same category as yours. You can think who and in what volume is ready to buy your products?
For example, you sell a software product which the whole world needs. However, your software product is only available in Russian language. Furthermore, your SAM is TAM but only for Russian market.
More interesting evaluation it’s to calculate your serviceable addressable market, count up all the potential customers that would be a good fit for your business and multiply that number by the average annual revenue of these types of customers in your market.
SOM (Serviceable & Obtainable Market, Share of Market)
SOM is the part of SAM, which your company is able to occupy, taking into account strategic development of this market and competitors’ activity.
To calculate share of the market, divide your revenue from last year by your industry’s serviceable addressable market from last year. This percentage is your market share from last year. After that, multiply your market share from last year by your industry’s serviceable addressable market from this year.
Let’s assume your company sells software product, some software tools. Your company has cash to pay salaries for 5 sales reps. You evaluated your SAM as 20,000 companies. Each sales rep can sell to only 120 companies per year. Consequently, your 5 sales reps can only sell to 600 companies annually. Therefore, your SOM is 3% of SAM.
As you can see TAM, SAM and SOM have different purposes: SOM indicates the short term sales potential, SOM / SAM represent the target market share and TAM shows the potential at scale. Each of these 3 play an important role when assessing an investment opportunity and the focus should really be on getting the most accurate numbers rather than the biggest possible numbers.
Do you run an innovative tech startup? We are investing in early-stage revenue-generating software startups across the world and would love to hear from you! You can reach us at leta.vc
