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Calculating TAM Is About Problem Size, Not Market Size
The problem size can be calculated by multiplying frequency, intensity, and the potential number of users.
The size of a market or Total Addressable Market (TAM) is almost always at the top of the list for what VCs are looking for when evaluating startups. Because so many startups fail, it’s essential that each investment has the potential for an exit that can return the fund. However, the primary method for calculating TAM of looking at existing industry data is often very inaccurate. ‘Bottom-Up’ approaches are often not much better as there is significant uncertainty about the inputs.
The problem with looking at industry data is that startups make products that are often much better and cheaper than existing products. This allows many more customers to enter the market than ever before and often renders industry data worthless. For example in the US, the Taxi and Limo industry was a $4.2B market when Uber first started and many investors passed because it was seen as too small of an industry. Today, the ridesharing market alone is almost $50B which would have been impossible to predict when focusing on industry data. Below is a market size slide from Uber’s original pitch deck.
Focus on Problem Size, not Market Size
Instead of focusing on market size, founders should look at the size of the problem they are trying to solve. The problem size can be calculated by multiplying frequency, intensity, and the potential number of users.
Frequency: How often are users experiencing this problem? Daily, Weekly, Monthly, Yearly, Every 10 Years?
Intensity: How much are customers already paying in terms of time or money for alternative solutions?
# of Users: How many people or businesses have this problem?
Dave Lu put together a nice diagram on the frequency x intensity (Average Order Value is a good proxy for intensity) part of this equation. Interestingly there is a pretty clear line through the middle and I would be suspicious of any ideas that fell below the line in that they were solving a low-frequency problem with low intensity. Even high intensity, but low-frequency problems like buying a used car have been stubbornly difficult for startups to solve.
Going back to Uber
Now let’s apply this to Uber. If the size of the opportunity had been driven by problem size as opposed to market size, Uber may have had an easier time fundraising; of course, hindsight is 20/20.
Problem: People need to get from point A to B within ~10-mile radius to go to work, the airport, events, restaurants, and more
Frequency: 2–4 times per day
Intensity: People buy cars to solve this problem and the average cost of car ownership is $706/month
# of Users: There are 200 Million ‘Working Age’ people in the US that are communing on a regular basis
In looking at the problem this way, you can tell you’re working on a huge problem. Hundreds of millions of people in the US are spending almost $10,000 per year to solve it.
In the words of YC’s CEO, Michael Seibel:
Let’s think about a company, like Uber, for example. Usually, when you are somewhere and you need to go somewhere else, it’s a pretty intense problem. “I have to go to work.” “I have to go to the doctor.” “I have to go pick up my kids.” They’re so intense you might have bought a $20,000 car to help you do those things, right? It’s an intense problem. And then when you think about frequency, how often do you move more than a mile, more than walking distance every day? Happens a lot. And so if you think about that, even though you look at the taxi market and you say, “Oh, taxis are before Uber.” Taxis, that’s not that big of a market. If you just look at the customer, you say, “High intensity problem that happens very often. There’s probably a good business here.”
Avoiding ideas that sound good, but are bad
This Problem Size analysis also allows you to avoid ideas that sound good but are bad because they lack frequency or intensity or enough users. In that same video, Michael went on to say with his full video below that is well worth watching.
I find a lot of founders think they have a good idea, but they don’t do this frequency and intensity analysis. And so if you have both an infrequent and low intensity problem that you’re trying to solve, you’re going to have a problem getting a lot of customers even interested in talking to you. All things being equal, if you graph problems, it’s nicer for them to be higher intensity, higher frequency.
When trying to understand the size of an opportunity, focus more on the problem size than the market size. It’s a much better indicator of if the problem you’re solving is an interesting one.
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