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Market sizing is the cause of a lot of confusion and fear for founders. This is unsurprising. Founders are being asked to come up with a believable estimate of how much all the relevant customers in the world would potentially pay for the products / services that they plan to sell. These products often don’t exist yet, and in many cases the market for them is yet to materialise. To make matters worse, there is a ton of conflicting advice out on how to do market sizing, that creates even more questions. Should it be bottoms up or top down? Should you present TAM, SAM or SOM? Which geographies should you include?
A lot of this confusion comes from the fact that market size analysis is not limited to the VC world, but is used by everyone from McKinsey and BCG types working with megacorporations like Unilever to investment bankers trying to justify the valuations they put on acquisitions. This means that if you google “how to do market sizing” you are likely to get advice that isn’t designed to help you raise from VCs.
This article is my attempt to cut through the noise and present an approach to market sizing designed with VC fundraising in mind. This post will be opinionated because that’s the only way to come up with something coherent. However, my opinion is grounded in years of experience as a VC where I evaluated thousands of pitches. Before we start, let’s establish a few hills I’m willing to die on:
I’m going to take a moment to explain these three opinions but if you want to simply skip to the nitty gritty of how to construct your bottoms up market size - click here.
Despite the fact that we see them in 80% of pitch deck templates, presenting your market size with three concentric circles for TAM, SAM and SOM is often counterproductive. Why? Because:
Top down market sizes are fine if you are doing market sizing for a business school paper but in practice VCs don’t trust them. As I’ve outlined previously:
This isn’t just my opinion. Pear VC conducted a survey of VCs on the topic and found that their “most consistent feedback.., was to dissuade founders from presenting their future revenue based on % market share of a large addressable market.”
When market sizing for a fundraise your goal is to present a number that is big enough to be appealing to VCs and that:
Assuming your number comes out large enough, bottoms up market sizes are the most efficient way of doing this.
The bottoms-up method calculates total revenue potential by grounding it directly in data from the market. First you figure out how many potential customers there are and then you multiply this by the amount the average customer spends in a year. It can be expressed with the following equation:
Number of potential customers x Revenue per customer = Market Size
Applying this method works well because it makes it really easy to satisfy the two criteria above.
As I’ve explained elsewhere, when VCs look at market size what they really care about is whether your company is in a market that can support a $1bn+ dollar exit. They assume that if you can reach some amount of annual sales you will be valued at $1bn (for SaaS companies this is usually $100m). If your market is 20x+ larger than this amount, it is considered ‘big enough’. Therefore when they look at market size estimates they need to be sure that the number contains only the revenue that relevant customers could pay for products that your business plans to sell and nothing else.
VCs are by default suspicious that market size estimates founders present them with include irrelevant revenue. This paranoia comes from the fact that situations like the below play out in what seems like half of VC calls.
$1trillion is wrong because it overshoots the market for construction procurement software by conflating it with the overall spend in the entire construction industry. As a VC, this will probably have happened to you ten times by the end of your second week on the job. Consequently, most VCs are distrustful of any market size number they’re presented with where they don’t know all the inputs - especially given the fact that founders have incentives to make their estimates as large as possible.
Bottoms-up analyses are the antidote to this paranoia. By default they are rooted in inputs specific to the product or service in question, meaning that, if done correctly, all the revenue in them is relevant.
By virtue of their transparent inputs, bottoms-up market sizes are easier to make believable. As long as the VCs believe the number of potential customers and the revenue per customer - they have no choice but to believe in the result of the maths. This way they come to the same conclusion as you rather than being sceptical about some random report you’re citing.
It’s much easier to make someone believe the fact that there are 100k plumbers in Europe and they could all pay $1,000 per year than to get them to trust that there is a $100m market for plumbing software based on a report. It doesn’t matter that the end result is the same.
To create a bottoms up market size that works the trick is to start with the equation I mentioned above.
Number of potential customers x Revenue per customer = Market Size
For most businesses creating a defensible market size is as simple as finding or calculating these two inputs (# potential customers and rev per customer) and multiplying them together.
And even in more complicated cases - for example where your business has multiple customer industries, sizes or product types - this formula still works. You just have to apply it multiple times for each type of product / vertical and sum up the results (a “Sum of the Parts” Market Size). For example if you planned to sell two products to two industries it could end up looking something like this.
Although for ease of presentation you might group customers as follows
Using these inputs requires no more than basic multiplication and addition - in reality the difficulty is in getting the right values for them. The rest of this article will focus on what these two variables represent and how to get defensible numbers.
Definition: This number is how many people or companies that are relevant buyers for the product(s) you are trying to sell. It is the number of entities that have the characteristics of individuals / companies you plan to sell to that are in the geographies you plan to serve.
Clarifying notes:
When it comes to actually finding this number, I have listed the best approaches I've seen or used in the past below:
Take it from a report: While VCs don’t trust actual market size estimates from reports, they are fine trusting reports with data points on things like the number of plumbers in the UK. Good sources include government data (e.g. Eurostat), reports by companies (e.g. McKinsey) and industry organisations (e.g. the British Medical Association), Academic Papers, or whatever else your Google searches can pull up.
Derive it from another statistic: Sometimes the reports you find won’t have the exact datapoint that you want. However, many will contain a figure or statistic which you can use to calculate the number of potential customers with a little bit of extrapolation or combination with your industry knowledge.
Here are two examples:
Take the number for a smaller geography and gross up: This is related to deriving it from another statistic. You take the number of potential customers from a region that is part of your target geographic area and extrapolate to estimate how many there are in the entire geography.
This works if you can:
If both of these are true, you can estimate the number of potential customers in the entire area, by:
To illustrate, here’s an example:
Creative approaches: I’ve seen a number of founders come up with creative solutions to figuring out how many customers are in their market. Obviously I can't provide a definitive list but one approach I've seen work is figuring out where your customer group lives on the internet and web scraping.
I once worked with a company whose target market was breweries. They figured out how many breweries there were by finding a site where people leave reviews on them and scraping it for data on all of the individual brewers. The internet is full of data hiding in plain sight just which you can often uncover with a bit of creativity.
Definition: The amount of revenue that the average customer in your market is worth to you per year.
Clarifying notes:
While the definition above is self explanatory, this number can sometimes be difficult to calculate if your business has a complicated revenue model. If you find yourself in this scenario, a helpful trick is to ask yourself the following two questions before coming up with a number:
To help you and to illustrate what this looks like in practice, I’ve included example calculations for several complicated scenarios and revenue models in the table below. I use the two questions above as helpers in the second and third columns.
Now that we have the definition and know how to calculate our average revenue per customer. The last thing to do is source the numbers that go into the calculation.
This is key to the whole exercise. If you are telling VCs that your market size is $2bn based on the fact that that customers will pay $100k p.a. for your widget and you have no evidence to back it up they won’t believe you - leaving you are back at square one.
To help you avoid investor doubt, below I’ve listed some approaches to sourcing this number that are actually convincing. I’ve ranked them in order of most convincing to least.
Use what you are currently earning from your average customer: If you are already earning and the revenue you are getting per customer is representative of what you expect to earn from customers going forward - then you should use this number. There is no more convincing proof that customers will pay you X a month than the fact that they are already paying you that much.
Use the pricing of similar products / services to yours: If you haven't launched yet or how much you are earning per customer today isn’t representative of what you think you can earn, then you can estimate revenue per customer based on what people pay your competition. This can often be done by simply looking up competitors’ pricing structures online or in public filings.
Where this information is not public you can often find out by asking prospective users what they are currently paying for competing services. VCs are happy to believe that, if you get it right, you can charge as much as your competitors are charging for the same thing. An additional benefit of justifying your numbers with this approach is that you also get to demonstrate to investors that you have a strong grasp of the competitive landscape.
Use a % of the value you deliver for customers: If the direct comparison to competitors' pricing isn't fully applicable you can justify how much you will be able to charge by quantifying the value you generate customers and saying that you will charge a percentage of that. To get the value you generate, you need to quantify either
To go from quantifying the value generated to an average price per customer you essentially assert that you will be able to charge a % this value. In terms of what % to use - 10% is a safe number, however, you can probably get away with up to 30%.
This approach, while less robust than the previous two, demonstrates that your pricing is grounded in the real-world financial implications of your product and also reiterates to investors that you have made something useful.
Now that you have both your inputs, number of potential customers and average revenue per customer, the final step is to simply multiply these two numbers together to get your market size.
Number of potential customers x Revenue per customer = Market Size
With your new defensible Market Size in place, your next task is to learn to present this in a meeting with the VCs you’re trying to raise from. Thankfully - I wrote another post breaking down exactly how to do this.
Happy hunting.
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