Everything you need to know to get funded – for beginners (Part 2)

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Product Market fit and early signs of demand: Beginners guide to get business funded- Part 2

Most entrepreneurs and investors will tell you that the biggest risk in any new venture is some thing called product market fit. Let me give you an analogy from the movies. However big the banner or however big the star, when a new movie releases on a Friday in theatres, that’s where its acceptance in the market gets tested. That’s the product market fit. Everything before that is theory.

Product-Market fit indicates the following:

• There is a need for such a product in the market by a certain Target Group (TG)
• This target group is able to discover the product and engage with the product. This may be through a direct sales channel, or through a marketing channel such as ad etc.
• The TG is taking a decision to try out this product and adopting it. Even paying for it.

The final test is that you are able to make money as well while doing all this, but that’s my next chapter.

Product Market fit is simply that whatever product you have created, there is a real market for it, meaning there is a demand for that product. While this idea seems simple, but company after company after company is not able to achieve this simple thing to the satisfaction of investors.

Lets look at and assess some typical situations companies are in:

We have completed the development, all we need now is marketing: Only if I got a penny every time an entrepreneur said it to me! This statement or other variants of this statement - “We have that feature too!” OR “Our software is configurable – we can provide everything” is a sure shot red flag for investors. It indicates that you have never entered the market and never validated the product. You may have spent a whole lot of engineering time but you have very little understanding of the market. You are not even at the beginning of the journey.

We are looking for a sales head to sell our product: Early product sales have to be done by the founders. It’s very hard to believe that if founders are not able to sell, a professional sales person will. Professional sales people can scale the sales operations and bring that experience to the table. However, looking for a sales person right at the beginning again points to lack of validation and is a big red flag for investors.

There is no competition in our market: Investors look for better substitutes to existing products that are servicing existing needs. If you are the only product in your category, that is a scary proposition for investors since it points to un-validated need. It’s much harder and takes much longer to create a new category from scratch and its very risky too. Ideally, as an entrepreneur you want to latch on to some existing need and serve it better. This would typically mean that there is some competition too and perhaps you can are focusing in a certain territory or demographic to establish your beachhead.

There are many ways how entrepreneurs demonstrate product-market fit. Lets look at some kinds of ventures:

In consumer products, adoption and usage are key metrics that prove product-market fit. A commonly used method to demonstrate product market fit is called cohort analysis. Early stage companies in consumer spaces live by their cohorts. For example, if you were doing a weekly cohort analysis, you would 

basically study the usage pattern of all new users acquired on a week to week basis and observe that over the following several weeks. An improvement in retention numbers would demonstrate that the product is going in the right direction and achieving better product-market fit. Deterioration in numbers or if most of the users stop coming back to the product after a few weeks, would show a week business. Investors ordinarily ask for cohort analysis while evaluating such a business.

In enterprise software, the best way is to have beta customers. I remember experienced entrepreneurs in the US, and they would only start building enterprise software once they had a beta customer. As an entrepreneur, you want to go on Day 1 with a PPT to sell and lock-in a customer. That ensures that you have product-market fit from Day 1. Traditionally people who had deep domain knowledge started these companies. So for example, you may be working in the collections department of a large Telco, you understand the need gap very well, you come out of that and start a company. But if you are coming from outside, there is very little chance that you will understand the needs well and hence its crucial that you sign-up early customers. They will sign up with you because firstly, you will give the product to them for very little cost, and secondly, it will be built to their specifications.

In Cloud software, these days the key metric is user adoption. Cloud software companies build simple key features instead of building large software and directly try to target users vs. going through an enterprise procurement process. Google Apps and LinkedIn have done this really well and now the newer companies such as Zenefits and Slack are doing the same. They seep into the user base with freemium offerings and then start selling. Even the more traditional Cloud companies such as SuccessFactors, WorkDay, SalesForce.com etc. have focused on 1 key function and incrementally built software over a period of time. A cohort analysis, just as in consumer markets, becomes very important too.

In Services space, such as IT services, healthcare, hotel, education etc. these tend to be more driven by execution.  Most services have a clear need more driven by location more than anything else. For example, outsourcing has a clear need – staff augmentation / specialty skills and offshoring has a clear cost arbitrage need. When you combine the two, there is a significant value to the customers and hence the industry has become so big. Similarly other services such as health care and education are clear needs and play into existing spends. In these businesses, the idea is to focus on execution. However, many of these businesses are not investible, since they do not have any leverage to scale. They have product market fit however they are not considered in an investible space, especially early on. As these businesses become big, they become more investible financially. This is more balance sheet and financial financing vs. risk financing. However, if you have a services idea at an early stage, it does not typically garner venture financing.

Product-market fit, combined with a large market size and the right timing is a fantastic combination and allow for rapid value creation, the kind venture investors are looking for. It’s a hard thing to achieve and most entrepreneurs achieve it through constant experimentation and pivoting. Smart entrepreneurs are quick on their feet today and keep looking for true market validation vs. just falling in love with their own ideas. They engage with their potential customers early, learn from that and keep tweaking their products. This fitment and early demand goes a long way in getting investors interested.

This article was originally published here