When looking for investment opportunities, investors, especially when it comes to early-stage startups in the technology sectors, beyond other potential metrics, primarily look for how big the potential market might be through what’s known as the TAM, SAM, and SOM frameworks.
Understanding how venture capitalists think
A venture capitalist is an investor that provides capital to start-ups that have high growth potential. In other words, for a potentially high return, the investor endows the company with equity for a stake within it.
It is important to highlight that not all investors and venture capitalists look for the same things or focus on the same aspects of a business.
In general, most investors look for interesting opportunities that would represent a good long-term investment.
How might those opportunities look like? It is crucial at this stage you get acquainted with the market you’ll be operating.
This means you’ll need to understand three key concepts: TAM, SAM, and SOM:
In short, you might want to start by understanding the size of the Total Addressable Market.
From there, you might want to understand the size of the Serviceable Addressable Market.
And what your Serviceable Obtainable Market will be.
Once you have defined the SOM, you can make a five-year projection of the expected sales (assuming you don’t have revenues yet).
Based on that projection, you will be able to apply a 3-5X multiplier on the revenues based on the market and business model you identified.
Quick case study
- Imagine you are evaluating how much your marketplace idea is worth.
- You operate in a market where the TAM is $10 Billion.
- That your SOM is 0.5% of that market in the year 5th.
- This means at the year five; you will have a volume of transactions on your marketplace of about $10 million.
- As a marketplace, you might make money through transactions fee.
- Assuming a transaction fee of 3%, you will have a turnover of $300K in year 5th.
- Considering that a marketplace business model is highly scalable and that the TAM is pretty big, you might want to apply a high multiple, let’s say 5X, on the revenues.
- This means that in the 5th year, your company will be worth $1.5 million.
Therefore, if the business angel invests:
- 10% = $150.000
- 20% = $300.000
- 30% = $450.000
- And so on…
Keep in mind the example above is just a simple case study.
The estimates will depend on what assumptions you’ll start with from evaluating your company.
So how big is the TAM? How much of that market can you service in 3-5 years? How will you make money? And so on.
Also, the ability to convince the business angel might depend on how good you will be at communicating your idea, the so-called pitch.
And suppose you’re looking for a business angel, venture capitalist, or investor. In that case, that means you might need a strategic figure able to help you scale your business as quickly as possible.
Related Market Development Frameworks
Stages of Digital Transformation
Platform Business Model Strategy
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