Total addressable market is useless

A few months ago, I came across a tweet that clearly stated something that had long rankled me as an early investor:

Source: Twitter

I firmly believe that TAM is pointless for early stage startups, and over-focusing on TAM actually ends up being counterproductive in the long run.

For those unfamiliar, TAM is short for Total Addressable Market. It’s a calculation meant to provide a rough heuristic for how many users a company’s product can ever reach, in extreme upside cases. For example, one can calculate that the TAM for the Internet is currently 7.88 billion people (the world’s population – i.e. each person can only ever be one “internet user”), while the TAM for a US credit card product would be 166 million (the total number of current credit card holders in the US).

TAM is meant to be an unrealistically large number, ostensibly to demonstrate to investors and employees that the potential growth of the company – just from selling into its core market – is unlimited. Of the 1,000 or so startup pitch decks I’ve seen over the past half decade, TAM is almost always present—and it’s rare to see a quoted TAM below 100 million users. This calculation is usually quickly followed by a claim that if the company can capture just 1% of the market, it can realize [x] in income (where x is also a very high number).

An incredible amount of consulting and corporate research resources are dedicated specifically to the calculation of TAM for various products. If you’ve ever seen a news article with a headline like “artificial intelligence market predicted to exceed $35 billion by 2027” or “crypto transactions projected to exceed $100 trillion in the next 5 years,” it’s a pretty good chance there’s a big four consulting firm behind the research, using it as marketing to attract businesses.

So what’s the problem?

There are three fundamental shortcomings of TAM – one with the metric itself, and two with how it is often used in various business contexts.

The problem with TAM

First, with TAM itself: the calculation of TAM by default always imposes a laundry list of assumptions, most of which are rarely commented on.

Let’s take cryptocurrency market size estimates as an example. TAM is usually determined via a bottoms-up analysis (ie: focus on the specifics of crypto users and then extrapolate to the broader population that matches those characteristics) or top-down (ie: focus on the macro drivers that may influence crypto adoption and then go in more detail on their implications for total market size). These factors are held to be constant, and then forecasted into the future assuming no major changes. Normally, TAMs are not built with reference to all applicable user-specific or macro factors, so each estimate refers to an incomplete set of key drivers.

This is how you end up with 2030 crypto market size estimates ranging from $2.4 billion to $4.9 billion to $11.7 billion to $12.1 billion to $347.5 billion – two orders of magnitude between higher and lower estimate. And every additional year into the future that TAM is predicted introduces a significant amount of uncertainty (who could have predicted a European land war or a banking crisis?) Net-net it should be illegal to publish TAM without a stated confidence level and annotated assumptions.

TAM for companies

The other issue is how large companies refer to TAM. As previously mentioned, one of the main reasons consulting firms publish estimated market sizes—with about as much predictive power as guessing—is to sell to clients. The customers are usually large companies that want to understand the investment case for a new product, business line or acquisition. For example: if I’m a software developer and I launch a new hardware product, how many people realistically know that hardware product? Depending on how I price this product, how much annual income could it possibly generate?

For these types of major strategic decisions – which have significant downstream implications and involve a large allocation of resources – it’s important to have a rough t-shirt size of the opportunity. An original equipment manufacturer (OEM) that dominates its niche in office computer manufacturing should have a good sense of whether the size of the cell phone market ends up in the millions or billions before deciding to launch a new phone hardware line.

But rough magnitudes aside, the details of the new product line matter infinitely more than market size. Which early adopters will you market to? Can the mobile product line leverage some of the core competencies developed by the computer industry? Are the products themselves compliments or substitutes? Can the company generate ecosystem lock-in by rewarding users for purchasing both products? These details will ultimately be much more predictive of the potential top line of the new product than whether the total addressable number of users is 10 million, 20 million or 30 million. A cell phone built for a 1 billion market can flop, then add a feature that only appeals to a niche millionaire user, and then significantly scale revenue and user numbers as a result. (I would argue that for most products – not all – knowing and focusing on the problems of specific sets of users is a better path to success than one size fits all, but that’s a different conversation.)

TAM For Startups

The last use case for TAM is one that I communicate with personally: early-stage startups that cite TAM as a reason to invest. As the GP of The Fintech Fund, I am very fortunate to have received many enlightening and exciting start-up pitch decks for early-stage fintech. I love reading about the founders’ deep convictions to solve specific problems, their analysis of why those problems are not yet solved, their proposed solutions, and the team they’ve built to tackle them.

I always skip the TAM slide.

And the reason is that successful technology products tend to grow in concentric circles over time. To borrow the analogy from Dimitri’s tweet above – when TheFacebook.com originally launched, the addressable market was decidedly niche: an online directory where students can connect with others at their college. Over time, as Facebook’s user base grew and its network effects attracted new sets of users, the product expanded—first to an inter-college network, then to non-college students with a .edu address, and then to the entire world. Today, Facebook has 2.9 billion users – but no one would have ever quoted that as a realistic TAM in a pre-seed or seed or Series A or Series B meeting.

The reason successful products tend to grow in concentric circles is that good teams figure out how to build something that appeals massively to a specific audience, develop learnings from those users, and then leverage those learnings to launch more products : either those that further monetize (and serve) their core users, or those that build on the original product’s core competencies to reach new users.

Source: Brian Pagan

Trying to build something that appeals to everyone initially is usually a recipe for disaster, as illustrated above. (The implied x-axis here is addressable users.)

This effect is even more powerful if the first products make a profit. Take Stripe as an example: The company began life as an online payment processor, before expanding into a huge suite of add-on products. Overall, the transactions that Stripe processes are unit profitable, meaning that it makes money on each transaction, rather than losing money. (Average; chargebacks, fraud, etc. make some transactions unit negative.)

By leveraging a profitable core product, Stripe had the ability to effectively subsidize its entry into adjacent products such as business incorporation, fraud tools, card issuance, etc., even though these products lost money. A cash flow positive baseline product gives companies the balance and flexibility to invest in R&D and experiment with new products that ultimately end up increasing their TAM significantly more than where it was ever projected to be.

So to translate that into investment: if I’m looking at an early-stage pitch deck, it doesn’t really matter to me whether the total number of users a product could ever have is in the billions, and it doesn’t really matter to me which 1% of the market corresponds to [x] revenues. (How does the company credibly propose to win over 1% of the market to begin with?)

A much more compelling narrative to me is “we have this specific set of users who are crazy about our product, tell us they can’t live without it, aren’t attracted to any competing products, and are willing to pay us for it.” Number possible users may be in the hundreds of thousands, but if the company is that good at serving them, they will quickly gain market share in a way that allows them to expand to their next adjacent product and expand their TAM.

At the end of the day, the only meaningful use of TAM that I can think of is as an interview question for consulting applicants. Other than that, I think it’s safe to avoid ever overfitting for TAM.