Over the past financial year, investments made by Australian venture capital firms soared to a colossal $880 million according to a recent report. That’s a significant investment in early-stage Australian businesses by VCs hoping to make a healthy return for their investors.
For VCs building their portfolio of investable startup businesses, there are generally three key attributes they will look for as indicators of future success: team, traction and size of market.
Much has been written on the composition of a winning founder team and the optimum combination of domain, technical and commercial expertise.
Certainly, investors and VCs are on the watch for the right combination of people to drive the early traction of an innovative idea. But a perfect team with an established early fan base will not by itself be enough to get investors excited.
A critical task for a founder to get right is valuing the size of their market and the opportunity for their product or service. Without an accurate estimate, it is nigh impossible to develop a business plan or to get the attention of VCs and investors.
Getting past first base
A typical VC fund exposes investors to about 20 startups. Of these 20 startups, the fund is banking on between three and six of these early-stage businesses to become their star performers, collectively returning the fund three or four times over. Experience tells investors the larger the market opportunity, the better the chance of success, and the more likely the business is to be the star performer for their fund.
By defining the size of the market, founders can excite their potential investors about how much potential business is out there. If, as a founder, you can’t answer these questions, you may not get past first base with investors.
TAM, SAM and SOM
So what metrics do investors look at in order to make their investment decision? TAM, SAM and SOM are all acronyms bandied about, giving investors very different information. As a crude explanation, the SOM generally indicates the medium-term sales potential, the SAM reflects the target market share, and TAM is the full potential.
The TAM, or total addressable market, is the total spend in the category in which the product sits. But realistically, no business can ever capture or reach 100% of the TAM, and will instead need to go after a subset of the market.
This is the reachable market or the serviceable addressable market (SAM). A startup will also find it difficult to penetrate the entire SAM, so will need to set realistic goals for the medium-term showing what is obtainable given the competitive dynamics, the strength of the distribution channels and the uniqueness of the product. This is the serviceable obtainable market, or SOM.
For example, if a tech startup is launching a food-delivery app and has done its research, it will know the takeaway and fast food TAM is worth about $20 billion in Australia. Sounds like a tasty investment, right? But what if we dig a little deeper and look at the SAM? Recent research tells us Aussies are reportedly Ubereating, Menulogging and Deliverooing about $2.5 billion worth of takeaway using delivery apps. This is the SAM. If the app is launching only with delivery in Melbourne and competitive dynamics are stiff, the founder might estimate the SOM at 10% of SAM or $250 million over a fixed time period.
A small SAM is not a deal-breaker for investors as the founders might set their sights on a bite-sized SOM if they can easily grow to adjacent markets. In the case of the fast food app, this might be another city or adding alcohol delivery within Melbourne, for example.
When calculating TAM, SAM or SOM, founders can utilise ‘top-down’ research techniques using data from the ABS or industry reports such as Forrester or Ibis. They might also use a ‘bottom-up’ approach as a proxy for an estimation. To provide investors with a more complete view, it’s wise to use a combination of the two.
Calculating the market size is difficult enough in an established market, but some startups may be so disruptive there is no existing market for the product or service. Airbnb is one such example where there was previously no global platform connecting homeowners with holidaymakers. In this case, the founder might look at what the product is a replacement for and, in the case of Airbnb, this would logically be hotels.
Getting the investor over the line will depend on the founders’ ability to paint a picture of the vision and gather research that shows support for and validates the concept. Other categories might provide some insight into the TAM, SAM or SOM, but the founder will still need to convince investors that this is the beginning of something big that could potentially be their next star performer.
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