• Causal Engines

Common pitfalls in TAM Analysis: when a failure to imagine can be expensive

TAM - or total addressable market - analysis is one of the most common ways for founders and early-stage investors to evaluate the potential of a startup. Measuring the total amount of demand for your product or service is the first step in understanding the future value of a company, after all, an incredibly tiny TAM means that even the most successful of companies will only have a tiny amount of revenue. However, sometimes investors fail to properly understand TAM, most often by vastly underestimating it and the implications that go with it. Most mistakes with TAM are mistakes of omission.

In 1980, when AT&T commissioned McKinsey to calculate cell phone penetration in 2000. McKinsey predicted 900,000 subscribers, so AT&T decided to not invest in the technology. By 2000, there were 109 million subscribers, and by 2010, AT&T had to acquire McCaw Cellular for about $12.6B to enter the market. Now ⅔ of the world has a mobile phone, at an annual growth rate of 2%. McKinsey’s inability to “skate to where the puck is going” was a costly, $12.6B mistake, and it’s one that often happens with TAM analysis. They failed to see long-term trends that would have drastically altered their analysis - increasingly cheap, fast and easy cell phones and a growing cellular infrastructure made cellphone adoption explode over the next few decades. Failure to understand TAM is a failure of imagination.

A more proximate anecdote is AirBnB, given its recent IPO. In 2009, when AirBnB was just a marketplace to rent and sell air mattresses on apartment floors, Union Square Ventures saw an interesting idea from an enthusiastic, hardworking management team, but they also didn’t see a large market for rentable air mattresses and didn’t pursue the venture. Today, AirBnB’s market capitalization is $83B.

Both of these stories remind us that TAM is a moving target, and that the important factor to keep in mind is anticipating if a product will “cross the chasm”: an idea from Geoffrey Moore’s book Crossing the Chasm that great products shift from the early adopters and other passionate consumers to the mainstream market. While in 2009, only a few users were passionate about renting air mattresses, over time as AirBnB’s feature selection grew they were able to shift into the mainstream market. In much the same way, cell phones in the 80’s were expensive, clunky, and significantly less easy to use than our modern day smartphones. McKinsey saw a few early adopters using them and not a disruptive product that had many more potential use cases.

Being able to identify the forces that push a small, niche market into a much larger one is difficult, but it’s absolutely essential for good TAM analysis. It can be the difference between a small bet, or a gigantic sized outcome.

We would like to thank AVC, Angel Lozano, and Geoffrey Moore for their inspiration.

This article is a collaboration between Archit Bhise, Alex Li, and Grant Sobczak.