We’re often told “bigger is better.” When it comes to height, cities, schools, meals – the public perception is always one of “bigger is always better.” This holds true for software as well. Investing behind a large TAM (or “Total Addressable Market”) is perhaps one of the first things investors learn. It’s chapter one in the textbook. A larger addressable market means more leads to call upon and more potential revenue. It means that the “ceiling” of the Company’s “size” (and valuation) is larger (i.e 1M customers x $10k ACV = $10BN TAM!). Wow, does that sound great. When growing up and deciding where to go you school or where to live – some of these same principles are also considered. Do you want to go to a large state school where you can make tons of friends, have access to a large network and pick between tons of majors, classes and teachers? Or do you want to attend a small liberal arts college in Vermont with 2,500 students? Do you want to move to a big city where there are more job opportunities, restaurants, people and parties – or do you want to move to a quiet lake town out in the mountains and open a café? Depending on who you ask, the answers can vary widely, but the presumption that bigger is always better is surely not true, at least not all the time. That goes for life, and it also goes for software.
In this growth parable, we’ll debunk this myth and highlight why opening a café in a small town might not be the dumbest idea on the planet. If you garner a reputation as having the most delightful dining experience, build up an extremely loyal customer base and serve the tastiest pastries – then who to say that you can’t win the day? Beats duking it out in the West Village as the nth Italian restaurant with negative margins and no meaningful reputation. There are clear, inherent positives around more well-define market opportunities.
As a general disclaimer, the “small town life” isn’t for every software entrepreneur or investor. If your goal is to be a unicorn or a public company and raise hundreds of millions of dollars – then yes, a large TAM is required. However, for those small towners out there that don’t prescribe to the silicon-valley capital ingestion diet – there are an exceptional range of outcomes available to the small-town café owners. Assuming strong execution, there’s always an opportunity to open more locations, expand the menu, or go full blown Jersey Mike’s and franchise your business, but the presumption that a "niche opportunity is not a valuable opportunity is simply not true.
What niche “small TAM” markets are we referring to? At PeakSpan we would say $100M to $300M is a niche market opportunity. This is not to be confused with initially focusing on a subset of customers who represent the highest value/highest probability revenue. Companies with a large TAM can still practice “focus” through identifying a smaller universe of ICP (“ideal customer profile”) prospects.
Back to our niche market opportunity example, if you sold software to sports team in the US across the five major sports, you would have an addressable customer base of ~150 (~30 x 5). Assuming $1M in software spend per team, you could generate $150M in revenue per year which would be the TAM. This would be an example of a small TAM. Why doesn’t this sound appealing to some investors?
This market doesn’t support large quantities of venture funding. The more funding, the greater the exit value required to satisfy all stakeholders.
The potential acquirer of this business might have trouble finding a path for continued growth. Even if you can grow to $20M, the path to $40M becomes that much harder. Especially as you’ve likely formed a relationship with each prospect and know where they stand on your software. Growth for a business with 150 potential customers is inherently low. If you start with one customer and double your customer base every year, you reach 100% penetration in less than ten years. Growth rates in these markets are more typically between 20% and 40%. Lower growth companies with high market penetration rates are typically not great candidates for further funding and certainly not great candidates for an IPO, which is why they are typically ignored.
So what’s a small towner to do?
Let’s think through and pick apart some of the fundamental assumptions that have led to the myth that bigger is always better?
If you haven’t heard the song Small Town by John Mellencamp, give it a listen. We all need to take a page from John’s philosophical playbook and embrace the small-town life. The notion than small TAM’s aren’t deserving of market leading software companies is not true. With more and more software being created, the rise of payment processing as a form of monetization in vertical markets and with the opportunity to expand into future verticals – the small TAM life can be a good one!