A Quick Primer on TAM
Total addressable market is calculated bottom up, not top down!
Top Down “TAM”
Top-down TAM estimates are at best futile. At worst, they betray a founder’s incomplete understanding of their customer and their market.
A top-down TAM estimate goes like this:
Pull an estimate of industry size in dollars from some global consultancy’s report
Determine what fraction of this big number is “addressable” and “obtainable”
Conclude that future ARR is indeed hundreds of millions of dollars
Add the 3-nested-circles diagram and the analysis might look credible. It’s actually meaningless.
It’s meaningless because all it says is that there exists some category of buyers (defined by someone else) who spends money on certain types of products (also defined by someone else). This is, at best, vaguely related to the question that the founder should be answering, which is: how much money can they make selling their product to their potential customers?
Global GDP is $106 trillion.If we capture just 0.0001% of this opportunity, we’ll make over $100 million in annual revenue.
Though I am only ten weeks into my VC career, I have seen dozens of decks where TAM is presented top-down thus achieving nothing towards the founder’s fundraising objective. That has motivated this short primer.
Bottom Up TAM
There is a correct way to calculate TAM. It’s not complicated, requiring just two numbers:
A. how many distinct people or businesses exist that you can sell to
B. How much can you charge each of themTAM is the product of these two numbers. That’s it.
You get A (customer count) by precisely defining the attributes of your customer and systematically determining how many people or businesses fit that profile. There is no meaningful TAM estimate that can be created without doing this exercise.
For example, your customer might be North American-based hotels with 100 rooms or less who are not affiliated with a major brand (Hilton, Marriott, etc). You and your AI assistant of choice will quickly learn that there are 11,500 of them.
You get B (price) from:
primary transaction data because you’ve actually sold your product a few times
primary research data because you’ve properly engaged with prospects and have a good read on the what they will pay for your solution
secondary data because you know what your direct competitors are charging for a similar solution sold to a similar customer
some other rigorous and reliable market research
Once you have A and B, one multiplication gets you TAM. It’s that simple. The work is all in the data collection.
For completeness, I will note often there may be several customer profiles and they might not pay the same thing as each other. In this case, the exercise needs to be repeated for each customer type. TAM is then the sum of these “component TAMs”.
Pitch Power
Apart from bottom-up being the only valid approach to calculating TAM, it also happens to be far more powerful as a tool of persuasion compared to some top-down hand wavy TAM/SAM/SOM cliché.
Sticking with our product for hotels, consider the persuasive power of being able to say this:
We’ve sold our MVP at $1200 per month to two different hotels. There are 11,500 other hotels that match the profile of our two pilot customers implying our TAM is $1200 * 12 * 11,500 = $165,000,000.
This message is so much more powerful than some stylized circle diagram starting with total IT spend by hotels in North America. Bottom-up TAM shows you know exactly who your customer is and exactly how big your market is. Furthermore, what you claim can be validated by a VC in about 30 seconds.
Actual Power
When a founder does TAM properly I’m impressed not because it gives me confidence in the opportunity size but because it shows me they truly understand their market and their customer. I know of exactly zero startups that succeed without this understanding.
Without the components of TAM there can be no credible sales strategy, no credible marketing strategy and probably no credible product road map. Abraham Thomas puts it more starkly: “defining your customer and their price point implies your go-to-market strategy.”
TAM is actually the tip of an iceberg. The part concealed underwater just happens to be the very foundation of the business. So, for pitching, bottom-up TAM is credible, persuasive, and—more importantly—the only valid way of taking the measurement. But the components of TAM also happen to be of existential importance to a startup and the reason why TAM is “required” in any pitch is not because VCs can’t figure out if the market is big enough. It’s there because it is the evidence that the rest of the iceberg is in fact present, below the surface.