From Pieter Welten – Prime Ventures (@pieterwelten)
All too often I find friends, family and entrepreneurs overestimating the size of a market when we are discussing the next big thing. I can’t blame them; I very much like their opportunism. Moreover, large companies including Tesla and Coca-Cola seem to overestimate the size of markets now and then. Therefore, I won’t argue that it is easy to estimate the size of ‘your’ market, but we are sometimes naïve in assessing realistic demand for a product or service in a particular geography. A proper balance between realism and naivety is required in order to be successful.
So how come that people tend to overestimate the size of a market? First of all, sometimes I realize that they don’t make a distinction between total addressable market (‘TAM’) and total available market. Lets define both first:
- The total addressable market reflects the overall revenue generation potential for a product or service, inclusive the market outside the scope of the company.
- The available market is the portion of the market that is specific to your product or service in your specific geography; we talk here about actual product/market fit. The available market can also be defined as ‘serviceable addressable market’ (‘SAM’).
You can find plenty of research and analyst reports about TAM, but next step is to carefully estimate the SAM. An online pet food retailer operating in the Netherlands can tell me that Europe’s pet food market is worth $20 billion. With only a humble 0.5% market share he must be able to grow to hundred million in revenues. Awesome! The problem is, though, that (i) the vast majority of pet food sales are still offline, (ii) the company only operates in the Netherlands, and (iii) probably a small percentage of pet food purchases take place online. I can imagine that the SAM of this business is maximum a few hundred millions. And 0.5% of a few hundred million is… less interesting.
Another, maybe more interesting reason, could be the fact that entrepreneurs are sometimes not entirely rational when it comes to their own ‘thesis’. Not sure whether you have read books from the psychologist Daniel Kahneman (I can personnaly recommend ‘Think, Fast and Slow’), but basically he states that a bias toward optimism (read: a large TAM) is bad, since it generates false beliefs (read: a $100 million turnover is feasible since it only represents 0.5% of the TAM). Exaggerated optimism is important as it strengthens resilience (and entrepreneurs need that), but it should not blind rationalism. Every entrepreneur should constantly challenge his or her own thesis. I believe Andy Grove (Co-Founder of Intel) once stated that ‘only the paranoid will survive’. So perhaps become a paranoid optimist?
Anyhow, I am firm believer that by properly understanding your available market (in any particular geography) and competition within this market, you are better positioned to develop an expansion and marketing strategy, identify your ideal customer, prepare a company budget and therefore improve your company pitch (to investors). Moreover, you won’t end up in the unfortunate position to label yourself as the ‘dominant player or ‘market leader’, whereas you aren’t or you shouldn’t want to be one in case your turnover is several millions. In this scenario an investor will argue that the ‘market opportunity’ is not interesting.
In my opinion one should estimate and treat market sizes with considerable caution. As an entrepreneur (or investor) you should be realistic in determining market size, especially in today’s rapidly evolving world, and you will increase chances of business success and be a able to deliver a much more powerful pitch! A correct estimate of market size is not a ‘nice to have’, but a ‘need to have’. I am sure you get my point. For now, I wish you a cheerful and successful 2017!
