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Market size assessment for startups: TAM-SAM-SOM method with examples

Monday, November 29, 2021

Startup Jedi

We talk to startups and investors, you get the value.

Assessing the size of the market is a very important stage both when working on a start-up and on any business. The paradox is that the initial assessment takes literally 30-50 minutes, but many beginning entrepreneurs forget about this stage and then spend months working in vain. Don't do that! Evaluate the market at the idea stage, there’s the TAM-SAM-SOM method to help you with this. Let’s learn more about it in today’s article.

What is market valuation?

The definition is very simple. Market assessment is a set of actions that help us analyze and understand the financial volume of the market of interest to us. Simply put, we find out how much money there is in this market.

A lot of aspiring entrepreneurs make the same mistake: for some reason they are sure that the market in which their product will work is endless. That an impeccable product will amaze the imagination of consumers, and they will immediately start buying it up, recommend it to friends and acquaintances, and the growth curve will creep upward to infinity.

In fact, the market volume in monetary terms is always a finite figure, albeit very large in some cases. The number of consumers in any market, whether buying pet food or learning the Korean language, is limited, and so is the amount of money that they are willing to allocate for the purchase. Therefore, no matter how perfect products come out, their growth will always be limited by the size of the market in a given industry. It will not grow indefinitely, even if it is an ideal product that completely defeats all competitors, simply because sooner or later customers will run out (and they will run out of money, too).

This is why it is so important to assess the market before taking on product development. How much growth is possible? Is there enough market size for the product to be scalable? Will the potential income recoup the work of the team and all other costs of creating a product? The benevolence and faith in the product of the investors (and the investment decision) depends on the answers to all these questions. Alas, even the most advanced technology is doomed to fail quickly or slowly decline in the "valley of death" if it has no market.

You can estimate the size of the market in literally half an hour —  but this procedure will save you invaluable months or even years of work. This is the answer to the question "why", but the most difficult question is "how".

How to assess market size?

Market size is a loose concept: the numbers will depend on the methods you use; the research you take and the startup's own metrics. So, during the pitch, the investor is unlikely to be able to convict you that the answer is wrong. But they will most likely ask “How did you calculate the market size?”

So, letting your imagination run wild and drawing impressive numbers with many zeros, as they do on some advertising sites, is not worth it: the market size is calculated using clear and definite tools. Here they are:

  • Data refers to all kinds of open data, on the basis of which the state of the market is assessed, including expert research and comments in the media, scientific publications of universities, analytics of search queries, and so on.

  • Metrics are generally accepted indicators that all investors and entrepreneurs are aware of. These include TAM, SAM and SOM.

  • Methods refer to the most common and effective ways to assess the market using data and metrics. The best option is to calculate the market size using several methods and then compare with numbers.

Next, we will talk about the TAM-SAM-SOM method —  one of the most common market assessment methods. Despite the scary abbreviations, this method is also one of the easiest to calculate as you do not need knowledge of further mathematics, just be attentive and use a calculator and several search queries. Well, it is also advisable to read this article to the end.

TAM-SAM-SOM method

First, let's figure out what each metric means.

TAM (total addressable market) refers to total market size. This figure shows how many users in your target market need services / products similar to yours. This is the largest figure that will allow the company to assess the potential of the product in the long term. The metric does not take into account competitors' market share, team capabilities, and so on.

F.ex: Let's say we want to create websites for online stores. We found a fresh study that states there are 6 million online stores in Russia (we made up all numbers). 90% of them need a website. Developing such a site costs an average of $ 300. So we can calculate TAM: 6 million * 90% * $ 300, the total volume of the target market is $ 1.62 billion. We do not take into account either other companies that make sites, or those stores that make a site on their own —  this is the overall financial potential of the market.

SAM (serviceable available market) refers to available market size, taking into account competitors. At this level, you need to understand the market share that belongs to the direct competitors of the product.

F.ex: We found out new details about online stores: some of them make websites on their own, some belong to large companies, and some are franchises. Let's say you specialize in retail websites. We find research that says half of the total number of such stores is 3 million, of which 80% need a website. The available market size for you and your competitors in this case: 3 million * 80% * $300 —  $720 million.

SOM (serviceable & obtainable market) is a figure specifically for your market coverage, taking into account current resources, the level of competition and other individual parameters. The metric shows the "bandwidth" of your business. It is good at helping with current and mid-term planning.

F.ex.: Technically, your team can build 50 sites per month. This means that your serviceable & obtainable market size is 50 * 12 * $300 —  $180,000 per year. Note that obtainable does not mean that you will actually obtain it. This is an "ideal world" where you will not run out of clients. But there is no guarantee that it will be so —  there are many risks, as well as competitors in the niche.

There is also the PAM (potential available market). In the case of our company, this is the entire world market for website development for online stores. But this figure is too global, so it makes little sense to use it at the first stage of business development.

What are the top-down and bottom-up methods?

When assessing market size using TAM, SAM and SOM metrics, two methods are most often used: "top down" and "bottom up". How do they work?

Top-down method involves moving from the largest TAM metric to the smallest SOM using open market statistics. It is as if you take the total figure for the market and start “cutting off” the excess.

What matters here?

  • Use trusted, reliable and up-to-date sources —  for example, the 2014 study on Internet sites in Russia is clearly outdated.

  • Understand how you will segment the market. The tricky part is that there are not always direct studies suitable for calculating each of the metrics.

Bottom up method — you are not compiling numbers from analytical studies, but moving from your product cost to larger metrics. In the simple case, you start with SOM by simply multiplying the value of your product and the potential number of buyers in a given time frame. Then, using the same formula "product cost * number of buyers", calculate SAM and TAM.

As a rule, the indicators obtained using the bottom-up method are less than those based on research analysis. It is advisable to use both methods, having received 6 metrics, and then you need to compare and choose which numbers to focus on. Most likely, the bottom-up SOM will be more reliable —  like the top-down TAM.

Let us remind you once again: the market assessment is in any case hypothetical. But you will get information to think about the limitations of the market and the potential of your idea.

Examples of using the method

Let's take a new example: we are going to sell specialized software in the engineering industry. Before embarking on the search for research and calculations, you need to answer a number of questions.

Who is the client? Will we be able to work with the entire industry or only with certain companies? Let's say, in our case, these are automobile companies.

Where do you want to work geographically? Russia, CIS, Europe? Let's stop at Russia.

What’s our product? Specialized software for personnel management.

So let’s apply the top-down method. 

1. We find relevant expert research on the annual volume of spending on software in the mechanical engineering market in the world for 2018-2020. We find information on what share of the market Russia accounts for. After calculating the interest, we got the figure of 58 billion rubles. This is our TAM.

2. Now we need to “cut off” the excess in order to move to the niche of interest. We will find out what part of the entire mechanical engineering market is occupied by car manufacturers. We find studies on the average spending on HR software in similar companies. This is how we get SAM.

3. We estimate what share of the SAM market our company is ready to cover, taking into account competitors. Let's say this is about 5% of the market —  this is our SOM.

Now let's try to calculate the indicators bottom up:

1. We know that with our current resources we are ready to serve 30 client companies a year. The service for the development and installation of software costs 1 million rubles. In total, our SOM is 30 million rubles.

2. We count SAM: we find information on how many companies are registered in Russia according to the profile we are interested in. We multiply the cost of the product by the number of companies.

3. TAM — we find the general figures for the number of companies using specialized software for personnel management in the field of mechanical engineering. We get TAM by multiplying the number of companies by the cost of our product.

The final step is to compare and analyze the indicators. Let’s take b2b with a small number of customers (albeit a high check). Assessing the size of the market will necessarily lead to questions about how profitable the business will be. Will you be able to maintain growth? Will you eventually run out of clients?

To sum up: what to remember about the market assessment procedure?

1. You have to evaluate the market at the start of work on the product: for this, an approximate calculation using one of the methods is enough to simply understand whether it is worth developing this idea further? This is especially true of b2b projects, which often have a very small market.

2. Perhaps 80% of success is a competent selection of statistical data for research. Pay attention to who performed them and when. Use only trusted and credible sources.

3. Remember that market assessment is always subjective and depends on who is doing it. You can not calculate the exact figure. It is also impossible to predict the real profitability and payback of your company as for this you need unit economics.

4. If the market assessment is for pitching, be prepared to explain exactly how you calculated the metrics and where you got the data from.

5. It is possible to count according to the TAM-SAM-SOM method both bottom up and top down. The best option is to use both approaches and then compare the numbers and select the most relevant ones.

Market assessment helps to match a product idea that usually exists in some kind of "ideal world" to the real world and real user demand.

Is it worth it to "hack to death" an idea that inspires, but after calculations on the market seems not very profitable or scalable? It's definitely worth talking to experts and the team. Here are some possible options:

  • Try to estimate the size of the market with the help of professionals (or more experienced startups). Perhaps you have not considered all the factors?

  • Think about a small pivot: Reformat the product idea into a more profitable large market.

  • Consider creating an ecosystem of products: developing related products and gradually building up a common customer base for everyone (let's return to the software example: you can sell additional products in the form of consultations, full company support, other programs and applications, and so on).

In the end, there is always an option to try and make a cool product at your own peril and risk (here the Lean Startup method comes in handy as it allows you to check the MVP asap). Perhaps it will boom the market and go viral? It's no coincidence that Y Combinator founder Paul Graham devoted his essay to these exceptional projects. «Do Things That Don’t Scale»

The simple TAM-SAM-SOM technique helps to see many risks and for the product even at the idea stage —  a tool definitely worth using!

29 Nov 2021

 

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