Market size matters for investors

Size matters

Starting a new venture means exciting and busy times ahead of you. Chances are that you will need to convince investors that your business has a bright future. One of the most important things investors want to know about is the size of your potential target market. Here is how to assess your market.

A Growing Market

Investors are interested in growth. They need to see that by supporting your startup, they will make a sizable return on their investment. Showing potential third-party investors, such as venture capitalists, that you are worth backing, starts with proving that your market is growing.

There is not only one way of assessing this. Looking at your overall industry is one starting point. Identifying key trends and looking at the opinions of industry heavyweights and influencers is worthwhile. Check statistics for industry growth over a number of years.

Beyond your industry, consider the economic environment you are operating in. Are investors confident, or are they waiting to see how leading economies are developing?

The answers to these questions will get you started in your analysis.

TAM, SAM, SOM

If you are a technology startup with a product that doesn’t exist yet, you may find that overarching industry trends are not ideal for assessing your market size. TAM, SAM, and SOM are acronyms for a complementary methodology that helps you clarify the size of your market.

TAM – Total Addressable Market

Your total addressable market puts a figure to the total market demand for a product or a service. Imagine you are operating worldwide and have no competitors – only in that scenario would you be able to reach this entire market.

TAM is a great place to start, but it is not a realistic figure for an early-stage business.

SAM – Serviceable Addressable Market

SAM narrows the size of the market identified in the previous stage to the number of people or businesses you can realistically reach over time.

If your startup relies on a physical product or a service, you will likely have geographic limitations. For example, your product may be useful nationwide, but at this stage, you can only roll it out across five states. These five states are your SAM. They become your targets for business growth.

On the other hand, if you are developing a software as a service (SaaS) product, geography may not slow you down. Instead, your app may be limited by only running on Android devices. In this case, Android users would be your target market.

SOM – Serviceable Obtainable Market

SOM narrows down your market even further. Your serviceable obtainable market refers to those people or organizations you can reach in the short term.

Considering your competitors and your own production capacity, for example, will help you make a realistic prediction here. If your market is already crowded, you will need to show how your product or service can cut through the noise and stand out.

How To Use TAM, SAM, And SOM

Broadly speaking, you can use this model in two ways to establish the size of your market: top-down and bottom-up.

Using the top-down method, you start with broad predictions of the market’s or the industry’s growth. Statistics or reports from global consulting firms help with this step. From that basis, you segment the target market and narrow it down. Eventually, your segmentation arrives at your sort-term targets.

The bottom-up method begins by taking limiting factors into account. It then expands the market potential of a business. This method can take longer as it requires more detailed data. However, it often results in more accurate figures, although they tend to be smaller.

The top-down approach carries the risk of over-estimating and over-promising. A combination of both works best for most startups.

As an entrepreneur, you need to understand how your business model impacts each of these three categories. Perhaps you can modify it to give you a better chance of success.

Investors are not only looking for big numbers under the TAM category. Venture capitalists are just as interested in understanding how well your product fits into an existing market (product-market fit or PMF). They also consider how quickly you can enter your market and reach your short-term targets.

CAGR – Compound Annual Growth Rate

Here is another indicator of an investment’s potential of delivering excellent returns – its compound annual growth rate. CAGR answers the question of how much a market will grow every year.

CAGR is a mathematical formula that predicts the development of a market and takes compounding growth into account. Don’t let the formula put you off. Especially if your existing TAM is relatively small, high CAGR can indicate that now is the time to enter this market.

Remember the saying that when everyone talks about an investment it’s too late to enter that market? Calculating CAGR helps investors avoid that pitfall and gives them the advantage of entering a market before major growth spurts happen.

Back To Your Business

TAM, SAM, SOM, and CAGR are useful tools to help founders, entrepreneurs, and investors assess the market potential of a business venture.

Each of these tools and approaches has its own advantages and limitations. Understanding those and how they apply to your business is important to help your startup grow. If you are preparing a pitch for third-party investment, these tools allow prospective investors to gauge the return on their investment.

It’s important to be realistic when assessing your market. Consider the reasons behind its growth (potential) and identify the causes driving this growth. It’s rare to see unlimited growth over long periods. Predicting future developments and having a good command of the dynamics at work in your market will help you make solid decisions for your company’s future.