“We don’t have product market fit.”
The Board room fell silent. How could a rapidly growing company with $50M revenues in a hot category not have product market fit? Yet having invested over $100M, we as a Board had just realized that lack of product market fit imperiled the business.
Product market fit (PMF) has evolved as a concept over time. Moreover, PMF requirements increase as a business matures. Here is a schematic that we use to assess PMF prior to investment and among our portfolio companies:
We think of PMF in three stages: Product Validation, Business Validation and Financial Validation. In our experience, these distinctions are meaningful.
Across over 100 investments and over 50 exits at NGP Capital, we found that, unsurprisingly, company success is correlated with PMF. It was striking to observe the extent to which company success differed across these three PMF stages.
Among our exited companies, those with Product Validation when we initially investment ultimately had a 25 percent success rate with success defined as a positive financial outcome for investors and founders. Companies with Business Validation had a 50 percent success rate. Those with Financial Validation have had over a 90 percent success rate.
Optimizing Product Market Fit
Entrepreneurs and investors have a shared interest in optimizing company outcomes — or maximizing value for risk assumed and capital or time invested.
We have found that understanding the key elements of PMF and taking a systematic approach in validating the product, business and unit economics at each stage can optimize company outcomes. Following are five principles that we have observed among our company successes:
1. Avoid Premature Scaling. A leading cause of startup death is mistaking early traction for PMF. Companies win markets by being first to PMF, not first to market. Hiring after PMF speeds up companies. Hiring before PMF slows companies down, increases burn and risks a death spiral. As Warren Buffett observed, “Only when the tide goes out do you discover who’s been swimming naked.” In the aftermath of the Softbank sponsored steroid era, there will be many new nude beach postings.
2. Go Deep Before Trying to Go Broad. Focus on and win a market segment. This is the fastest, most efficient way to test PMF and the business model at scale. Ganji first proved its mobile classifieds business in Beijing. When launching Shanghai, Ganji developed its expansion playbook and tested transferability of its model to a new city. Only after winning Shanghai did Ganji expand rapidly across China. Ganji sold for $3.6 billion in 2015, the largest tech acquisition in China at that time.
3. Iterate Quickly. In biology, species that reproduce rapidly (r-selection) survive and thrive best in unstable ecologies. The same applies to startups. Rapid iteration is essential for success in any fast-changing environment. Market segmentation allows companies to run multiple carefully designed experiments in parallel to test key hypotheses and optimize business models. UCWeb, a mobile portal that Alibaba ultimately acquired for $4.9 billion, ran A/B tests daily on its mobile portal. Lime opened initially in a half dozen cities of varying size and demographics to test variations on its shared bike and scooter offerings before expanding to over 100 cities.
4. Focus on Revenues. This may sound obvious, yet we frequently hear companies say, “We are focusing on growing our user base before we monetize it.” Monetizing is essential to strong PMF and is often harder than anticipated. Moovit launched its public transit app in over 2000 cities and had over 50 million users before seriously testing revenue models. CEO Nir Erez now agrees Moovit could have benefited by starting to monetize earlier. Though it took much longer than expected, Moovit is fortunate in finding a revenue model that scales. Too often funding runs out before a company with great traction learns how to monetize its users.
5. Measure Product Market Fit. NGP Capital benchmarks companies using key metrics for each of the nine categories identified in the above schematic. While entrepreneurs are understandably focused on their business, peer group comparisons help them see where their companies must improve or course correct. Growth efficiency — a ratio of revenue growth to burn rate — should improve over time if a company has PMF. High-performing companies tend to be early adopters of Net Promoter Scores. Phil Koen converted Intermedia, a cloud services business, to NPS early in his tenure and reported it in his CEO report at each Board meeting signaling his focus on customer service. Intermedia performed superbly under Phil’s watch and ultimately sold for about $500 million.
6. Move Up the Product Market Fit Ladder. Successful companies generally first validate the product then perfect the business and go to market model and finally prove unit economics as the company scales. Yet only half the companies that achieve success at one level successfully graduate to the next level as these are distinct business phases requiring different skillsets and organizational requirements. The challenges of product validation and scaling a business are fundamentally different as Bain has observed in its study of successful startup companies and illustrated below.
Source: Bain and Company
Each startup and industry is different and there is no single formula for successful graduation from one stage to the next. Nevertheless, there are a few common practices that entrepreneurs can undertake to speed and improve graduation success rate. First, recruit advisors and investors who have demonstrated success at building and scaling businesses and can help you think through requirements for scaled success at the outset: failing to plan is planning to fail. Second, your company will require different skills and processes to graduate from one stage to the next. Anticipate requirements for scaled success but focus on building your business well one stage at a time. Third, consider each phase as a distinct business effort and recruit relevant talent for the next phase of the business as you prepare to graduate. They can help you introduce the processes and organizational changes needed for success at that stage.
While varied in nature, startups follow a common path to success. Buzz around unicorns and large funding rounds easily distract founders from the mundane, but more vital, task of achieving PMF. Product market fit accelerates revenue momentum, shortens sales cycles, lowers customer acquisition costs and produces more lucrative outcomes. Ultimately, as the points above suggest, you may be pleasantly surprised to find that success is the accumulation of small things done well.
