AdAge published an interesting article this week with a subtitle that caught my eye:

“Entrepreneurs Discover Digital Spending Isn’t an Infinite Quantity” .

The author of the article, Michael Learmonth, focuses on Web 2.0 startups and discusses how many are now learning the hard way that the advertising revenue they thought would one day be there for them, probably isn’t going to be:

“In the past five years, trends have justified that optimism and helped fuel massive venture-capital investments in online start-ups that will, theoretically, one day be advertising-supported. But what if the advertising isn’t there, or if the shift doesn’t happen as fast as once thought?”

“That’s the new reality filtering down to start-ups: If advertising was your panacea, better think of something else and quick.”

Learmonth goes on to note that the “onetime hyper-growth” of the online advertising industry is inevitably “coming to an end” and that given the economic downturn, “advertisers are about to get a lot more conservative than they’ve been for the past three years.”

This doesn’t mean that advertisers will flee online altogether but they will flee to quality – “which means a flight to search and proven sites and less experimentation with social media and new platforms.”

In fact, I note that there was only so much to go around at the beginning of the year when I told Allen Stern of Center Networks:

“On the startup side of this equation, the most dishonest part of the hype is that there’s this huge and growing pie of advertiser cash up for grabs and that every Web 2.0 startup can get enough of it to build a great business. The truth is that a relatively small number of big properties and networks are getting most of that cash and the proportion they get is only likely to increase the bigger the pie gets.”

While I won’t harp on about Web 2.0, I think Learmonth’s article actually touches on a subject that impacts entrepreneurs beyond Web 2.0 – estimating the size of your market and how much of that you can really capture.

Many, if not most, entrepreneurs take a “top-down” approach to this challenge. They first ask themselves how much the market they’re service is worth or will be worth (often using less-than-reliable projections). They then “work their way down” to figure out how much of that they think they’ll be able to realize.

For example, if an entrepreneur is targeting an industry projected to be worth $50bn within five years, he’ll often come to the conclusion that his company can acquire x percent of that market, giving it revenues of y.

This type of approach has been evident in the consumer internet space over the past few years as entrepreneurs gleefully touted the fact that spending on advertising on social media properties, for instance, would rapidly grow to billions of dollars.

Of course, few wanted to recognize that only a small handful of “winners” would receive any of those dollars.

But the consumer internet is hardly the only market in which this occurs. In fact, if you read 1,000 business plans for all sorts of companies, you’d probably see some sort of “top-down” approach to estimating revenues in the vast majority of them.

And for good reason – estimating revenues using a top-down approach is simple and usually leads to a significant overestimation of one’s potential (which is handy when you’re looking for validation that you’re starting the next Google).

The reality, however, is that a “bottom-up” approach to estimating revenues is far more realistic. And, inconveniently, far more difficult.

Clearly, few ad-supported Bubble 2.0 consumer internet startups asked themselves “bottom-up” questions, such as:

  • How much traffic will we be able to acquire?
  • How much of that traffic will generate saleable advertising inventory?
  • What rates will we realistically be able to achieve?

Similar questions are frequently left unasked – and unanswered – by businesses in other markets.

If you’re selling a piece of software, for instance, your focus shouldn’t be on the total size of the market you’re serving and how much of that you think you can capture. Your focus should be on determining how many copies of your software you are realistically capable of selling.

The truth is that the total dollar size of the market an entrepreneur is entering or competing in can be extremely deceptive because it masks the following:

  • For new companies, capturing any sales within any market – no matter how large – is a difficult task. It’s easy to build a product but finding a customer and closing a deal is often much harder than expected.
  • A growing market is not necessarily indicative of an “expanding” market. That is, just because you’re entering a market that is growing at 20% annually doesn’t mean that the growth is being realized by more participants. Oftentimes, in fact, the growth is being realized by fewer participants.

Unfortunately, companies that aren’t realistic when it comes to estimating their revenue potential because they took the wrong approach usually learn this the hard way when their expectations don’t quite pan out.

Speaking of ad networks, for instance, Learmonth observes:

“Few believe the market will support all of the 400-odd ad networks that have launched in the past five years. Consolidation seems inevitable as those with no unique technology or selling proposition are swallowed by those with either scale or expertise in a particular niche.”

Another topic I’ve discussed before.

The lesson, of course, for entrepreneurs, is clear – when estimating the revenue potential of your business, the “bottom-up” approach may not be easy and it may not provide the desired results but it is almost always far superior to taking a “top-down” approach.

As the subtitle of AdAge’s article reminds us, nothing is infinite. And as Drama 2.0 will remind you, 0% of $5b is $0.