What is TAM?

In case you are wondering, TAM stands for Total Addressable/Available Market. One of the most common questions we get is calculating a Market Size.

What is TAM in the first place?

To answer this question, we need to start with what a TAM analysis is for. Simply put, investors (and smart management teams) use TAM analysis in an attempt to identify gating factors on the growth of a startup over time. At Tyke, we’re transparently looking to associate with companies that can one day become billion dollar businesses, and we see many pitches where the founder simply isn’t targeting a market big enough to get there and doesn’t have a plan to do so. A TAM slide’s role in a pitch deck is to convince investors that the company is chasing an opportunity big enough to achieve venture-scale returns with the right execution.

In the very best pitches, founders use their TAM slides to show insights into how they think about the market they are serving, the extent of their product-market-fit and their product roadmap. The goal of this piece is to help build a slide that accomplishes these goals and elevates the TAM conversation from a throwaway slide to a positive contributor to the pitch and discussions that follow.

There are three distinct ways to calculate TAM. Here is our attempt at explaining them using Uber:

Top-down, using industry research and reports:

Top down, which takes the form of “this is a $Xbn market by 2022” or “we serve potato farmers, a $40bn industry.” This is by far the least favorite way to frame a TAM discussion. It contains remarkably little information, and relies on my faith in the analysts. They’re smart people, but market sizing is hard and often reliant on self-reported data or difficult-to-make estimates about the revenue of private companies. In cases where there are mixed pricing models (consider a software segment transitioning from license to SaaS pricing), the analysis can be confounded further. When a founder presents a number taken from a report, the default presumption is that they did some Googling in the midst of the deck-building process and found a number big enough to get the job done.

There is another major pitfall here: it assumes that the company’s disruptive product won’t change the size of the TAM meaningfully. Too many pitches use industry TAM numbers, then boast about undercutting the pricing of incumbents by 50% or more. Consider if you saw a pitch for an online encyclopedia in 1999, and sales of physical encyclopedias were used to frame the TAM. In reality, online encyclopedias shrunk that TAM meaningfully.

Or on the flip side, consider the case of Uber. Cabs and car services were the incumbents- assuming that this captured the extent of the TAM (a mistake Uber’s founders made, ironically) would miss the fact that a superior product could dramatically increase usage and revenue for the whole “chauffeured rides” category.

Bottom-up, using data from early selling efforts.

Bottom-up, which takes the form of “here’s how we price and how many units of that price we can sell.” This is a much better option than #1, because it involves tangible, relatable data on current pricing/usage of the product and imagines a larger customer base. A software startup successfully selling human capital management software at INR 1000 per employee per month might reasonably take the number of employees in its target market and multiply that by pricing to estimate its TAM.

You can probably see where this is going: in the ideal case, the company is able to carefully explain why certain categories of companies will use its solution, excluding those that aren’t likely to. For example, a mid-market provider might use employment statistics to find how many employees work at firms between 100–5,000 employees, and then adjust for blue/white collar mix if it predominately sells to white-collar firms.

This turns the TAM discussion from a simple statement of industry size into a much more interesting discussion: breadth of potential product market fit. Instead of an inarguable statistic, the TAM number is built up with assumptions about which types of customers the company can serve and win. For example, a company might describe the breadth of its current customer base in terms of industries and geographies as evidence that the product works broadly, and then cite how the product roadmap will gradually take it up-market or into new verticals, each with a corresponding TAM estimate.

In Uber’s case, the company might have used early data from San Francisco to show how diverse its ridership was and estimated total long term potential ridership and rides/user based on early usage rates. Assumptions on top of assumptions, but nonetheless valuable things to think through as the company expands. For example, if Uber could show with some survey work that its early customers were using the product more than they had ever used cabs, it would have a credible argument that its eventual TAM could be larger than that of the incumbents.

Value theory, using conjecture about buyer willingness to pay.

Value-theory, which takes the form of “here’s how much value we can add, and why we’ll be able to capture it.” This is where things become more of a dark art, but are nonetheless useful. A value-theory TAM relies on an estimate of the value provided to a set of users by the product, as well as a guess at how much of that value creation can be captured through pricing.

Here’s how we might estimate Uber’s TAM using value. We’d consider the use case, transportation, in which users choose between alternatives including staying put, walking, public transportation, biking, taking a taxi or driving themselves. Notice that Uber has the potential to draw from ALL of these buckets, and indeed it seems to. We might look at transportation data and ask the theoretical question: “how much would a user pay to be driven instead of X?” and solve for a number. Next, we need an argument for how much of that value unlock we can capture with price. If a startup sells a soon-to-be-commoditized product that adds a ton of economic value, it may struggle to capture that value and see the benefits accrue to customers.

This approach often comes to the fore when companies are considering expanding their core product and cross-selling into existing customers as part of a long term strategy. Many pitches include some version of this, implicitly or otherwise, because big parts of the product are yet to be built. What is helpful is that this approach helps management teams show that they are thoughtful about what customers find valuable and are willing to pay for.

Unsurprisingly, We strongly recommend using frameworks #2 or #3 and turn their TAM slide from a set of meaningless numbers into a structured model for the potential future scale of the business.

Of course, we know that over time TAMs and plans change and that startup decks are often an almost silly attempt to predict the future, which is why we place so much emphasis on backing great teams. Demonstrating an intelligent approach to thinking about the potential future size of the business is a great way to provide proof-points that a team has what it takes to guide a company to epic scale: ambition, smarts and the ability to identify markets where there is customer willingness to pay for a better solution.

Give us a visit at our website https://tyketech.squarespace.com/

In case of queries, write to us at Contactus@tykeinvest.com

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Tyke is a private investment platform where startup investments start at INR 5,000

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Tyke

Tyke is a private investment platform where startup investments start at INR 5,000