One of the most crucial tasks an entrepreneur has is to calculate the size of their market, and the potential value that market has for their startup business. Without this data you can’t create a viable business plan, or be taken seriously when approaching potential investors.
As described in my book, The Art of Startup Fundraising, the market needs to be in the billions. Otherwise, even if you have the perfect team and product the returns will be limited for potential investors making your investment opportunity less attractive.
Market Size for Startups
Determining the market size is critical. It tells you and your partners, team and investors how much potential business is really out there. It helps calculate how much value there really is for your individual venture. This is critical to know, even if you never plan to raise a dime in outside capital.
Market size becomes far more important if you ever need to raise funding for your business. It is one of the most basic digits every potential angel and VC investor is going to expect. Even your friends and family should be asking about it during seed and pre-seed financing rounds. Coming up empty handed is going to destroy your credibility instantly.
Unfortunately, this is one factor which entrepreneurs frequently blow when formulating initial plans, stepping out into a new business and when pitching investors. So, how do you do it right?
How to Determine Market Size
To calculate your market size, you’ll either be looking for data on the number of potential customer, or number of transactions each year.
For example; if you are selling toothbrushes, virtually everyone can be counted in your big whole market figure. If people are listening to their dentists, and they are purchasing new toothbrushes 2-4 times per year, that number is even larger. If you are selling houses, then there may only be an average of 5.34M transactions in a good year, in the entire United States.
The Art of Startup Fundraising book
The Art of Startup Fundraising bookKeep in mind:
- Show projections going out 3 years (it’s hard to accurately analyze after that)
- Account for organic growth or decline in the years ahead
- Your roll out to geographic areas over time
There are a variety of ways to acquire this data. Census and labor bureau hold a lot of information, and most industries have formal associations which compile and track this type of data. You can also commission your own research or purchase studies.
Once you have the data you want to make sure that you are presenting it in a powerful way in your pitch deck since it is one of the most important slides. A good pitch deck template is the one created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash. Thiel actually includes not one, but two slides around the market and its size. Moreover, I also provided a commentary on a pitch deck from an Uber competitor that has raised over $400M (see it here).
Below is another example of how to show in your pitch deck your market growing over time.
The Art of Startup Fundraising book
The Art of Startup Fundraising bookHow to Determine Market Value
Market size, or the number of potential customers or unit sales is one thing. How much that is worth, is a completely different, and perhaps more important figure.
You need to know how much revenue that market has to offer. For example; UpNest is one of the fastest growing real estate tech startups, which helps home buyers and sellers save on Realtor commissions. If the average home price is $394,300, and there are 5M sales per year, and the average Realtor commission is 5% of the sales price, and 90% of users use a Realtor, UpNest is in an $88.7B per year industry. Or has a market size of $88.7B.
Determining Total Addressable Market (TAM)
Realistically, no startup should or can expect to gain 100% market share. Trying to capture an entire market, without first targeting several niches, price points, customer sizes or geo areas for roll out, is going to be financial suicide for the vast majority of entrepreneurs.
The Art of Startup Fundraising book
The Art of Startup Fundraising bookFor example; even giant online real estate firm Zillow, which dominates the marketplace, has far more modest estimates for its own new venture in buying and flipping houses directly with consumers. The company’s CEO recently said that if it could acquire 275,000 units a $3,500 profit each, it would be doing very well. That’s about $1B a year from just one extra revenue stream, at just over 18% of the available market share.
Of course, most new startups can’t expect to even command that much market share. Even if you could, most seasoned investors won’t believe it until you prove it. Tx Zhuo of Karlin Ventures says “If it’s 1 to 5 percent of the pie, you have a realistic plan.”
If you have no idea what’s a reasonable amount of market share in your industry, Projection Hub says one hack is to anonymously call around to all of your local competitors and find out how much volume they are doing. Then estimate you’ll be doing a fraction of that as you gain traction.
The Art of Startup Fundraising book
The Art of Startup Fundraising bookAlso factor in the static versus evolving marketplace. Do population growth rates mean there will be more prospective customers in your market in 5 years, or less? Don’t forget to factor in your own impact on the market.
For example; if you were Amazon a decade ago, you should have factored in the fact that you are about to destroy the marketplace for regular bookstores. Their price cutting also slashed the value of the market in a huge way.
Early stage startup investor at Matrix Partners, Jared Sleeper notes there are actually :three distinct ways to calculate TAM.”
They are:
- Top-down, using industry research and reports.
- Bottom-up, using data from early selling efforts.
- Value theory, using conjecture about buyer willingness to pay.
It’s best to know them all before you go into an investor meeting, or finish polishing your pitch deck.
Summary
Knowing your market size is a basic foundational part of launching any startup venture. Every entrepreneur needs to know how to calculate it, and how it relates to potential revenue in their addressable market.
Be realistic. Investors like big numbers, but don’t have patience for flakes over-inflating numbers. You should be able to show the potential to achieve VC sized growth and returns over time. Just make sure you can back up your claims with the data and research, you derived your numbers from, and how you arrived at your assumptions.
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Make sure there are enough customers to make your business idea viable.
Imagine that you've just spent three years building a fantastic business – your product is great, your website is cutting edge, your people are well-trained and enthusiastic, and your customers love what you do.
The problem is, you're running at a loss – there simply aren't enough customers in the market to support the business.
This is a heartbreaking, and very common, position to be in. It's why many professional entrepreneurs and investors conduct "market sizing" exercises before they invest in a new business.
In this article, we'll look at how you can analyze your market size, and how you can use this data to make informed strategic decisions.
What Is Market Sizing?
The "market size" is made up of the total number of potential buyers of a product or service within a given market, and the total revenue that these sales may generate.
It's important to calculate and understand market size for several reasons.
First, entrepreneurs and organizations can use market sizing to estimate how much profit they could potentially earn from a new business, product or service. This helps decision-makers to decide whether they should invest in it.
If you choose to move forward, this analysis will also help you to develop a marketing strategy that addresses the unique needs and potential of your core market.
Market sizing can also help you to estimate the number of people that you may need to hire before you launch a new product or service, rather than "feeling your way" as you test your new market. If you know this from the start, you can optimize your approach to recruitment, so that you have the right people in place when you need them.
Market Sizing Methods
There are two methods that are commonly used for market sizing:
1. Top Down Market Sizing – although the top-down method is simple, it's often unreliable and overly optimistic. It looks at the "relevant" market size for your product or service, and then calculates how much your organization might earn from it.
For example, imagine that your organization markets learning resources to schools. Your research shows that there are 6,000 relevant schools in your country. You know that the average sale per school is around $50,000, which means that your market size is $300 million.
Of course, this is an incredibly optimistic and unrealistic figure. Not every school needs your products, and they're unlikely to purchase $50,000 worth of goods each, so it could be a real challenge to capture even a small percentage of this market. A top-down approach gives you inflated data, and you often can't rely on it to make good decisions.
2. Bottom-Up – This approach is often more time-consuming than top-down market sizing, because you do all of your own market research and you don't rely solely on generalized forecasts and trends. However, you'll get a more realistic and accurate assessment of your market's potential.
In this article, we'll focus on how you can use a bottom-up approach to determing your market size.
How to Calculate Market Size
Follow these three steps to identify your market size:
1. Define Your Target Market
To predict the size of your market, you need to know the type of person that your product or service is best suited to. Your offering has to fulfill a need – or solve a problem – uniquely well for a group of people, and you need to define who these people are.
Also, think about how you can access these customers – there's no point considering them if you can't reach them cost-effectively.
You can use market segmentation to divide your market into specific groups. This will give you a greater understanding of each group that your product or service will appeal to, and will enable you to tailor your offering to the specific needs of each group.
Once you've identified the different possible segments in your market, choose the ones that you want to focus on to build your business.
Now you need to determine how large the market is for each segment you've identified. To do this, contact business organizations, data providers, civic organizations, city and state development offices, or regulatory agencies that handle business and commerce; and do what you can to source a list of potential clients in your chosen segments.
Example
Your organization wants to develop point-of-sale software for mid-sized grocery stores. But, before you invest the time and money to develop the software, you need to make sure that the market is large enough, and that people are interested enough in your product to buy it.
After researching online and contacting your region's business and commerce department, you determine that there are roughly 10,000 mid-sized grocery stores in your country, and you source a list of these stores.
2. Use Market Research to Assess Interest in Your Product
Obviously, not everyone in your target market will want to buy your product. So your next step is to estimate realistic interest.
One way to do this is to focus on competitors who target the same group of buyers. What is their market share? And what are their annual sales for similar products or services?
If your competitors are exclusively focused on this market, this can give you a good estimate of potential market size. However, it can be almost impossible to source this information if they focus on other markets as well, or if they are part of larger business groups.
Another way to assess interest is through individual interviews, focus groups, and surveys. Question a sufficiently large sample of people or businesses that fall within your target market, and explain what you have to offer. The larger your sample, the better your analysis will be.
Ask them questions like:
- Does this product interest you?
- What would they feel comfortable paying for it?
- How likely would you be to purchase this product or a similar product within the next two years?
It's important to draw conservative conclusions based on the feedback you get from these focus groups or surveys. Often, people will say one thing and do another. People often "think twice" before actually making a purchase, and this is especially true as budgets, interests, and market conditions change.
Example
Over the course of three months, you talk to 100 randomly selected mid-sized grocery stores, which represent one percent of your target market. You explain the idea behind the new software, and the benefits it will provide to the store owners.
After the presentations are finished, 35 stores express a strong interest in the software, and a willingness to buy once it's available. To be conservative, you reduce this number to 18. So, 18 percent of stores in your market will be interested in this product. Out of 10,000 possible grocery stores, this means that 1,800 could buy.
It will obviously take a lot of time to set up and conduct this type of research. Think carefully about any other market research information you might need, and, where appropriate, gather this at the same time.
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