The cardinal rule of the venture capital industry is to invest in startups with big TAMs (Total Available Market). Most founders know that. They try to find solutions to big problems. And they should spend time finding out the market size of their problem once they have identified the problem.
VCs love big opportunities. They invest in startups with big TAMs or rapidly growing TAMs. The startup can grow into a big company with hundreds of millions of dollars in revenue if it builds products with a big TAM.
TAM in simple words is the potential market size of a particular startup. A large TAM means the startup has a theoretical chance of becoming a big company. While no company can capture 100% TAM, if a startup can obtain 5% of its TAM in 10 years (a realistic scenario), it will achieve significant revenue and valuation.
TAM increases with time as the economy grows. Sometimes TAM of a particular startup can become 10x because the startup's unique business model makes it a competitor in related industries.
Uber is a prime example. It created a TAM that didn't exist. Its original TAM was the US Taxi market because it was competing with Taxi companies. But as its popularity increased, Uber became an alternative to car ownership. Millennials stopped buying cars because Uber was cheaper and more convenient. Suddenly, Uber's TAM became 10x because it was competing with new cars.
But sometimes a rapidly growing TAM is also fine. Take Amazon. When Amazon started, the market size for online book delivery was tiny because the internet was a niche service. But Amazon's TAM multiplied with the exponential growth in internet users.
While there is no standard definition of a large TAM, most VCs prefer a TAM that is at least a few billion dollars ($5 Bn or more). A $5 Bn TAM means that if the startup becomes a dominant player, it can achieve a $250 Mn revenue (5% of $5 Bn). $250 Mn revenue translates to at least a Billion dollar valuation and the coveted unicorn status.
Startup Valuation = A fixed multiple of its annual revenue.
This multiple typically varies between 5x and 25x depending on industry growth, competition, startup unit economics, etc.
The most successful startups already had large TAMs when they started and their TAM also grew exponentially with time. Google’s TAM (online search and advertising) was big when it started, but no one predicted it to grow the way it did. But the TAM was already large enough to attract VCs at the start.
How to find TAM for a new startup?
If you've seen a startup deck, chances are you have come across a slide on TAM. Marketing analysis and sizing are taught in every business school. Marketing professors teach students how to calculate the market size and revenue potential for businesses. Since VCs want to see big TAMs, all startups try to show a big TAM. In most cases, founders use data from some report or news article about the industry size. They don't check whether the market size is correct or the industry is right.
And we can't blame them. Founders are too busy with other stuff to spend time on academic exercises like market sizing. But founders should spend time estimating TAM. Even if you don't want to raise venture capital, it is imperative to know the magnitude of the problem you are solving.
Few founders identify a problem, estimate its market size and then build a product. Most have an idea or a product in mind. They are so sure that it's the best problem to solve that they convince themselves that it has a big market. So, we get founders convincing themselves and their potential investors that the opportunity is massive.
Most problems indeed have a big TAM if you define them broadly. And a $2 Bn TAM or a $20 Bn TAM doesn't make much difference in the early stages. You are anyways going to capture a fraction of it, if at all. So as soon as some founders arrive at a big TAM through some internet browsing even though it's incorrect, they use that number in their deck. They don't care about the accuracy of that number.
I am not saying you should invest months in figuring out their market size. That would be stupid. But we help many startups and founders prepare their decks and financial plans. And we spend some time finding true numbers. We also question founders' hypotheses regarding market size because it's a valuable exercise. It makes founders challenge their existing notions and find more accurate answers.
Let's say you want to create a packaging solution for the automobile industry. The carmakers can use your product to ship components from their suppliers to their factories and from their factories to dealerships. How big is the TAM in India?
You should start with the annual revenue of the Indian automobile industry. Revenue includes both domestic consumption and exports. Our target is the domestic market.
The automobile industry has several listed companies. You can download the annual reports from their websites. Annual reports have financial information (Balance Sheet, P&L, Cash Flow, etc.) that details the revenue and expenses.
Once you read a few annual reports, you will understand the supply chain of automobile manufacturers. You will know how much they spend on their supply chain (warehousing, packaging, logistics, etc). You should also speak to a couple of automobile consultants.
You want to know how much companies spend on packaging as a % of their revenue. You will get a good estimate if you analyse the financial numbers of a few carmakers. This number multiplied by the total domestic revenue of the industry is your TAM.
Here is an example of the Indian Auto Industry.
Annual market size = $200 B
Domestic share = $150 B
Total Supply Chain spend = 3%
Packaging spend = 1%
TAM = $1.5 Bn
This TAM will grow as the automobile industry grows. But this is a good start. Compare this TAM with the industry reports. If both numbers are close, this is a reasonable estimate. Otherwise, speak to more experts and do more number crunching.
Why is TAM research important?
A good deck is critical for raising venture capital. You should spend time researching while making the deck. Research helps in finding the right answers. It helps if you know everything about the industry, market, competition, product, etc. before you approach a VC. You come across as better informed than everyone else. Investors like such founders.