Welcome to a new BetaKit weekly series designed to help startups and entrepreneurs. Each week, investors Roger Chabra and Katherine Hague tackle the tough questions facing founders today. Have a question you would like answered? Tweet them with the #askaninvestor hashtag, or email them here.
This week we’re talking product-market fit. The term product-market fit was coined by Marc Andreessen of Andreessen Horowitz back in 2007 as a way of describing a startup in a good market with a product that can satisfy that market.
Andreessen’s belief is that in a good market — one with lots of real potential customers — the market pulls product out of the startup. Markets with a strong need would be fulfilled by the first viable product that comes along. The product doesn’t need to be great, it just has to basically work; the team doesn’t even need to be great, as long as the team can produce that viable product.
Today, product-market fit is cited by many venture capitalists as one of the most important indicators of startup success. At the seed stage, some investors will fund pre-product-market fit startups based on a hypothesis or minimum viable product. However, beyond the seed stage, product-market fit is often seen as a prerequisite for financing.
So many founders and investors claim that their startups have product-market fit, when, in fact, very few companies ever truly reach this milestone. In this post, I want to talk about how I measure product-market fit, and I’d love to hear in the comments how you measure product-market fit in your company.
Investors doing diligence on your startup will look for evidence that you have (or are quickly approaching) product-market fit.
In my experience, most investors and founders use traction and revenue metrics as a quick proxy for product-market fit. If someone is willing to pay for the product, there must be demand. But this simple way of looking at product-market fit is often to a company’s detriment. Product-market fit is more than just revenue, and often one metric is not enough to truly understand whether a company has product-market fit.
In many cases, product-market fit, or lack of product-market fit, is not necessarily something that you can measure. It is often more of a feeling. Without product-market fit, customers aren’t getting the value they want, the product isn’t spreading, and the company isn’t growing. When product-market fit happens, customers are buying, the company is growing and hiring, and everybody is talking about the company, from investors to customers to the media. In short, you know it when you have it, and if you have to ask, you probably don’t have it.
Despite its innately intangible nature, there are four metrics that, together, are strong indicators that a company is on the path to product-market fit. These include conversion rate, revenue, churn, and net promoter score.
High conversion rates from lead to customer indicate that there is a strong market need. A company’s ability to collect revenue indicates that customers are willing to pay for the proposed solution, and underscores the value the proposed solution provides. Low churn rates indicate that a product has successfully addressed the customer’s problem, at least in part. And finally, a high net promoter score helps confirm that a product is, in fact, addressing the customer’s need, while also indicating how likely the solution is to spread naturally.
If a company does not yet have strong conversion rates, revenue, churn and net promoter score data, proving product-market fit can be difficult. For a company in this situation, raising money will depend on the company’s ability to prove, at a minimum, that there is a viable path to product-market fit. To do that, a company must show that it is tackling a big enough problem, in a big enough market, and that customers will (as Andreessen would say) pull the right product out of the team.
Not realizing that your company, or a company you have invested in, is pre-product market fit can be disastrous. Believing you have product-market fit before you do can lead to pre-maturing scaling, which is the biggest cause of startup deaths. If you are pre-product market fit, the healthiest thing you can do for your startup is to admit it. Step back, make sure you are in a market that has a burning need, and then set about creating a product that can convert at high rates, that customers are willing to pay for, that has low churn, and a high net promoter scores. When you’ve done that (and it’s a tall order!), only then is it time to start investing in scale.
Investors doing diligence on your startup will look for evidence that you have (or are quickly approaching) product-market fit. Product-market fit is evidenced by different things to different startups. For example, if you’re a consumer app startup which is pushing off monetization, we look for evidence that your early users are addicted to your app.
Typically, we’ll pour through your engagement analytics and cohort data to look at metrics such as Daily Active Users (DAUs), Monthly Active Users (MAU) and churn. If your DAUs and MAUs and DAU-MAU ratio is growing at a good clip, you’re on to something. For us, it then becomes a matter of how big we think this something can be. That’s more of a gut call and much more difficult to decipher.
We want evidence that your early customers are representative of many other customers out there. This proves fit and gives us comfort.
In contrast, an enterprise SaaS company calls for very different diligence to understand if you have product-market fit. We’ll want to talk to your early customers to understand why they selected you, how important this solution is to their business, and whether they see their spend increasing with you over time and to what levels. We want evidence that your early customers are representative of many other customers out there. This proves fit and gives us comfort that you are ready to scale.
Importantly, you’ll need to showcase a few customers that bought your identical solution with minimal customization. The less customization, the better, as far as we are concerned. VCs want scalable plays. Customization work, though it can be lucrative and potentially lock you in to your customer, is not as valuable to us in this scenario as a repeatable product and revenue stream.
For an ecommerce company, product-market fit is evidenced by metrics such as customer acquisition cost (CAC), lifetime value (LTV), and churn. We have rules of thumb, such as LTV needing to be three times your CAC, and so on.
If you have a good base of customers that are buying from you often, it’s a good sign of product-market fit. The question to us then becomes whether you can sustain and increase this buying behaviour with a broader set of your market. This is tricky and requires both quantitative and qualitative analysis.
LTV is particularly tricky as you are often presenting projections into the future (around two or three years) based upon a short time of history since you launched; around six months or a year. We will project your CAC creeping way up, and we’ll want a feeling that your LTV/CAC ratio can stay above three times. There are numerous other heuristics we use, but this should illustrate the point.
So, again, product-market fit means different things to different companies. Investors use a mix of hard and soft analysis to understand if you have it, and if it is truly time to pour some fuel on the fire in the form of serious financing.
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