Your market size is only a fraction of what you think it is.

We’re a startup building software to manage your client communications for beauty salons. This is a massive opportunity in a $49.3B market!!! We will become huge. — Fictive Startup

This is not a very uncommon pitch we hear. Many founders have snapped up that VCs like to invest in big markets, and they articulate huge numbers to justify how amazing this particular opportunity is.

Even though the industry market size of beauty salons very well may be $49.3B, what’s essential for you (and any VC evaluating your company) is the portion of this market which is relevant for your product — your total addressable market (TAM). Your TAM is only a subset of the overall industry market and can often be only a fraction of it, and you need to learn to distinguish between the two of them.

In the beauty salons market a majority of the industry spend will derive from two large buckets: service revenue (from hair cutting, nail care, skin care) and merchandise sales (of beauty care products). And a fairly small subset of this revenue could be used to purchase your software. Much of the revenue have to cover the high costs for labor, real estate and products that constitute a beauty salon business. Your market is NOT $49.3B. It’s far from it…

With startups pushing innovation and often creating new or disrupting old markets, it’s rare to find external market studies who have defined your exact market size. So how do you size your market? More than often determining your TAM is a game of estimation. You have to do the math and there are two basic methods for estimating market size: top-down and bottom-up.

Top down

With a top-down approach, you use broad industry figures as input and break them down into what you believe your market may represent out of that. Make sure to always use i) reputable data sources and ii) have a clear line of thought in terms of how you break down the numbers. In the case of beauty salons, you may start with the fact that the $49.3B actually is aggregate revenue in for beauty salons, and that SMBs generally spend 6.9% of their revenue on IT, which gives you a $3.4B market for IT services and products in the beauty salons industry. About 3/4 of IT spend is devoted to services ($929B vs $321B) meaning about $850M is spent on software in the beauty salons industry. Within software spend, CRM systems represent 7% ($23B vs $321B) giving us an addressable market size of $59.5M. Only 0.12% of the overall industry (= $59,500,000/$49,300,000,000) would be applicable for you to capture, and that is assuming you own the entire market through an unlikely monopoly. Obviously far from as attractive as the billion USD market mentioned earlier.

Bottom up

The bottom-up approach, rather than breaking down big numbers, you build it up by adding together all main variables of your business model. The most basic model takes expected price times the total number of potential customers. If your companies have several revenue streams, you need to add them together. In the instance of beauty salons, let’s say your software has two pricing tiers which sell for $49 and $99 per month. And let’s assume 2/3 of the market are so small they would only need the low tier product, and the other 1/3 would be suitable for the higher tier. With 86,000 beauty establishments in the US, your total addressable market is $67.7M (86000*2/3*$49*12 + 86000*1/3*99*12).

Triangulate

The top down and bottom up approach in our example above are fairly close which gives certain comfort to our estimations. The best TAM estimations are triangulated using a combination of both methods, and sometimes a few different version of each. For example, an additional market sizing to the above example would be a top down approach starting with the size of the CRM market and break that down into the addressable part for beauty salons.

Unfortunately, there’s not one format that works for all companies, as it depends on what data and information are available, so it’s up to the founders to figure this out. And don’t strive to come up with the ultimate final number. And don’t make it too complicated. Feel free to present a spread if your various market sizings come out far from each other, and make sure you can explain your sizing process and estimations clearly.

But also remember that the size of the market is only one dimension determining how attractive it is. Investors will also want to understand forecasted growth in the overall market, if you’re offering a replacement to an existing product vs introducing something completely new (existing budget vs new spend), competition and fragmentation of existing providers, barriers of entry, lock-in effects, sales cycles, supplier dependencies, and many more things.

So, don’t be a n00b and use industry market size in your company’s pitch. What’s relevant for you is only a portion of that. TAM FTW! 💪 👊