A lot has been written about this. (Google: Bottom up market sizing). For an example written by a VC, see A Startups Guide to Market Sizing from DocStoc. (OVP Venture Partners)
My own take on this is that a business plan with a bottom up forecast demonstrates an understanding of the potential market that investors love. It reduces perceived risk and produces assumptions that can be measured and improved. It welcomes feedback from potential customers and experts, reduces the cost and risk of the startup and can potentially drive success quickly. It can also drive fast cheap failure which is a great second alternative.
(The fast failure allows us to move on to Plan B rapidly and with a lot of learning from the structure, controlled and tested failure in Plan A).
A bottom up market model goes something like this.
1. Our product/service will save (audience) a lot of money. In fact, we estimate $X per year based on current spending for this product/service. [So this is the general premise for who in particular the early buyers will be and why.]
2. An average customer will spend $X per year with us because they spend three times that now. Our solution requires no capital expenditures nor any method change on the customer's part. It's low risk for them.
3. Using (example) sales as a proxy (such as copier sales) we think that our average sales rep can make 10 cold calls per day and develop 3 solid leads per week. Of those, the rep can close 2 per month.
4. At a 2 per month closing rate per rep, that's $Z on an annual basis. Here's a table of the cash flow based on this: (TABLE)
5. Using our experience in (market) as an analog, we estimate that customers will stay with our product for 3.5 years. (Here's a factoid from (example) industry suggesting an average lifespan of 5 years, so we think this number is defensible.
6. If we time these cash flows correctly, we can hire 5 new reps per month. Assuming 90 days to train them and a maximum of 15 reps, here's a table of what we will look like at a full up run rate.
7. Notice that at about 36 months our hit rate drops off and our development $ go back up. By this time we anticipate competitive pressure and we will use leads acquired per day and time from conversions to sales as an early warning metric.
8. After we see market #1 begin to slow, we will use the following method to move to market #2 (Etc)
Makes your heart smile, doesn't it?
Here's the assumption list:
1. Customer premise - who will buy and why. (Test with a Five Forces Analysis? Talk directly to potential customers? Understand who in the organization can make the buying decision? Is higher up worse or better? Why?) What is the competitive environment from the customer's point of view?
2. Pricing. How much % of the savings is reasonable? Are there analogies? What does the customer say?
3. Rep performance. At a similar price point in a similar industry, what are the rep comparables? Do sales rep organizations have this kind of data? Where can we get it? Let's make sure we aren't premising the best rep performance in the world to date as the base case for our assumption.
4. Check the math but it's pretty easy.
5. Again, what is comparable performance? What is the role of actual or potential competitors? How lucrative is the competitive position vs.us and to whom?
6. Again, what are the comparables here? Do recruiters think we can do this?
7. How do we know this is the right timing and cash reserve for development? If we can turn on a dime the timing is less important than the cash. Do we have an ongoing relationship with the customer that can give us very early feedback and product improvement expectations?
8. Do the same exercise for market #2
Entrepreneurs that can do this build an understandable environment that is friendly to investors and welcomes discussion and feedback from experts.