Startups are about the future. You've got a small business (or an idea for a small business) — but that's just the beginning. You're hoping to turn your venture into the Next Big Thing.

But just how big should you dream? Beyond that, is your idea even viable? Or, if your startup or small business is already established, how should you think about expansion? How much revenue could a new product or service generate?

To answer these questions, you need to consider a very specific statistic. You'll need to determine your total addressable market, or TAM. In this article, you'll see how to calculate this critical figure and how this number can contribute to your overall planning process.

What is your total addressable market?

As we’ve noted, a startup represents a bet on the future. Any new business looks to grow over time. That’s the driving force behind entrepreneurship — and the basis of the cliche of the tiny firm started in someone's garage that eventually becomes a global behemoth.

Total addressable market, or TAM, represents a key part of the planning process for any new venture. It helps contextualize the possibilities and provides a figure that contemplates the highest potential a venture can aspire to.

In specific terms, TAM represents the total revenues you can expect to generate if you fulfill all the possible demand for your product or service. Imagine if everyone on the planet who might want to buy your offerings made the purchase — that's the total addressable market.

Benefits of calculating TAM

Now you know the basics behind TAM. But what exactly does running this calculation teach you? Here are some of the specific benefits you can receive from computing the total addressable market for your company or for particular offerings:

• Framing your long-term planning: As you plot your long-term expansion, TAM will help you maximize ROI. You'll see which areas deserve the most aggressive investment of resources.

• Figuring out whether new products are worth the effort: TAM gives a broad overview of a new offering's potential. This will let you make rational decisions before you get too far down the road on a new endeavor.

• Understanding the ROI of competing opportunities: As your startup grows, you'll reach many forks in the road. Choosing which direction to take your expansion gets easier when you master TAM.

• Communicating your long-term value to investors and lenders: At certain points in your development, you'll need additional resources. That means raising cash. TAM provides a key part of those communications, letting you convey your potential.

How to calculate TAM

There are two main factors that go into understanding TAM for a particular product or service. You need to know the price of the offering in question — how much a customer will pay. From there, you need to determine the total number of clients you could potentially reach.

Eventually, TAM boils down to a single number. However, to get to that point, you need to consider some existential topics about your business. Here are some questions you need to answer as part of the process:

• What defines a potential customer?

• Do any similar products/services exist?

• What are the general industry dynamics?

• Are there existing TAM estimates that can guide your approach?

• Is the market growing, shrinking or stable?

• If the market is changing, what is the rate of change?

• What is the value of your offering to potential customers?

This is just a sample list of potential questions. The main goal is to understand the relationship between your offering and its customer base, using comparable situations to help guide your estimates. From there, you'll have the data you need to begin your TAM calculations.

At this point, you'll need to determine the best way to compute your TAM figures. There are three main methods for determining your approach:

Top-Down

This method starts with a wide view and narrows to fit the particular product. To make a top-down determination, you are using demographic and industry statistics to define your TAM. Your goal is to use broad data to determine how many potential customers exist in the market. Then, multiply this figure by your sales price, reaching your TAM.

Bottom-Up

Rather than basing the TAM calculations on industry data and other broad statistics, you concentrate on information you've generated through your business activities. Essentially, you're using your own experience in the marketplace to inform your understanding of the total market.

The key stat here is known as annual contract value, or ACV. This figure indicates the yearly revenue generated from your customers. Multiply this by the total potential customers in the broader market and you'll have your TAM figure.

Value-Theory

Top-down calculations can leverage industry data for established markets. Meanwhile, a bottom-up approach lets you conjecture based on your sales experience. But there are situations where these troves of information aren't particularly helpful.

What do you do if there isn't much precedent for your planned product or service? Value-theory calculations provide an option in these cases. Here, you model the approximate value your offering will provide customers. This lets you estimate price. From there, you can multiply based on your projection of total available customers, giving you a TAM figure.

When to perform a TAM analysis

Now you understand the benefits of discovering the total addressable market for a product or service. However, as you've probably noticed, a lot of research and consideration goes into the process. You can't constantly update your TAM determination — there are certain key times when the process makes sense.

With that in mind, here are the crucial moments when a TAM analysis represents an essential endeavor:

Prior to establishing a new business

If you haven't launched your startup yet, TAM provides an excellent place to begin your process. Calculating this figure will let you put your investment in context. As we've seen, it can also give you ammunition when you reach out to potential investors and lenders.

Before launching a new product or service

TAM isn't limited to the early development of your business. Well-established companies still leverage the strategy in their planning process. Specifically, you can use this information to plan your future projects, giving you important information about your potential expansion opportunities.

When you are looking for additional capital

We've already touched on how TAM can help you raise money when you're first launching your startup. Don't think of raising capital as a one-time event. Rather, as your small business develops, calculate TAM whenever you get to the point where additional resources are needed.

Whenever you are conducting longer-term planning

You can't constantly update your TAM figures with each incoming bit of data. However, the consideration should be part of your routine budgeting and planning process.

As you develop longer-term plans, make sure you have accurate TAM calculations for any products and services competing for your attention. That way, you can direct your resources towards the offering with the largest potential market.

Using TAM to understand your startup or small business

Whether you're launching a startup or launching a new product or service for your already established business, performing a TAM analysis represents an important step in the process. This calculation will let you better understand your total earning potential. That information will help you steer resources, make decisions, and communicate your value to potential outside stakeholders, like investors and lenders.

Whether you're launching a startup or launching a new product or service for your already established business, performing a TAM analysis represents an important step in the process.

To get the most out of a TAM analysis, it's important to understand the process and the benefits it can bring. You also need to know when running the analysis makes sense and how best to undertake the process. Use the information here to get started!