Understanding Total Addressable Markets:

When investors refer to a business's total addressable market, they are referring to the revenue potential of the company's products and services within the business's current market.

While at face value, this concept seems very academic, there is practical value in understanding it. We'll briefly discuss why this concept is important for business owners to understand.

• First, when start-ups are evaluating markets, it's useful to assess the size of the opportunity. Some start-ups prefer very small "micro-niches" as ideal starting points. Regardless of where you start, you want to make sure that you are building a product that enough customers will benefit from to be able to sustain a company.
• Second, from a marketing or selling standpoint, it's important to look at a market's size to understand the remaining market potential. How much of your total addressable market have you reached so far? How long will it take you to make contact with your total market? How much would this cost?
• Third, total addressable market is a useful concept when trying to determine product pricing and assessing demand. By segmenting customer groups within a market, sales and marketing teams can learn a lot about their market.
• Fourth, the size of your TAM may influence your decision to expand or differentiate into new markets, versus doubling down on your existing strategy. Often, TAM is useful when trying to justify how much money should be invested into a project.
• Fifth, when it comes time to sell a business, the size of the total addressable market will impact the purchase price. Professional investors, want to see that there is an opportunity for growth with the business they are buying. Much of a discounted cash flow valuation is based on projections for growth. Normally, a faster growth rate is experienced in earlier years, and as a business matures, growth slows down. So, the size of your TAM will be a point of evaluation when the time comes to think about an exit. Growth opportunities are valuable.

How To Determine The Size Of Your TAM:

The value of a total addressable market is normally calculated with a "top-down" metric. Here, we start with the total number of people we determine to be in our TAM and we multiply it by our value metric.

For service businesses, it's common to use "annual contract value" as a value metric. So as an example let's assume that our TAM has 2 million people in it and our annual contract value for our core service is $10,000. This would give us a TAM of $20 Billion (2,000,000 x $10,000).

Breaking Down Total Addressable Markets:

Investors and acquiring companies take TAM seriously, however just because you have a TAM of $20 billion doesn't mean you are going to make $20 billion.

In this light, commonly when TAM is discussed, it is broken down further. So, not only will we look at the total addressable market, but we'll also look at the "serviceable addressable market" and the "serviceable obtainable market."

These are essentially just different perspectives or frameworks for breaking down a business' target market even further.

So, before we defined TAM as the revenue potential of the company's products and services within the business's current market. If we break this total addressable market down a step further, we get to the "serviceable available market."

When we look at the "serviceable available market" we're trying to see the percentage of our TAM that has the strongest need for our product or service. Essentially, these would be the prospects that we feel we would have the strongest product/market fit with, based on the information we have and the way we intend to position our product or service. A good example to understand this might be "location" If we were a local restaurant we could define our TAM as everyone within a two-hour driving distance of our location. While it's certainly reasonable that people living two hours away may come to our restaurant at some point over the next five years, we could look at our serviceable available market to people who live within 30 minutes of our restaurant.  

Moving further in this direction, if we were to break down our TAM down further from "serviceable available market," we would end up with our "serviceable obtainable market." This metric looks at the people we believe we can realistically win as customers from within our "serviceable available market."

Why TAM Is Important:

Understanding the total addressable market, serviceable available market, and serviceable obtainable market will require that the company do market and industry research.

Often, this research proves tedious, but it is important that business owners take the time to do it for several reasons.

1. Through the process of defining your TAM you will learn a lot about your market, industry, and competitors.
2. You will learn about your target customers. Understanding your customers leads to better marketing and sales messaging.
3. You can't build accurate projections (or set realistic goals) if you haven't defined the size of your market.
4. It will force you to think through your business model in a practical way rather than a wishful way.
5. If you are looking to raise capital, you will probably blow your pitch if you show investors that you haven't taken the time to understand who you are planning to sell to.

Recommended Resources:

• Organic vs Inorganic Growth
• Discounted Cash Flow (DCF) Valuation
• Sell-Side M&A Process
• Types Of Mergers & Acquisitions