If you’re an investor, angel or venture capitalist looking for a big payoff in the future, you might want to consider the outcome: could this be a company that goes public and continues to trade higher in the stock market?
It’s an important marker, because public investors tend to reward companies that have impressive market leadership, strong growth, profitability, and positive free cash flow (or, at least free cash flow trending in the right direction). For example, Shopify or Snowflake.
But how do you get there?
Operating leverage
One measure to watch for is operating leverage, or the point when profit margins increase at a faster rate than revenue grows. For example, if a company puts up year-over-year revenue growth of 50% and operating margins move from 30% to 35% during that period, we say that it demonstrates positive operating leverage. If the greater portion of costs are fixed and these fixed costs grow at a slower rate than revenue grows, then the business becomes more and more profitable as revenue grows.
Operating leverage is distinct from financial leverage. With the latter, the company borrowed money, maybe to pay out a dividend to shareholders, confident that the firm can service its debt with the free cash flow generated by its ongoing operations.
A company with strong operating leverage, strong financial leverage, strong revenue growth, and positive free cash flow is a rocket ship.
Of course, it cuts both ways. Strong operating leverage and/or strong financial leverage can really hurt if revenue drops significantly. Just ask any airline CEO what happened to their revenues in 2020.
But let’s assume that we’re investing in a startup.
We want to invest in companies that can eventually generate strong revenue growth with positive free cash flow and positive operating leverage.
There are two dimensions to revenue growth that the investor is looking for: demand and the ability to manage it.
Product-market fit
Product-market fit is about demand. It is the pivotal point in a startup’s development. In a startup’s evolution, there is the period before product-market fit and there is the period after product-market fit.
Imagine an oil wildcatter: someone who drills speculative wells hoping to find oil. They will come up with a hypothesis for why a particular location has potential to find deep reserves of oil and they will drill a hole to test it. Often these holes come up dry. Or they send up oil but with disappointing pressure, suggesting that there is a reserve but not a very large one.
But when they work, the oil comes spurting out of the ground at high pressure, leading them to conclude that there is a vast quantity for them to tap.
It’s the same with a startup. Many of them fail. One of the most common reasons is that they drill dry holes.
Establishing product-market fit is the critical task for a new startup. So much so that we use different language. A company that is in the pre-product market fit phase is called an “early-stage” company. One that has established product-market fit is said to be a “growth-stage” company.
The key challenge for an early-stage company is to prove to the world that it can achieve product-market fit, while the primary issue for a growth-stage company is to scale up the firm as quickly and thoughtfully as possible, to establish a sustainable enterprise capable of exploiting that newly-discovered opportunity.
It is straightforward for the wildcatter to know if they hit the mother lode. The oil comes out of the ground like an erupting geyser.
Eating the dog food
How do we know if the early-stage company is ready to transform into a growth-stage company?
Like many things in life that are difficult to describe, it’s one of those cases where you know it when you see it.
Product starts flying off the shelf. The company’s good or service starts selling itself.
But just as importantly, there are other indicators of product-market fit.
There is engagement: how often do customers use the service? Do they use all of its features (i.e., broadly) or just some of them (i.e., narrowly)? How important is it to their daily lives? Do they recommend it to others? Is it selling without much advertising?
In assessing product-market fit, a commonly-asked question is, “are the dogs eating the dog food?” Here’s Andy Rachleff quoted by Andreesen Horowitz on the topic:
“If you address a market that really wants your product – if the dogs are eating the dog food – then you can screw up almost everything in the company and you will succeed. Conversely, if you’re really good at execution but the dogs don’t want to eat the dog food, you have no chance of winning.”
Or, there is Marc Andreesen:
“And you can always feel when product/market fit is happening. The 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. Money from customers is piling up in your company checking account. You’re hiring sales and customer support staff as fast as you can. Reporters are calling because they’ve heard about your hot new thing and they want to talk to you about it.”
The more important of the two dimensions is market.
For the oil wildcatter, the equivalent to the demand the early-stage company seeks to identify and tap into is the amount of oil in the ground. He can be good or bad at extraction. It’s the amount of oil in the ground that actually matters.
Startups can be good or bad at exploiting an opportunity, but if they have product-market fit in a massive market, then they are golden.
Transitioning to growth-stage
Product-market fit marks the company’s life-cycle transition from early-stage company to a growth-stage company. The kinds of people who invest in the different stages usually differ. So do the people who work at companies on either side of the divide.
This is because obtaining product-market fit is a vital step in reducing the risk of the enterprise and because it requires different skill sets.
People in the early-stage need to hustle to establish product-market fit in a race against time (principally determined by the rate at which they are burning through their cash). Those in the growth stage focus on scaling up the company to extract the maximum amount of value as quickly as possible from the opportunity.
The reduction in risk means an increase in valuation, enabling the founder to raise money with less dilution to their own proportional stake and those of the existing investors.
Consequently, there can be a lot of tinkering with product-market fit.
Do you really have product-market fit?
Founders have an incentive to think that they have reached the point of product-market fit because it gets easier to raise money and to recruit people. It feels like there is a greater chance of lift-off — because there is. And the founder can bask in the validation of their abilities as an entrepreneur. Wildcatting for demand with a new product is very difficult stuff.
Sometimes they fool themselves into thinking that they are there when they are not. Sometimes they fool others, including investors.
At its core, product-market fit is about proving to all of the relevant stakeholders that the founder’s initial hypothesis about demand was correct. The best kind of product-market fit is when a founder can find a deep reserve of demand in a place that nobody expected to find it, for which their company uniquely is positioned to exploit, at least for a while.
This is the seventh of a series of articles about startups and venture capital, where we’ll explain some of the concepts people might see discussed in the press. We’d love to hear your feedback.
