The Dilemma in Defining Active Users

A few years ago, Andrew Chen posted a list of 10 "magic metrics" that suggest if a consumer startup achieved product-market fit.

The metric from his list that we'll review in this article is "actives/reg > 25% (validates TAM)," seems like it could be explained in a 140 character tweet. After all, only one operation is needed to calculate this metric.

However, the difficulty isn't in the math, but rather, in defining "active," "reg," and "TAM."

First, let's define each:

• "Reg" or registered users are the users who registered for your product or service (i.e., sign up)

• "Actives" or active users are the users who engage with your product or service

• "TAM" or total addressable market is the amount of revenue a business could generate by selling their product or service in a specific market

Overview

Whether you're a founder, investor, product manager, strategist, sales manager, data scientist, or growth marketer, you've either created or received a report measuring active users and total addressable market.

Over the past decade of working with startups, I've seen many curious active users and TAM calculations. Often, many startups too broadly define active users, and others make wild assumptions when calculating TAM.

Let's discuss best practices and common pitfalls when measuring total active users and calculating TAM.

Registered 

First, defining "registered users" is straightforward. For example, if you run a blog collecting email addresses, and a user submits their email address, then they're considered a registered user. The same goes for products requiring a user to sign up with an email and password. If the user enters their email and password and completes sign up, then they are considered a registered user.

Active 

Active users are the users who engage with your product or service. But, how should one define "engagement" when calculating total active users? The truth is, from product-to-product, there's no single definition — every company defines active users differently.

Let's use Soundcloud as an example. 

First, if asked how you would define Soundcloud's active users, you could provide dozens of reasonable definitions. One of them being, "users who played a track." This definition is useful and could serve a purpose, given that streaming music is Soundcloud's core value proposition. However, Soundcloud offers more than music streaming, so perhaps this definition is too narrow.

Second, you could say, "users who opened Soundcloud's app or visited their website." This simple definition, although common, isn't the best measurement, because it inflates the active user count by including users who visited the service and didn't interact with Soundcloud in a meaningful way.

For instance, if non-targeted ads drove a high volume of users to Soundcloud's website, there is a fair percentage of users who will bounce from the site without engaging. Perhaps the users who bounce are diehard Spotify customers or classical music junkies. Active users becomes a vanity metric when non-engaging users are included in the calculation.

Third, Soundcloud has embeddable widgets that websites can use to embed audio tracks and playlists. You could also include users in your calculation who opened the app or visited the site or interacted with one of Soundcloud's widgets on a third party site. This definition is potentially broadest of the three, creating the largest active users count, but it's also the most misleading.

For instance, a press release reporting "300 million active users" would lead most people to believe 300 million users visited Soundcloud's website or mobile app. But, in reality, if Soundcloud used the last definition, it's likely a large percentage of the "active users" never even visited the Soundcloud website or mobile app, but instead engaged with a track on a third party site.

Which Definition to Choose? 

The truth is, the definition of "active" might be arbitrary for one company and useful for another. It's essential to understand which levers drive meaningful user engagement and then craft a definition of "active" that supports it. 

For Soundcloud, a useful definition could be, "users who engaged with Soundcloud's website or mobile app, whereby the user played an audio track, posted a comment, liked a track, sent a message, or followed another user." In this case, you know that every user you're reporting as "active," actually used the service in a meaningful way.

Total Addressable Market (TAM)

As mentioned earlier, TAM stands for "total addressable market" or "total available market," and it's most commonly reported as the amount of revenue a business can generate by selling its product or service in a specific market. It's the amount of annual revenue, in dollars per year, your company could earn if you achieved 100% market share. 

Sweet Spot

So what's a total addressable market size worth pursuing? Most VCs are looking at opportunities where the TAM is greater than $5 million and less than $1 billion. If too small, the opportunity might not be worth pursuing because even if you capture a large percentage of the market (e.g., 50%), the return will likely be too small to justify investing. And if a total addressable market size is too large, the market is likely saturated with competition, which requires a highly differentiated product or a lot of cash to penetrate the market.

Calculating TAM

There are a few common ways to calculate TAM: bottom-up, top-down, and value-theory. A bottom-up approach is often preferred because this method uses actual data points relevant to your target market (e.g., competition, pricing models, user or customer base). 

Bottom-Up Approach

With a bottom-up approach, you need to calculate the average revenue per user (ARPU) and multiply it by the total potential users or customer base. 

Calculate ARPU by analyzing competitors' pricing models in your target market. For example, web-based services could earn money on subscription fees, advertising, referral links. Whereas, a product company might sell products along with installation and maintenance services for an additional cost.

The total user/customer base is trickier to estimate, and there's a variety of ways to do it. Fundamentally, the first step is to gather market-specific data focusing on customer density, quantity, and segmentation of customers, and extrapolate within relevant segments to estimate the size of the market and the types of customers the company can serve and win. 

Other Methods

Top-down is quite straightforward, but there are drawbacks to using this method for calculating TAM. And value-theory serves a purpose, but it's mostly conjecture about buyers' willingness to pay. David Skok wrote a great article about the various ways to calculate the total addressable market, read more here.

Conclusion

So now you know how to calculate active and registered users in a meaningful way. This second metric, "actives/reg > 25%," can indicate how effective you are at acquiring a dedicated user base. 

Do you agree with Andrew Chen that this metric validate TAM? Or do you agree that more analysis is required? Let us know what you think in the comments below! 

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