For founders, creating a realistic estimate of your addressable market may seem daunting. However, the math behind these calculations is usually relatively simple — basic arithmetic.
Your intuition might tell you that any simple estimate won’t be appreciated by venture capital firms. However, this isn’t the case.
VCs want to see that you used an easy to understand and logical methodology to generate the estimate that you’re giving them. The easier it is to understand (while still being relevant) the quicker they can get comfortable with it and focus on other questions that they might have. At a high level, there are two methodologies used for making an estimate: top-down and bottom-up.
In general, the top-down method uses a broad market size figure (often provided by an analyst, industry participant or other) and whittles it down to the target market segment. For example, an ecard company targeting kids, might start with the total revenue generated in the card market, multiply it by the percentage of revenue generated from ecards and then by the percentage of ecard revenue generated by kids.
To do each of these steps there might be a bit of behind the scenes analysis — figuring out the percentage of ecard revenue generated by kids might take some additional estimating leg work. Make assumptions that need to be made and have the details of that analysis available on a backup slide when you present. While you should be prepared to explain your entire approach, first present just the highest level drivers and the resulting estimate. If VCs want more detail about your methodology they’ll ask for it.
The bottom-up method builds up the total addressable market (TAM) by using the main variables of the revenue model. For example, expected price times the total number of potential customers will yield a bottom-up addressable market. Using the ecard example, multiply the total potential page views from the kids market by the average revenue generated per page view. If you have several revenue streams, you will likely need to calculate the bottom-up estimate for each of them independently and add them together.
The bottom-up method is generally considered more robust. There’s a good reason for this — the broad market size figure used as the starting point in the top-down analysis often includes a slew of different market segments. It’s easy to forget to take some of these out of the estimate. In contrast, a bottom-up method the estimate is less likely to include non-addressable revenue.
In addition to being more reliable, the bottom-up analysis can be used as a starting point for financial projections and operational planning. With this model in place annual revenues can usually be created by varying a key driver, such as the number of customers. With a projection of the key drivers of the model in place you will be able to begin making operational plans. For example, with the number of new customers already projected you can back into how many sales people you will need to acquire them, enabling you to determine costs, profitability and cash burn.
With either approach you will often find that one or two assumptions in the estimate are less reliable numbers — you may not trust the sources. If you’re not comfortable with an assumption do a low and a high version of the estimate. For the low version, use the lowest reasonable value for the unreliable variable; for the high, use the highest.
Highlighting discomfort with an assumption and offering a range for the size of the addressable market can demonstrate your thoroughness to an investor. To really impress VCs with the rigor of you analysis, you should consider estimating the market size in more than one way (if you can).
You might do two different bottom-up estimates or one bottom-up and one top-down. If you can show that you can get to a big number no matter the approach, you mitigate some perceptions that your methodology might be wrong. Be sure that the two approaches yield a somewhat similar number. If they don’t, this tactic can backfire and create questions about the validity of your approach.
Estimating the market size is usually something that can be done in a very short period of time — it should be a relatively easy analysis. If you find yourself creating a very complicated methodology, stop yourself — remember that you might have to explain this in your pitch to VCs.