Gauging Customer Demand is Knowing Your TAM, SAM and Then SOM
The most memorable startup business plan that ever landed on my desk began with the declaration that if every American substituted one hamburger a week for a rabbit burger, the company would sell over 12 billion rabbit burgers a year. As insanely laughable as that statement is, too many entrepreneurs make the same mistake when pitching their companies. They see the grand international market as theirs for the taking without understanding the tremendous amount of time and capital global domination will require. Many first-time founders fail to understand the difference between the potential of the Total Addressable Market (TAM) and the very finite subsection they can hope to capture. No company ever captures the entire market they pioneer. Innovation doesn’t happen in a vacuum and others will jump in from the moment you’ve identified the potential. Most startups fail not because they had a bad product or idea, but because they fail to accurately gauge customer demand and underestimate the cost of customer acquisition. Aware of this, most venture capitalists and sophisticated investors will only back companies that understand their TAM, SAM and SOM.
Total Addressable Market is easy to identify and basically useless. The purpose of identifying your TAM is to immediately discount it to a much smaller and more realistic Segment Addressable Market (SAM). If you are starting an online women’s shoe store, knowing that 3 billion women have feet is irrelevant. Knowing that Zappos has 24 million customers is your SAM. How you plan on reaching those 24 million is more important than the 2 billion women who have never purchased shoes online. Every industry has segments and sub-markets. Never expect that your startup can cover every aspect of the market. The key is knowing what segment will respond to your unique offering. Who your product appeals to is just as important as the product itself. The more specific your SAM, the more effective your marketing spend. Validate every assumption with limited media buys and AB testing. Targeted marketing delivers a lower customer acquisition cost and gets you to profitable growth faster. The goal is to quickly identify the costs associated with acquiring your most profitable segment of customers and the incremental value — if any — of going beyond your core. But, here again, too many entrepreneurs make the mistake of assuming that the SAM is their market.
Americans bought over 15 million automobiles last year, but that doesn’t mean a $90,000 Tesla has a multi-million unit SAM. Elon Musk focuses on the Share of Market (SOM) interested in luxury, high-tech and the environment. By growing and owning this SOM, Tesla is able to expand the brand (and its market) to more mainstream vehicles in the future. When Tesla launches their $40,000 Model E next year, they will expand their SOM. If your SOM is geographically diverse, start with a small test market to prove your concept. Groupon started in Chicago, before spending millions to be a national company. Mark Zuckerberg built Facebook for the Ivy League before becoming a global network. Each test market helps the entrepreneur gauge customer demand and refines their business plan. Once you nail your SOM and your customer acquisition costs, late-stage VCs and private equity firms will line up outside your door to fund your growth. Test markets minimize risk and maximize an investor’s return on investment.
The last and most important step in gauging customer demand is knowing your Defensible Addressable Market (DAM). When Sean Fanning first approached me with Napster, I knew that he had completely disrupted the music industry. I also recognized that he had failed to find a way to capture any of the value he had unlocked. Having a startup that disrupts the existing status quo only makes sense if you are able to defend the new opportunity that you created. If the hole in the market you hope to fill really exists, you will not be the only one going after it. The first person that you will educate in business is your competition. They may have been asleep at the wheel, but once made aware of your innovation, how will you fight off their response?
Your new product isn’t your most defensible asset. Products can be copied and knocked off. Your most defensible asset is the data you created during the process of learning your market. All of that testing you did to gauge customer demand in your test market while refining your SOM is the secret sauce to your success. By being first, you will have gained market insights that no other competitor has. You will be able to spend your marketing dollars more effectively and improve your offering to match actual customer feedback. Data makes the old adage “the best defense is a good offense” ring true. Potential investors are looking for data that proves out your market assumptions, predicts the cost of scaling and provides a realistic view of the company’s true market potential. In short, investors are looking for a DAM good plan.
This post first appeared in the Wall Street Journal November 13, 2014