Lesson #284: How To Calculate Your Total Addressable Market Size

January 04, 2018


I have written many posts about the importance of determining your industry size for strategic planning or investor pitch purposes.  But, determining your industry size is not always easy, and more importantly, determining your total addressable market (which I will define later), is even more important and an even more nebulous calculation.  So, here is everything you need to know to make sure you are correctly calculating your total addressable market and going after the biggest total addressable market you can (which will attract more investors for your business).

THE DIFFERENCE BETWEEN INDUSTRY SIZE AND ADDRESSABLE MARKET

In this lesson, let's use the example that we are selling social media marketing software into small businesses.  If you go to Google to search for "marketing software industry size", you will stumble on many industry research reports written by professional research firms, that estimate the marketing software industry was approximately a $37BN market size in 2017, on a global basis.

Many entrepreneurs will just stop there, and say they are serving a $37BN industry.  But, are you really?  First of all, you are not selling globally today, you are most likely only selling in the U.S.  And, with the U.S. around 30% of the global market, your market size just cut to $11BN.  And, you are only serving social media software, not other types of marketing software.  So, estimating that social media only makes up 20% of all marketing software, that means your market has just cut down to a $2BN market.

But, it doesn't stop there.  Perhaps half of the social media marketing software business is for managing free social communications, and the other half is focusing on managing paid social media advertising campaigns.  Let's say, you only do the latter, so now your industry size is down to $1BN.  But, remember, we only serve small businesses, not large enterprise-scale corporations.  With small businesses comprising 50% of the U.S. economy, now you are down to a more realistic $500MM total addressable market size.

Furthermore, assuming there will be plenty of big competitors going after this exact same space, it is unlikely that you will ever drive in excess of $100MM in revenue, with a hefty 20% market share in this space.  So, don't show your revenues ever getting larger than that . . .  unless you broaden your product offering or expand your target client base or take your business global.

THE DIFFERENT WAYS TO CALCULATE TOTAL ADDRESSABLE MARKET

There are a few different ways to calculate total addressable market size.  The above example was a TOP DOWN look, starting with the overall industry size and paring it back to the market you are actually serving.

A second way to calculate it would be BOTTOM UP.  That would start with actual data from what you are actually selling today, and grossing it up for your potential future selling efforts.  Let's use this same example as above, and take a bottoms up look.

Let's say you have been in business for a year and already have $1MM in revenues at a selling price of $25,000 per customer (serving 40 customers today).  Let's say there are 16MM small businesses in the U.S., but only half of those are B2C marketing driven companies (taking us down to 8MM B2C small businesses).  But, only 10% of them would ever be able to afford a software like this, since the average small business only does $5MM in revenues.  So, there are 800,000 potential customers over time.  Of which, you would not be able to get more than 20% market share, so 160,000 potential clients of yours.  So, that suggests a total addressable market of $20BN (or $4BN to you with a 20% market share), as your current $25,000 selling price.

A third way to calculate total addressable market would be the value-created model.  That says your solution is going to help your customers drive additional revenues, or save future costs, and they will share a portion of that with your business.  So, let's say there is $30BN in social media advertising spent every single year in the U.S., half of that by small businesses, or $15BN.  Let's say your software can save them 10% on their marketing expense, with better efficiency from your tool.  So, $1.5BN in value created.  And, let's say you sell them on giving 10% of those savings to you, creating a $150MM market opportunity for you and your competitors (and a $30MM revenue opportunity for you, assuming you get a 20% market share).

NOW COMES THE SANITY CHECK

We tried to calculate the total addressable market in three different ways, and got three completely different answers.  Top down suggested $500MM, bottom up suggested $20BN, and value-created suggested $150MM.  We obviously were too aggressive with our bottom up thinking.  It is not rational for us to serve a $20BN market in bottom up analysis, when the overall marketing software industry in top down is only $11BN.

So, I would go back to the drawing board on bottoms-up, or ignore it altogether.  On the second try, I would cap it based on how many sales people I can afford to hire in the next five years.  So, if we have 20 sales people in year five, each doing $1MM in sales each, that suggests your business is $20MM in size and serving at least a $100MM market.  If not more, as you will most likely not have a 20% market share as early as your fifth year.  Maybe you only have 5% market share by then, and the market is really $400MM in size.

That leaves us with two reasonable numbers with the top down and value-created analyses.  But, two thoughts here.  First, I would always lean towards the lower number, to be conservative, or the $150MM value-created number in this case.  And, second, I would also lean to a bottoms-up or value-created number, over a top down number, as those are more real based on known data points for your business, as opposed to pie-in-the-sky estimates from the industry research created by an analyst you don't know is any good, or not.

WHAT DOES THIS ALL MEAN FOR YOUR  BUSINESS & FUND RAISING

So, hopefully, you know have a better understanding on how to calculate total addressable market for your business.  Stop embarrassing yourself with inflated numbers trying to impress investors.  They will be more impressed with your more scientific, data-driven approach to a more conservative and realistic number.  So, put that number in your investor presentations.

But, in all cases, venture investors are trying to build $1BN companies, so if you can't reasonable build them $100MM revenue company that can be sold at a 10x revenue exit multiple, you might need to either expand your product offering to attract more revenues, or know that your business will most likely not attract venture investor attention.  So, in this case, the value-created model only gets us to $30MM in revenues.  That will not be enough.  Back to the drawing board, if venture investors are what you are looking for.


For future posts, please follow me on Twitter at: @georgedeeb.


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