I have previously written about Minimum Viable Product (MVP) and Product/Market Fit (PMF). These are important processes based on the scientific method that can be used to test a value hypothesis. That hypothesis does not just appear via spontaneous generation. Andy Rachleff describes what should be included in a value hypothesis as: “the features you need to build, the audience that’s likely to care, and the business model required to entice a customer to buy your product.”
At the center of any value hypothesis is “core product value” and the idea or vision behind that CPV is created by the entrepreneur.
As an example of how this process works and fits into a bigger picture, Chamath Palihapitiya’s approach has been depicted below by one of his colleagues:
Core product value represents a solution a real problem that is valuable enough to cause people to want to pay for a product. Core product value is first recognized when the customer connects with the product in an A-Ha moment.
Core product value is an essential element of product/market fit which is a broader concept that requires additional elements. Andy Johns says: “For products that get the ‘magic moment’ and ‘core product value’ right, the top of the funnel naturally and rapidly fills.” in other words, without core product value and a magic moment it is not likely that people will convert from guests to customers. In a talk at Index Ventures Andy Johns talked about an example of what he feels is core product value:
“One current company with a clear core product value, Johns says, is Snapchat. Their core value isn’t just sexting as some like to believe; rather, it’s the removal of a designated target and mental friction from messaging. Users receiving snaps don’t have to worry about who else may be seeing a message or what their response is, and by removing that moment of hesitation, a social burden is lifted.”
You can disagree with his conclusion but I think even then you will understand his point. As another example, Johns believes that for Wealthfront, where he works now, core product value is giving any customer access to low-cost, tax-efficient, diversified investment portfolios via a direct to consumer model.
Finding a new source of core product value is: (1) very hard to do and (2) a rare event. As context, there are roughly 5,000 seed stage startups a year and only 800 of them raised a Series A round in 2016 reported Mattermark. Why do so many startups fail to successfully raise an A round? There are many reasons for this but most often it is because there is insufficient confidence among investors that the business has found or will find core product value or product/market fit. Andy Johns points out that among the right questions to ask when thinking about whether something has core product value are: Is the problem your product is solving (1) painful, (2) important for your customers, and (3) is there a sizable market behind this problem? He adds that: “some firms create new, meaningful experiences, rather than solving an existing, painful problem. One could count Facebook, Twitter, Snapchat, Instagram, and others in this group.”
Fred Wilson describes the steps on a startup’s journey:
“The first step you need to climb is building a product, getting it into the market, and finding product market fit. I think that’s what seed financing should be used for.
The second step you need to climb is to hire a small team that can help you operate and grow the business you have now birthed by virtue of finding product market fit. That is what Series A money is for.
The third step you need to climb is to scale that team and ramp revenues and take the market. That is what Series B money is for.
The fourth step you need to climb is to get to profitability so that your cash flow after all expenses can sustain and grow the business. That is what Series C is for.
The fifth step is generating liquidity for you, your team, and your investors. That is what the IPO or the Secondary is for.”
Fred seems to be saying that he wants his portfolio companies to have product/market fit before the Series A which means they will also have discovered core product value as part of that process. It is worth pointing out that what constitutes product/market fit is always to a degree in the eye of the beholder, is not a discrete event and can disappear (e.g., a competing product emerges) and reappear like a Cheshire cat. I did a quick survey of a few VCs to get a current sense of what the standards are on product/market fit at a Series A financing. One venture capitalist I talked to said that only 5% of Series A rounds involve a company that does not have product/market fit. Another said that the percentage ranged from 10 to 40% depending on the firm and that it varies by partner. He also said that Series A rounds that do not have product/market fit “tend to skew smaller ($3-5M) and the firm tends to lead taking the whole round.” Another VC mentioned that there has been some easy grading on whether product/market fit exists and so that impacted her estimate of 20%. Another VC said: “15-20% are non-PMF A rounds, but they seem to be exceptional either by virtue of all-star founding team or a particularly hot area.” Another VC joked that that 30% of A rounds funded by VCs did not have product/market fit intentionally and another 29% failed to achieve this unintentionally. Raising funds after the seed round without proven core product value and product/market fit or can happen for many reasons including because the venture backers: (1) confuse progress on the growth hypothesis with a solution to the value hypothesis (product/market fit); (2) hope that product/market fit can still be discovered with more cash or (3) various errors in judgment caused by a really great story told by a really great story teller. The startup landscape is littered with the invisible dead bodies of failed startups.
The VCs I talked to generally said that a Series A without product/market fit was more likely if there is a huge potential market, a great story is being told and the specific venture capitalist involved is a “people person” on a relative basis.Having said that, Josh Kopelman’s advice on this issue is excellent: “Keeping your burn rate low until you have product/market fit will give you the best chance at building a big company. There’s nothing that increases your odds of a successful A round like a successful launch followed by customers that really love what you’ve built. These inflection points change year to year — so be sure you know what’s currently fundable.” Someone like Elon Musk may be able to raise an A round without core product value and product/market fit, but you are not Elon Musk, and neither am I.
As an aside, as Mark Suster and others have said:
“what actually IS the definition of a seed vs. A-round.
‘Cautionary note: No competent VC is actually fooled when you show up after raising $6M in seed financing and say you’re now raising an A!’
— Marc Andreessen (@pmarca) October 7, 2014
This is something I think entrepreneurs don’t totally understand and it’s worthwhile they do. My view: “Spending any time or energy trying to game the ‘definition’ of your round of fund raising is a total waste. Nobody cares. No VC will be so naive as not to see straight through it. And actually many will probably find the gamesmanship as a bad sign of lack of property priorities or perspective.”… If it looks like an A-round, smells like an A-round & tastes like an A-round … it’s an A-round…. if you raised $3–5 million from well-known seed funds or from a VC and you’re asking for $8–10 million in your next round … that next round is a B-round no matter what we collectively decide to call it when we VCs fund you.”
It is possible for a startup which has not proven that they have core product value and product/market fit raise a Series B? Sure. But is it likely? No. is is significantly less likely that in an A round. Significantly fewer firms raise a Series B than a Series A. Sreies B is often called the hardest round to raise. Fred Destin writes: “Series B is hard for a simple reason: suspension of disbelief fades and is replaced by an increasingly cold, hard look at milestones and progress. Series B is the round where the rubber meets the road, where the promise has to be met with numbers and projections.”
Andy Chen has written about TTPMF – the “Time to Product/Market Fit.” Remembering that you must have core product value to get to product/market fit his view is:
“TTPMF has to be less than 1-2 years or else your startup will implode. Ask anyone who’s been working on a product for more than 2 years and doesn’t have traction to show: It really, really sucks. The first 6 months can be fun because it feels like you’re painting on a blank canvas, but soon enough, there’s just fatigue and the window of opportunity shifts. Platforms change, investors get disengaged, your employees start getting excited about other companies. So if you miss your window, then you’ll run out of money or energy or both.”
Chamath Palihapitiya has a gift for getting to the point. You can’t make the most important point about core product value in a simpler way than this slide:
Steve Blank believes: “The best entrepreneurs are the ones who are passionate about solving a problem because they’ve had it or seen others have it, love those customers, love solving that problem or have been domain experts. Those are authentic entrepreneurs.” He believes “entrepreneurs, at their heart, are artists. … What comes out from the great artists is something completely unexpected. World class entrepreneurs understand something that is driven by passion.” He believes world class entrepreneurs are connected to their subject and with their customers.’ Blank believes entrepreneurship is a calling rather than a job. I believe that this is why many venture capitalists describe what they do as “artisanal.” Blank believes:
“Founders fit the definition of a composer: they see something no one else does. And to help them create it from nothing, they surround themselves with world-class performers. This concept of creating something that few others see – and the reality distortion field necessary to recruit the team to build it – is at the heart of what startup founders do. It is a very different skill than science, engineering, or management. Entrepreneurial employees are the talented performers who hear the siren song of a founder’s vision. Joining a startup while it is still searching for a business model, they too see the promise of what can be and join the founder to bring the vision to life.”
The great entrepreneurs tend to be persistent, obsessive and relentless, but the really great entrepreneurs also seem to have a gift for looking at the world from a customer’s viewpoint. These entrepreneurs seem to know instinctively what the customer wants. Most artistic entrepreneur I have ever seen is Craig McCaw. He has an amazing way of putting himself in the shoes of the customer. Rich Barton is very similar in his ability to know whether (1) the customer’s problem is real and significant enough that they will pay for the solution, the market is big, and that there is a business model with a potential moat. Steve Jobs had an artist’s skills in understanding what customers wanted. Bill Gates, Jim Sinegal and Howard Schultz all fall in the artist category. The people are also missionaries rather than mercenaries. Missionaries are far less inclined to sell the business and more inclined to build a franchise that is truly lasting. Do all founders who are missionaries, visionary, persistent, obsessive and relentless succeed? No. But they succeed more often. I talk about this is my blog post on the wonderful Michael Mauboussin book The Success Equation. Mauboussin wrote: “The trouble is that the performance of a company always depends on both skill and luck, which means that a given strategy will succeed only part of the time. So attributing success to any strategy may be wrong simply because you’re sampling only the winners. The more important question is: How many of the companies that tried that strategy actually succeeded?” Once up a time long ago I read a book called In Search of Excellence. The authors analyzed leading companies are sorted out the secrets of success in a way that suggested that it was a formula that could be replicated easily. The best companies do X, Y and Z was the claim. What was missing of course were all the companies that did X, Y and Z and failed. Mauboussin writes:
“There are numerous books that purport to guide management toward success. Most of the research in these books follows a common method: find successful businesses, identify the common practices of those businesses, and recommend that the manager imitate them. Perhaps the best known book of this genre is Good to Great by Jim Collins. He analyzed thousands of companies and selected 11 that experienced an improvement from good to great results. He then identified the common attributes that he believed caused those companies to improve and recommended that other companies embrace those attributes. Among the traits were leadership, people, focus, and discipline. While Collins certainly has good intentions, the trouble is that causality is not clear in these examples. Because performance always depends on both skill and luck, a given strategy will succeed only part of the time.Jerker Denrell, a professor of behavioral science, discusses two crucial ideas for anyone who is serious about assessing strategy. The first is the undersampling of failure. By sampling only past winners, studies of business success fail to answer a critical question: How many of the companies that adopted a particular strategy actually succeeded?”
The best venture capitalists want to be involved in enabling entrepreneurs to be successful in this artistic process. You will sometimes hear people say “providing venture capital is just finance. You go to school and listen to a bunch of case studies and learn the formula.” That’s bullshit. I don’t know anyone with any significant degree of success in venture capital who thinks that way. The more the venture capitalist understands that finding core product value is an art and what they do is provide a service that goes beyond finance, the better their financial result. The best venture capitalists spend a lot of time listening, let the founders do the heavy lifting and do not try to supply the vision (“You do not want a venture capitalist who hires a dog and then tries to do the barking”). Marc Andreessen says: “You want to have as much ‘prepared mind’ as you possibly can. And learn as much as you can about as many things, as much as you can. You want to enter as close as you can to a zen-like blank slate of perfect humility at the beginning of the meeting saying ‘teach me’…. We try really hard to be educated by the best entrepreneurs.”
Some of the best venture capitalists are people who ask great questions that help the entrepreneur find core product value and get to product market fit. Bruce Dunlevie is a great example of someone who has a service mentality in his work as a venture capitalist. Many entrepreneurs trust him implicitly since they know he asks great questions and has sound judgement. Here’s a story told by Jeff Hawkins about that skill:
“Hawkins: Yes, Palm was struggling. We had 27 employees, we had a couple of million dollars left in the bank. All of our partners had abandoned us on doing Zoomer 2. No one was interested in doing PDAs at all, and there was no real business selling PalmConnect and Graffiti. We were kind of bummed out, everyone was sort of miserable about it. But I still believed in the mobile computing space. So Donna Dubinsky and I went and visited one of our VCs one time, Bruce Dunlevie. We were sitting in his office and we were complaining about how our partners had abandoned us and how everything was hard, and Bruce said– my recollection was in an annoying tone, “Well, I don’t want to hear you complain about this. Do you know what you should be doing?” Something along those lines. And I said, “Yes, I know what we should be doing,” although I had no idea what we should be doing. But I said, “I can think of it”– immediately I said I can think of what we should do. If you ask me, I’ll tell you what we should do, something different. It occurred to me right away. I said, “Well we should do a new computer and we’re going to take everything we’ve learned and fix all the problems and do it again. That’s what we should do.” I didn’t know what that would look like yet because we had never really considered doing the whole computer again ourselves. We were still trying to work with Casio and GeoWorks and other people. And Bruce said, “Well if you know what to do, why don’t you go do it?” And our answer was, “We don’t really have the money to do that, we don’t really have the right type of people to do that– we only have software people. But if you think we can, if you don’t mind us trying, we’ll go do it.” And that was the beginning, the genesis of the Pilot. That night I went home and– I’m not sure, I think it was that night, maybe it was the next night, I don’t remember, I think it was that night.”
Here is an example of what WeWork’s Adam Neumann says about Dunlevie’s contribution:
“One example of this is Benchmark Capital, one of our investors. It’s a very successful VC firm, that works with companies like Uber, Snapchat, and Instagram. The partner that brought me in, Bruce Dunlevie, one of the original founders, is one of the smartest people I’ve ever met. Immediately after I met him, he became one of my five to seven close “advisors” that I asked a lot of both business and personal questions.”
There are many other successful entrepreneurs who tell the same story about Bruce. Someone I know said once: “Most stories about Bruce revolve around him being the world’ greatest person who is the best advisor anyone could ever hope for.” Those are qualities that an entrepreneur should seek in a venture capitalist. Dunlevie said to me once: “pattern recognition is an essential skill in venture capital.” While the elements of success in the venture business do not repeat themselves precisely, they often rhyme. In evaluating companies, the successful venture capitalist will often see something that reminds them of patterns they have seen before. It might be the style, chemistry or composition of the team or the nature of the business plan. Some things will be fundamentally different but other things may be familiar. While the pattern will be similar, something in what the team is doing will seem to break a rule. Part of the pattern that is being recognized is a rule breaking innovation of some kind which drives new value.
Creating “core product value” by finding a value hypothesis that is capable of being the foundation of a valuable business is a process similar to alchemy says Benchmark Capital’s Peter Fenton:
“Doing this job for almost 20 years now has taught me far more about people than about business. So let me first answer what I’ve learned about business, and in this case I mean the business of investing in startups. I started out as someone who had all the conceptual overhead needed to sound intelligent in our world, Porter’s 5 Forces, the Innovators Dilemma, and Crossing the Chasm. I would, in my former firm’s parlance, develop a “prepared mind” in a sector so I could see where the logical opportunities should exist. I became an expert on Storage, on Application Software, on Supply Chain. All of that, I came to realize, was useless without the alchemy of an entrepreneur who was playing around with explosive market forces. Yes we can look, and it helps to look with a lens, but the best ideas and companies aren’t filling logical white spaces. They are touching nuclear reactor of some force that will yield, and yield quickly, to an entrepreneurial leader.”
“I also came to realize that at the beginning, no analysis can capture ‘what can go right’ without sounding like you are clinically insane. Having seen the Series A pitch for Facebook, Uber, Snap, Twitter, Vmware…$1B in revenue for any of those companies would have been nearly impossible to imagine. Yet in each of those cases, I vividly remember the meetings, the day, the setting…and this feeling that an exceptional entrepreneur had touched on something nobody else had understood at their level of depth and insight. Each in its own way felt limitless. I’ll never forget meeting Evan Spiegel in 2012 at Sightglass in SF and leaving thinking, I know with all of my being that this person, this product, will give humanity back the playful joy of self-expression, which had been stolen away by then current social networks. Sometimes it’s obvious.”
What else helps someone find core product value? Domain expertise, beginner’s mind, and a personal desire to solve a problem that has caused the entrepreneur genuine personal pain. Jim Goetz of Sequoia believes:
“Many of the entrepreneurs that we back are attacking a personal pain.” “The common thread [between Sandy Lerner and Len Bosack (the founders of Cisco), Reid Hoffman (LinkedIn) and Omar Hamoui (AdMob)] is that these were all sketchy misfits, unknowns, who all focused on [solving] personal pain points and were all willing to put something out early and iterate.”
The best case happens for the venture capitalist when someone has the savant qualities I described when it comes to products and is attacking a personal pain that the care about is a missionary fashion. Michael Moritz of Sequoia not surprisingly has the same views as Goetz: “When we help organize one of these companies at the beginning, it never looks like the world’s greatest idea. I think it’s the marketing and PR department that rewrites history and tells you that it was always the world’s greatest idea. What they don’t say is that at the very beginning there was great uncertainty and a great lack of clarity.” “We just love people who perhaps to others look unbackable. That has always been our leitmotif of doing business.” “If you have been around the start of success it is far easier to recognize it again.”
Steve Blank said this during a GigaOm video interview: “I did this at SXSW. I said ‘There are 500 people in this room. The good news is, in ten years, there’s two of you who are going to make $100 million. The rest of you, you might as well have been working at Wal-Mart for how much you’re going to make.’ And everybody laughs. And I said, ‘No, no, that’s not the joke. The joke is all of you are looking at the other guys feeling sorry for those poor son-of-a-bitches.’” Financial success in creating and funding startups follows a power law. This means that a very small number of startup founders, employees and investors will reap most all of the financial rewards. The overconfidence heuristic will make most everyone overconfident that the winners will include them. The inevitable failures are hard for individuals, but the right thing for society as a whole.
One thing is clear: if an entrepreneur wants to discover core product value they should find a venture capitalist who knows that journey well, has a service mentality, asks great questions and has sound judgment.
Alex Schultz: https://www.youtube.com/watch?v=n_yHZ_vKjno
Bruce Dunlevie interview: https://books.google.com/books?id=FCMbUYFSZVQC&pg=PT297&lpg=PT297&dq=%22what+we+do+has+nothing+going+for+it+at+the+time+we+look+at+it%22+Bruce&source=bl&ots=FrkZgK8a-h&sig=_QzYXUyWiAeN3wDRNT1sgX9HUGE&hl=en&sa=X&ved=0ahUKEwiI7YPF_-nSAhXhr1QKHVCdBTUQ6AEIGjAA#v=onepage&q=%22what%20we%20do%20has%20nothing%20going%20for%20it%20at%20the%20time%20we%20look%20at%20it%22%20Bruce&f=false
Fred Wilson: http://avc.com/2014/06/what-seed-financing-is-for/