How Should Founders Think When Calculating Market Size? | VC Jobs
Power law of Y Combinator startups & More Customer Support Ticket = PMF?
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Deep Dive: How Should Founders Think When Calculating Market Size?
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On the power law of Y Combinator startups
Jessica Livingston: More customer support tickets are a sign of product market fit.
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TODAY’S DEEP DIVE
How Should Founders Think When Calculating Market Size?
I've previously written about proving market size to investors and evaluating market opportunities (You can check out the archive page). However, I've recently noticed a troubling trend in startup decks. While many teams have strong experience and are solving significant problems, founders often stumble when asked about market size. Some even struggle to explain their approach to calculating it. This lack of clarity is a major red flag for any startup. Remember -
Without a market, a business doesn’t have much of a future. Understanding the potential size and shape of the market is a critical step in the early stages of developing a business, as it will help to inform everything from your short and medium-term objectives, and product development, right through to the way you pitch to investors.
Here's a beautiful example of market research in action, at the genesis of a business. Facebook (now Meta) is almost ubiquitous in modern life. However, it wasn’t always like that. When Facebook was new, the entire social media sphere was effectively untested and unproven. Facebook (then TheFacebook) needed to prove a lot—not least that there was an actual audience for it. Here’s an actual slide from those early days:
It makes a pretty compelling argument, right? Without Facebook having such a successful proposition early in its life, it may have never had the opportunity to grow into what it is today, but investors bought into the promise of tapping into the college students market, and the rest is history.
So how did Facebook arrive at those numbers, and how can you do the same for your startup? Being able to do this for your startup idea comes down to three acronyms: TAM, SAM & SOM.
What is TAM, SAM & SOM
TAM = Total Addressable Market (Or Total Available Market)
This represents the revenue opportunity that a company has if it has a full 100% of the market share, and there is no competition.
SAM = Serviceable Addressable Market
This represents the “slice” of the TAM “pie” that can be served by a company’s products and services.
SOM = Serviceable Obtainable Market
This represents the actual amount of the market that is being served by the company’s products and services.
These three terms are related to one another, and are generally depicted as a series of three circles -
Of the three, TAM is the foundation, so we’ll start by calculating that first.
Total addressable market (TAM)
TAM is the “pie in the sky” number. It represents the absolute maximum possible revenue that a business could generate in the market, if every single potential customer is converted into a paying customer, and each of those customers is providing the full maximum revenue.
It’s a useful number as it helps to understand the potential scale of the business, and can help to establish a seed of the go-to-market strategy. However, it’s not a realistic goal. No matter how well you execute the business strategy, you’ll never reach the TAM number, because it assumes that you’re the only provider of the product or service and have zero competition.
How to calculate TAM
When calculating TAM, there are a few different approaches you can take. These include:
Top Down Approach
The top-down approach starts with a broad market size and narrows it down to your specific market segment. This method typically relies on industry reports and market research studies.
Step 1: Identify the total market size using industry data from reputable sources such as Gartner, Forrester, or industry-specific reports.
Step 2: Segment this data to reflect your specific market. For example, if you are targeting small businesses with your software, you would narrow the data to show the number of small businesses in your market.
Step 3: Apply relevant percentages to reflect the portion of the market you can realistically target.
Example: If the overall software market is $100 billion and small businesses represent 20% of this market, your TAM would be $20 billion.
Bottom-Up Approach
Alternatively, you can make TAM calculations based on previous sales and pricing.
ake the total number of potential customers in a market, and multiply that number by the annual contract value (ACV).
The ACV is the amount of revenue that you would gain from each customer contract, on average.
This is a simple equation. Say you sell medical software, at an average of $1,000 for a year’s license. The only customers that are going to be interested in this software are hospitals, of which there are 1,352 hospitals in the particular country. Your TAM, therefore, is $1.35 million.
Value Theory Approach
The third method of determining TAM is a little more subjective but particularly useful for entrepreneurs in highly innovative sectors, or those that aren’t yet selling a product. The value theory approach is based on how much customers are willing to pay for your product or service in exchange for the value that they’re getting for it.
The calculation is the same as the bottom-up approach, above, but rather than calculating the average sale price, you’re looking at what a comparable product sells for, and what premium your superior product could attract.
To use the medical software example above, say that your software is the first in the space that sits in the cloud and allows hospital administrators to access the software from anywhere. In this instance, you would want to include the premium that administrators would pay for that convenience to the TAM, to represent the greater expected revenue you would get from each customer for your unique feature.
Service Available Market (SAM)
With the SAM, we start getting a little more realistic about things. , SAM is a calculation that understands that no product can service an entire market.
How to calculate SAM
Calculating SAM is a continuation of the bottom-up approach that you used to calculate TAM. This is the point where you start to get more realistic about just how much of your product you can sell.
Every startup entrepreneur fantasizes that their product will be relevant to everyone in their category, but that of course is not the case.
To continue our example above, perhaps your product has a set of features that make it more relevant to the public hospital sector than the private hospital sector. A percentage of the private hospitals in the particular country might still purchase the solution (more if your sales team is good!), but the SAM calculation would therefore be based on the number of public hospitals in that country. There are 695 of them, meaning that with an ACV (Annual Contract Value) of $1,000, the SAM for your software package is $695,000.
Service Obtainable Market (SOM)
Finally, we come to SOM. This represents the actual amount of the market that is being served by your company’s products and services, and while it’s only relevant once you’re in the market, it becomes a critical component in assessing your startup and its potential going forward.
How to calculate SOM
You’ll want to start calculating SOM once your business is in the market and has customers.
The SOM is determined by calculating last year’s market share, multiplied by this year’s SAM value.
First, you need to determine market share. Say there are only two businesses that sell software with this functionality, and your business sold $400,000 in software last year. Your market share is that number, divided by the SAM (around 0.58, or 58%). Your rival has the remaining 42%.
Now, say there were an additional 20 hospitals brought online in the year. The new SAM for the next year is $715,000. Your SOM is determined by multiplying the market share from last year with the SAM for this year—or roughly $414,700 in this example.
If you end up earning more for the year than that number, then you’re taking market share from your rival. If you earn less, then you’ll want to explore why your competitor is gaining traction.
Note:
While SOM measures market share, and therefore is 0 until your business is in the market, there are, of course, ways to estimate the market share that your product will target once in the market. For illustrative purposes—for example, when pitching to VCs—creating hypothetical SOM scenarios in this way might be a useful exercise for a founder.
Why Do TAM, SAM and SOM matter to a startup?
Investor attraction: TAM especially tells a story that can attract investors. They prefer a "Goldilocks" TAM - not too high (suggests saturation) or too low (limited growth potential).
Growth potential: A larger TAM allows startups to show how they can expand their market, either by adapting their product or entering new markets.
Market positioning: In saturated markets, the gap between TAM, SAM, and SOM indicates the difficulty and cost of acquiring customers, which affects investor interest.
Funding prospects: A small TAM may limit large funding rounds unless expansion potential can be demonstrated.
Strategy development: Understanding these metrics helps startups identify underserved segments within mature markets where they can quickly gain market share.
Five things you should consider while creating a market-size slide
First, opt for a bottom-up approach over a top-down. This shows you've done original research and analysis, rather than just grabbing numbers off Google.
It demonstrates how you see your startup fitting into the market. Second, don't inflate your numbers. Stick to your core audience - if you're targeting Gen Z in a particular country, don't include millennials or global figures. Third, be clear about geography. Unless you're aiming for global operations from the start, make sure your TAM data reflects your specific target market.
Fourth, be prepared for scrutiny on pricing. If you're pre-revenue, your TAM will involve assumptions about the average selling price. Make sure these are defensible and have the math ready when investors ask. Finally, show a vision for future growth. Highlight how your product roadmap could expand your TAM over time. Think about how Facebook started with college students but now includes boomers and Gen-X. A well-crafted TAM slide can set you up for success with investors, so it's worth putting in the effort to get it right.
That’s it.
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QUICK DIVES
1. On the power law of Y Combinator startups
I recently came across an article (kind of mathematical article) by Jared Heyman, the founder of Rebel Fund. In it, he shared fascinating insights about Y Combinator startups and the power law that governs their success.
He shared -
One of the most striking things we've noticed is how extreme the differences in success are among YC startups. It's not just that some do better than others - a tiny fraction of these companies end up being worth more than all the rest combined. We're talking about companies like Airbnb, which at one point was valued at around $100 billion!
To give you an idea of how dramatic this is, let's look at some numbers:
Only about 6% of YC startups become "unicorns" (valued at $1 billion or more)
These unicorns account for 90% of the total value created by all YC startups
Even among unicorns, the biggest winners (called "dec acorns" - worth $10 billion or more) make up more than half of that value
And get this - just two companies, Airbnb and Stripe, represent more than half of the deacon’s value!
This pattern, where a tiny number of massive winners dominate, is called a "power law" distribution. It has big implications for investors like us.
For one thing, it means that to make good returns, you need to catch some of these rare, super-successful companies in your portfolio. But here's the tricky part - even among YC startups, which are already a select group, these big winners are hard to predict and easy to miss.
So what's the best way to invest in this kind of environment? We've done a lot of number-crunching on this, and our conclusion might surprise you: it's better to invest in a large number of startups rather than concentrating on just a few.
Here's why:
With a small portfolio (say, 10 companies), you have a pretty high chance of missing out on any unicorns at all. That would mean breaking even at best.
With a bigger portfolio (50-150 companies), you're much more likely to catch at least a few winners. You might not hit the jackpot, but you're also much less likely to strike out completely.
The bigger your portfolio, the more stable and predictable your returns become. This is important for professional investors managing other people's money.
Now, this doesn't mean you should just invest randomly in as many startups as possible. Skill in picking good startups still matters a lot. If you can avoid the weakest half of YC startups, for example, your chances of success go way up.
Another crucial factor is access. Unlike buying stocks, where anyone can purchase shares of any public company, with startups you need to be invited to invest. The best startups often have more investors wanting in than they can accommodate. T
hope this explanation helps you understand why startup investing works the way it does.
2. Jessica Livingston: More customer support tickets are a sign of product market fit.
A counterintuitive tip about startups is that more customer support tickets are a sign of product market fit.
If users didn’t love the solution your product was offering to a painful problem, they wouldn’t care enough to write in support tickets. And more tickets = more users.
But when support tickets grow at an exponential rate, they become a problem where you simply can’t get to all of them and still work on the product, growing it, managing the team, talking to investors, etc.
So how do you solve that?
Most people’s first instinct is to hire a customer support person, but this is almost always the wrong first move:
You take yourself further away from your users, making it more complex to understand their issues.
If your startup keeps growing, you’ll just have the same problem again soon.
Instead, take Jessica Livingston’s (Founding Partner of Y-Combinator) advice (below) and focus on making the product better.
3. VC Incentives
VCs live in a cutthroat world.
No, really.
There are only a few true breakout companies each year, and a limited amount of desirable jobs in VC to find them.
As a result, VC behaviour is entirely driven by the incentives governing success in the role (i.e. finding and backing the winners).
Before a VC invests, they’re incentivized to gather as much information about the opportunity as possible. The quickest way to do this is to show intense interest to the founder.
You’ll never have trouble building a relationship with a VC if they’re interested in what you’re doing.
But once they decide for sure that they don’t want to invest, they pull back and move on.
And this continues even after they invest — if your startup is failing and the VC is writing it off as a losing investment, they’re not going to go down with the ship with you. They’re going to spend time helping their potential winners.
It’s a tough pill for some founders to swallow, but it isn’t personal — it’s just the nature of the game on their side.
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That’s It For Today! Happy Friday. Will meet You on Tuesday!
✍️Written By Sahil R | Venture Crew Team