May 21, 2020
When you set out to sell your SaaS business, you’re hyper focused on a handful of key SaaS metrics that measure how your business is performing in the historical and present moments - revenue, EBITDA, churn, etc. Running a business requires you to spend a lot of time on the present. The reality is the future potential is equally as important as the past. Buyers measure that future potential in a metric called the total addressable market (TAM).
TAM is an essential part of a company's valuation. So what is TAM, and how does it help founders and investors determine the company’s ability to grow in the future?
Total addressable market quantifies the total annual market demand for your solution in a dollar amount.
Simply put, TAM is the total amount of revenue a business can generate selling its product to every prospect or customer that is addressable.
Now addressable means that the solution is tailor made or has a use case for that particular type of business. After identifying the number of addressable customers, you just multiply your annual contract value by the number of customers.
Annual Contract Value x Addressable Customer Count = TAM
For example in the real world, if you develop and sell practice management software to legal firms to be used by lawyers and paralegals, your addressable customer base would include all attorneys and legal staff across the globe. We could identify what that number is by searching the Statistics of US Businesses (provided by the US Census Bureau) to determine a rough number of law firms in the U.S.
You can find a handful of reliable sources to give you a rough number, but it won’t be exact.
Where you can become more exact is by having multiple sources support your claim on how many addressable customers exist.
To make the math simple, let’s say there were 1 million lawyers and legal staff in the US and the subscription per user is $50 per month.
$50 (subscription price per month) X 12 (conversion from monthly to annual contract value) X 1,000,000 (addressable users) = $600,000,000 TAM
Where Buyers and Sellers tend to have disagreements on how TAM is calculated is really on the “A”. Addressable means that there may be other customers that are similar to the ones you serve, but for whatever reason, don’t count as addressable. For example, a Seller might broaden the legal addressable market to include other types of professional services like accounting. While that would expand the number of customers the solution could service, it would not be true to calculating the TAM for legal practice management.
It is important to recognize that TAM is not specific to your business solution, but to the market your business solutions serves. Which means, your TAM is also your direct competitor’s TAM and their competitor’s TAM. Therefore, you can break TAM down into two unique categories: Penetrated and Unpenetrated. As operators of our own businesses, we call this Rip & Replace versus Greenfield.
A penetrated or Rip & Replace market segment means that those addressable customers are already using a solution that is comparable to yours. That might mean they are using one of your direct competitors or that they have developed a system in-house.
In either case, for those addressable customers to become yours, you must first have them rip out their existing solution and then work to replace it with yours. This process is generally a hard one given most software solutions are mission critical to the daily workflow of a customer, which is why we love software so much! As we know, customer retention is one of the key SaaS valuation metrics.
On the other hand to complete our TAM is unpenetrated or Greenfield. This means that the addressable customer is using no solution. Now it’s not literally no solution at all as the particular workflow still needs to get done, but they might be using spreadsheets or pen & paper. These customers are typically easier to acquire as they are starting from scratch. Often times, they will not have ever used a software solution to fit this need, resulting in their amazement of how much benefit they can get from buying something like this.
The challenge with these types of customers is you are having them switch from the status quo, which we all know that when people are given the choice to change or stay the same, most opt to stay the same.
The mix of Rip & Replace versus Greenfield will hint at the number of competitors in the market. If the market is mostly Greenfield, it might mean that the number of competitors is low, giving you the head start to capture as much of that TAM as possible. As a Buyer, a TAM with more Greenfield than Rip & Replace is more valuable.
Is TAM really that important? Yes!
TAM gives Buyers an important data point to help them think about how big the business can get. After diving into the mix of the TAM, it also tells them what go to market strategies might work best to try to gain market share.
And while Founders often assume TAM is only important to Buyers, the truth is Founders should care about TAM as well.
TAM can help business owners understand the trends in their market (growing or declining) as well as market share by competitors trending over time.
If you are gaining market share in a TAM that is growing, that is a great sign for your business.
When discussing TAM with a Buyer, be ready to share the assumptions you've made when doing the calculation. Understand that the Buyer may view your assumptions about market share, addressable customers , and other factors in a completely different way and that can be okay. It's not just demonstrating to a Buyer where your company will go, but helping them figure out how it will get there.