When venture capitalists tell you “your TAM is not big enough” what they are really saying is “I don’t think your team is smart enough to move to an adjacent market once you dominate your initial niche.”
They are not really saying your TAM is too small. Great VCs invest in companies with small TAMs all the time. They might believe that the founders’ think too small or that the founders just are not very good.
Many great companies started in markets where the TAM (Total Addressable Market) is small. In some cases, the companies under-estimated the TAM (the TAM got way bigger over time). In other cases, the team was smart enough to move to other adjacent markets.
Of course, it is really hard for a venture capitalist to tell a founder “we do not think you are talented.”
Even when a VC truly believes that, they can never actually say it. But founders want to know why a VC is passing and the VC wants to preserve some optionality to invest in the founder in the future (in case the VC’s assessment about the founder was wrong) or in the founder’s friends. So VCs come up with another reason not to invest. A good one is that the TAM is small — that usually satisfies the entrepreneur (who thinks the VC is just not smart enough to see the bigger picture) and satisfies the VC (who wants to preserve the relationship).
Investing in companies that are initially focused on a smaller niche is actually easier to do than investing in companies that are going after a giant market.
If the company is going after a giant market, then there is usually massive competition in the market and you really have to spend a great deal of time understanding the market (and each competitor) before investing.
For instance, if we were thinking of investing in Ford Motor Company (which competes in the giant market of automobile sales), we need to understand a ton of things:
- What are the future of of cars? Will demand increase in the short term? What about the long-term?
- How does the rise of places like China and India change the demand curve for autos? Even if it greatly increases the demand for cars, will Ford be able to capitalize on it? What about auto tariffs?
- Ford makes much of its income on selling trucks (like the F150 — one of the most amazing vehicles). How does the demand curve for trucks change in the future?
- What will happen to emissions policies? Is Ford investing in enough green vehicles to take advantage of potential policies?
- While Ford is a big company, its market share in the auto industry is really low (because there is SO MUCH competition). So now we need to know about ALL the other car companies (and even potential car companies like Apple) to understand the future competitive dynnamics.
- And many, many more things (like the financial profile of Ford, its labor contracts, its capitalization structure, and more).
It is much simpler to invest in smaller businesses that are tackling a smaller niche. We can get our head around the niche faster. We can assess the competition faster.
The essential questions we need to answer when investing in a niche business are just four:
- Will this company be able to dominate the niche? Sometimes the company is already dominating the niche. Sometimes there is a network effect reason to dominate the niche.
- Is this niche more important than other people realize? Maybe most people think the niche caps out at $50M/year in revenues but you believe it is five times bigger. Sometimes the niche gives the business a jumping off point to other niches because of its centrality. In general, niches that are more central (have more adjacent niches) are more valuable than niches that are less connected.
- Is the team capable enough to move to adjacent niches once it dominates its first niche? Some teams find themselves in a good position but cannot take advantage of their position. This is actually why most VCs pass on companies. Of course, they cannot tell the founders that they passed because they do not think the founders are smart enough. So they make up another reason (the “market is not big enough”) which is just code for “we do not think you have an excellent team.”
- Is the price of the investment reasonable? This one is hard to understand but if the first three are yes and only a few investors think they are all yeses, then the price is probably reasonable.
LiveRamp’s niche dynamics: dominating onboarding
One interesting example is LiveRamp (NYSE:RAMP). (note: I was the founder and CEO of LiveRamp for its first 9 years … so I am incredibly biased). LiveRamp launched its initial product at the end of 2010 going after the “onbooarding” niche. At the time, the market was less than $3 million worldwide! (Now that is a really small niche).
LiveRamp’s first year revenues from on boarding was $1 million and we ended the year with about 25% market share. But there were a few things that made the niche interesting:
- We believed the niche was a total of $50M year. (Turned out we underestimate the niche by 4-6 times). So there was room to grow.
- We thought there were network effects in the business — it made sense (for a bunch of reasons we will not go into now) for one company to be the winner — essentially it was a winner-take-most market. Ultimately we were proven correct as LiveRamp quickly got to over 70% market share.
- We understand the capabilities of all the competitors and figured that they would not invest appropriately to dominate the onboarding market. Each competitor was already in many other markets and it did not make sense for them to continue their investment.
- We believed that onboarding, while a small niche, had significant centrality to other markets in the marketing ecosystem. We assumed we could use our position to move into those other niches. This ultimately turned out to be true in some cases and more difficult than we hoped in our cases.
- We had a lot of confidence in our team. Even today, almost nine years later, LiveRamp is known for having an extraodinarily talented team. Of course, most start-ups think they have a great team (and many overvalue their talent). But in 2010 our team was extremely young and inexperienced — so one could forgive an outside investor for undervaluing it.
Carta’s niche dynamics: dominating cap table management for start-ups
Carta, formerly known as eShares, is a great company. (another disclaimer: I am an investor in Carta and also a customer across many businesses).
Carta helps companies manage their capitalization table. If you have invested in a bunch of start-ups, you almost surely have gotten some of your stock certificates via Carta. In fact, of the 130+ start-ups I have invested in, Carta is the ONLY forward-facing cap table management system that I have ever interacted with (except for mergers and acquisitions where I have seen many different systems).
Carta, even from its early days, dominated the cap-table management for start-ups. And yes, it was a small niche (one that many VCs underestimated). But even today, most start-ups run their cap table on Excel — so there is still a lot of growth in the niche.
If you were an investor when Carta was starting, the first thing to understand was do you think Carta could dominate its niche. Surprisingly, many investors that passed on investing actually thought Carta WOULD dominate its niche. Given Carta’s huge current success, the investors either made one of two errors:
- They underestimated the power of owning the niche of cap table management in start-ups.
- They underestimated the talent of Carta’s team and its CEO (Henry Ward).
My belief is that any VC that passed for Error #1 should stop being a professional investor. That is not a good mistake to make.
However, my guess is that the vast majority of VCs made Error #2. That error is much easier to make as it is extremely difficult to evaluate people (especially after just spending a few hours with someone). Henry Ward has turned out to be an excellent CEO. But everyone has vastly underestimated people before. And everyone has vastly overestimated people before.
What you should do when a venture capitalist tells you that your TAM isn’t big enough
Obviously you should spend time evaluating the TAM. But you should also take solace that many, many great businesses (from AirBNB to Zoom) were passed by talented VCs who underestimated the team.
Summation: When VCs tell you “your TAM is not big enough” what they are really saying is “I don’t think your team is smart enough to move to an adjacent market once you dominate your initial niche.”