I’ve heard this sentiment more than once over the course of my career: “Market size is a made-up number.”
And the facts support this.
Consider Uber. (A business we'll cover in-depth here.) The ride-hailing company's first investor pitch deck estimated its market size at $4.2 billion. That's a far cry from the corporation's valuation of $147 billion today.
Far more common than this example is a vast overestimate of a business's likely market size (and market share).
But market-sizing exercises, even when the results are off and don't align with initial forecasts, have real value in surfacing key business assumptions, including those around customer segmentation, business model, and pricing.
What is market sizing?
Market sizing is the exercise of estimating the number of people who could feasibly be customers for a given product or service. In other words, they estimate the size of their buying audience in their target markets.
Startups often calculate the market size for their offerings by multiplying the total number of potential customers by their possible penetration of a given market (i.e., the likely revenue that could be generated from them).
Accurate market-sizing requires knowing the potential market size of the customer base (i.e., the total sales opportunity). This could be by geography (e.g., in New York City or the United States) or industry and vertical (e.g., the healthcare sector or sub-sectors, like pharma, biotech, or life sciences).
- Some companies use a bottom-up approach to market sizing. They establish the product and pricing model, then figure out the revenue they could generate by finding target audiences who could buy from them.
- Others use a top-down approach. They take a macro view of the market, see how much estimated revenue is currently generated by incumbents, then zero in on one or more markets they could realistically target.
The more specific and granular a startup's market segmentation is, the easier it is for them to forecast the number of customers they could theoretically secure in the first six months, year, two years, and beyond.
When venture capital firms look at market sizing, they often want to ensure two things:
- Entrepreneurs’ clarity of thought regarding key business assumptions
- Amarket big enough to support a big company.
So, how can you ensure your venture-building team — whether you're a corporate-backed venture studio or university-endorsed innovation hub — can conduct thorough market research that helps you determine the likely market size (and potential revenue) for your prospective startup?
It starts with comprehending a few highly important three-letter acronyms.
TAM, SAM, and SOM: A breakdown of these common market-sizing concepts
There are many methodologies out there for estimating market size.
That said, Total Addressable Market (TAM), Serviceable Addressable Market (SAM), and Serviceable Obtainable Market (SOM) are the go-to market-sizing assessment criteria early-stage entrepreneurs tend to utilize most.
Pear VC’s recent survey of 30 investors found TAM and SAM, in particular, are the top metrics for estimating a startup's ability to scale at the seed stage. That’s likely because other metrics (e.g., projected revenue) offer false precision at this stage, when even the pricing model may not be tried-and-tested.
But there’s a caveat to the importance of these market-sizing barometers: They only help as long as your methodology around them is clear.
Any entrepreneur can put three big numbers on a page. However, it takes a lot of research and footnoting to reflect what each number really means. Pear VC's poll also discovered that more than 25% of seed-stage investors only roughly know the true definition of TAM, SAM, and SOM (or simply find that definitions seem to vary).
That percentage only rises further in later funding stages. Given the ambiguity, a solid market-sizing approach puts clarity above all else. Here's a bare-bones breakdown of what the three metrics truly mean.
Total addressable market
This is basically a top-down estimate of the total market size that the company plans to build in. In other words, TAM is the “the overall revenue opportunity that is available to a product or service if 100% market share was achieved," Highline Beta Founding Partner Ben Yoskovitz recently wrote.
Back to Uber. The company likely searched for the taxi and limousine market TAM worldwide, as evidenced by the data from the aforementioned deck.
This example alone (in hindsight, at least) shows one of the challenges with TAM, given Uber’s sizable (and growing) valuation. Many startups are "category creators," so there isn’t an easy phrase to Google to discover the likely TAM.
Like Uber, other category creators (and especially early-stage startups) may settle for a 'good-enough' estimate of their total addressable market.
But even this acceptable estimate can expose an entrepreneur’s early thinking, and serve as an opportunity to show clarity of thought. For instance, when estimating TAM, Uber had to show clarity of thought on several points:
- Who is the competition (taxis, limousines, private shuttles, public transit)?
- What is the long-term plan (bike share, service/goods delivery, trucking)?
- What is the ideal operational territory (U.S., North America, international)?
- How much is the TAM expected to grow within ~5 years (1%, 10%, 50%)?
When thinking about the questions TAM raises, a narrative of geographic and product expansion and market growth should begin to emerge. By breaking TAM down, venture capitalists can better parse out the pieces of the business story and build their own hypothesis on the validity of the concept.
Serviceable addressable market
Simply put, SAM is a facet of TAM that can likely be served today by your proposed products or services, based on your business model and the actual, quantifiable number of households or companies who consume your offering.
Some startup builders hone in on factors like where a given product is used most, the demographics to most often use it, or some other form of segmentation.
For Uber, geography played a central role in forecasting its potential serviceable addressable market — but it was far from the only element it could have chosen to factor into its SAM.
Remembering its breakdown of TAM by product segmentation (retail vs. business, airport vs. non-airport), Uber could have used any of those criteria to make informed assessments about the idea's potency. Its choice reflects the narrative of the business: a city-by-city go-to-market strategy serving rideshare needs across use cases.
This metric, like TAM, pulls out some of the entrepreneur’s key assumptions:
- What does the market look like (segmentation, competitive landscape)?
- Who is the user (demographics, company size, geography, price point)?
- What’s the go-to-market strategy? (territory expansion, product roadmap)?
- What’s the company’s "edge"? (first mover advantage, product quality)?
These are questions someone can ponder for months and still not get right. Nevertheless, it’s crucial to find the middle ground between waving our hands and letting perfection be the enemy of progress.
Let's try another example.
Toast, the point-of-sale system provider, may identify its target customers as restaurants. It may also get more granular with this through SAM identification: "non-franchise restaurants located in the U.S in these 10 locations."
While “restaurant” is likely too vague in any instance, the ideal level of specificity varies by business and stage. The important thing is to have a working hypothesis about target market and keep refining based on new learnings.
Serviceable obtainable market
This is the part of the SAM that can be realistically captured and served in a five-year horizon.
It brings up even more clarifying questions for startup creators:
- What is the pricing model (monthly/annual subscription, freemium, per user, by tier)?
- What is the customer acquisition strategy? (inbound/outbound marketing, partnerships)?
- What is the expected user retention/churn (anticipated number of loyal/lost customers)?
Uber’s pitch deck points to SOM in different scenarios, though not strictly defining it. For example, what assumptions are part of the jump between 5% of the top U.S. cities to the projected $20M-$30M in annual profit?
Let's circle back to Toast too.
When mocking up an early pitch deck, the founders might have Googled “restaurant management software market size,” and found estimates ranging from $4.5B to $8B, chosen the most favorable, and multiplied it by a projected market share of 1% to get a top-down estimate.
This market-sizing estimate — unlike Uber’s — is fairly ambiguous. There isn’t much clarity of thought around what is and isn’t included in their target market, or even what the product/solution that could help said market is.
The takeaway?
Narrowing in on the distinct customer base you can feasibly serve first through a serviceable obtainable market exercise is ideal for your new business, as it helps establish an entry point into potentially loyal and/or high-paying buyers or subscribers who can get your company started on the right foot.
The key market-sizing question: How big does my market actually need to be for my startup to thrive and scale long term?
Venture capitalists and founders have an interest in the market being “big enough." You may hear $250M thrown around as the "right" number that can be cut once or twice and still make for a big SOM.
But it's essential to avoid this VC question: "Is that really your market?"
Whatever your market size is, be sure you can defend it. The best way to do so? Use an approach to market-sizing that navigates you to the key assumptions that will ultimately drive your business forward.
Skepticism surrounding market sizing is understandable, given the inherent uncertainties and challenges of the idea. Pre-seed stage, though, market-sizing exercises can unveil critical insights, if used correctly.
As exemplified by Uber's initial market estimation compared to its staggering current valuation, market sizing may not always yield precise forecasts, but it serves as a powerful catalyst for surfacing critical business assumptions.
