Why and How to Calculate a Realistic Market Size

Multicoloured segmented pyramid on black background

Calculating the size of a startup’s market is not a simple exercise. Its a delicate mixture of art and science with a little bit of pure guess work. It is even more difficult to be accurate when the product may pivot many times in a short period of time to serve a different segment of the market than originally conceived. However, a value for potential market size that is calculated based on validated assumptions and accurate references is something all startups should know.

Why bother?

Firstly, building a startup is hard, exhausting work that requires significant sacrifice. Most startup teams may work 80+ hours per week for several years before they see any financial reward for their work. Quite understandably, founders and team members will want to know that there is potential for a large pot of gold at the end of this rainbow. If a large enough opportunity does not exist, it may be difficult to motivate team members and investors to remain engaged with the venture for the long battle. Being able to convince the team of the potential of the opportunity may help keep them motivated throughout the long work days and daily frustrations or running a startup.

Secondly, investors will want to know this value in order to determine if the potential upside is lucrative enough to warrant the risk of investing their capital. Most angels expect a financial return of between 3x and 9x of their investment. To convince an angel of that expected return, a founder must craft a story indicating that not only does a massive customer group exist for the product, but also how the venture will capture customers in that market. Founders can tell this story in a more convincing manner by showing a market analysis that shows a well-defined customer segment along with size estimates per region and growth rate. Another good reason to spend time creating a realistic market estimate is to demonstrate to investors the capabilities of the founding team and their ability to put in the necessary work to perform such a calculation.

Thirdly, knowing market size is an important input when analyzing the financial model for the venture. A financial model, also known as a P&L (profit and loss), is the estimate of how your venture will perform financially over a period of time, including estimates for revenues and expenses. It is typically calculated on a monthly or quarterly basis for one calendar year, however startups may prefer to forecast on a more or less frequent basis for a longer or shorter period of time depending on cashflow urgency and industry. Knowledge of market size is used as an input to calculating and analyzing revenue forecasts. The market size information will indicate important information such as sales volume, purchase frequency, and seasonality of purchases. Better quality market size information will show these values divided into more precise groups, such as regionality. Information from this analysis, combined with the pricing model, establishes a top-line revenue value for the venture, being the foundation for the remainder of the financial model.

Calculating Top-down Market Size

One method to calculate market size is called the top-down method, and is probably the most commonly used estimation technique. To perform a top-down market estimation, start with a value that represents all the revenue generated in the entire market. Market research companies like Gartner and Forrester, industry and trade journals, and government statistics agencies such as Statistics Canada are great sources.

Next, identify the specific criteria of your market. Region, product type, sales channel, and price are some examples of criteria. Its important to identify the criteria that are most appropriate to your specific venture and products. Getting the criteria wrong may result in finding a market that is too big (creating a false sense of encouragement of chasing a massive opportunity) or too small (discouraging entry into the market).

Apply those criteria against the total market size to distill it to the segment relevant for your venture. This step should be repeated several times to define a very specific market definition and size that exactly matches target market criteria.

An alternative top-down method is to identify the size of the total market, as above, then multiply that value by the market share the venture forecasts capturing in a time period. For example, if the total market size for lawnmowers in Canada is $10m annually, and a new lawnmower startup plans to capture 2% of the market in its first year, than its market estimate will be $200k. Obviously, this method is not very scientific. There is no guarantee that the venture will achieve its goal of capturing 2% market share. The target market capture value is questionable. The founders could have easily chosen 1.5% or 3% as their target. Perhaps some research-backed logic exists that explains why this value was chosen, however there is a significant amount of guess work here.

Calculating Bottom-up Market Size

Market size can also be calculated using the bottom-up technique. This method begins looking at data at the micro, or individual business, level, then aggregating to the higher macro level, such as across a nation. In many ways, this estimation can be more accurate than top-down because it uses actual values provided by real market players. While some assumptions are involved, gathering more data from individual players can help minimize the range of error.

The technique starts by gathering the actual number of sales for a given product from a single business in a single period of time. To get an accurate value, one should ask their target customers or actual business owners to share their average sales volume. If the customer is not comfortable sharing real values, ranges or averages are fine.

Using this value, one then multiplies it by the number of stores or sales channels in a region. Counts of number of channels or stores can be found using market research reports or various government census or statistics agencies. Directories like Yellow Pages or Yelp can also be great sources of this information.

The result will be the total market size for that region for a period of time. To estimate for a larger region, one can then multiply by the number of regions that exist in a larger area, such as a province, state, or country.

Conclusion

Savvy founders know the size of the market their venture operates. This knowledge can help motivate teams and investors who want to work hard to attack big problems for a chance at capturing an equally big reward. It also plays a key role in building an accurate financial model that is based on facts and intelligent estimates.

Founders can use either top-down and bottom-up techniques to calculate market size, however it is recommended to perform both techniques and compare the results. A significant difference between the two values may indicate some poor quality information was used or an unknown market factor exists. If this happens, founders can re-analyze their assumptions, segmentation, and data sources to find more accurate numbers to incorporate into the business plan.

These values should not be considered static. Founders should re-evaluate their market size calculations at regular intervals. Business, technology, and consumers are ever changing at an increasing rate. Understanding these changes and how they affect the number of customers available to a venture ensures that founders are making informed decisions regarding their business.


What are your thoughts on the methods listed above? Has your startup experienced using one or both techniques? What were your results, and how did they provide value to your venture? Please leave a comment below as I would love to discuss further.

Leave a Reply

Your email address will not be published. Required fields are marked *