8 minute read 20 Mar 2018
Why top-down forecasting is a crucial exercise for startups

Why top-down forecasting is a crucial exercise for startups

By Alexandros Matthiessen

EY Netherlands Finance Navigator Leader & Senior Manager CFO Consulting

Innovative. Entrepreneurial. Results-driven. He is very proud when a startup makes another step forwards.

8 minute read 20 Mar 2018

Financial modelling can be challenging for startups. Learn how top-down forecasting can help you substantiate your numbers.

Are you a startup founder? Are you looking to raise funds? If you are, you will need to convince an investor of the potential of your company. A crucial part of this is to create a revenue projection that is realistic yet ambitious enough, to give the financier enough confidence to get him/her on board. So how to substantiate your numbers? Top-down forecasting can help out!

Many entrepreneurs already get a headache when they just think of the idea of forecasting their financials. However, two widely adopted approaches to financial forecasting exist that are fairly easy to understand. They take a bit of time and research to implement but are not difficult to adopt.

1. The top-down approach works from a macro/outside-in perspective towards a micro view. This means industry size estimates are taken as starting point and narrowed down into sales targets that are fit for your company. 

2. The bottom-up approach is less dependent on external market data, but leverages internal company specific data such as historic sales data. Contrary to the top-down method, the bottom-up approach takes a micro/inside-out view and builds upon the maximum capacity of your company. This means a projection is made based on the main value drivers of your business. For a sales forecast for instance that could mean a company defines its marketing budget, the number of leads it can generate with that budget, and the conversion from sales lead to actual client.

There are good reasons to use both methods. As a matter of fact, it is advisable to use a mixture of both to arrive at a well substantiated forecast that shows ambition as well as proper assumptions that back up the projections. In this article we focus on the top-down approach, but definitely check out this blog if you want to learn how to combine both methods.

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Top-down forecasting

Top-down forecasting is most easily illustrated by projecting company revenues. The top-down method starts with an assessment of the total market size. That means you first define the specific market for your offering and factor in any trends going on to make sure you also take into account the growth rate of the market. A declining market size is usually not a good sign as consumers are moving away apparently.

The second step is to estimate the chunk of the market that wants to buy your product/service. This share of the market is therefore equal to the market size you would like to capture relative to competitors. A useful aid to perform top-down forecasting is the TAM SAM SOM model.

TAM: Total Available Market

TAM represents Total Available Market and is the total market size if a company “would aim for the moon”. For a cola company (let’s call this one ‘Happy Cola’) this would mean the total value of all bottles of coke sold on a global scale without taking into account any competition or internal limitations on the firm’s capacity. Happy Cola’s TAM thus reflects the total worldwide demand for cola. Its value equals all cokes sold on a global scale expressed in a specific value: for instance a money value, liters, or the total number of consumers.

How to calculate the TAM? Spending a couple of hours researching the internet for industry reports can provide a substantiated estimation of the total market in a specific sector. Sometimes you have to do some calculations yourself, for instance if you can only find data on continent level and need to add up or split several figures. Or when you only know the total number of consumers and the average selling price and you need to multiply both with each other to get to the market’s value.

In case you cannot find any industry reports about you company’s sector you could also perform keywords research. Open a Google Adwords account, open the Keyword Planner tool and look for keywords that relate to your offering. This shows you exactly and per city, country, continent (whatever you want) how much monthly searches are performed for that specific keyword. Doing keyword research does not provide you with an exact estimation of market size, but if can give you a good indication on the demand for certain offerings across different countries.

SAM: Serviceable Available Market

SAM stands for Serviceable Available Market and is the total market size taking into account a company’s geographic reach, type of client and product type. SAM is therefore a fraction/percentage of TAM.

For example, the TAM for a running shoe company (let’s call this one ‘Happy Shoe’) could be the value of all shoes sold on a global scale, but its SAM is defined much narrower. If Happy Shoe focuses on kids running shoes specifically and is launching in the US, the SAM would be the value of all running shoes sold to children in the US. You can imagine that SAM (US kids running shoe market) is thus only a small percentage of the TAM (the worldwide shoe market). Just as TAM, SAM is often based on macro-economic data which makes industry reports the right channel for performing your market research.

SOM: Serviceable Obtainable Market

SOM represents Serviceable Obtainable Market. SOM is the share of SAM a company can realistically obtain in a couple of years time. SOM is therefore a percentage of SAM and shows the desired market size relative to competitors. In essence, SOM is your sales target based on the market share you aim to capture.

Important to remember: Serviceable Obtainable Market is the share of the total market you hope to capture with your company. Therefore it is equal to your company’s revenue target.

As you might have noticed the TAM SAM SOM model is a perfect illustration of top-down forecasting: industry estimates are taken as starting point and narrowed down into targets that are fit for a specific company.

Below you can find a screenshot of the dashboard of EY Finance Navigator’s financial planning software.  Part of building your financial forecast is estimating your market size, which is visualized in the EY Finance Navigator software using the TAM SAM SOM model.

Example of a TAM SAM SOM visualization (source: EY Finance Navigator’s financial planning software for startups)
TAM SAM SOM visualization. Source: EY Finance Navigator financial planning software

Pros of top-down forecasting

Below you can find several reasons why top-down forecasting might be the way to go for your company.

No historical company data needed

Top-down forecasting is usually faster and easier than bottom-up forecasting. If we are talking about sales forecasting specifically this has to do with the fact that for bottom-up forecasting you need to assess (historical) sales data and capacity and need to be able to rationalize every sale you perform based on that data. However, past sales data is often not available for startups as they might not have launched yet and are thus not generating sales. Using the top-down approach can thus be a quick win as it is based on market data, which is often more easily available for pre-revenue startups than sales data.

See how you stack up against competitors

Top-down forecasting allows you to benchmark yourself against competition, which gives you valuable insights in your competitiveness. Ideally when you decide upon your SOM, the market size you realistically aim to capture is based on a SWOT (Strengths, Weaknesses, Opportunities, Threats) analysis. A SWOT analysis forces you to think about how company-internal strengths and weaknesses affect your strategy, as well as how external opportunities and threats do so. Ideally you leverage strengths and opportunities and try to reduce the impact of weaknesses and threats.

Strong competition is definitely a threat for starting companies and should impact your SOM/sales targets. If your market research shows you the current market leader owns 15% of the market, it is very unlikely you will reach 20% in the short term. If it shows you the market leader has been around for years already and only owns a couple of percent, it is an indicator competition is fierce.   

It shows ambition

If you are a startup founder and you wish to show a growth path for your company that sparks the interest of investors, it could be advisable to use the top-down approach for your financial forecasts. As the top-down approach is derived from narrowing down a certain market and taking a percentage of the market’s value it usually shows a more optimistic view than the bottom-up approach in which you need to rationalize every sale you make. If you need to back up every single sale with data there is no room at all for unforeseen growth engines for your business that you are simply not aware of yet at the moment of building your forecast.

Investors typically look for investment opportunities that show ambition and optimism and that aim to gain substantial market size quickly. After all, in most cases investors are in for the money! 

Cons of top-down forecasting

When performing top-down forecasting be careful not to fall into the following two traps.

Overambitious targets

When performing top-down forecasting, be careful not to create a too optimistic forecast. Often entrepreneurs calculate SOM by taking a random percentage of the market, without really assessing whether this target is realistically achievable. A tiny percentage of a market might seem insignificant, but could be way too optimistic, especially if your company is pre-revenue and does not have any sales data available to substantiate your targets.

Too generic

A second pitfall is that your forecast can become too generic using top-down forecasting. You might want to address the market with different offerings at different prices and perhaps even targeting different regions and/or customer segments. This might not always be correctly reflected in your sales target if you simply take an X percentage of a market.

Whichever forecasting technique you would like to use, as a startup looking for investment it is almost impossible nowadays to get away with a pitch that does not include proper market research. So if you need to spend time on doing market research anyway, you better kill two birds with one stone by leveraging your market research for your sales forecast as well!  

Summary

As a startup it can be difficult to come up with financial projections as historical financial data is often missing. However, financial planning is an important task when running your own firm, especially when you are raising funding and need to convince an investor of the potential of your company. Top-down forecasting can help substantiate your numbers and this article explains how to apply it as an approach for financial planning. Need more support with creating sales projections? Check out our financial planning software for startups.

About this article

By Alexandros Matthiessen

EY Netherlands Finance Navigator Leader & Senior Manager CFO Consulting

Innovative. Entrepreneurial. Results-driven. He is very proud when a startup makes another step forwards.