Top-Down vs. Bottom-Up Revenue Modeling: Which Is Right for Your Startup?
By Lior Ronen | Founder, Finro Financial Consulting
Revenue projections are integral to different aspects of the business. They can be used to secure funding, create a business plan, or better understand your startup's financial future.
There are two main methods for revenue forecasting:
Top-down approach: estimating the total market size and then working backward to evaluate how much of that market your startup can capture
Bottom-up approach: estimating future sales for each product, then aggregating those figures to arrive at a total revenue figure.
Both methods have advantages and disadvantages. Founders should choose the proper method for their business based on their industry, the startup's growth stage, and data availability.
This article introduces both methods of forecasting revenue, providing readers with an overview of each one and highlighting factors to consider when choosing between them.
Top-Down Revenue Modeling Approach
This method, also known as the TAM-SAM-SOM model, is often used when there is limited data on the startup's specific market or when the startup targets a large, established market.
Businesses can use the TAM-SAM-SOM model to understand the market size and potential of their products or services. The model is often used to assess a business's potential before entering a new market or building pricing, marketing, and sales strategies.
To create a top-down revenue model, we estimate the total addressable market (TAM) and then work backward to estimate the startup's potential revenue.
Total Addressable Market (TAM).
The Total Addressable Market is the total market demand for a product or service. It represents the maximum possible revenue generated if a company captures all of its target market's demands.
There are a few ways to estimate a business's market size: by using reports or doing it yourself.
You can use industry reports, government data, or other sources or calculate it yourself. To evaluate the market size, you can usually get a reasonable estimate by multiplying the top-selling products' figures and market leaders and multiplying them by the total number of units sold by all brands.
Serviceable Addressable Market (SAM).
The Serviceable Addressable Market is the segment of the TAM that your company can realistically target with its products or services.
The SAM represents the portion of the TAM that you can realistically reach and sell to.
To calculate the size of the SAM, estimate its share out of the TAM in percentage and multiply that by the TAM you calculated above. Consider the startup's value proposition, target customer segments, and competition in your estimates.
Serviceable Obtainable Market (SOM).
The Serviceable Obtainable Market is the portion of the SAM that your company can realistically capture. The SOM represents the segment of the market you can sell to based on factors such as competition, pricing, and distribution channels.
SOM is your annual revenue under this method. It is calculated as a percentage of the SAM.
Advantages of TAM-SAM-SOM Model:
It provides a quick, high-level view of the startup's potential revenue.
It's useful when there is limited data on the startup's specific market or when the go-to-market strategy is not finalized.
Can be used to estimate revenue for multiple customer segments or products
Disadvantages of TAM-SAM-SOM Model:
The TAM-SAM-SOM model is a high-level estimate of the business potential and should be used in specific cases only. It's inaccurate by definition. You should use the bottom-up approach when looking for a more accurate forecast.
This method does not consider the company's limitations, specific requirements, market acceptance, product adoption, execution capabilities, and ability to close deals.
Bottom-Up Revenue Modeling
The Bottom-Up Revenue Forecast Model is the traditional forecasting method widely used across every industry. In this method, we're projecting revenue more accurately based on unit prices and expected sales volume. This is the monthly subscription price and user base in subscription-based businesses.
This method is often used when the business has a clearer picture of its target market, and customer segments and more granular data on sales and expenses is available.
To create a bottom-up revenue model, in Finro, we focus on the customer acquisition process:
Identify sales segments: we start by identifying the sales segments through which the startup will generate sales. These can be by product or services, business model, geography, etc.
Map client acquisition channels: once we have identified the key sales segments, we need to map the relevant acquisition channels for each segment. These are the specific channels you will initially interact with the clients. These channels include social media marketing (SMM), search engine marketing (SEM), search engine optimization (SEO), organic traffic, promotions, conferences, etc.
Quantify prospects: in this step, we quantify the potential prospects in each acquisition channel—for example, 10,000 prospects for an email marketing campaign and 5,000 viewers of an Instagram ad.
First conversion rate: this is the initial conversion rate from prospects to leads. Once we have estimated the potential number of prospects in each acquisition channel, we need to assume how many prospects will contact us by guestimating or using common assumptions in the niche.
Second conversion rate: here, we estimate how many of the leads that contacted us will set up a demo, discovery call, or introduction call.
Third conversion rate: how many leads from the calls or meetings will turn into paying clients.
Pricing: how much will you charge for each plan? Are there different prices for annual plans vs. monthly plans? Are there different price plans? What are the differences between the other plans?
Once you have the user base and the pricing forecast, you can combine them into a complete revenue model. Now, you've provided a significant amount of data and information that explains how you acquire or plan to acquire users from this marketing channel.
Advantages of Bottom-Up Revenue Modeling:
Provides a detailed view of the startup's revenue streams and associated costs
Allows for more accurate revenue projections based on specific sales channels and customer segments
Disadvantages of Bottom-Up Revenue Modeling:
Can be time-consuming and complex, particularly for startups with multiple sales channels
Relies on accurate data and assumptions about the sales volume and costs
May not provide a high-level view of the startup's potential revenue compared to top-down modeling
Choosing the Right Revenue Modeling Method
There is no one-size-fits-all approach to revenue modeling for startups. The right method depends on factors like the startup's stage of development, target market, and available data.
Here are some tips for choosing the proper revenue modeling method:
Consider Your Stage of Development: If your startup is in the early stages of development and you don't have a clear picture of your target market or sales channels, top-down revenue modeling may provide a good starting point for estimating revenues. But if your startup has more established sales and expense data, bottom-up revenue modeling may be more accurate.
Assess Your Data Availability: if you have limited data on your target market or sales channels, top-down revenue modeling may be the only feasible method. But, if you have detailed sales volume and expenses data, bottom-up revenue modeling may be more appropriate.
Consider Your Target Market and Sales Channels: If your startup targets a large, established market, top-down revenue modeling may be more appropriate. But bottom-up revenue modeling may be more suitable if it has unique sales channels or targets a niche market.
Consider Your Goals and Objectives: If you are focused primarily on high-level revenue projections and market sizing, top-down revenue modeling may be sufficient. But bottom-up revenue modeling may be more appropriate if you are more concerned with optimizing specific sales channels and improving profitability.
Summary
Revenue modeling is crucial to a startup's financial planning and forecasting. By creating accurate revenue models, startups can better understand their revenue potential, make informed decisions, and secure funding from investors.
In this article, we discussed two main methods of revenue modeling: top-down and bottom-up, and outlined the factors to consider when choosing the proper method for your startup.
As always, working with experienced professionals, such as Finro, can not only save you much time and effort, it is essential to ensure your revenue models are sound and reliable. With the right tools, knowledge, and expertise, startups can create revenue models that help them achieve their goals and drive long-term success.