Determining TAM When Selling Your Business [Top-Down vs. Bottom-Up]

When marketing your software or internet business to prospective buyers or investors, market size is certain to come up. Consequently, how you calculate and position your company’s total addressable market (TAM) will be an important factor in building interest in a transaction.

Opinions about how to calculate TAM will vary depending who you talk to. Based on our experience advising 100+ software and internet founders through successful transactions, here are our thoughts about how to properly calculate and position TAM in a way that investors and buyers will best receive.

Why Buyers and Investors Care About TAM

Both strategic buyers and investors will have questions about your TAM, but private equity investors especially so.

PE investors are insistent about TAM because they’re trying to determine if your market is big enough for them to grow the business to later make a good exit down the road. Looking for a 3-5x return, PE firms don’t want their portfolio companies to prematurely reach a ceiling.

Strategic buyers, on the other hand, likely already operate in the market you do and therefore already have an understanding of market size. As long as your calculated TAM is comparable to the buyer’s, they’ll be less concerned about market size and more concerned about synergies and expanding their ACV.

Given that private equity investors will be more rigorous in their interpretation of TAM, calculating your TAM with an investor’s objectives in mind will best position you for success, regardless of whom you end up transacting with.

Why Investors Care Strongly About TAM

The smaller your market size, the lower the ceiling on valuation. Generally, $1B in market size is a crucial threshold for most investors to consider investing in a software asset. Above this mark exists a spectrum of better outcomes. The smaller the market, the less interest you can expect from VCs and large PE shops looking to write bigger checks.

Something to note is that investors aren’t just evaluating overall market size, but also your company’s current size relative to the market. For example, if your company can grow 3-5x and still only represent 1% of the market, that scenario feels much more attainable and lucrative to an investor than having to obtain 30, 40, 50+% of the market to grow 3-5x.

While a bigger TAM would put you in a better position for negotiating with buyers/investors, your TAM analysis always needs to be credible.

Remember that private equity investors are fairly conservative in their calculation and interpretation of TAM. On the strategic side, buyers have preconceived ideas about market size built from years of working in the space. As such, being too liberal in your TAM analysis can damage your credibility and hurt the momentum of your transaction.

With that in mind, how you calculate TAM is as important as the number you put forth to buyers/investors.

Calculating and Positioning TAM

Calculating TAM is as much art as science. While common methodologies exist, there are no hard-and-fast rules for determining TAM except one: it must be credible and defensible. Regardless of your approach, investors are going to drill into your logic, so you need to be prepared to justify that logic.

While there are many paths to arrive at TAM, any approach to calculate it will fall under one of two categories: top-down TAM or bottom-up TAM.

Top-down TAM

A top-down approach to TAM is when you first consider the market as a whole, then narrow down to the portion that applies to your company. Most founders start with this approach because it seems more intuitive: start big then segment down.

A common process is as follows:

1. Start with the total market size (e.g. real estate)
2. Narrow the market size to the portion spent on your sector (e.g. real estate software)
3. Further narrow the market size to your category (e.g. real estate scheduling software)
4. If necessary, segment the market further (e.g. geography, customer size, etc.)

Many founders will stop after step 2, but investors will take the analysis as far as they deem necessary. A founder should fully complete the analysis in order to better align their numbers with that of a prospective investor.

Bottom-up TAM

Bottom-up TAM is the approach most investors will use as it tends to be more indicative of true market size. With this approach, you start with a basic unit of your company’s economics and then multiply by average deal size.

A common process for bottom-up TAM is as follows:

1. Identify a target customer profile (e.g. real estate brokerages with >20 employees)
2. Determine how many prospective customers match that criteria
3. Multiply the number of prospective customers by what you charge the average customer

Take the time to consider different units of analysis and the effect those will have on TAM. For example, while an enterprise software company could base a bottom-up TAM analysis on the average contract value of an enterprise customer, an alternative calculation based on total potential users and the average revenue per user license might paint a more accurate picture of the total market opportunity.

Is bottom-up better than top-down?

Given that the bottom-up approach tends to produce a more accurate representation of market size, is a top-down analysis necessary?

Even if bottom-up tends to be more accurate, a top-down analysis that lands in the same ballpark as your bottom-up TAM can help strengthen the credibility of your analysis when presenting to buyers/investors.

In addition, the bottom-up approach has limitations that make the top-down approach a good alternative. For example, quantifying how many viable customers exist in your market may be highly difficult, in which case the top-down approach may be more appropriate.

Be Prepared to Defend Your TAM Analysis

Like with a doctoral thesis, you will need to be prepared to defend how you arrived at your final TAM. As a founder, however, you can’t expect yourself to fully anticipate how buyers/investors will respond to your analysis. They will have questions and they will expect answers.

Among other aspects of a transaction, an investment bank can help you synthesize and solidify your TAM analysis so that when buyers or investors have questions, you’ll be in a position to provide strong justification for your final number.

Learn more about how an investment bank can help you position your business.