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Aligning Startups with their Market

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Syllabus

Andy Rachleff, co-founder Benchmark Capital, Lecturer GSB

Contents

Class summary

I - Getting off the Ground

Starting with a market, identifying a problem, and building a solution tends to lead only to modest businesses

Don’t be consensus (see below). Do things you’re uniquely positioned to do.

Great companies are enabled by changes in the system, which can often be “technological inflection points”

Startups are generally doomed if the tides of their industry are relatively calm. Incumbents can adjust to incremental changes in consumer preferences. The best companies are able to ride a wave of fundamental changes in their system. Many times, this happens in the form of a technological inflection point, and other times it comes in the form of shifting consumer preferences (e.g. dating apps) or new business models (e.g. Netflix).

Example Technological inflection points:

  • Google - cost of computer power
  • Uber - mobile devices
  • Netflix - internet bandwidth

The best startup ideas are usually not found. Instead, they find the founder, often by accident.

The fact that the best startup ideas find the entrepreneur is the opinion of Andy Rachleff, who’s seen hundreds, if not thousands, of founding stories. The underlying mechanism is that the best ideas are often non-consensus, so by definition we’re not looking for them. Airbnb is a perfect example. As Brian Chesky and Joe Gebbia were looking to start a company, they started renting out an airbed in their apartment for side money. They had no idea it would turn into a company.

The best startup ideas are often perceived as crazy ( = non-consensus)

The more outlandish the claim or assumption, the more likely you’re going to be wrong, but the greater the payoff you’ll experience if you’re right. If everyone likes your idea, you’re too late. Hearing “your product can’t possibly work” can be a great sign.

  • Not Right
  • Right
  • Consensus
  • XX
  • Small return
  • Non-consensus
  • XX
  • SWEET SPOT

Look for “authenticity” in a founding team

The nebulous concept of authenticity arose repeatedly in our course as an important characteristic of successful companies. Authenticity comes in two forms, according to Rachleff:

  1. solving one’s own problem
  2. deep domain expertise

A classic example of (1) solving one’s own problem is Facebook. As a college freshman, Mark Zuckerberg was simply trying to bring the ladies of Harvard into one domain. He had no intention of building one of the most prominent companies of the 21st century. On (2) deep domain expertise, Sergey Brin and Larry Page developed the PageRank algorithm during their PhD studies at Stanford and were able to apply that expertise to search engines.

II - Disruption

To greatly increase your chances of success, rely on a disruptive technology and/or business model

“Disruption” allows David to conquer Goliath. It routinely evaporates billions of dollars in enterprise value. Large companies know this, but they still fall prey to it. Most people know about it, but the word is commonly misused, even by the person who invented it (Clay Christensen). The class relied on the following definition of the word:

Disruption = a product/service that is: Simpler, cheaper, and more convenient than existing products/services Uneconomic for incumbents to address*

  • The definition of disruption is slightly modified from Christensen’s works on “disruptive innovations” vs. “sustaining innovations”, which serve a foundational purpose in his writings. In our course, we focused on his book “The Innovator’s Solution” (see p. 34 for the relevant passage on disruption, also p. xv in “The Innovator’s Dilemma”).

The best products often start as the worst

A key characteristic of a disruptive technology is that it usually results in worse product performance, at least in the near-term. This is precisely what makes disruption so dangerous to incumbents. Even if they’re fully aware of the technology, they deem it unimportant to their core businesses (see Ch. 7 of “The Innovator’s Solution” and Ch. 2 of “Seeing What’s Next” for more details). It is uneconomic for the incumbent to address these markets because the price and/or profit margin is typically lower. Startups, however, only need to satisfy their new business model. They’re also willing to stick with the worse product performance in the short term because they’re driven by a different set of motivations and their vision of a new world.

Startups start by selling the product to (1) the low-end of the market, which is typically over-served by the incumbent or (2) a new market, which did not purchase from the incumbent because it was impractical, too expensive, or not useful to do so. Since the economics and the markets are different for incumbents and disruptors, they often don’t use the same channel (see p. 45 of “The Innovator’s Solution” for additional reading).

Alter the dimensions by which consumers value the product/service

Sometimes the disruptive technology will fundamentally alter the dimensions along which products are valued by consumers, which starts to turn the tables in favor of the startup.

Netflix offers a perfect example of this (note: Netflix was not a disruptive technology, rather it had a disruptive business model). Blockbuster dismissed a subscription DVD rental service because the value proposition didn’t align with that of in-store rentals. Customers enjoyed driving to the store, on demand, to pick out their evening’s entertainment. In the store, they purchased popcorn and candy that subsidized the costs of the video rental service. Many weren’t willing to wait several days for their rentals to arrive. Blockbuster assumed this as well. But Netflix persisted in offering a worse product along traditional value dimensions but developed a loyal customer base. Netflix took advantage of the long-tail of selection enabled by centralized distribution systems and superior economics without a brick and mortar presence. They eventually improved their product and attracted more customers. As the benefits of a subscription DVD rental service became apparent to customers, the importance of the pain they experienced from not being able to get a movie immediately began to lower. This is how the value dimensions of rental DVDs began to shift, which of course favored Netflix in the long run.


III. Achieving Product-Market Fit

“Product-market fit” is necessary for a startup to succeed, and is the precondition for growth.

Are customers demanding your product? Are they miserable without it? In the words of Rachleff, are the “dogs eating the dog food”? Product-market fit is one of the most profound yet elusive concepts for startups.

Product-market fit is found when customers love you so much that they cannot do without you; they’ll also be your greatest source of marketing (see below).

What matters is not first to market, but instead, first to product-market fit (Professor Barnett is adamant in saying the “first-mover advantage” is a myth).

Product-market fit is found by finding--and capitalizing on--DESPERATION

The concept of “desperation” is fundamental to building a successful business. The best products are sold to customers who are desperate for a solution. Signals of desperation: Customers are already trying to solve the problem and they’re spending money on it Customers are willing to pay you in advance for a prototype Customers reach across the table and ‘grab you by the collar’ to demand it now

“Discovery beats planning, so plan to discover” (Bill Barnett)

“Planning is a tool that only works in the presence of a long and stable operating history.” Eric Ries in “The Lean Startup” (p.72)

Product success is almost never planned. No company has ever executed on every aspect of their original pitch or business plan. But that doesn’t mean success is haphazard. Instead, it’s found through the Discovery Process.

It’s imperative to have a feedback loop between customers and the product. Put a product in front of customers. Observe how they use it. Improve the product. Give it to customers again. Never lose touch of how customers are using your product, and for what jobs they’re hiring it for.

Do not waste time building the “perfect” product. Release the most bare-bones version possible that conveys the value you’re attempting to deliver. This is commonly referred to as a “Minimum Viable Product” (“MVP”). Note the delicate balance between “minimum” and “viable”. Most of the time, companies overestimate “viable” and spend too much time on extraneous features. On the other hand, in the example of a well-known tech company, a CEO’s engineers focused too much on “minimum” and needed to be given criteria for “viable”. The key criteria isn’t the particular technology leveraged, but instead the value provided to the customer.

Note: the basis of this is Steve Blank’s “Four Steps to the Epiphany“ (he refers to it as “Customer Discovery”). The book is gold and is highly recommended.

Have an open mind. Develop assumptions. Repeatedly test hypotheses. Fail fast and cheap.

It’s also imperative to have an open mind about your product, your customers, and the way the two interact. Be explicit about the assumptions you’re making. (Write them down!) Prioritize and test them. Test hypotheses sequentially, and not in parallel, because they may interact in unexpected ways. Be open to the results of the and update your assumptions accordingly. Rinse and repeat in the cheapest, quickest manner (“fail fast and cheap” is a commonly-used phrase).

For more reading on this, see Eric Ries’s book “The Lean Startup” (specifically chapter 4), a “classic” in modern-day entrepreneurship.

“Savor surprises”

Let yourself be guided by customer data (e.g. objective metrics but also observations). Don’t let biases influence your thoughts on the fit between your product and your customers.

“Savor surprises” is a phrase coined by Intuit CEO Scott Cook. He and his finance- and tax-software empire conduct experimentation as effectively as any organization. One of their most profitable business segments was a surprise discovery while iterating on another product. Says Cook: “When a surprise happens – either an upside surprise or a downside surprise – that’s the market speaking to you trying to tell you something you don’t yet know. And so, you need to listen.”


A successful startup must prove two things: (1) Value Hypothesis and (2) Growth Hypothesis

Value Hypothesis

An informal definition for the value hypothesis is: the reason your customer buys (or “hires”) your product. The value hypothesis tests if a product is valuable to potential customers.

More specifically, the class defines the value hypothesis as “the who, the how, and the what”. These components of the value hypothesis interact with the startup’s context: technology, product, organization, and market, as shown in the diagram below.

“What” = the technology a company is attempting to deliver. Netflix’s “what” is video content.

“How” = the way the organization is set up to deliver the product to market, including the business model, structure, and leadership. Netflix pivoted on the “how” by switching from per-rental pricing to subscription, and then from physical DVD rentals to streaming.

“Who”: The “who” are your customers. Fairly straightforward.

In the B2B space, you know you’ve found the value hypothesis when your average sales rep’s revenue is equal to their fully-loaded costs.

Growth Hypothesis

Only focus on growth after you’ve nailed the value hypothesis. The growth hypothesis is an assumption on how existing users will continue to find value from your product and new users will find your product. If you think you know the way your company grows, test it. When a method works, keep doing it. If a method doesn’t, abandon it.

In the B2B space, you know you’ve found the growth hypothesis when your average sales person’s revenue is 3x (for software) / 2x (for hardware) their fully-loaded costs. (See the “Sales Learning Curve” for more related information.)

A network effects business is a special case of the value and growth hypothesis: the value hypothesis is the growth hypothesis. You can measure the network effects by the virality factor, or the conversion rate * engagement rate * invitation rate, where each is defined as follows: Conversion rate: % of invited users who install the app Engagement rate: % of users who invite at least 1 friend Invitation rate: average # of invites sent / engaged users


The best form of marketing is word-of-mouth.

Don’t try to woo customers to a product they won’t love. If they love it, they’ll rave about it to their friends and colleagues. This phenomenon has been validated by research to be the most powerful method of marketing, by far. See the book “Contagious” by Jonah Berger for more on this theme (in addition to other effective marketing tactics). Similarly, be wary of customer acquisition that is too expensive - it’s likely to be self-defeating.

“Iterate on the WHO and the HOW, are not the WHAT”

When you start with the underlying technology (the “what”), you can change the “how”, i.e. the way that it’s delivered or the way you talk about the value to customers. But do not change the “what” itself. If you do need to change the “what,” consider it a RESTART. When the “what” is set, iterate on the “who” and “how.” To PIVOT is to change the “who” or the “how,” and is a hallmark of successful startup businesses.

IV. Growth / Crossing the Chasm

Most startups fail because they focus on growth before they prove the value hypothesis.

Don’t focus on hitting growth metrics. Focus on giving your customers the best possible experience they’ve ever had.

You can’t fake product-market fit. The value hypothesis needs to be proven before anything else. Once you have this, the focus on growth.

Also, see “The Death Spiral” in Steve Blank’s “Four Steps to the Epiphany” for an epic account of what happens when the value hypothesis isn’t proven but the company moves forward anyway.

Don’t focus on the competition. Focus relentlessly on “delighting the customer”

Competition is good because it drives competitors to become better. It removes the threat of complacency and enables the best product to be delivered to the customer.

While sales folks need to be able to sell against competition, looking to competition is not a useful guide for developing the value or growth hypothesis. Reid Hastings is known for saying you’re wasting your time if you’re not focused on delighting the customer.

Competition may pursue a channel or product development that works for them but not for you because of differences in strategy. Or, they may be too wed to their current strategy as the incumbent, and benchmarking to them will just enable consensus thinking.

See here for Brian Chesky (CEO, Airbnb) explaining why a company should focus on having fewer customers love you vs. many “sort of” like you. (YouTube video “PandoMonthly: Fireside Chat With Airbnb CEO Brian Chesky”, time = 57:11).

Corporate partnerships only work if the company’s success is tied to yours.

You don’t want to be a hedge in a corporation’s portfolio. You want your corporate investors to “kill” for you to be successful.

Accelerate and broaden customer adoption by “crossing the chasm”

I find Geoff Moore’s ideas on the Technology Adoption Life Cycle to be profound. Collectively, they can serve as a tremendously useful lens by which the complexity of startups can be distilled into simplicity. In fact, some have argued the Nobel Prize should be awarded to Geoff Moore for this.

Moore only intended his theory to apply to “disruptive innovations” (also “discontinuous innovations”, p. 13 of “Crossing the Chasm”)*. But what makes it fascinating is the extent to which it applies to other situations.

Those who wield the theory with the most aptitude are able to recognize when it holds vs. when it must be disregarded, which I suggest can give them an advantage relative to others in both evaluating the potential of companies as well as advising them on their product strategies.

  • (Moore defines “discontinuous or disruptive innovations” as “products that require us to change our current mode of behavior or to modify other products and services we rely on” (p. 12 CtC). These stand in contrast to “continuous or sustaining innovations”, which refer to the “normal upgrading of products that does not require us to change behavior.”)

====Many products pass through the same 5 customer groups throughout their life cycle. Understanding the characteristics of each group positions the company for success. Honor the progression - DO NOT attempt to start at the 3rd group (the early majority), as many startups commonly do.

According to Moore, “any new technology product” that’s build on a “discontinuous or disruptive innovation” progresses through the following types of consumers over the course of its useful life.

(1) Innovators (“tech geeks”) (2) Early adopters (“visionaries”) [CHASM] (3) Early majority (“pragmatists”) (4) Late majority (“conservatives”) (5) Laggards


(Image courtesy of SmithHouse)

Innovators / “Tech Geeks” These are the “tech geeks” who appreciate the product for what it is. They’re willing to put up with a faulty product because they appreciate the underlying technology. This group is small and not big enough to build a business around, but their support is important to show the other players in the marketplace that the product can work.

[“The First Crack” → virtual reality has fallen into this crack; it’s a product that “cannot be readily translated into a major new benefit” (p. 22)]

Early Adopters / “Visionaries” (next 13.5%) Like the innovators, visionaries are also able to appreciate the vision of a new technology. But unlike the innovators, they’re not tech geeks who only appreciate the technology for what it is. Instead, they’re able to connect it to strategic opportunities and have the charisma to get the rest of the organization to buy into the product (p. 16 and 42). They’re willing to take on the risk of a new technology in order to get a jump on their competition (p. 25). Important: they do not rely on references in making their buying decisions, relying instead on their own intuition and vision (p. 16).

[CHASM (see below)]


Early Majority / “Pragmatists” Because the early majority comprises at least ⅓ of the entire market (60% according to Rachleff), it’s where every business should strive to be. However, companies often jump the gun and market to this group before they go through the tech geeks and visionaries.

Like the early adopters / visionaries, the early majority / pragmatists appreciate a new technology, but their defining characteristic is the value references hold in their decision making. Simply put, they will not buy unless the peers they reference also engage with the product (or similar products) (“they know many of these newfangled inventions end up as passing fads, so they are content to wait and see how other people are making out before they buy in themselves” (p. 16)).

[“The Other Crack” → “products that are not easy to adopt will stall as they’re transitioning to the late majority” (p. 24)]

Late Majority / “Conservatives” The late majority buys a product only when it’s the “established standard” (p. 17). Moore doesn’t give much attention to this group because it’s relatively easy to get here once you’ve penetrated the early majority.

Laggards This group is irrelevant in the context of a startup. They “simply don’t want anything to do with new technology”, and will only buy it when “it is buried deep inside another product” (p. 17).

Many companies fail to “cross the chasm” into the 3rd and largest group.

Going from the visionaries to the pragmatists is arguably the greatest challenge any startup faces.

In his 2014 edition, Moore cites holograms, pen-based tablets, fuel cells, QR codes, and Massive Open Online Courses as technologies that hadn’t achieved mainstream status despite the fact that they actually work reasonably well (p. 26-27). The Segway is also a classic example of a product that fell into the chasm.

“Crossing the Chasm” Principle #1: Don’t worry about the size of your market. DOMINATE a niche segment.

Too many startups focus on building a product that can scale to greatness. This is the wrong approach.

Instead, a company should focus its efforts on becoming the undisputed market leader of a small niche. Moore cites three reasons for this (p. 85). (1) First, dominating a niche allows the company to build the “whole product”, a product that completely fulfills the customer’s reason to buy (as opposed to an MVP, to be discussed in the next point). Without the whole product, the early majority will not purchase. (2) Second, dominating a niche maximizes word-of-mouth effectiveness (remember, referencability is a defining characteristic of the early majority). (3) Third, Moore cites “perceived market leadership” (p. 84-85), which builds on the first two points and reinforces the fact that the early majority are naturally drawn to market leaders.

“Crossing the Chasm” Principle #2: Building the “whole product” is paramount to achieving product success.

How does a niche product cross over into a set of customers who need references in order to buy? The answer lies in the concept of the “whole product” (see p. 82, 121, and 130). A company must deliver a product that addresses all of a customer’s “desired result” (p. 82, aka the “compelling reason to buy” p. 121). If this doesn’t happen, according to Moore, the product will never achieve traction in the mainstream market.

Counterintuitive insight: do not fix deficiencies in your product. Instead, look for what it does well, and double down on that.

Counterintuitively, one of the best ways to achieve product-market fit is to enhance what your product is already good at, rather than focusing on fixing bugs.

Airbnb provides a classic example. Their early product had problems with the payment process. They fixed it, but didn’t see any additional growth. Then they realized listings with higher quality photographs were rented out at higher rates. Then they started offering professional photographs across the board, and the business took off.

Of course, bugs in the product must be fixed. But this is a reminder to double down on one’s strengths rather than focusing on weaknesses.


Rachleff's Axioms

  1. Everyone shouldn’t like your idea (non-consensus)
  2. Appealing to everyone appeals to no one (Aim to delight the customer, see Airbnb video below)
  3. Without change there is seldom opportunity (See “technological inflection points”)
  4. To get big you have to start small (Crossing the Chasm - dominate a niche market, delight the customer)
  5. VARs don’t work for new markets
  6. Sometimes you need to build it all yourself
  7. Not all minimum viable products are minimal
  8. Savor surprises (Intuit / Scott Cook, see below)
  9. Look for the good and double down on it. (see below)
  10. Don’t try to fix the bad. (corrolary to #9, see below)
  11. Aim to fail fast & cheap (Lean Startup, Steve Blank, discovery process / iterative optimization)
  12. Don’t wait until your product is done to ship (MVP, discovery process / iterative optimization)
  13. Stealth doesn’t matter (???)
  14. When launching, revenue is more valuable as a product/market fit signal then as a source of cash
  15. It’s not first to market, but first to product/market fit (Bill Barnett: “the first-mover advantage is a myth”)
  16. Don’t evaluate your growth hypothesis until you confirm your value hypothesis (CRITICAL takeaway of the course)
  17. The best ideas can come from the most unlikely team members (diversity)
  18. Word of mouth trumps promotion (see below)
  19. Brands get built through experience, not promotion
  20. Market research is of little value (consensus / non-consensus, get an MVP in front of customers)
  21. Controlled platform is lower variance than a dynamic platform (???)
  22. Do the right thing rather than do things right (???)
  23. For whom have you built a whole product? (see below for “whole product”, identifying first “bowling pin” - crossing the chasm)
  24. Succeed with an application before you pursue a platform (an application is defined as something that gets a job done)
  25. Slowing decay can be more valuable than adding users ( = retention)
  26. Corporate partners impede discovering product/market fit (see below)
  27. De facto standards trump De Jure standards
  28. You need to determine to whom you are disruptive
  29. You don’t need to own the IP to be disruptive
  30. Don’t pay attention to your competition (focus on ONE competitor, otherwise it’s too complicated e.g. Benchmark vs. Kleiner Perkins)
  31. Don’t let authenticity get in the way of intellectual honesty (***)
  32. More than one benefit is a negative (“customers don’t buy more than one value prop”)
  33. Don’t hit the accelerator until you are successful (prove value hypothesis before growth hyp)
  34. Market concentration invites entrepreneurial specialization
  35. Focus on momentum, not scale
  36. Hardware discovery requires technological iteration at the design stage
  37. Technological discovery requires technological authenticity; growth requires market authenticity
  38. Carriage trumps content
  39. Foolishness is the price of genius
  40. Only sell your company if your market ain’t happening or if you get a ridiculous offer