So you’re feeling entrepreneurial, burning with ideas, or maybe just a passion to try new things. The question is, how does one narrow down the storm of thoughts to better find those ideas that may have some potential?
Total Addressable Market (TAM)
Most startups fail, but if yours does make it, you don’t want to get stuck with a small piece of a small pie. Now, if yours is a passion project, you already know it is niche but simply know your target, the issue you’re fixing is such that you just know it’ll work, etc. Go ahead, pursue your passion, build a cool thing.
That being said, from the perspective of Venture Capital, we’re usually looking for a TAM of at least $20 Billion because capturing 5% of that market means an achievable annual revenue of $1 Billion. Startups that reach a billion dollar + valuation milestone are called “unicorns”, but that can’t be reached if the TAM is too small.
erm… sorry, what is TAM, and how do I calculate it as a founder?
The Total Addressable Market (TAM) refers to the overall revenue opportunity available if your product or service achieved 100% market share (recall we discussed targeting 5% of an at least $20B TAM). In other words, it’s the largest possible market size for your product or service, assuming there were no competition and every potential customer was converted. Understanding TAM is important because it gives you a sense of the scalability of your business and its potential to grow into something substantial.
There are two main approaches to estimating your TAM:
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Top-Down Approach: This method involves starting with broad industry data and narrowing it down to your specific market segment. For example, if you’re building a tool for remote teams, you might start with the global market size for all workplace productivity software and then refine that by focusing on companies with remote workers.
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Bottom-Up Approach: This approach takes a more granular look. You estimate how many customers fit your ideal profile, what each customer might spend annually, and then multiply that by the total number of potential customers in your market. This method often feels more grounded because it’s based on your understanding of the customer and pricing.
It’s virtually impossible to get an exact number, but the point is to be realistic and demonstrate to potential investors that there is room for growth. Note that it is easy, really easy, especially as an optimistic founder to get carried away with the early projections. Take a step back and review your approach. Your pitch will be far more compelling if your numbers are backed by a sound, well-rounded estimate.
Great Salespeople are Top Managers are Great Salespeople
It can happen that founders are product geniuses, but the best entrepreneurs and top CEOs are effectively really fantastic salespeople. The early stages of a company involve constant efforts to raise money. That’s a game of relationships, credibility, presentation, and integrity.
You can fail quite a few times at launching a venture, in fact, it can kind of be expected, but do something that tanks your reputation and destroys your integrity? You’ll be on your own. Now, if you’re well-connected and have lots of capital around you, the rules may be different, but for the average person, integrity is all they have.
It seems more and more of a forgotten thing in our world of marketing, public relations, performative-ness, but transparency builds trust. Especially in crisis management. In 1994, Andy Grove, then CEO of Intel, found out about a design issue (calculation error) that would compromise a small portion of Pentium processors. He was transparent, issued a recall, and it cost half a billion to the company, but the publicity it gave Intel - not a super well-known company by the general public at the time - shined a favourable light and painted the brand as trustworthy. Frankly, it’s probably the most important marketing campaign in semiconductor history.
Other companies understand this principle and make an effort to be transparent as well. In a competitive landscape, these details and such transparency let investors and customers feel more comfortable doing business or taking a risk with the underlying business and that makes for better brand loyalty and long-term, translates to shareholder value. Salesforce brands itself as a trusted partner and discloses outages here.
Be transparent in business. Especially as a founder, don’t undersell, but be transparent with the risks of the product or service you’re selling. Fairly early in your meeting with a potential client, unless there’s a confidentiality issue at play, present your risk, it establishes trust and transparency, and if your product isn’t worth the risk for the returns then it likely won’t sell, and you need a better or different product anyway. To address the issue early is an opportunity to show the value add while also being upfront and trustworthy. The world is smaller than you think; your reputation will follow you so don’t close any doors you haven’t encountered by compromising your values for a chance at money.
“It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.” - Warren Buffet
Investment Stages
So your newborn company is in the seed stage. It’s little more than a concept, perhaps early proof of concept, but you don’t really have clients lined up just yet to test or use your product. You’re raising money from personal funds1, friends and family, or from “angel” investors. Usually this is a smallish amount. Tens to hundreds of thousands, perhaps. Beware of raising money from friends and families as it can strain relationships.
It can take a while to become cash flow positive and, typically, after a seed stage there will be more “rounds” of funding and an eventual Initial Public Offering to a successfull venture. This can come from Venture Capital or Banks. Generally, avoid banks in the first 2–3 years of a company’s life. Banks have very limited risk apetite and a single missed payment can kill your business as the banks come for the assets. We’ll explore other details of funding in other posts.
Legal Registration
So your seed venture is setting up for success and as the idea gets more serious and real, you should set up a Legal Entity around your business.
Your best option at this stage is almost certainly a Limited Liability Company (LLC) or something akin to this in the jurisdicition of your business. Since this discussion here was started by looking at California’s Tech landscape I’ll be discussing the USA. An LLC protects your home and your personal assets in the case of a lawsuit because the owners (called members) have limited liability unless they’ve guaranteed something personally. LLCs can be managed by members (owners) or by appointed managers. It offers flexibility in terms of ownership and management structure. By default, LLCs are taxed as pass-through entities (income is reported on the owners’ personal tax returns, avoiding corporate taxation), though they can elect to be taxed as a corporation if desired.
The simplest form of business is a sole proprietorship. Simple, in part, because it is not a separate legal entity from the owner. Thus, there isn’t really a need for formal legal registration in most states, though some areas of practice may need specific permits or licenses. The owner reports income on their personal tax returns. It’s taxed at individual rates, and the owner doesn’t have to worry about the complexity of corporate tax filings. One downside is that the owner is personally liable for any debts or legal actions taken against the business. These business are common for freelancers, or other scenarios where a single individual manages all aspects of a business.
In a General Partnership (GP), all partners (2 or more) share responsibility for managing the business and its liabilities. Each partner has unlimited personal liability for debts and obligations: their personal assets are subject to seizure if the partnership becomes insolvent. GPs are relatively easy and inexpensive to set up and often don’t require registration to function legally. Profits and losses “pass through” to the individual partners’ personal tax returns. The business itself does not pay taxes directly. These businesses could be law firms, medical offices, family businesses, etc.
In a Limited Partnership (LP) there are two kinds of partners: General Partners (who manage the business and have unlimited liability) and Limited Partners (LPs) (who invest but have liability limited to their investment). Like a general partnership, an LP doesn’t pay taxes itself. Instead, income or losses are passed through to the partners and taxed at their individual rates. Most hedge funds or private equity funds are set up this way. A typical fee structure might be “2 and 20” where the General Partner (the fund manager) charges a 2% management fee (based on assets under management AUM), typically for operation costs and management of the fund; and a 20% performance (carry) fee based on the profits generated by the fund, typically paid to the fund manager once a minimum return (often called the “hurdle rate”) is achieved. The Limited Partners are the investors who provide the majority of the fund’s capital, but do not have a role in day-to-day fund management. Their return comes from the fund’s profit where they usually receive a share of the fund’s returns proportional to their investment.
Limited Partnerships are very interesting for tax purposes in the investment sector because The 20% performance fee, often referred to as “carried interest,” is typically treated as capital gains (specifically often as long-term capital gain) rather than ordinary income for tax purposes. This is because the carry is considered a reward for the GP’s role in creating value through the investment process, such as buying and improving assets, and selling them at a profit. In other words, the carry is treated as a share of investment profit, not as compensation for managing the fund. The GP typically holds the carried interest in the form of a partnership interest, which, upon sale of an asset or distribution of profits, is taxed as long-term capital gain rather than as ordinary income (which would be taxed at higher rates for the amounts typically involved).
Of note, these incorporations can and are often shelled into one another. A PE fund may be a Limited Partnership where the General Partner is a Delaware incorporated LLC, and a separate investment manager (handling day-to-day operations) is a New York registered LLC (these can be the same persons).
Finally, a Corporation is its own legal entity, distinct from its owners (shareholders). This provides a high level of liability protection for shareholders. Corporations have a formal structure, necessary for an IPO, including a board of directors, officers, and shareholders. They are subject to more regulations and oversight, but can also issue multiple classes of stock (common, preferred). Finally, they typically face double taxation: once at the corporate level on profits, and again at the individual level when dividends are paid to shareholders.
We described C-Corp type corporations, the most common, but technically there exists S-Corps as well, typically for smaller businesses that want liability protection without C-Corp structure and unlimited shareholders. S-Corps have a limit on the number of shareholders (maximum 100), and shareholders must be U.S. citizens or residents. S-Corps can only have one class of stock (no preferred stock). Moreover, unlike C-Corps, S-Corps are pass-through entities, meaning the company’s profits or losses “pass through” to the shareholders’ personal tax returns. This avoids the double taxation issue.
We summarise the main type we’ve discussed below:
| Entity | Pros | Cons |
|---|---|---|
| Limited Liability Company (LLC) | -Liability is limited, -cheaper than corp. | -More expensive than a general partnership, -can be harder to raise funds (worth for the protection), -harder to sell |
| General Partnership (GP) | -cheap, -quick to set up | -personal liability, -tough to raise capital, -tough to sell |
| Limited Partnership (LP) | -cheap, -limited liability | -passive investor, -hard to sell, -hard to raise capital |
| Proprietorship | -cheap, -quick to set up | -personal liability, -tough to raise capital, -tough to sell |
| Corporation | -access to capital, -easy to sell, -corporate gov. | -board meetings, -expensive setup/run, -dealing w/ shareholders |
Get help for this step, make an informed decision. As an unafiliated place to start: https://www.legalzoom.com/business/business-formation/ has a lot of info and resources to help you file.
Another important question to discuss with the people helping you file is where to register your company (ie, where to incorporate), by which I mean, in what state. Many companies choose to incorporate in Delaware.
Delaware’s corporate laws are considered among the most adaptable and well-developed in the United States, with a long history of modernizing legislation through bipartisan consensus and expert legal advice. The court has the specialized Court of Chancery, a dedicated court system for corporate disputes that features experienced judges who specialize in corporate law, ensuring faster and more predictable legal outcomes compared to general courts in other states.
Tax advantages also play a significant role. Delaware does not impose a corporate income tax on companies that do not conduct business within the state, meaning out-of-state revenue is generally exempt from Delaware taxation. Additionally, the state has no sales tax, no personal property tax, no inheritance tax, and no tax on investment or intangible income for companies with limited in-state activities. Delaware also offers strong privacy protections, as it does not require the public disclosure of shareholder, director, or officer names, only the registered agent’s information. You can see why it’s a popular choice, although operating elsewhere may need you to register in another state as well. This is mostly useful for larger businesses that have the revenues warranting shopping for a tax advantage.
That seedling company of yours is starting to build more complete products, shaping its corporate identity. How do you protect your brand and products from competitors copying you? Next time, we’ll talk about Intellectual Property: Patents, Trademarks, Copyright, and NDAs.
Footnotes
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It’s okay to use some of your own money to fund a venture, but budget for it and avoid this unless you have a full emergency fund, maxed out pension, generous savings and otherwise a lot of money. ↩