Get investors excited about the opportunity without losing credibility
The investor pitch usually starts with problem and solution, followed immediately by market size.
This gives the market size huge importance in the presentation, and for good reason. There are a plenty of great products that fill unmet needs, but unless there is a huge market, they fail as investments.
That doesn’t mean these solutions won’t make solid, profitable businesses, only that they won’t grow to the size needed for a huge acquisition or IPO.
If you’re creating a consumer product, an organic cola for example, I’m not concerned about the market size. I’m sure it’s well into the billions.
But if you’re building a B2B product, or a niche consumer product, my biggest worry, the reason most of my investments fail, is whether the market opportunity is big enough. You’ll have to convince me.
The standard format for breaking down the market size for investors is the TAM/SAM/SOM. The SOM (Service Obtainable Market) — the revenue you expect to generate once you’ve fully saturated the market — is the only number that matters, but we want to see your assumptions in a top down analysis to get to that critical opportunity size.
TAM — total addressable market — is the size of the market for your specific product. It is NOT, as often presented, the size of the entire sector.
Making a network simulator? Don’t try to wow me by quoting $45 billion as the size of the software testing market. That huge number includes testing services, QA software, traffic generators, and many other products and services that aren’t network simulators.
It’s a big, impressive number, but tells me nothing about the market for network simulators. Quoting that number feels like you’re trying to mislead me into thinking there’s a bigger need for this niche product.
Making an organic cola? I don’t care about the size of the drinks market, or even carbonated beverages. The market you’re taking share from is colas, so that’s the total addressable market.
But is that really true? Are you competing head on with Coke and Pepsi on the shelves of Safeway? Or is your go-to-market to compete in the organic drinks space? If so, that’s a different market with a different TAM.
(Hint: large market sizes sound impressive, but you never want to have a tiny share of a big market. It’s far better to be the leader in a narrower market.)
Next, we narrow down our total market TAM to the SAM — the Service Addressable Market. This is the segment of the market that we can actually reach.
Why can’t we reach the entire market? Here are a few common limitations:
- Economic constraints: are there parts of the world that can’t afford our product?
- Regulatory issues: are we allowed to sell it everywhere?
- Language or cultural issues: is our product easily adapted for every different market?
- Features and capabilities: are there parts of the market that require different features than our product is designed for?
The network simulator market is divided between expensive devices built on proprietary chips, and lower precision devices built on standard CPUs. Of the total market for network simulators, only 10% can be reached with devices built on CPUs. That brings a healthy $1B TAM down to a somewhat anemic $100M SAM.
Lastly, we need to determine the number that actually matters — the SOM — the Service Obtainable Market. This is how much revenue we can realistically expect to generate eventually.
To calculate the SOM, we determine how many of the potential customers in the SOM will realistically use our product. In other words, our market share considering the competition.
Yes, there may be a $25B opportunity for organic colas, but there’s bound to be a lot of competition. Even if there isn’t any competition now, once we’re selling hundreds of millions of dollars per year, there’s guaranteed to be a Coke Free and Pepsi O, plus dozens of other competitors lining up to eat our lunch.
How large can our organic cola business actually grow? After analyzing the growth of La Croix, Hint, White Claw, and other drinks startups including from the adjacent alcoholic drinks market, I’m confident that if we do everything right, we can eventually reach $2B. That may only be 10% of the market, but that’s still huge.
The network simulator market? That’s more of a challenge. Even with a $100M SAM, there’s multiple competitors and plenty of crappy freeware available for customers to build their own. With a better product and great marketing, I think we can reach a heroic 40% market share. Unfortunately, that’s only $40M, too small for venture investment, so we’ll have to find another way to fund the business.
The SOM is how much revenue we expect to generate annually once we’ve fully saturated the market.
The 5 year revenue projections therefore should approach the SOM as the limit. It might take 3 years to get there or it might take 20, but we should eventually reach market saturation. From that point, growth is limited to the market CAGR.
These 2 pieces of the pitch — the SOM and revenue projections — need to fit together. The SOM tells us the size of the opportunity, the revenue projections tell us how long and how much it will cost to get there.
Sometimes I see pitches that show projected revenues larger than the SOM. That’s a head scratcher.
More often, founders start the pitch with claims of a market in the tens of billions, then show revenues that only reach the low millions. I have to assume the market size is bullshit and you’ve lost credibility.
Founders are usually advised to find market data from industry reports. That’s fine if you’re making drinks to compete with Coke or developing new batteries to replace Li-Ion, but useless for almost anything else.
Most startups are either creating something new, for which there isn’t already a distinct market, or are building a niche product for which there isn’t any data.
So most founders will have to do their own analysis. The market size slide seems simple, just a diagram of 3 bubbles. But getting the information to estimate the TAM/SAM/SOM can take deep industry knowledge and weeks of piecing together estimates from customers, distributors, industry experts, and other sources.
Here are a few shortcuts I use to determine the market size:
- Estimate the number of potential customers for a new product and how much each would be willing to pay in a bottoms up analysis.
- Narrow down a broader market, like drinks in general, and estimate how much of that is applicable to your submarket.
- Talk to distributors to estimate market shares and revenues.
- Analyze the annual reports for public company in the sector. Examine the detailed notes for their breakdowns by product lines. If you can find the revenue of the market leader and can guess their market share, you have the market size.
- Find complementary products that customers would use together with yours. The same people who need network simulators also need traffic generators which is a bigger market with more available data.
- Find revenues for similar, non-competing products that have followed a similar path. A good way to estimate the market size for an organic cola is to examine the revenues of La Croix, even though they don’t make a cola.
Investors don’t expect market size estimates to be accurate. We understand the difficulty of estimating revenues for a market that doesn’t exist. Like much in the pitch deck for early-stage startups, it’s about the story. Is there a big enough need for this product, who are those target customers, and how do you plan to reach them?
For consumer products, I’m not concerned about market size. It’s huge. I’ll focus on the go-to-market strategy which is the biggest challenge for a consumer product.
But for B2B and niche products, the biggest cause of failure is that the market isn’t large enough to reach critical mass. That means for investors, the market size is more important than the product itself. Make sure to work through the TAM/SAM/SOM and show how there’s a large enough market to generate a big return from our investment.
