The first step to take to take to build your financial projectsions, after the market analysis and validation, is therefore laying out the expansion strategy with realistic figures.
We start from calculating the Total Addressable Market (TAM). Depending on your sector, you can calculate this in terms of value, volume or number of customers. Value is the total spending per year in your target market, volume is the total number of products/ units sold per year in your target market, and number of customers relates to the number of people or companies carrying out a transaction in your target market every year.
Market value is generally the easier value to find, but not the most useful. Most new ventures will have different pricing models and marketing strategies, therefore by using volume, in many cases you will not be able to realistically project your financials. Value, however, is a great figure to use for those businesses that earn income on a project-basis, where every contract may have a very different price (B2B advertising income, for example may be difficult to project based on number of clients), or for transaction-fee businesses, where a certain percentage of an industry transaction value is earned.
Volume figures are recommended for those businesses where the number of products purchased on a per-client basis is difficult to determine. Calculating your projections based on the number of customers, is typically the most accurate option and helps greatly when measuring the company’s performance, particularly for B2C startups, as well as helping in the calculation of marketing and sales costs on a per-customer basis, which for some sectors is necessary.
There are some rules to remember when calculating the total market size:
- Be as specific as possible; if you are in a niche sector, research its size or make some assumptions to reduce the market size to what is suitable to your specific company
- Use values that are suitable to how your revenue will develop
- For new disruptive startups, your market size may measurable but not straightforward, you can draw it from where your future customers will come from
You can repeat this exercise, and the following steps, according to your expansion strategy, using your first target market, second target market, and so on. The market can be defined in terms of countries, regions, different customer groups, different product users within the same industry, different industries or a combination thereof. Be focused by using only few expansion steps that are relevant to your business.
When you have a very disruptive business model, this may be a little harder to calculate, as there is little or no market data to draw from. In this case you can use data from different industries together or make estimates yourself based on macroeconomic data. In some cases, companies create new markets, or expand current markets: this, however, is not easy to do, therefore do not overestimate your ability to influence the market if you lack the resources to do that. In any case, even with scarce market data, market sizes have a limit that can be drawn with a simple and free market research on other industries. In too many cases these limits are disregarded, and it results in niche companies claiming the potential to become unicorns.
The Total Addressable Market will also grow. Typically, VCs and other investors are interested in markets growing at a higher rate than the economy, otherwise growth will be impaired. Most startups, and even more so disruptive sectors or new technologies, are easily growing at double digits at the time of the investment, as that leaves space for new incumbents. Slow-growth industries would be interesting for investors only when you are targeting the industry with new products or services. You will then need to apply a CAGR (Compound Annual Growth Rate) to your Total Addressable Market to measure how it grows, and recognise that double-digit growth rates will eventually slow down after a few years.
A Serviceable Addressable Market (SAM) instead indicates that portion of the market that can effectively be served and targeted, by further cutting down your target market size. Even though the entire target market buys a certain product, when you introduce an innovative product, you know that a portion of the market will not switch due to certain characteristics, demographics or habits, or you and your direct competitors may not be able to target them through typical marketing channels. Taking a clear-cut example of a developing country with lower internet penetration: your market for physical goods or offline services is of a certain size, but once you offer the same services on an internet platform or marketplace, you will not reach the entire user market for that product; only those who will be able to access or know how to use the platform have the potentials to be your customers.
The Serviceable Obtainable Market (SOM) relates to that portion of the market that your company can effectively obtain as customers with your set marketing strategy. This is hard to determine, but there are ways to do it more effectively. If your SAM only includes the market that you and your direct competitors target, the SOM can be divided into the number of competitors in the market, accounting for market leaders when possible. This will not lead to very precise values, but still more precise than most methods in use. You can divide, let’s say a 2 million customers market by 4 competitors, which results in a 500k target market for your company. However, what if your competitive strengths differ? You can adjust it by how much your company’s competitive advantage can contribute to winning more or less customers. This exercise is very helpful in order to consider the company’s own strengths and competition, as many owners falsely believe that they can reach the entire market with only a slight competitive advantage.
What if your company has first-mover advantage? Regardless of the barriers to entry, if it’s a profitable market you’re very unlikely to remain the only competitor. Especially when it is easy to enter a new market, many founders believe that earning possibilities are endless, whereas low barriers to entry lead to too many companies entering new startup markets and leaving little earnings left, even when moving into the market later. You can also consider consolidation, or in slow-growing markets, decreasing competition, when suitable. Again, future competition is hard to predict, but do not underestimate the power of using simple logic. If you are knowledgeable about your market on how it developed in the past, it’s possible to roughly predict how competition can develop, and in any case, it’s always a factor worth considering.
What happens after this? Many falsely project, due to the lack of better financial tools, that the SOM will be obtained on Day 1. You can set the Serviceable Obtainable Market as a time-bound target, between 5 and 10 years, or possibly the same length of your financial projections. Then you can build up your market reach to reach 100% during this timeframe.
As complicated as this may seem, one of the most incorrect variables to use for seed or early-stage startups is growth rate. Growth rates are important to analyse, but projecting them from 0 is pretty much impossible, or leads to many mistakes, for example taking over more than 100% of the market – we’ve all seen these financial plans. Defining your target market and building up to it is more correct, and you can still use different growth rates in different years to portray, usually, a slow market entry, a very fast growth for 2-3 years and then a fast growth more in line with your market, depending on your sector and stage.
Using these values results in the projected number of customers for the duration on the financial plan phase, for each of the target markets that you have used (or volume of products sold, or sales/ transaction volume, depending on the variables that you have used).
How do you reach these customers? Once you have projected your customer base, you can calculate your marketing and sales costs and split these costs into the different channels that you are using. By doing so, you can validate every channel and see if you can realistically win that certain number of customers with your marketing strategy. This is also useful for the internal day-to day company management and to measure marketing effectiveness. You can then project retention and number of active customers.
For a more simple exercise, it’s possible to research, in a few cases, the Customer Acquisition Costs of larger competitors that have recently got stock-listed, by measuring marketing costs vs the number of new customers acquired during that period of time. By doing some research online, it’s possible sometimes to find a few general industry values, but it’s generally important to know that B2C CAC is lower, let’s say around $10, while for B2B this can be much higher, let’s say $150. The values depend on the specific sector and company.
Your marketing and sales strategy can include a variety of methods and channels. It’s possible to establish how many customers in percentage can be earned through each channel. These can include: social media, Adwords, media advertising, traditional advertising, referrals, direct sales, sales partners, trade fairs, shops, and others. For example, you can project a sales or marketing funnel with costs, audience target, leads, and customers won over time. For sales funnels, you can then establish, based on capacity, how much sales personnel you need to achieve your targets. This generates the expenses for each channel used, as well as the total marketing and sales costs.
In advanced financial plans, you can also include the cost to retain current customers.
Calculating your Customer Acquisition Costs (CAC) should also be at the basis of the company’s financial management. For a healthy business, it’s usually recommended that LTV (Customer Lifetime Value) is at least 3 times the CAC, and that in any case, in the long-term revenue per customer is clearly in excess of the Customer Acquisition Cost.
To measure how healthy and realistic your business and revenue model is, you can input all these values into excel while carrying out the validation of your business model, before proceeding to the company’s financial projections.