Reflections on Total Addressable Market (TAM); why TAM doesn’t matter but thinking about it matters.

TAM is the carpet under which the lazy VC buries his no’s.

If you are a founder and get a pass from a VC who cites low TAM (Total Addressable Market) as a reason for passing, then rest assured that in nine out of ten cases, that is not the real reason. The real reason most often is that they have something better than you, something that they think is likely to grow faster and bigger than your startup.

I have written about the stackrank rationale before

For some reason VCs find it hard to articulate this. They resort to, oh you are early for us, or your TAM is too small for us, as convenent carpets to bury their no’s.

So do TAMs not matter at all? Should founders pitching to VCs not put a TAM slide? Should they not think about TAM whilst building? Well, I wouldn’t advise these extreme measures, yet. TAM and its close relations SAM (Serviceable Addressable Market) and SOM (Serviceable Obtainable Market) are useful mental constructs that help you think about the opportunity, or showcase it better. That said, it is useful for founders to get where TAM’s usefulness begins, and where it ends. This article attempts an answer.

Look at problem size, not market size

In 2018, in my first year in venture, I met a founder who pitched me about his plan to start a coding program for kids in India. I immediately passed, for I couldn't see how the startup could get more than ~15 million kids (and that too assuming it got 100% of the addressable market). My calculations were given the then ~25 million households who constituted the consuming class (India1) and at about 60% of them having at least one kid in the relevant age bracket to consume coding classes. The reality was the startup would get at best 10% or 1.5m of the addressable market. This seemed too small a number to justify a venture-scale opportunity. The founder persisted, and after he got a lead termsheet reached out again. I passed again.

The startup was WhiteHat Jr and the founder was Karan Bajaj. In less than two years, the startup would exit to Byju's for $300m, yielding tremendous returns to the VCs who had backed it, and giving me heartburn! [Of course, subsequently as we all saw, its performance under Byju’s has not been impressive. In hindsight, it was perhaps a textbook case of pandemic market fit and not true product market fit.] My expensive lesson was that I should never make TAM a filter for passing. For, even if the TAM is limited, provided the immediate addressable market (or beachhead market as Jim Goetz termed it) can be targeted effectively, it will provide sufficient revenues and growth, to help attract the next round of capital, which the founder can use to expand into adjacencies.

Today when I evaluate a startup pitch, I tend to look more at problem size than the market size. The market size is essentially the reflection of a solution that the founder adopts to attack a problem. For instance, the problem could be to make children more real-world ready, going beyond mere curricular rote learning (or some similar problem), and coding could be one solution, not the solution itself. There could be other solutions as well a la coding. Each solution, like coding, is implemented through a business model (full stack or marketplace, saas or transaction etc) and operates in a specific segment of the economy, yielding a potential market size. If you come up with an entirely new solution that doesn’t have existing parallels, or doesn’t fit into a pre-existing category, then it is hard to estimate TAM.

“The best products induce a market to manifest itself”

When you are a category creator, and not a disruptor of an existing category, then you will always struggle to estimate market size. Jason Calacanis opened my eyes to this in his 2020 interview with Shane Parrish of Farnam Street, when he said “The market for a meditation app and the TAM / total addressable market of meditation when I invested in Calm, 5-6 years ago when nobody else would invest in this company or very few people, the TAM of meditation apps was zero. There were none. People didn’t pay for meditation, people didn’t know what meditation was, people thought it was kooky. And now LeBron James is the spokesperson for Calm and there’s millions of paid subscribers and everybody’s releasing a meditation and sleep app. So you have to, I think if you’re going to be great at this, not try to be a coward and hang your hat on the market size.”

As Jason says “The best products induce a market to manifest itself”, whether it is Uber for rideshare, Airbnb for homestays, Calm for mindfulness. Great founders and great products can create markets out of nothing. But, when you don’t have an existing market to benchmark against, or when your solution has no clear parallels, it can be a challenge then estimating what the potential opportunity is. Like the proverbial island where everyone goes barefoot, is there then a great opportunity to sell slippers here, or is there no opportunity to sell slippers?

Tobi Lutke elaborated on the challenge of estimating market size in his podcast with Dan Martell where he mentioned how he was passed by most investors because the addressable market was small - just 40-50k online stores then. Years later, after Shopify was a success, Tobi met one of the VCs who passed on him, who was humble enough to ask him what he had missed, and Tobi said: “You were actually correct, but what you didn’t realize was that Shopify was the solution to the very problem you identified. The reason there was only 40,000 online stores was because it was hard, expensive, and everyone who tried ran into all these brick walls of complexity, which Shopify, one after another, smoothed over and made simple to do.”

Bill Gurley says much the same thing in his 2019 podcast with Harry Stebbings of 20VC: “I’ve come to believe that people get into more trouble by over focusing on TAM analysis - especially in these super early stage companies. Example: Saying Uber should only be valued at $5 billion based on the existing black car and taxi market. All too often what I’ve seen is if technology brings about an easier, simpler, cheaper solution there is a good chance the thing could expand the market and blow things out of proportion.” [Here is a fascinating read, where Gurley rebuts NYU Professor Aswath Damodaran’s TAM claims about Uber.]

When supply creates its own demand, like in the case of Uber, or Airbnb, or Shopify, it can be hard to estimate market size, given it is effectively a tabulation of the existing demand potential for the solution space. TAM measures existing, not new demand that comes as a result of the product being launched, or expandable or persuadable demand demand.

Total Expandable or Persuadable Demand matters, not TAM

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I like the above framing of Total Persuadable Market by Mike Fishbein. It or ‘Total Expandable Market’ (you pick the phrase you like), I feel is a better framework than mere TAM, given it covers both existing and new or expanded demand that emerges as a consequence of the product.

Here is Modern Treasury’s Dimitri Dadiomov on why TAM is essentially a static metric that doesn’t take into account product expansion and evolution.

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Or Sam Altman on the fallacy of thinking markets can’t grow exponentially too.

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If you thought that TAM is expandable only in new categories or emerging markets, then Ben Gilbert and David Rosenthal, who run the Acquired podcast, have a clarification to make. Per them, even in the legacy or existing markets, typically where the TAM is considered to be less malleable and expandable, if the founder ‘gives a damn’, then the TAM is expandable here too. Per David Rosenthal in their podcast with Patrick O’Shaugnessy: “TAM expansion very much happens in legacy. If there's a space where nobody has given a damn before, by give a damn I mean, build the right product with love and care and something that customers are really going to want.. Just look at electric cars before Tesla. No analyst was going to model the TAM expansion of electric cars to what Tesla became more rockets and SpaceX. Photo sharing was dead before Instagram, Instagram and Kevin Systrom. And here's the best example, web video conferencing. How crappy was web video conferencing? Legacy market, old, done. Well, then along comes Eric and Zoom. I think the common thread for all of those founders was they just really gave a damn.”

TAMs don’t matter as much as thinking about TAMs

I should caveat this now by saying that, if I have given you the impression that TAM is something that is totally irrelevant, and can be dispensed with, as it can be continually expanded, then I have gone too far. Yes, TAM is a blunt tool, in that it largely measures existing demand, and not new / expandable demand. But it is still a relevant tool, especially if you are launching into an existing category, where there are existing players and a clear customer base and demand for their products. Here TAM can be estimated, and you should have an estimate that is top of mind, that can be shared ahead with investors, and used for your business plan projections.

Just as Eisenhower said: “plans are worthless, but planning is everything”, so we could say TAM is not as important as how you think about or estimate TAM. This is what Tanay Jaipuria, early stage investor at Wing VC, and a prolific writer, alludes to in his article about how startups should think about TAM. The gist of his article is that most startups are in emerging markets where TAM is small or nonexistent. The most successful startups, expand TAM through removing consumption friction through an innovative never-before product that provides a superior customer experience. But he says “calculating TAM’s can be a worthwhile exercise because it forces you to think about the dynamics of the market and the business and how value gets created and captured.” In his article he describes the different ways in which you can calculate TAM, and recommends the bottom-up approach.

I do think Tanay’s thoughts make a lot of sense. Even outside the VC discussion, it makes sense for the founders to spend some time thinking about their TAM and how they will expand it. The VC derisks herself by investing in several startups at a time. The founder can only pick one at a time. Each pick is far more expensive for a founder, given that it takes a minimum of two or three years for the pick to play out (if a failure), and sometimes more. A founder has three or four picks or startups (perhaps more) in his or her lifetime, and hence it makes sense to spend some time thinking about the TAM and the size of the opportunity. And then, for a VC discussion, it makes sense to have a broad construct around TAM, and how expandable it is. Even if the VC is someone who doesn’t use TAM as a filter, they still have to sell it to their partnership, and there will be someone in the partnership who will ask the TAM question, and hence it is better to have the TAM construct (TAM + thinking) ready.

Sometimes TAM matters even if you are a category-creator

In a 2021 podcast, Abhiraj Bahl of Urban Company shared his perspective on how if you are a category-defining company like Urban Co or Airbnb, you will be always addressing the TAM question for he said, at every stage, the incoming investor is betting on your growth, and as the category-creator, you can only grow if the category grows, correction, you grow the category, and hence the question of the industry’s TAM comes up.

Abhiraj Bhal says in the podcast: “In the very recent round of financing in which several public market investors participated, like Wellington and Prosus and so on, we did a fairly extensive TAM exercise and defended you know, the TAM and what the TAM is. If you are a category-defining company, you will always have a TAM question, if the category is defined by somebody else, you will not have a TAM question. So if you are starting an e-commerce company, e-commerce has already been, like the category-defining company is Amazon, maybe someday you will beat Amazon. But till then, the category-defining company will be Amazon. So you will never have a TAM question. For us, we had to answer the TAM question because there is no category-defining company in Home Services. We believe we are the category-defining company. I know Airbnb has been answering the TAM question for itself forever. But even if you become very large, the guy who's coming in at that time wants to see a 10x TAM, a 10x opportunity from there. We have been answering the TAM question throughout.”

I thought this was a fascinating perspective. Even if you are in a nascent category, so long as you are the category-creator you will be answering TAM questions from incoming investors.

TL;DR

If a VC says they are rejecting you because of low TAM, push back and ask them to double click as to how they arrived at it. Most often, it is a lazy VC using TAM as an excuse instead of working harder to explain why they had to pass on you. As a founder who has invested a few hours pitching your story you deserve to know more. Now to TAM.

Founders should be aware that TAM is not terribly relevant for new emerging categories, given that TAM largely measures existing demand. The best founders and startups help expand TAM, primarily by removing friction in consumption, or by creating an entirely new customer experience via a Delta4 product. As Jason Calacanis said: “The best products induce a market to manifest itself”. But the best founders don't stop at just the great product. Subsequently they think about expanding TAM by expanding to new geographies, or selling to new customer categories, or through layering on additional new revenue streams (payments, lending, ads etc). Really what matters is Total Expandable Market or TEM, not TAM.

Finally, what matters is not so much TAM or TEM, so much as thinking about TAM in a structured manner, and bringing that structured thinking to drive business operations as well as VC discussions. And as we heard from Abhiraj Bahl, if you are a category-creator then you are going to be answering TAM questions for a very long time to come.

Let us end this by watching I think the single greatest short video on TAM thus far:)

https://x.com/TrungTPhan/status/1788961738400108994