Growth sounds empowering and exciting and it is of little surprise that a lot of founders are often very eager to begin working on growth-related activities in the infantile stages of their company. Yet the time and resources spent on these activities are often disproportionate to the output they produce, causing all kinds of trouble. Hence, I thought I’d share three prerequisites to growth that I think an early-stage company ought to address before turning to growth.
Product Market Fit
Product Market Fit – PMF. We all know what it is, and yet we’re all guilty of ignoring it. And that’s totally understandable – it’s a lot more exciting to say you’re doubling your users every month, than saying “I’ve spent the last six months on figuring out how to make sure the only 10 people using my product don’t leave”.
A lot has been written on PMF so I won’t go into much detail here. I think the most important takeaway is understanding that without achieving PMF, your venture is ultimately doomed. It may be around for a little while, it may get some traction, raise money, but it will inevitably collapse. The whole point of working on your startup is that you build something, which satisfies a strong market demand.
How do you get to PMF?
It’s a bit of a paradigm shift. You have to understand and be comfortable with the fact that your MVP’s primary goal isn’t to generate money, but to generate feedback. There’s a ton of literature which describes this process in a much more elegant way, but I think the gist of it is this:
- Define your value hypothesis
What is it that you’re trying to solve? What are you going to build to solve it? How will you make money – i.e. what will be the business behind it?
- Get an MVP
The next step is to go and get the data to test your value hypothesis, which you defined above. The way to do that is to create the absolute minimum, which will resemble the set of features you imagine your product will have to solve the customers’ problem.
- Define your value hypothesis
Note: although it has the word “product” in it, an MVP or a Minimum Viable Product is not actually a product in the business sense. Think of it as a tool for you to answer the fundamental questions around your value hypothesis.
How do you know if you have or you don’t have PMF?
It’s one of those things that you’ll know intuitively when it happens – does it feel like you’re onto something which people want? Do you see numbers going up every day/week – like people spending more time, clicking around more, telling more people or getting more people to sign up and play around with your product? These are early indicators that you’re on the right path.
In more formal terms, I think nothing speaks more PMF than retention metrics: if your users are sticking around, it means that they see some value in your product. You may want to also compliment this data by asking them Sean Ellis’ PMF Survey.
Product Channel Fit
Now that we have some validation that we’re on the right track with our product, it’s time to look for a scalable and repeatable way to distribute that product. And while PMF is something we talk about quite often, it’s not as often that you hear people talking about Product Channel Fit.
The basic premise here is that although you’re on track of building a great product, channels will not adapt to your product. It’s your product that needs to fit into a channel. And while this process is also iterative, there are some fundamental assumptions that we can begin with:
- Paid Advertisement
If you’re running a transactional business, say eCommerce for example, you can probably begin by testing paid ads as a way of reaching our customers. So you may start with Facebook Ads, Instagram Ads, Google Search, Google Display, Twitter, LinkedIn, etc.
- Word Of Mouth, Virality
If your product is creating a network effect, then you’re relying on WOM and viral channels. These are harder to spot, but if you’ve nailed your PMF, then the channels will somewhat be embedded in the product, as network value typically grows with each subsequent node.
- Paid Advertisement
One of the mistakes that founders make at this stage is trying to test way too many channels at once – “we’ll do paid social, and search, and display, oh and let’s throw in some content as well, some SEO, and some influencers on Instagram…” What ends up happening is that they’re spreading their resources way too thin and achieve rather deceiving results on a channel/platform level. Instead, I would urge early stage founders to:
- Understand the difference between a channel and a platform. Paid advertisement is a channel – Facebook and IG Ads, billboard ads, TV ads are the platforms.
- Come up with a process to prioritize channels to test. This will come somewhat naturally after gaining some insights into the market. If you understand that you’re selling to enterprises and the sales cycle is long, it’s rather unlikely that you’re going to start off with Instagram ads.
- Document your findings – and by this I mean, have a clear understanding of how your distribution channels and platforms performed. What was the blended and segmented CAC? What’s the time to return? What do you think will happen if you 2x your investment into this channel? What if you 10x it?
This part does not necessarily come after having reached/neared Product Market Fit and after seeking Product Channel Fit, but instead, it occurs while we’re doing everything else. The main point here is to understand whether or not we’re in business or if we’re on the right track to realistically be in business in the foreseeable future if XYZ happens.
The basic set of metrics that you want to understand about your business early on is the following:
Customer Acquisition Cost (CAC)
How much does it cost to acquire one paying customer?
CAC = (Total Cost of Sales and Marketing) / # of Customers Acquired
- Segmented vs Blended
Make sure you’re measuring your CAC segmented per channel. Don’t simply blend everything together – this will skew your data.
- Fully Loaded?
Are you offering a free trial? A first-time promotion? Are you running retargeting ads? Make sure to include all costs relevant to the acquisition of a customer.
- Segmented vs Blended
What is the percentage of customers who leave over a given period of time divided by all customers?
Churn = Revenue lost from a cohort in a period / Recurring revenue per period
*Cohort = a group of customers with a common characteristic (typically, became customers over the same period of time)
**Period = typically month, quarter, year.
Customer Lifetime Value (CLV)
How much is a customer worth to you over their lifetime to you?
CLV = (Revenue per User * Gross Margin) / Customer Churn Rate
Note: this metric is a bit tricky, especially when you’re an early-stage company and have very little, if any, historic data. What you may want to do is look at the time to recover CAC or Payback Period.
Payback Period or Months to Recover CAC
How many months of revenue will recover the cost you paid to acquire a customer?
Months to Recover CAC = CAC / (Monthly Recurring Revenue x Gross Margin)
Alternatively, you may also use
Time to Recover CAC = CAC / (Average Revenue Per Account x Gross Margin)
Where Average Revenue Per Account (ARPA) = MRR / # Customers
Finally, the CLV to CAC ratio is a metric, which expresses the value of a customer as a fraction of CAC. In other words, is a customer worth 2x of what you paid to acquire them? 3x? Or are you losing money on each customer you’re acquiring?
CLV:CAC Ratio = CLV / CAC
The universally accepted ratios here are as follows:
CLV:CAC = 1
This means that you’re break-even on your investment to acquire a customer, i.e. you’re not making any profit.
CLV:CAC < 1
This means that you’re paying too much to acquire a customer and you’re actually losing money with every new customer.
CLV:CAC = 3
This is probably where most companies want to be – you’re getting 3x on your investment.
CLV:CAC = 5+
Although there’s plenty of room to debate that, there’s a point to be made that especially if you’re an early stage company, if your CLV to CAC is 5 or over, you’re probably not spending enough money on acquiring a customer.
These three elements present the essential groundworks that need to be laid before we even begin thinking about applying a growth framework to our startup:
- Some indication that you’re nearing Product Market Fit – generally expressed as – accounts/users are sticking around.
- Some indication that we’ve discovered a scalable and repeatable sales/distribution process – i.e. we have a way of reaching our customers in a manner that can scale 10, 50, 100x.
- A good grasp on unit economics – we know our numbers and we know what needs to happen so we can remain in business.
Without these three very basic notions, I think growth can only occur as a product of pure chance. The only other growth that we’ll see is a negative one, and here’s why:
- No PMF = users don’t stick or churn before generating any value. This means more spending on replacing users that churn, higher CAC.
- No PCF = no predictable way of reaching customers. Number of new customers is volatile, so is revenue.
- Broken unit economics = negative CLV:CAC ratio, means the more money we spend on acquiring new customers (CAC already going up because of lack of PMF), the faster we’re digging ourselves into the hole.