The first step any business plan is to identify the Total Addressable Market (TAM) for its product. And I still find many neophytes cannot determine what that should be. The next step, equally important, is estimate what market share of that TAM can be seized within the first year, given the market’s economic and marketing parameter. And, again, I am always shocked how people cannot calculate those figures or even insert unrealistic numbers.
The healthcare industry is one of those industries where business plans never truly scope out the TAM. For example, I had to work on a healthcare software which would be embedded in a piece of electronic hardware implanted inside the patient. First, I had to determine the purpose behind the software: to manage and control chronic pain without chemicals.
Now everyone has a headache, breaks a finger or a limb. Everyone, at some point in his or her life, suffers some pain. If that were the definition alone for the market for this product, the TAM should be 370 million U.S. inhabitants. However, the product requires a well skilled surgeon to insert wires between the fourth and fifth vertebrae, wrap that wire from the back to the front, to a small electronic device near the abdomen that discharges electricity to right to the nerves located between the two vertebrae, which would then deaden pain. The software, the potential investment, regulated the amperage.
I doubt that the whole U.S. population could afford such surgery for minor or even temporary pain. And the original business plan did not identify the TAM. I had the responsibility of due diligence on the company’s technology and business plan. And that number was necessary to determine the value of that technology.
After attending a couple of pain conferences, I then understood that chronic pain throughout the medical industry meant patients who suffered pain over 300 days a year. That would narrow the TAM to less than 100,000. That number alone influenced my final report to declare that even though the technology was unique and necessary, the maximum total sales were finite and small. An investor would not lose money, but overall potential growth would be limited, even while capturing 100 % of that TAM. What even reduced the potential market further was the existence of alternative products that inserted chemicals into the spine rather than discharging electricity to control chronic pain.
But again, this true life exercise clearly demonstrates that every business plan author or analyst has to understand the product and the market in order to assess the TAM.
The second step is determining how much of that TAM could the startup company seize in one year. For this I will use another example. One New York software company had developed a financial software online platform for consumer transactions that could only be licensed by banks. The original plan stated that the company would be licensing 8 platforms in its first year. The TAM is easy: identify all commercial banks with online banking transaction platforms. That number can be gathered from public information. However, the chief marketing officer claimed in the business plan 8 units being sold in one year. Was that number realistic?
The TAM are commercial banks. And banks are very conservative potential customers whose sales cycles are extremely long. One experienced Managing Director from a very reputable investment group noted that in his 10 years in the industry, the most software licenses sold in this space never exceeded 5. In other words, the projected first year sales were inflated by 60%. This huge error in projections demonstrated that the marketing chief had little or no experience in the industry. Or that marketing manager failed to do due diligence in his industry – a major flaw for this startup’s management team. Had someone done the homework, or evaluated the potential sales, the marketing guru would have gotten decent first year projections right and discounted them by 20%. Any projections should understate their sales enough, but not too much, in order to under-promise, over-deliver.
To sum up, any business plan writer has to identify the true TAM. Then once that TAM number is circled, then calculate the potential first year sales that is rational and achievable given the customer profiles and working capital.