“What Changes to Make After Finding Product-Market Fit (Part 3)”

Show Notes

One of the biggest challenges for startups is turning product-market fit into profit. Since startups have the benefit of finding outside investments, traditional financing practices don’t always apply. The question then becomes how to find the right profit margins over time while using investment funds to grow.

On the newest episode of the Midstage Startup Momentum Podcast, startup coach Roland Siebelink discusses how to manage margins and profitability after product-market fit. He shares what to do and not do following product-market fit so you don’t sacrifice growth for profitability while also making your startup appealing to potential investors.

• The importance of locating gross margins so you don’t lose money in every sale.
• Why optimizing for growth will make your startup more appealing to investors.
• Cautionary tales of companies that grew too big before finding the right gross margins.
• The step-by-step process for becoming profitable over time.
• How the product margin can decline for software companies over time.
• Why it’s best not to optimize for profitability immediately after finding product-market fit.

Transcript

Hello and welcome back to our five changes that startups must make after reaching product market fit. In our previous sections, we’ve talked about verifying if you’ve really reached product market fit because you do not want to be applying these prescriptions too early. If you have, you want to start redefining your mission around product-market dominance, start capturing latent demand - not just the people who come to you - design your product for automatic upgrades and upsells, and now let’s talk about margins and profitability.

Our advice is to ensure healthy, gross margins before hitting the gas. When you talk to finance people, they will say what matters is cash generation, or at the very least profitability. However, traditional wisdom does not apply to startups in this sense. Why? Because the ability to attract external funding. The cash you need to grow is available to you from investors - from angel investors and venture capitalists - that love your growth story so much that they want to be a part of it.

That investor money can postpone the reckoning - the need to generate positive cash flow. They will invest more in your startup if you can show more growth because then the potential in the future is even bigger. That’s why you see so many funded startups optimize everything around hitting those growth numbers, even at the cost of profitability. However, growth doesn’t last. Relative growth always slows down, so over time, you also have to make sure that you can actually pull the levers and start optimizing your finances a little bit differently. For example, by the time you raise a Series C, you will typically want to see a profitable product, including the expenses you make for marketing and sales, probably even at an operational level. We can talk about that later.

What matters right after hitting product-market-fit is that you have enough of a gross margin so then at least you do not lose money on every single product you sell. But gross margins - and this is for the finance people out there - are also sufficiently attractive. No need yet to show that you’re profitable after sales or marketing costs. Definitely no need to optimize for profitability at an operations level or a level on after taxes, if you were to pay. Gross margin is enough. Investors will fund fast growing companies when they can project good profits in the future, even if it is the far future. We want to show these investors that this was the right thing to invest in. You want to optimize for growth, not profitability. Those startups that try to be profitable too early at the expense of growing in their markets will actually be less attractive to investors than the startups that say: “Let’s just hit all the pedals and let’s get as much growth as possible.”

However - and this is the question about gross margin - what goes too far is to buy yourself growth. For example, everyone can sell dollar bills for 80 cents. But of course, investors are wise enough to say, “That’s not our real growth model.” What matters is that the value of the individual unit of the product is established and that investors then pay you for it to actually build a bigger base of customers to get to profitability in the future.

There are quite a few companies that have actually grown before they could make their core product profitable on a gross margin basis. And these are cautionary tales. We see a lot of them, especially in B2C businesses or with a B2C component, where just because of a lot of traction, people said, “Okay, let’s just invest in this.” And the biggest example these days is probably Lyft and Uber or other car sharing companies that said, “In order to gain market share, let’s just sell these rides under what it costs us to provide them,” so that they’re now locked into a highly unprofitable market where drivers want more for the rides and riders want to pay even less.

You see a little bit the same in the kinds of housing and office spaces that recently went out of business, as well as WeWork that had famous candles around its finances. And even in some cases, you could argue that companies such as Twitter have never figured out how to properly monetize and make a profit based on the surface that they provide. Lots of cautionary tales, especially in B2C, where typically it’s a matter of building a huge mass of users and then just hope that one day profitability will come.

Our advice at the Midstage Institute is to take the profitability step-by-step. Starting from the top, the very first market that you want to optimize for a marker that you want to optimize for is traction. Just showing that people are signing up, returning, and referring your products to their friends. Then you want to go to gross profit - people pay more for the product than it costs you to make one unit of it. Afterward, after you raise your Series B, in particular, you want to show that you’re profitable after customer acquisition cost. And it’s only in the far future that you want to optimize for a full operating profit so that you don’t need to raise additional funding.

For software businesses, in particular, I always advise to look at the product margin. What does this mean? It’s the margin that is after you take into account the cost of goods sold and products and engineering costs, as well as support per user. And in the beginning, you will see that that cost is very high. There’s actually nothing left out of the price that the customer pays you. But over time, since you can sell more and more software without an increase, especially in product and engineering costs, you can see that that margin starts rising and the relative cost per units sold of the product and engineering cost goes down. And hopefully, you also make sure that your support cost does not rise with the number of customers.

The other thing you want to look at over time is a labor efficiency ratio. This is particularly important when we look at hiring. When do you start hiring again? Typically, that’s when people start screaming at a department. But the problem is that over time, they learn they should start screaming sooner. You want to identify the range between which you’ve reached a minimum amount of gross margin per employee. Then you wait until that gross margin goes up again. And it’s only when you’ve reached that maximum again, that you will start hiring again. Share this number with your people and with your managers so that they know they first have to make new employees work and generate money before it makes sense to hire even more.

That’s our advice at the Midstage institutes to grow with healthy, gross margins but do not optimize for profit right after reaching product-market-fit.

Roland Siebelink talks all things tech startup and bring you interviews with tech cofounders across the world.