Measuring Product-Market Fit

It’s never been easier to start a company. Advancements in technology and digital commerce have drastically reduced the cost to create and distribute products and services. Fueled by democratized access to information and cloud computing, founders can launch a business from anywhere in the world. And when they do launch, there’s a myriad of financing options - angels, VCs, crowdfunding - and support networks - incubators, accelerators, studios - to choose from.

These breakthroughs have led to a saturated market. While the barriers to entry are lower, competition is cut-throat, and most companies become commoditized before sadly flaming out. According to the Bureau of Labor Statistics, nearly 20% of new businesses fail within their first year, and 90% of them fail during the broader lifecycle. While these stats may be familiar, it’s still shocking to see. They clearly depict The Power Law, the relationship that has defined the venture capital industry for decades. The Power Law, in conjunction with the Pareto Principle, refers to the observation that a disproportionally large amount of investment returns results from a small number of companies.

So why are so many companies unsuccessful? Post-mortem analysis is often done to explain startup failures, with the survey below citing the most common causes.

These reasons are not mutually exclusive, but they boil down to one thing: a lack of product-market fit (PMF). Running out of cash results from not having enough investors willing to take the risk of another financing round. And savvy investors avoid unnecessary risk when they know that a startup is lacking PMF (or quickly losing it due to changing trends). Other reasons like mistiming a product launch, or failing to pivot after launch, means the entrepreneur didn’t understand the market dynamics to begin with (i.e. they never had a chance at PMF).

Defining PMF

So what is product-market fit, and why is it so important? Legendary investor Marc Andressen popularized the term when he wrote the following:

“Product-market fit means being in a good market with a product that can satisfy that market. And you can always feel it when it’s happening. Customers are buying the product just as fast as you can make it - or usage is growing just as fast as you can add more servers.”

In other words, it means providing a product or service that meets the needs or solves the problems of a target market, at least in that period. It’s a temporary state, where the products that are offered (and the price they are sold for) match consumer demand - where target customers are continually using your product, such that the yields from referrals outpace that of your marketing campaigns.

And it is essential for long term success. Scaling before finding PMF can be a death sentence. A startup without it will struggle to generate revenue and grow sustainably, no matter how well-funded it is. A lack of market demand makes it difficult to attract and retain customers, which can lead to cash flow issues, inability to cover expenses, and ultimately, failure.

Product-market fit can happen at any time, but evaporate just as quickly. Blockbuster stores met demand by removing the need to purchase expensive movie tickets, until Netflix removed the need to leave your couch. Blackberry met messaging demand by providing a full keyboard, until Apple iPhones removed the keyboard altogether. The list goes on and on.

Addressing this challenge requires a deep understanding of the target market, the problems it faces, and how the startup's product or service can provide a solution. The chart below outlines the process for achieving PMF. Although it varies from business to business, it should take roughly 2 years to obtain.

Key activities include defining the size of the market, the competitive landscape, and the desire for new solutions. After lining up product goals and developing a hypothesis, a minimum viable product (MVP) is released, and iterations are made based on customer feedback. Run-away growth happens when customers eagerly share your product, sales drive healthy cash balances, and enhancements are made.

This is not the only tried and true formula. Founders can estimate PMF by using proxies, such as content that covers the product and provides information to those interested. This can take the form of landing pages encouraging people to sign up, product-market fit canvas templates, or high-fidelity prototypes which customers can explore.

Challenges with PMF

Product-market fit does not happen incidentally - it requires constant iterating to product features and marketing tactics, often with limited runway. Successful product management is driven by these efforts. Founders need to conduct market research, gather customer feedback, and track relevant metrics, which can be time-consuming and costly.

Given the level of uncertainty at the early stage, many startups don’t understand where they are in the process. There is no standard framework to measure PMF, and businesses may define it differently based on their goals and target markets. This makes it difficult to determine whether they have achieved product-market fit or if they need to pivot their business strategy.

And there’s the issue with data quality. There may not be enough data to make informed decisions about PMF, or the available data is unreliable or incomplete. With so many metrics to choose from, it can be challenging to determine which ones are most relevant for a business.

Vanity metrics are a prime example - they make a startup look good on the surface, but do not provide meaningful insights into the success or growth of a company. Startups often focus on these because they are easy to measure, creating a false sense of progress. Examples of vanity metrics include website traffic, social media followers, or app downloads. 2M Instagram followers don’t mean a thing if you can’t monetize them. And there is no value in increasing website traffic without understanding the quality of that traffic.

Vanity metrics lead to poor decision-making, like investing in areas that don’t contribute to growth. In the worst-case scenario, a startup exhausts its resources and fails because it did not focus on the metrics that matter.

Other warning signs include:

1. Slow sale cycles

2. Free users not using your product

3. Weak conversion (customer churn post free trial)

How to measure and achieve PMF

So, what should startups focus on? And how do they know if they’ve achieved PMF?

People often hesitate to switch to new products if the magnitude of improvement isn’t 10x compared to the status quo. Assessing your value proposition means evaluating how well your product differentiates itself from competitors (using that multiple in mind). Consider Venmo - the company achieved PMF by streamlining P2P payments in seconds. The unique value proposition (sending money quickly) far outweighed the manual process of sending checks and wires. Uber’s value proposition - allowing anyone to hail a ride in minutes - solved the complicated process of scheduling a taxi in non populated areas.

Fortunately, there are several metrics that help measure the value proposition of any startup. Don’t we all want to find and invest in the next Uber?

Market Size

Finding PMF is almost impossible without knowing your market. The closer you are to your customers, the closer you are to finding PMF - this can be achieved through surveys, interviews, or user testing. It also gives you a strong understanding of the players operating in the space.

A large, growing market is also necessary. Total Addressable Market (TAM) represents the total demand for a product or service, essentially the max revenue a startup can generate if it sells to all customers. Obtaining 100% market share is unrealistic due to competition, resource capacity, and channels of distribution, so founders need to define their Serviceable Available Market (SAM) and Serviceable Obtainable Market (SOM). Ideally, investors look for market sizes of at least $100B, where 1% market penetration yields $100M in revenue potential.

Sustainable Business Model

Unit economics, sales growth, and traction can paint a clear picture of how your product is performing. By focusing on these areas, teams can make informed decisions that contribute to success while gaining insights on resource allocation. You can also see how these metrics stack up against those of your rival products.

A common ratio used to measure PMF is lifetime value to customer acquisition cost. LTV/CAC is a measure of how much you make from a customer relative to how much it takes to acquire them (typically through ads). If $20k is spent on marketing in a year and you obtain 2,000 new customers, your CAC is $10. Healthy unit economics normally call for a 3:1 ratio in this area, with anything below 1 signaling an unsustainable business model. Strategies to increase LTV include upselling and cross-selling, increasing the frequency of purchases, and optimizing pricing.

Many founders become obsessed with LTV/CAC, since the common thinking is the better the ratio, the more effective the marketing strategy, and the more you can spend to grow. But there’s no such thing as a free lunch in business. Markets change and competition can shift overnight, which often increase the cost of marketing channels. Initial customers tend to be ‘low hanging fruits’, who are cheaper to acquire. As you move past early adopters, you must spend more to acquire the same number of customers - and they tend to churn at a higher rate. So, the uphill battle just gets steeper and more expensive. Not to mention that the success of your product in the market may attract even more competition, which can further increase CAC while simultaneously putting you on the defensive to retain the customers you already have. Don’t believe an entrepreneur that says they will reduce CAC over time.

Traction and Financial Health

While the LTV/CAC ratio can be engineered, growth and monthly recurring revenue (MRR) cannot. MRR tracks the amount of revenue generated monthly, adjusted for non-recurring revenue and bookings, and provides insight into the financial health of the business. Typically, 10-20% MoM revenue growth is good for a startup, with 30% and above deemed great. The same can be said for user growth.

Once your product is out in the market, there are two key levers that help you determine whether your product has achieved—and is continuing to achieve— PMF: growth and profit. For Software as a Service (SaaS) companies, the Rule of 40 states that companies with a combined growth rate and profit margin equal to 40% have achieved PMF.

Customer Behavior

At the end of the day, people need to love your product and stick around for the ride. Customer retention rate measures the percentage of customers that continue to use the product over a given period, providing insight into the product's lifetime value and overall customer satisfaction. Startups with retention rates above 60%, meaning annual churn rates of 40% or below, tend to be in healthy standing.

Although it’s difficult to measure the emotional impact that a company has on its customers, the Net Promoter Score (NPS) can be a useful metric for gauging customer loyalty and the likelihood of retention. NPS is calculated based on a single question survey that asks customers to rate how likely they are to recommend a company's product or service to others (on a scale of 0 to 10). Depending on their answers, customers are segmented into three cohorts: promoters, passives, and demoters. The NPS score is then calculated by subtracting the percentage of detractors from the percentage of promoters - a score of 30 or above is considered great.

The timeless question of "how to find product market fit" is a difficult one for businesses. It requires a lot of time and effort to find what works for your industry. It's hard to know when you've found it because the exact formula might elude you. And it’s dependent on other factors not mentioned above, such as barriers to entry and economic moat. Remember, this is just as much of an art as it is a science. The only true validator of PMF is if a customer will pay again to use your product or service.

Cheers for reading.