Weekly Briefing Note for Founders

20th June 2024

This week on the startup to scaleup journey:
  • Why VCs 'pass' when market size (TAM) falls short

Why VCs 'pass' when market size (TAM) falls short

Total Available Market ($TAM) has always been a critical investor metric. But with deal flow jamming up investor inboxes more than ever, it has taken on even greater significance.

TAM is a proxy for potential. It's used by VCs to quickly decide how exciting the investment opportunity is. If the market is large enough, the revenue growth potential is there. If the market is too small, it's probably an immediate 'pass'.

TAM determines scale. In VC land, scale is everything. If a business can't generate big revenues over time, it will never become valuable enough to drive venture-scale returns.

Of course, there are many great businesses that may never exceed $50M in revenues. At the founder level, even much smaller businesses can be a personal goldmine. But it's a different story for institutional investors, in particular VC funds.

As one well-known Seed stage VC recently commented, "Niche products have a much higher chance of success than shoot-for-the-moon venture businesses. I’ve worked in niche businesses; I’ve built niche businesses; I love niche businesses. But niche businesses are not viable venture investments.

"If the company doesn’t have a coherent story for how they’ll reach a run rate of at least $50M within a few years, I may love you to death, but sorry, as an investor, it’s a pass."

Linking TAM and fund size

Experienced founders understand the link between market size ($TAM) and VC fund size. Market size determines how big a startup can become, i.e. its revenues will represent a certain market share.

The power law of VC determines that they are looking for investments that will 'return the fund'. If this is a $200M fund (a typical upper quartile European fund), then they will be targeting a $200M return from every investment - even if only a small number will eventually perform this well.

If the investor expects to be holding 20% of the equity at exit, then this requires a $1B exit. If they are projecting a final 10% shareholding, then the exit target doubles.

In hot markets, an acquirer (or public markets) may be willing to pay 10x annual revenues. If so, that would need $100M in revenues to hit a $1B exit valuation. That should enable the 20% shareholder to 'return the fund'.

Investors will make a broad assumption on market share over time. For example, for market leading SaaS companies, 10% market share would be considered a great success (market leaders may even get to 20%). This would again indicate a $1B TAM requirement for the $200M fund (with a 20% shareholding) to have a 'fund returner'.

In other words, if you are pitching a $50M revenue business in 5 years to a $200M fund, you are probably wasting your time. That's why its so critical to target the right investor audience. That could mean a smaller fund, or another form of investor that isn't measuring the outcome by financial means alone. For example, this could be a regional fund looking to drive local employment, or a Corporate VC looking to leverage the strategic value of the relationship.

Bottoms up vs Top Down

The conventional approach to determining the TAM is a top-down analysis. This usually incorporates some form of independent market research. Expected market share can then be computed based on revenue projections. This is a useful place to start and provides an overall scaling for emerging or established markets.

But for institutional rounds, a bottoms-up analysis will also be needed. This not only supports the numeric scaling potential but demonstrates a much deeper understanding of the target market structure.

A bottoms-up analysis takes into account your target customer profile, their willingness to pay for your product or service, and how you will market and sell your product. Take the example from a16z's blog on startup metrics:

"Let’s say you’re selling toothbrushes to China. The top-down calculation would go something like this: If I can sell a $1 toothbrush every year to 40% of the people in China, my TAM is 1.36B people x $1/toothbrush x 40% = $540M/year. This analysis not only tends to overstate market size (why 40%?), it completely ignores the difficult (and expensive!) reality of getting your toothbrush into the hands of 540M toothbrush buyers: How would they learn about your product? Where do people buy toothbrushes? What are the alternatives?

Meanwhile, the bottoms-up analysis would figure out TAM based on how many toothbrushes you’d sell each day/week/month/year through drugstores, grocery stores, corner mom-and-pop stores, and online stores.

"This type of analysis forces you to think about the shape and skillsets of your sales and marketing teams — required to execute on addressing market opportunity — in a far more concrete way."

Pitching TAM figures without an explanation of market structure casts immediate doubt on your plan.

Existing markets vs New markets

Benedict Evans wrote an excellent piece on understanding market maturity and the amount of data available when computing TAM. He describes 3 basic scenarios:

At one end of the scale, there are those people who are entering an existing, fairly mature market, with a superior product or price, expecting to take market share. In that case you already know how the market size works - you know why and how people use these things. You can get people to buy yours, but not to buy more than they did before, so the question is how much market share you can take with a better operating model.

At the other end of the scale, there are companies that are creating something entirely new. He cites the personal computer (accelerated by the advent of the internet), the mobile phone (initially only a tool for professional users) demonstrating that all bottom-up calculations were wildly conservative at the outset. You had to say ‘I believe’ that this experience will be transformative, and everyone on earth who has the money will get one. Here, the TAM depends on the ability to sell a compelling vision.

Third, you have companies that sit somewhere in the middle - companies that are entering a market in which the top line dynamics are mostly fixed but there remains plenty of scope to change things. This is where the iPhone and Android came in. Evans says: "Everyone likes to quote the Wayne Gretzky line that he was skating to where the puck was going to be, not where it was, but Apple and Google didn't do that - they changed what the game was. In the same way, saying that you’re aiming for x% of a $ybn industry is unambitious - great companies change the y, not the x."

Growing the TAM

Any TAM growth story is rarely a straight-line graph. Investors expect that market growth will more likely look like a series of overlapping adoption curves.

Lightspeed Partner Sebastian Duesterhoeft, the “Michael Jordan” of TAM, says, "I like to think about TAM maturity as S-Curves. You don’t want to be too early, when the market is still in the very early, flat part of the S-Curve where it takes a long time for value to be captured. Ideally you want to “catch” a market when there is a clear catalyst that drives the transition from the flat part of the S-Curve to the steep part of the S-Curve."

Duesterhoeft adds that 'extensibility' (e.g. the layering of S-Curves for different use cases) is the key driver behind durable revenue growth. The initial TAM of a company will eventually run out, or at least enter the later stages of the S-Curve where growth will become harder and harder to get by.

"At the earliest stages I am looking for a founder’s ability to articulate a strategy that will allow the company to expand the initial TAM. At the growth stage I’d like to see some actual proof points in the form of new product launches or new verticals that start to contribute some ARR."

In summary

However exciting your revenue projections are, they will always be limited by market size (TAM). That's why investors often use market size as an initial interest filter rather than revenues.

The power law of VC determines if the exit can be big enough to 'return the fund'. If the TAM isn't big enough to support the revenue required, a financial investor will likely just 'pass', no matter how compelling the rest of the proposition is.

A bottom-up TAM analysis is required to convince institutional investors, such as VCs. This reveals the market structure and corroborates the go-to-market plan.

Most venture propositions aren't about simple competitor displacement or creating something entirely new. They are about redefining the market in a different way and finding new levels of scale enabled by technology. Great companies change the 'y'.

TAM is often underestimated. It isn't a static figure. It is a dynamic measure, which is the result of layering multiple S-Curves for different use cases. Durable revenue growth comes from greater conviction that there will be a multitude of use cases over time.

Let's talk!

back to newsletters

Subscribe to our Newsletter

Stay informed. We will email you when a new newsletter is published.

* indicates required

To subscribe to our Blog Articles click here