Defining your TAM, Total Addressable Market
TAM or Total Addressable Market is something VCs care a lot about. Too small and VCs get scared off. Too big and you might be trying to boil the ocean and haven’t picked out a specific customer.
But what I want to talk about is what TAM actually means. I see a lot of presentations that conflate TAM with TM and unfortunately that “A” in there is really critical. For instance, you’re an e-commerce company that plans on selling infant diapers online, InfantDiapersDirect.com. You could say, “Consumer Packaged Goods are a $2 trillion Industry!!!” But that’s not fair and you’ll only come off looking like you either tried to BS or didn’t understand what you were talking about. Unfortunately, we see this a lot…
Sure, you may eventually plan on selling more than infant diapers, but you have to define TAM for the foreseeable future. In our example, VCs are interested in knowing how big the US diaper market is (as measured by annual retailer revenues since you are a re/etailer). What % of that and $ value are infant diapers? What is the year to year growth rate? What is the average gross margin for retailers and etailers? Let’s suppose it turns out diapers are a $27 billion US market and Infants (and you always want to explicitly say how you define your market, in this case take 0-12 Months) are a $5 billion market. HOWEVER, only some customers will buy online for various reasons, so your addressable market will be smaller, let’s say 50% for the sake of argument. It is obviously your job as the entrepreneur in this example to figure out precisely what percent will be willing to shop online and justify that estimate with great research (ideally, both first-party and secondary). This is especially hard and important for new to the world / new to your customer segment products & services (ie if no one had ever bought a diaper online or online through a subscription service.)
We have arrived at a reasonable TAM, which happens to be $2.5 billion. This is what the VC was looking for. He or she will likely also want to know the gross margins and growth rates associated with the TAM as well as what percent of the TAM you think you can capture (ie market share) as obviously any incumbents or other startups may take share as well. You don’t have to bake in your assumption about market share into TAM because that would simply yield / approximate your revenue and not the TAM!
Now let’s suppose that TAM turns out to be $100mm instead of $2.5bn. This will be “too small” for most VCs (though maybe not all angels). What should you do? Well, potentially nothing. If you really want to build an awesome niche business, don’t let any VC steer you wrong. There are plenty of businesses that make tons of cash and make their founders very rich off of niche applications (thermometers for milk storage containers and trucks anyone?). But be prepared to be turned down by a lot VCs quickly and don’t let it damage your psyche. Another possibility is broaden your idea. Are you thinking too narrowly? Going back to our previous example, is there any reason to only sell infant diapers? Won’t the same customers who buy infant diapers buy other sizes as well? Perhaps you broaden the idea / TAM and become Diapers.com. But whatever you do, whether the market is tiny or huge, please don’t misquote the TAM.