A. Product/Market Fit

In his now famous 2007 blog post, Marc Andreessen made a bold statement, which he credited as Rachleff’s Corollary of Startup Success:

“The only thing that matters is getting to product/market fit.”

He went on to define product/market fit as:

“Being in a good market with a product that can satisfy that market.”

In the decade since, product/market fit has stuck as the descriptive phrase explaining one of the most important early goals of a startup: creating value for customers. Like any overused catch phrase, there are proponents and detractors. A catch phrase, like a framework, attempts to simplify the complicated, which is a risky endeavor.

To explore product/market fit, we are going to deconstruct Marc’s definition into three key questions about a startup:

  1. How are we solving customers’ problems?  — Value Proposition
  2. Are there enough customers out there?  — Market Size
  3. Can we prove that customers really want it?  — Traction


1. Value Proposition

From Idea to Value Creation

In the late 1800s, Ralph Waldo Emerson made a statement that evolved into the well-known adage: “Build a better mousetrap, and the world will beat a path to your door.”

Turns out, it’s a lie.

Far too many entrepreneurs have holed away in their garages perfecting mousetraps, thinking that the world would indeed beat a path to their doors, only to discover that the current mousetraps were good enough. VCs have seen many “better” mousetraps that went nowhere. They know how hard it is to get the world’s attention.

For an idea, like a better mousetrap, to become a startup opportunity, we need to translate that idea or innovation into “value creation,” which we articulate in a statement we call the “value proposition.” It is not good enough to be clever or novel. An idea must somehow make the world a better place. It must change the world for the better. However, this needs to occur in the context of a world that hates change.

Special note to college students: I need you to take a leap of faith with me here. Your world is so full of profound changes, you may find it difficult to fully comprehend the rest of the world’s aversion to anything that rocks the boat. Every few months, you are changing schedules, housing, cities, friends, activities, jobs… But you will soon find permanent employment and begin falling into comfortable routines like the rest of us. Despite your current ability to adapt quickly, be aware that most people are doing everything they can to keep an even keel.

And groups of people are worse! Organizations are notoriously resistant to change, even in the face of obvious need. Institutional inertia is perhaps a stronger force than gravity (I’ll check with Newton on this one). As a small example, students, have you ever been a leader in a student club? How many of the things your club did were the result of “that’s how they did it last year”?

Understanding this resistance to change is a first step toward articulating value. Build a better mousetrap, and the world will not beat a path to your door! The world is busy, and the old mousetrap has been working fine. How then can we make the world a better place in a world that is unwilling to change?

The key is to identify something that is making the world uncomfortable, so much so that the world is already looking for a change. VCs have a handy metaphor for this phenomenon: customer pain.

Also covered in this chapter:

  • Customer Pain
  • Segmentation
  • Better/Faster/Cheaper
  • (Early) Competition
  • Incremental vs. Disruptive
  • Platform vs. Focus
  • Push vs. Pull
  • B2B Value Creation
  • High Concept Pitch
  • Getting Granular

For more, download Venture Capital Strategy for $9.99 using discount code “VCIC” or purchase on Amazon for $24.99. 

2. Market Size

We’ve already talked about the market from the customer perspective, specifically their pain points being addressed. Our next investigation into the market fit has a singular focus: to size the market. How big could this thing get?

Market sizing is tricky business. A market size is an abstraction onto which we assign misleadingly specific numbers. Years ago, a founder speaking to my class said, “Market size is just some BS number you have to make up because VCs want to hear something.” He went on to raise over $25M in venture capital funding.

I believe he was expressing frustration with assigning too much meaning to something that is highly speculative. However, I think he was misunderstanding the point and context of market size, and would have benefited from thinking like a VC. True, in the abstract, the number itself has very little meaning. “We have a $1B market!” What does that mean exactly? It needs context.  Most people think market size is a number. It is really a story about a number.

My favorite market size anecdote of late comes from a VC whose firm passed on Airbnb. “We didn’t see a big enough market there. We thought it was only going to be dudes crashing on friends’ couches.”

This anecdote demonstrates the importance of vision when defining a market size. One venture capitalist may envision a small niche market adopting an innovation, whereas another may have an insight for world domination. Dudes on couches vs. what we all now know Airbnb to be.

Because market size is often given as a number, founders often over-emphasize the number at the expense of the explanation of the number. The meaning of market size emerges as we weave it into the narrative that was begun in the last chapter. We began with a value proposition statement. If we did our jobs well, we identified specific pain points for specific customers. Now it is time to count those customers to determine if the startup has the potential to grow as large as our investment would require.

In theory, market size is the summation of all the conceivable future transactions in our value network.

Figure: Market size, all transactions in the value network

That’s the concept, but in practice, the data for all those transactions is unobtainable. Most of the data doesn’t even exist, and the data that does exist, like sales data for competitors, is closely guarded information. We won’t have any luck calling our competitors and asking them to share their financial statements with us!

Again, we’ll be looking for a narrative to tell a story of how big this could be. We will find all the data we can and speculate about the data we can’t find. It must all then be put in the context of our value network.

A helpful metaphor here is pond size. We are metaphorically trying to quantify the size of the pond (the market) in which our fish (the startup) will be growing.

When VCs are assessing a market, we want to make sure that the pond is big enough for the startup to grow exponentially. An old rule of thumb is that there needs to be the potential for a $1B market to warrant a VC investment.

I have found it to be particularly challenging for some business school students, immersed primarily in quantitative lessons, to reframe market size as a creative endeavor rather than a numerical calculation. At this point, I often think of the concept of the soccer mom as an example. Somebody created that phrase to identify a group of people.

Sizing a market is both creative and quantitative, and again uses data and narrative to paint a picture. Below are some of the approaches we can take as we create our story about market size.

Also covered in this chapter:

  • Total Addressable Market (TAM)
  • Founder Credibility
  • Competitors’ Sales
  • Cost Savings
  • Pre-Existing Macro Market Size
  • Market Trends
  • Niche, Platform and Future Markets

For more, download Venture Capital Strategy for $9.99 using discount code “VCIC” or purchase on Amazon for $24.99. 

3. Traction

Imagine a startup pitching on a Monday morning at our VC firm’s partner meeting (for some reason, all VC firms have partner meetings on Monday mornings). Their big idea is an amazing new dogfood. They talk at length about a proprietary synthetic ingredient, how the processing plant is a green facility and that the packaging is state of the art. They even mention their product’s great mouthfeel.

Meanwhile, we (the VCs) just want to know one thing: will the dogs eat the dogfood? This was a popular VC catch phrase a decade ago. It’s outdated now, but the metaphor is still vividly effective: a bunch of humans sitting around a boardroom discussing whether dogs are going to like something. This happens all the time: a bunch of _{fill in the blank}__ sitting around a boardroom discussing how _{fill in the blank}__will behave.

Before the founders say another word, the VCs want to see a video of a big group of dogs running away from Purina toward this new dogfood.  The VCs are looking for validation that the theory being asserted about a value proposition has some basis in reality. It sounds good, but what proof do we have that this new product really better/faster/cheaper?

At this point, we are looking for evidence, not reasoning. Plenty of logical ideas turn out to be wrong. The world is too complex for us to be confident with a purely logical approach. Customer behavior is almost impossible to predict with logic alone. We need proof that our value proposition has merit. We need empirical data.

Let me emphasize the word empirical, which means, “based on, concerned with, or verifiable by observation or experience rather than theory or pure logic.” (Source: Dicionary.com) Just as VCs have a simple phrase for the concept of a differentiated superior solution (better/faster/cheaper), they also have a word for empirical evidence that validates the value proposition: traction.

The music industry used to call this buzz. They wanted to sign bands that already had a buzz. I had a wall of rejection letters from major labels. None of them said anything disparaging about our music (i.e., our value prop). Most rejection letters encouraged us to go out and create some buzz. Years later, I better understand what they were saying, just as VCs say, “Go out there and get some empirical evidence that your music/product could take off. If you can show us that people will like what you are doing, we can take you to the next level.”

From the Market Size chapter, this may sound a little bit familiar. Nail the niche, then go big.

There used to be a prevailing mythology that A&R guys sat up in ivory towers and cherry picked great talent, plucked from obscurity and thrust into the limelight. “She was discovered in a coffee shop!” The myth has some basis in reality but is still steeped in plenty of mythology. Yes, it has happened. But no, it doesn’t usually go like that. The normal process includes years of “paying dues” while trying to create buzz/traction, i.e., iterating and validating the value proposition.

What is much more common in the myth above is the move from obscurity to the limelight. That rings true, as even a band with tons of buzz is relatively unknown. They may have a great following in a geographic region or within a certain circle. Major record labels know how to take that limited success (relative obscurity) and go big with it (limelight). There is still significant risk in making that transition, but it is a far cry from the “discovered randomly while walking down the street” myth.

Same with VCs and startups. Even with significant traction, startups are largely unknown to bigger markets, and often it requires an influx of venture capital to break through to the next level. But first a startup needs empirical evidence that it is ready to go to the next level.There is an exception to this rule: serial entrepreneurs, which we’ll discuss in the Founder Fit chapter. If the founding team  has previous successful exits, VCs are often willing to take a leap of faith on traction.

For everyone else, we want empirical evidence, which can come in many forms. Below is an upside-down pyramid that represents, in priority order, some of the more common types of validation venture capitalists are looking for.

It should be noted that nearly every one of the data points on the pyramid can be represented with numbers. Once again, the numbers will only tell part of the story. We’ll want numerous sources as we weave a narrative about traction. For example, note the “everything we can learn about them” under Paying Customers. Sales figures are important, but the story behind them is equally relevant. Once again, we have a story about numbers.

Also covered in this chapter:

  • Paying Customers
  • Engagement Metrics
  • Letters of Intent (LOIs)
  • Inferior Competition
  • Seed Investors
  • Industry Validation

For more, download Venture Capital Strategy for $9.99 using discount code “VCIC” or purchase on Amazon for $24.99. 

B. Founder/Industry Fit

“Product/market fit” is a well-known and often used phrase among venture capitalists. It is also the place to start when assessing the viability of a startup. Question #1: can we create value?

It is not surprising the VCs often focus on this first point, as there is little reason to proceed unless we have product/market fit. I have also heard VCs use the phrase “founder/market fit” in reference to the team having what it takes to succeed with a particular set of customers. However, the phrase “founder/industry fit” is a new one, which I believe gives us a more holistic view of the enterprise and how it fits into the value network.

We can agree that market fit comes first, but even if we are able to identify customers who are in need of our offerings, we also need to have the right management and be in an industry in which the startup can thrive. We’ll break down our investigation of the founder/industry fit into three sub-chapters: team, competition and secret sauce, answering three fundamental questions:

  1. Do we have the right people in place? — TEAM
  2. How will we stop copycats? — SECRET SAUCE
  3. How quickly and perhaps profitably can we grow? — BUSINESS MODEL

4. Team

In his book The Startup Game, VC pioneer William H. Draper III asserts that one of the key ingredients for a successful startup is having founders who are “…smart enough to understand how the world works today and are able to envision a range of better outcomes for the future.” He’s talking about the ability to understand the industry and create value by disrupting it.

Most VCs agree that there is one factor that is most important when deciding to invest in a startup, one thing that predicts success better than anything else: talented management. The people are paramount.

To my ear, when I hear VCs say this, I interpret it as a risk reduction strategy. I would say it this way: the #1 way to mitigate risk in any new venture is to have the right people—ideally, seasoned entrepreneurs who are experts in their industry. One of the biggest misconceptions about entrepre­neur­ship is that the idea is paramount. Many people believe that the key to success in a startup is the great idea. VCs disagree. It’s the people who are most important; ideas cannot do anything. VCs would rather back an A team with a B idea, or an A jockey with a B horse. It takes people to get things done, and not just any people, the right people.

For example, imagine you are just meeting me on an elevator, and I begin telling you about my idea for a new sharing economy startup. You may be in the middle of a yawn (who is this Vernon character thinking he knows about the sharing economy?) until you hear that my co-founder just quit her job as the chief marketing officer at Uber. Can you feel a large portion of the risk leave the room?

If we are looking to minimize risk with the best possible team, let’s look at how VCs would define “the best.”

Also covered in this chapter:

  • Serial Entrepreneurs
  • Industry Expertise
  • Vision, Coachability and Customer Passion
  • Origin Story
  • Skin in the Game
  • Founder/Investor Conflict
  • Replacing the CEO
  • Holes on the Team
  • Advisory Board

5. Secret Sauce

When VCs talk about a “secret sauce,” they are referring to a startup’s ability to do something that nobody else can easily replicate, something that makes this startup special. Specifically, they want a unique ability that gives the startup an edge, a competitive advantage. In this book, the phrase “secret sauce” is synonymous with “competitive advantage.” Both refer to barriers to entry that keep the competition out.

Before we dive into some of the elements of secret sauces, we need to agree on a definition of the oft-misunderstood phrase “competitive advantage.” First, it is important to understand the difference between a competitive advantage and a differentiation.

Differentiation refers to how a startup’s offerings are better/faster/ cheaper than competitors. If that sounds familiar, it should. We’re talking about value proposition, part of the product/market fit. Recall our definition for value proposition: how a startup addresses specific customer pain points with a better/faster/cheaper solution, i.e., a differentiated solution.

Here’s the confusing thing: having a differentiation appears to give a company an advantage. However, for business strategy purposes, being superior is not considered an advantage unless you can protect it by preventing copycats. If you cannot protect it, everyone will copy your “advantage” and you’ll have no advantage.

For example, Quizno’s took the sandwich world by storm by toasting sandwiches. That was a differentiation. However, there was nothing to stop Subway from installing toasters at every location, which it did, thereby copying Quizno’s idea and eliminating any advantage.

A competitive advantage, on the other hand, is a barrier to entry, something that will stop or slow down competitors who want to copy our differentiation. These are sometimes called “unfair advantages,” though that phrase will probably never catch on since nobody wants to be associated with being “unfair.” But let’s be clear, creating unfair advantages is perfectly legal and ethical. In fact, it is written into our constitution:

“The Congress shall have power…to promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries.”In one sentence, our founding fathers put copyrights and patents in the constitution, guaranteeing an unfair advantage for writers and inventors. They have the exclusive right to profit from their writings and discoveries “for limited times.”

Quizno’s would have had an unfair advantage had they invented and patented the innovation of toasting sandwiches. Then they would have had the exclusive right to their discovery. Unfortunately for Quizno’s, toasting sandwiches was a differentiation, not a competitive advantage. Once Quizno’s proved the market, copycats followed. In conclusion, differentiation refers to value proposition, usually articulated as better/faster/cheaper. Competitive advan­tages, or unfair advantages or secret sauces, are barriers to entry, there to stop copycats.

Also covered in this chapter:

  • Macro: Comp. Landscape
  • Micro: Key Players
  • Barriers to Entry
  • First-Mover Opportunity
  • Network Effect
  • Sticky Products
  • Trade Secrets
  • Strategic Partnerships
  • Intellectual Property

6. Business Model

Before we can have a coherent conversation about business models and startups, we need to talk a little bit about how “business model” became a catchall catchphrase. Coming out of the dotcom bust, “business model” evolved as the vague term of art used to describe monumental startup failings. You would hear analysts say things like, “Of course Pets.com bombed. Mailing big heavy bags of pet food is a terrible business model.”

The problem with a catchall catchphrase is that it has too many variables baked in. There is no way to know specifically what fundamental business rule is being broken. What exactly is wrong with delivering heavy things? Bad margins? Limits to scalability? Supply chain? The cost of delivery as compared to the value being created? Is there some inherent weakness in the strategy to deliver dogfood to people’s homes rather than sending it to retail outlets to be held in inventory before being purchased and self-delivered by consumers?

Adding to the confusion is the common conflation of “business model” with “revenue model.” The revenue model only includes how a company transacts with customers, i.e., how it makes money. The business model includes much more, like building infrastructure and developing strategic partnerships.

In this chapter, we’ll deconstruct the phrase “business model” from the VC’s perspective. Let’s start with a fundamental definition:

Razor Definition, Business Model:

 The competencies, systems and infrastructure developed by a company to facilitate interactions and transactions within its value network with the goal of creating and redistributing value.

There is a lot to unpack there. Let’s start by focusing on the last portion of the definition, which articulates the goal of the business model: to create and redistribute value. For traditional businesses, this could be reworded into the objective: to grow and profit. It turns out that those two outcomes, growing and profiting, are in conflict, and for venture-backed startups, the latter half of the goal (to profit) may not even be necessary.

Also covered in this chapter:

  • Growth and Profitability
  • Path to Exit
  • Barriers to Scalability
  • Scalability and P/M Fit
  • CAC & LTV
  • Products vs. Services
  • Margins
  • Revenue Model

C. Fund Fit

Up to this point in the book, we’ve been exploring the market and industry aspects of the value network. Now it is time to look at the mechanics of how an investment in a startup would fit into our fund, or as VCs like to say, “can we make the math work.” We will explore strategies to maximize financial return.

As we are looking at a startup from the VC fund perspective, it may not be surprising that many founders have not deeply considered this point of view. They understandably focused first and foremost on product/ market fit, ensuring that they could indeed create value.

They may also have considered the competitive threats to that value creation. Only the most seasoned entrepreneurs, usually ones who have a worked with venture capitalists before, are able to sit in the shoes of their would-be investors.

What this means in practical terms is that VCs may not get much help from the founders in determining whether the startup is a fund fit. Whereas, we’d expect slides in their pitch decks to cover the key aspects of product/market and founder/industry fit, we will have to perform much of the fund fit analysis on our own.

Further, we’ll have to gauge whether the founders will be on board with the direction we would need to take to make the deal work for us. With our hit-driven investment thesis, we count on a small number of startups in our portfolio to outperform the rest. We need each investment to have the potential to be one of those hits to move the needle on our fund.

This focus on the endgame and whether a startup might be a hit for us creates a structural challenge for this book. Arguably, these chapters are out of order. Rather than starting with growth milestones, we should probably put the exit first (as we discussed in Part I, “Work Backwards from the Exit,” p. 68). However, I have decided that the exit feels more natural to be at the end, but we will necessarily allude to our exit strategy as we look at the growth milestones we intend to hit along the way.

Another consideration for these sections of analysis is that they are even more future-focused than any chapter we’ve covered so far. In competition, we were concerned with today’s threats as well as how competitors may react tomorrow. In product/fit, we wanted to understand product/market fit for the current target market as well as future segments.

However, fund fit is all about the future, specifically a new future for a startup that only becomes possible if the startup receives our venture capital investment. This is a future that we will help create. Every venture capitalist must have a vision for how to make this happen, becoming both strategist and prognosticator.

Given the level of uncertainty in predicting the future, different VCs will have different approaches and will often disagree. This level of analysis does not lend itself to right and wrong answers. More relevant are compelling narratives, weaving numbers and story into a vision for the future. We will never know what was right or wrong. We will know, with the help of time, if the path chosen worked or not, but we’ll never know what might have worked.

We’ll be investigating three elements of fund fit: growth milestones, exit strategy and return analysis, answering these fundamental questions:

BONUS: there is also a bonus MORE VC MATH section on this website, as well as a RETURN ANALYSIS WORKSHEET.

7. Growth Milestones

Perhaps the most important strategic concept for maximizing financial returns in a venture capital investment is milestones. Any time a milestone is hit, the underlying valuation of the startup increases, just as a public company’s stock price rises when the company hits its numbers. Setting, funding and hitting milestones are imperative for creating value in a venture.

Each milestone is tied to one or more key risks. Hitting a milestone results in demonstratively lower risk, which translates into higher valuation. Though there are some shared characteristics across all startups, every industry has its own set of inherent risks. Biotech companies, for example, will have vastly different milestones than software startups. The challenge for venture capitalists is to identify key risks in a startup and determine whether there are milestones the startup could achieve to mitigate those risks. The second part of that challenge is to fund the activities required to hit the milestones.

For example, a software startup may have beta testing, new feature releases and/or strategic partnerships to forge. Biotech companies have regulatory and approval processes. Hardware companies build prototypes and release products. Young founding teams need to recruit seasoned executives; experienced founders may need to bring in young, energetic talent.  Most startups will benefit from many of the achievements listed, and it will be the job of the venture capitalists to figure out which of the activities should be funded with a round of venture financing.

Example Milestones Also covered in this chapter:

  • Functional prototype
  • First paying customer(s)
  • Beta customer(s)
  • Successful clinical trials
  • Proof of concept
  • Technical achievement
  • Product release
  • New feature release
  • Site goes live
  • Strategic partnership
  • Critical mass
  • Patent secured
  • FDA approval received
  • X number of customers
  • X daily average users
  • X dollars of revenue
  • X number of page views
  • X% repeat customers
  • X decrease in COGS
  • Hired rockstar CMO

  • Milestones and Risk
  • Use of Funds
  • Hit Movie Example
  • Building Equity
  • Airbnb Example
  • Negotiated and Time Limited
  • Seed Stage Valuations
  • Convertible Notes
  • Dilution and Pro Rata