Total addressable market (TAM) is calculated with two methods: top-down, where you start from an industry-wide revenue figure and narrow it down, and bottom-up, where you count your actual reachable customers and multiply by expected revenue per customer. Bottom-up is generally more reliable because top-down numbers tend to include revenue you could never realistically capture. Once you have TAM, you narrow it further to SAM (serviceable addressable market) and SOM (serviceable obtainable market) to get a realistic view of what you can actually win.
Market size is one of the key factors founders need to evaluate and take into account when they want to start a new venture, launch a new product, or branch out into a new market. Understanding how to identify the biggest opportunities in the market can help founders make more informed decisions and ensure they’re targeting the right niche for growth. Assuming that the target market is much larger than it actually is is one of the biggest mistakes a founder can make. Below, we will explain how you can accurately evaluate the size of your market.
Evaluating the Size of Your Target Market
There are several metrics you need to calculate when determining the size of your market:
- Total addressable market (TAM)
- Serviceable addressable market (SAM)
- Serviceable obtainable market (SOB)
Calculating the Total Addressable Market
Before you can start measuring the total addressable market for your product, you need to determine who your key target customers are. Then you can use a top-down or bottom-up method to carry out the market size evaluation.
The Top-Down Method
The top-down method involves using publicly available information to calculate your market size. While this method can be quite convenient and easy to use, it can often cause you to overestimate the size of your market, so you need to be extremely careful and diligent.
Let’s discuss this approach using an example. Say you’re building a cybersecurity or IT services offering aimed at small and mid-sized businesses that don’t have an in-house IT team, the kind of company a managed service provider (MSP) typically targets. In this case, a lot of the publicly available data you may find will lead you to overestimate your market share. For example, if you see reports stating that the managed IT services industry is worth tens of billions of dollars globally, you can’t simply assume that that is your market size. This is because this number constitutes the revenue earned by the entire industry, including large enterprise contracts, national and global providers, and adjacent services you don’t offer. So it doesn’t represent the amount of money your actual target segment, small and mid-sized businesses without an internal IT function, spends on the specific services you sell.
However, you will be in a much better situation if you can find information regarding the amount of money businesses in your target segment spend on IT services in general, or better yet, on the specific service category you offer (helpdesk, managed security, cloud migration). Then you can try to calculate your total addressable market by taking into account the proportion of businesses in your region or vertical that fit your ideal client profile.
The Bottom-Up Method
As you can see from the previous section, the top-down method leaves a lot of room for mistakes and overestimation. As a result, most business experts and investors prefer to use the bottom-up method when calculating the total addressable market. When you’re ready to scale your business, learning how to find small business investors can be a crucial part of your growth strategy. Under this approach, you will need to calculate the number of your key target customers, estimate the average annual revenue your company can get from one customer, and multiply the two values together to get the total addressable market. When valuing a business, another reliable approach is to use a revenue-based valuation to get a more accurate picture of its potential.
The first step is to determine the number of key target customers for your product or service. For an MSP or agency, that might mean finding the total number of businesses in your target region or vertical, then estimating what share of them fit your ideal client profile, headcount range, current IT setup, or budget tier. Alternatively, you can and should use the data obtained by your own team to carry out accurate calculations. For example, if you know how many qualifying businesses there are in the territory you already serve and what percentage of them fit your ideal client profile, you can then use this data to estimate the number of key target customers across the wider region or vertical you want to expand into. Once you have this data, you will need to multiply the number of key target customers in the market by the average annual contract value one client brings to your company.
Evaluate Results Obtained Using Both Methods
If you have done your calculations using both the top-down and bottom-up methods and got drastically different numbers, you will need to use your intuition and knowledge of the field to figure out which number closer represents the truth. Of course, you can always simply take the average, but it can sometimes lead you to overestimate your market size. Remember that being overly optimistic with your market sizing efforts can lead you to develop a faulty business model that doesn’t work, which will likely cause your company to have a hard time raising money from investors. It’s much better to underestimate your market size than to overestimate it if you want to ensure that your business stays afloat.
Calculating the Serviceable Addressable Market
Unfortunately, there is no universal set of instructions for calculating the serviceable addressable market, as this process will largely depend on the nature of your business and the market where you operate. Thus, you and your team will need to use your understanding of the market to evaluate what portion of the total addressable market your company can theoretically service. For example, if you have found a channel that reliably brings in clients (referral partnerships, a specific vertical, a geographic radius you can service on-site) and discovered that certain other channels absolutely don’t work for your business model, you will need to exclude prospects reached through those channels from your serviceable addressable market.
Calculating the Serviceable Obtainable Market
While every company generally strives to capture as much of the market as possible, you will never be able to sign on 100% of the serviceable addressable market as your customers. As a result, you need to realistically evaluate what market share your company can capture. For example, you can use your close rate as a rough estimate of the potential market share your company can reach, provided you are able to get in touch with all businesses that make up the serviceable addressable market. You should also keep a close eye on your competitors and understand what portion of the market they can capture.
Think About the Bigger Picture
Having a good understanding of the market size is crucial for creating a robust business plan, but it’s not the only thing you need to take into account. It’s also important to consider profit margins and market dynamics. Naturally, a business with large profit margins and a growing market will be much more viable than a company entering a diminishing market with razor-thin margins.
You should also keep in mind that most markets, tech and B2B services alike, are ultimately left with a handful of leaders and a long tail of much smaller followers. So unless you can achieve a defensible position in your niche, it will be very difficult to create a massively valuable company. This is why you need to be extremely rigorous and realistic when sizing up your market and planning your business strategy, as it is your key to success.
Key Conclusions
- One of the biggest mistakes a founder can make during the early stages of building a business is assuming that their target market is much larger than it actually is.
- You need to define your key target customers before you can calculate the total addressable market, serviceable addressable market, and serviceable obtainable market.
- It’s crucial to remain as realistic as possible and avoid inflating your numbers when evaluating market size. Otherwise, you risk betting your time, effort, money, and reputation on a business that’s not viable from the start.