TAM

One of my unpopular opinions as a venture capitalist is the metric of Total Addressable Market (TAM) is impractical. I find that investors in general idolize the idea of a start-up being able to reach a large enough market to be able to make a return off of it.

But what I’d argue is that in early-stage investing that doesn’t matter. The feedback “this isn’t a large enough problem for us to solve” is a placeholder said by investors meaning something incredibly different.

Most companies pitching use TAM approximations usually either from popular journalistic sources (like the Wall Street Journal, New Yorker, Economics, Forbes, et cetera) or, more frequently, from one of the “state of the market” reports from Investment Banking or Consulting shops (the names which keep resurfacing being McKinsey, Goldman Sachs, Deloitte, EY, BCG, et cetera). After being on the receiving side of a decent number of pitches, I’m also convinced that you can find SOME source to back up whatever number you wish your TAM to be at.

The advice I found myself giving founders time and again is that TAM is just a slide investors need to see on a deck and as long as it’s not too low or too high, you’ll get a nod and the conversation will move on to the next slide.

There are also a couple other issues with the core concept of TAM which I believe this article does an excellent job of talking about. What Arpit Lahoty of this article effectively argues is that there are two primary shortcomings to the idea of TAM - firstly the fact that it only focuses only on existing markets (and how, as the article illustrates, Uber created it’s own market of it’s own) and secondly, it ignores economic realities. What the author means by that is this method doesn’t account for the economic diversity and purchasing power of its population. For example - while India boasts a large number of internet and smartphone users, the assumption that this translates directly into a homogeneous market for e-commerce and paid services is flawed.

Until approximately a Series A, I don’t think TAM is a valid metric investors should be looking at. In all realism, there is a high statistical likelihood that the company’s direction would meander more times than one and their ICP would deviate far from the initial idea.

I do however want to reiterate the fact that post a Series A, when the company, their offering and business model has a more defined structure, TAM does play an important role to see what the limit to the company’s value can be without expanding.

I think Paul Graham puts it in a rather interesting way -

Founders think of startups as ideas, but investors think of them as markets. If there are x number of customers who'd pay an average of $y per year for what you're making, then the total addressable market, or TAM, of your company is $xy. Investors don't expect you to collect all that money, but it's an upper bound on how big you can get. Your target market has to be big, and it also has to be capturable by you. But the market doesn't have to be big yet, nor do you necessarily have to be in it yet. Indeed, it's often better to start in a ~small~ market that will either turn into a big one or from which you can move into a big one. There just has to be some plausible sequence of hops that leads to dominating a big market a few years down the line. [Source]

My (slightly unconventional) advice to founders at early stages is to target niched sectors. Try and find specific demographics/ psychographics of people and start out by solving their problems. This gives you a competitive advantage in a few ways -

Firstly, solving for a very specific ICP allows you to build a very customizable solution for a specific problem. If you’re building for (say as an example) sales people selling to supply chain adjacent companies, you can build a very tailored product for the kind of problems people in that niche are dealing with (versus, for example, sales people selling B2B expense management software). Because of this specialization, you can charge a higher premium for the software (it is, at the end of the day custom-made for a specific use-case and therefore will be quite significantly have the upper hand in adding value). There’s also the added incentive of being able to reduce the number of generalist tools they have to use is an additional competitive advantage and often helps the sale process further. You also have the competitive advantage of having a very active feedback loop and can afford to take the feedback of one ICP at face value and just optimize the product for them.

Secondly, it gives you a leg in to expand horizontally or vertically. Continuing the previous example of building a sales tool for selling to supply chain adjacent companies, once you have a relatively high penetration over the market (say ~60%), you can now choose to either expand either to modify the sales tool to cover other domains OR to other functions in the same companies. What this would look like is either going on to become a sales tool for say logistics companies, operations management, procurement sourcing OR now expanding to HR tech for these supply chain companies. To do this vertical/horizontal expansion, you already have the upper hand - you’re already a known name in the industry/ company - you have a certain amount of trust associated with you and it’s easier to get introductions and word of mouth sales. More so, when you need to figure out what those next steps look like, it’s a relatively easy process of getting to those people.