TAM is a way to quantify the market size/ opportunity. But using the size of an existing market might actually understate the opportunity of new business models: For example, SaaS relative to on-premise enterprise software may have much lower average revenue per user but more than make up for it by expanding the number of users, thus growing the market. Or, something that provides an order of magnitude better functionality than existing options (like eBay relative to traditional collectible/antique dealers) can also grow the market.
While there are a few ways to size a market, we like seeing a bottoms-up analysis, which takes into account your target customer profile, their willingness to pay for your product or service, and how you will market and sell your product. By contrast, a top-down analysis calculates TAM based on market share and a total market size.
Why do we advocate for the bottom-up approach? Let’s say you’re selling toothbrushes to China. The top-down calculation would go something like this: If I can sell a $1 toothbrush every year to 40% of the people in China, my TAM is 1.36B people x $1/toothbrush x 40% = $540M/year. This analysis not only tends to overstate market size (why 40%?), it completely ignores the difficult (and expensive!) reality of getting your toothbrush into the hands of 540M toothbrush buyers: How would they learn about your product? Where do people buy toothbrushes? What are the alternatives? Meanwhile, the bottoms-up analysis would figure out TAM based on how many toothbrushes you’d sell each day/week/month/year through drugstores, grocery stores, corner mom-and-pop stores, and online stores.
This type of analysis forces you to think about the shape and skillsets of your sales and marketing teams — required to execute on addressing market opportunity — in a far more concrete way.
It is important not to “game” the TAM number when pitching investors. Yes, VCs seek to invest in big ideas. But many of the best internet companies sought to address what appeared to be modest TAMs in the beginning. Take eBay (collectibles and antiques) and Airbnb (rooms in other people’s places); in both these cases, the companies and their communities of users took the original functionality and dramatically expanded use cases, scaling well beyond original market size estimates.Posted by