I Don't Give a TAM

ONE HUNDRED BILLION DOLLARS!!!

Such was a startup founder’s recent description of his total addressable market (TAM). This assertion was clearly meant to impress, and served as the key argument for a high valuation for his company.

Hearing this bluster led me and my partners to an interesting question: how much does projected TAM matter in seed stage valuations? Answer: not much.

As a thought experiment, consider two companies, Alpha and Bravo. They are both pre-revenue hard-tech startups. They have great IP, smart and enthusiastic founders, and excellent reviews from prospective customers who have tested prototypes. The only difference? Alpha has a TAM of $1B, and Bravo a TAM of $2B.

Given that set of facts, is Bravo worth twice as much as Alpha? They have similar risks, and if successful Bravo will eventually generate higher cash flows because of its larger market. It just seems obvious that it should be worth more today.

That argument looks logical, but it’s wrong. There are at least three reasons this instinct leads you astray:

First, neither of these companies has made a sale yet. There is a reasonable chance that one of them won’t ever make a sale, or will make just a few and then peter out. In other words, both could still go to zero with some relatively high probability. The fact that they could go both to zero greatly reduces the impact the different TAMs have on the current valuation.

Second, any TAM over a few million dollars is heterogeneous: it is made up of different segments of customers who all have different requirements. Just because you meet the needs of one doesn’t mean you meet the needs of others. Such segmentations tend to whittle down what is actually “addressable,” so taking a big TAM at face value is likely to be a mistake.

Finally, if you do a proper DCF of these companies, with a very high venture-risk discount rate, the cash flows in earlier years dominate the current value. The cash flows 10 or 15 years out, which might be bigger for Bravo, have a minimal impact on today’s valuation because they are so heavily discounted.

Bottom line: beyond some minimum threshold (which changes depending on how much capital a company requires to get to cash flow positive) the TAM is irrelevant for seed valuations.

So what does matter? At seed stage, founders should be much more focused on existence proofs than on sizing. Are there customers who will pay for what your selling? What will they pay? What will it cost you to deliver? How will you find customers and sell to them?

For the development stage hard technology companies Rhapsody works with, demonstrating customer traction is difficult but not impossible. Even though there may not yet be commercial product to sell, we often see startups sell samples, sign MTAs, establish JDAs, and so on. All of these are much more important signals than TAM at the early stages.

What you focus on says a lot about your priorities. If a founder is focused on building customer relationships, it is clear he wants to build a business. A founder focused on spinning a story about the biggest possible TAM is probably more interested in raising venture money than building a real company.

Jason Whaley