Size matters: How to estimate your total addressable market.

May 5, 2010

Market size is important, because it provides a general idea of just how big an opportunity you’ve got. If you are going after a market where customers currently spend $10 million per year, it’s probably unrealistic to think that you’ll generate $5 million in revenue anytime soon – that would require a 50% market share, which is more than Coca-Cola has, and they’ve dominated their market for more than 50 years.

Still, sit through enough pitches, and you are bound to hear something like the following:  “This is a $1.5 billion market. It’s huge! If we capture just one percent, we’ll have a $15 million business!!!” Trouble is, the $1.5 billion market size is pretty much irrelevant because it includes lots of segments that have nothing to do with their business. Also, one percent is arbitrary—that could be a little or a lot, depending on the competitive dynamics.

When sizing up a market, focus on the part you can sell to—the total addressable market. That’s the amount of revenue your company could generate if you got 100 percent of your potential customers.

For example, let’s say you are starting a cosmetics business, selling high end products (“prestige” in industry parlance) through U.S. specialty stores like Saks, Sephora and Neiman Marcus. Total annual sales of cosmetics may be more than $40 billion on a global basis, but that’s not your opportunity. You won’t be selling lipsticks at Wal Mart, for example. Instead, you’ll compete in the U.S. market for “prestige” cosmetics, which is closer to $3 billion in revenue.

It may seem like bigger is better, but overstating the market opportunity is bad for everyone. It can mislead founders and shareholders, who will be disappointed when sales are lower than expected. It can also reflect poorly on founders, especially when pitching to investors who know better.