This is the first in our series on how to grow your startup from seed stage (where you have developed your prototype with some angel funding) to being worthy of a series A investment.
The market size or total addressable market (TAM) is very likely the first filter any VC will use to screen your startup. If the TAM is too small, then your startup is an easy pass.
But in reality, most consumer-focused startups we see in Asia have very large TAMs, and only few B2B startups are targeting markets that are too small. Nevertheless, you need to be able to define and quantify your TAM when pitching for investment.
Why is TAM so important?
Early-stage investors like us always look for companies who are capable of returning at least 50x on an investment. If the average seed-stage company in Hong Kong or Singapore is valued at around US$5 million, then we would need to see a path for a company to achieve a US$250 million valuation.
As a rough benchmark, if we assume that a high-growth company would be valued at 10x revenue, then to achieve a US$250 million valuation, the company will have annual revenues of US$25 million.
Imagine your startup is building a B2B marketplace for used office furniture. If the total value of used office furniture traded in your target market is only US$75 million annually and your marketplace fee is 10 percent, then the TAM would be a mere US$7.5 million and achieving US$25 million revenue would be impossible.
Thus, it is imperative to demonstrate to VCs that your TAM is large enough to support your valuation.
There are two methods for arriving at a TAM: top-down and bottom-up.
A top-down TAM estimates the market size by taking broad market size data and adjusting it for your product’s focus. For example, if you are selling a pet food subscription service in Thailand, you might use the total value of the pet food market in the country and then possibly adjust it for your market segment (such as pet food purchases by people in urban areas who would be your likely target market).
By contrast, a bottom-up TAM starts with an estimation of the number of customers and builds up a TAM from there. In the case of the Thai pet food subscription service, a simplified bottom-up TAM might be :
There are 5.3 million pet owners in Thailand. We estimate that 3.25 million live in metro areas, where we can deliver pet food. Subscription costs US$15 per month, so the TAM is US$48.75 million.
A bottom-up TAM is almost always preferable. It requires an estimation of the size of the customer base and can help with evaluating critical issues, such as the ability to reach customers, price sensitivity, and marketing channels.
From a VC’s perspective, a bottom-up TAM is by far the most useful, as it gives a more granular breakdown of the market. On the other hand, top-down TAMs almost always overestimate the market size.
An obvious solution to a low TAM is to expand into adjacent markets. For example, if you are providing a small business invoicing solution and the TAM is too small, you could factor in your future plans to include other services such as payments or credit facilities.
This is often referred to as the “land and expand” strategy, whereby the initial product is a loss leader designed only to establish a relationship with the customer, who is then upsold on other, more profitable services.
If your TAM includes additional markets, you will be expected to demonstrate a deep understanding of these markets. A common mistake founders often make is they only develop a deep understanding of their core market and make false assumptions about the ease of expanding into adjacent markets.
Many Asian markets (excluding China and, perhaps, Indonesia) are too small to build a sufficiently large TAM. Therefore, the TAM usually includes other regional markets in addition to the launch market.
As with adjacent market expansion, you should fully understand and be able to describe the regional differences for your product and issues with launching in other markets.
For some tech solutions, there is no existing to market to reference when establishing a TAM: Prior to Slack, HipChat, and Yammer, there was no company that offered chat solutions. Prior to Airbnb, there was no broad-based home-sharing service.
In these circumstances, you will need to demonstrate two things: that the potential market is huge and that there is currently a big problem that your product addresses.
I discuss these principles more extensively in a seminar called Seed to Series A. In the next article, we will examine how a VC validates your startup idea.