• Why does product-market fit matter?
• What is a market?
• So what is product-market fit?
• What product-market fit is not
• Qualitative measurements of product-market fit
• Quantitative measures of product-market fit – the importance of retention
• Advanced methods for calculating product-market fit
• 7 strategies for increasing the likelihood of achieving product-market fit

People throw around the phrase product-market fit, often without really knowing what it is, what it feels like, how to test for it, and how to know when you’ve achieved it.

Some people believe the answer is “when you can sustainably acquire customers for less than the value you extract from them.” 

In SaaS, for instance, they commonly talk about the ratio between acquisition cost (CAC) and lifetime value (LTV), suggesting that benchmarks like 4:1 LTV:CAC are indicative. 

The problem with a definition like this is that, especially in the beginning, you don’t know what your LTV will be, and you don’t really know what CAC is either. 

True, you might have directional data on both. But really calculating LTV takes time, and CAC at your eventual scale will be difficult to estimate.

According to this definition, there are companies have have gone public that don’t technically have product-market fit. Uber and Blue Apron, etc. would be  fantastic examples.

Really any company that has decided to “blitzscale” will probably not fit this definition. In markets that are considered winner take all, the organization will plow tons of money into acquisition to drive market share, and worry about profitability later. (Although, it should be noted, that most proponents of this approach to rapid expansion will strongly argue that you should achieve product-market fit before engaging in such activity.)

While not specific, this is perhaps our favorite description:

“You can always feel product-market fit when it’s happening. The customers are buying the product just as fast as you can make it—or usage is growing just as fast as you can add more servers. Money from customers is piling up in your company checking account. You’re hiring sales and customer support staff as fast as you can. Reporters are calling because they’ve heard about your hot new thing and they want to talk to you about it. You start getting entrepreneur of the year awards from Harvard Business School. Investment bankers are staking out your house. You could eat free for a year at Buck’s.”

Tren Griffin

While this doesn’t exactly define it, it does provide a fantastic litmus test. 

Can you honestly say the above about the thing you’re working on? Most people who think they have product-market fit probably can’t say this.

Why does product-market fit matter?

You might be thinking:

“So what? I use products all the time that don’t fit that definition.” 

That’s probably true. There are many good businesses making good products people use that don’t look like that.

It’s helpful to understand that product-market fit is primarily a construct used by the world of venture capital. They want companies to achieve product-market fit because they aren’t looking for “good businesses”.

They are looking for companies that have the potential for explosive, exponential growth. The kind of growth that disrupts huge incumbents, changes markets, and drives meaningful returns for their LPs.

We would argue innovation teams should have the same goals, at least with part of their broader innovation portfolio. 

Assuming you believe that your industry or organization has the potential to be disrupted, and assuming you agree that disruption often looks like a hyper-growth startup eating your lunch, it makes sense to be measuring your initiatives similar to how their investors would. 

Because after all, you’re effectively the VC of your innovation group.

What is a market?

In order to adequately define product-market fit, you first need to be clear on what you mean by a market.

We like the definition from Bill Aulet. You know you have a market when:

• The customers within the market all buy similar products.
• The customers have a similar buying process.
• The customers expect products to provide value in similar ways. 
• The customers talk to each other, such that a product meeting their needs can have organic word of mouth.

Market is incredibly important. It’s one of the most critical elements a savvy VC will consider when evaluating a potential opportunity. And for good reason. A big market simply makes everything else you do easier. Again, in the words of Andreessen:

“The #1 company-killer is lack of market. When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins. When a great team meets a great market, something special happens.”

Marc Andreessen

So what is product-market fit?

“Product-market fit means being in a good market with a product that can satisfy that market.”

Marc Andreesen

In other words, you’ve answered the questions who, what, and how:

• Who is your customer and what is their problem
• What is your solution to their problem
• How do you solve that problem in a way that creates proven value for you and the customer.

When you can satisfactorily answer those questions, you have product-market fit.

What product-market fit is not

If you haven’t launched yet, you don’t have product-market fit.

Many people think they’ve achieved product-market fit by answering the who and what questions.

They’ve done the work of going outside the building and talking to customers to validate that customers have the problem. 

Maybe they make a “smoke test”, putting up a landing page and testing acquisition channels to validate demand and (obliquely) willingness to pay.

Maybe they’ve gone out and secured letters of intent or made some sales on the basis of a deck and a clickable prototype.

Those are all extremely valuable activities. And they directionally point to the potential of achieving product-market fit. We use these strategies ourselves on a regular basis to validate concepts and hone in on our MVP.

But don’t confuse them for the real thing. 

You haven’t validated the how yet. The how requires that your product is live. It requires demonstrating you can acquire customers, adequately solve their problem, and do so in a way they are willing to part with their money on an ongoing basis (and ideally tell their friends).

If you can’t say that, you aren’t there yet.

Raising money doesn’t necessarily mean you have product-market fit

Sometimes people make the mistake of confusing successful fundraising with achieving product-market fit.

You might have product-investor fit (meaning investors buy into your vision sufficient to write you the check). But investors vary in their level of sophistication in all sorts of ways. Some don’t have good frameworks for assessing product-market fit themselves. Others, in spite of their best efforts, will let internal biases color their perspective and chase deals they otherwise shouldn’t.

Raising money is useful – as long as you have cash in hand you have a fighting chance of getting to product-market fit. But don’t assume that they are equivalent.

Qualitative measurements of product-market fit

There have been many ways over the years people have attempted to measure product-market fit.

For a long time, these were largely subjective measurements. Because of the lack of clarity on what constitutes product-market fit, people used qualitative proxies.

Sean Ellis was one of the first to attempt it. He used a single question:

“How would you feel if you could no longer use this product?” 

The potential answers were: 

• Very disappointed
• Somewhat disappointed
• Not disappointed. 

Ellis argued that when you achieved 40% of respondents saying very disappointed, you probably have product-market fit.

This qualitative approach continues to this day. Superhuman uses a four question survey, starting with Ellis’ question and augmenting it with additional details to help them clarify positioning:

• How would you feel if you could no longer use product?
• What type of people do you think would most benefit from product?
• What is the main benefit you receive from product?
• How can we improve product for you?

Quantitative measures of product-market fit – the importance of retention

In the last few years, especially amongst VCs, there has been a push to quantify product-market fit.

For a while now, VCs have recognized that the most important metric worth measuring for most products is one related to engagement or retention. 

They rightly understood that things like total users, total revenue, etc. are meaningless numbers easily manipulated.

Many have expressed engagement and retention using some measurement of active users – monthly active users, monthly recurring revenue, or something similar. 

There have been a variety of benchmarks folks have used to assess whether these numbers are good or not. 

Andrew Chen, for example, has suggested measuring Daily Active Users over Monthly Active Users (or DAU/MAU), and suggests that >25% is a solid place to be. 

Chen has also suggested Day 1 retention rates above 30%, as Day 1 retention rates can be predictive of long term retention. 

There are several mechanism folks use for visualizing retention. Triangle charts are perhaps the most common, as they are baked into most event-based analytics platforms like Mixpanel:

Another way of visualizing retention has been through the use of retention curves. Brian Balfour in particular popularized their use. 

A retention curve charts what a single cohort of users do over time. It can be used to measure specific features, or simply broad usage in a product. 

It always goes down and to the right – some percentage of your users end up not using the product over time. But as long as some of those users keep coming back, your curve eventually flattens out. If that happens, then you’ve at least achieved product-market fit for some subset of users.

A final way of thinking about engagement is with Smile Charts, so named because they tend to form a “smile” if they’re good:

These plot the number of days in a month that your users are engaging in the product. While you will almost certainly have plenty of users on the left who’ve used it once or twice, in a healthy product you also have a reasonable % of users on the far right, who use the product every day. 

(note: you can adapt this chart to visualize by the week or month, depending on the metric that most reasonably reflects natural user behavior in your product). 

There is additional nuance here, specifically the idea of  “meaningful use”. 

There have been products that were “viral” in the past that defined engagement as a user going to the site and doing anything. But in many cases the “anything” was simply accepting invites from other users, etc. 

This was an issue, because these users weren’t actually engaging in the core experience of the product. Balfour rightly suggests that such products have a great referral loop, but not necessarily product-market fit.

Advanced methods for calculating product-market fit

A company with aggressive acquisition targets and the budgets to match can mask retention problems for a while. 

If they do have a retention problem eventually they always tip over, when they can no longer spend the increasing amounts of money they need to on acquisition to hit their growth targets. 

But by then you might be the unlikely VC who invested on the basis of that growth.

Studying your retention curves can help. If the curve tapers, there’s something there. But where it tapers matters as well. And specifically it matters in relationship to growth.

VCs have started working on understanding the relationship between growth and churn. Social Capital developed what they call growth accounting. The idea in a nutshell is to break monthly actives into several buckets:

• New revenue
• Retained revenue
• Expansion revenue
• Contraction revenue
• Resurrected revenue
• Churned revenue

They then developed what they call a “quick ratio,” which effectively measures the sum of those gains in revenue (or users) over the losses. If you have a quick ratio over 1, you’re growing. If it’s less than one, you have a problem.

Other firms have taken this approach and added to it. Tribe Capital uses these metrics and in addition to quick ratio will look at gross retention (retained revenue over total revenue from the previous period).

7 strategies for increasing the likelihood of achieving product-market fit

One of the things you’ll find when you start measuring product-market fit this way – it’s actually really hard. Many companies never make it.

What can you do to increase the odds of success?

Start with a BIG, established market.

A large, existing market that is underserved by competitors is a fantastic place to achieve product-market fit. In most cases, the customer already knows they need what you have to offer. They know how to evaluate you relative to the competition. They are used to talking about products like yours. And as long as you have a clear differentiated value proposition you can be successful.

One of the misconceptions about “disruptive” businesses is they are pursuing green field. But think about the word “disruptive” – it implies the existence of a status quo. 

Disruptive doesn’t mean there is no competition – it means that you attack the competition, usually in ways that are un-economic for for the incumbent to compete.

Many people are terrified of competition. They assume that because someone is actively operating in a market they’re necessarily doomed.

VCs will routinely pass on deals that look like good businesses but operate in markets that are too small. The larger the market, the bigger the impact “success” will represent for you.

But focus on a segment of that market.

This might sound counter-intuitive. Having a large market is ultimately going to be super important. But that doesn’t mean you attempt to talk to all of them at once.

Many startups get their initial toehold by focusing relentlessly on the needs of a small subset of a larger market. Doing so makes everything you do easier. Your value prop is laser focused on their needs. Your marketing channels and creative are designed specifically for them. Your roadmap maps closely to their needs.

This works because usually the features that REALLY matter to these folks will also matter to the larger market. 

A good market segment is typically one full of folks who tend to be open to new things, have a willingness to pay, and like to talk to each other. They also tend to be aspirational to the larger market, making the move from early evangelists to the larger market easier to pull off.

There’s often an advantage to further segmenting your market by constraining to a specific geography. This is the idea of “network compression”. Targeting first time moms is good. Targeting first time moms in Seattle is arguably better, because you increase the likelihood of them talking and spreading the word with each other.

A big pitfall at this stage is failing to keep your eye on the segment long enough. You will see the larger market out of the corner of your eye. You’ll have customer development conversations where they talk about how they’d love to use your product if it just did X. 

Make a note of it. But then ignore them. At least for now.

Truly get in front of your customers.

How do you figure out what they want? You ask them.

Any customer feedback is better than none. But some are better than others.

Strategies like surveys can certainly be helpful. But there is often nuance missing, and requires you crafting the survey really well to maximize the effectiveness of the feedback.

We leverage customer interviews on a regular basis because they’re cheap and you get to ask follow up questions and study body language. It turns out there’s a huge difference between “Sure, I’d use that” and “SURE, I’D USE THAT.” Surveys don’t capture this nuance particularly well.

An even more robust, albeit more time and cost intensive, approach is to shadow your customers. You will ALWAYS get more helpful insights than you can by simply talking to people about what they think.

We’ve shadowed patients and families inside of hospital facilities and learned about limitations of products. 

We’ve discovered things like high contrast screens matter a ton for people doing mechanical integrity rounds at manufacturing facilities, because they have to stand on roofs in the bright sun. 

It’s extremely unlikely people will surface these kinds of insights in an interview alone. And these tiny details are often the difference between a good idea and a product that people actually adopt.

There are many areas where there are diminishing returns. Talking to your customers isn’t one of them, at least not for a long time.

See how hard it is to generate demand.

One of the more overlooked aspects of a good market is the ease with which you can reach them.

I’ve made this mistake personally. We invested in a company at one point that was solving a meaningful problem for a demographically expanding segment of the population.

The problem was there was no easy way to find these people. They couldn’t be targeted demographically or psychographically.

The most cost effective channel ended up being through partnerships with non-profit associations, which was hit or miss depending on the organizations’ sophistication and level of commitment.

In the end, their acquisition cost was too high relative to the average useful life of a customer.

Some markets are simply hard to reach easily. Achieving product-market fit is hard enough as it is – don’t make it harder on yourself.

You can de-risk this somewhat easily by creating a growth model. We’ve talked before about the myriad benefits of modeling growth. One that isn’t immediately obvious is the sense it gives you on the relative difficulty of reaching your market.

Creating the model properly involves doing keyword research to assess the level of potential inbound organic traffic available, as well as the cost of showing up in those searches via paid search. It involves doing research on paid acquisition platforms to assess the size (and cost!) available audience you can effectively target. It involves assessing the potential reach of some of the publications you might want to target to estimate the potential lift from earned media.

And while all of these are estimates and surely will be wrong, they give you sense of where you’re headed. And sometimes you stare at that model and think to yourself, “This is going to be a lot harder than I thought.”

Better to know now.

Ship. Quickly.

While customer development, smoke tests and other strategies can be helpful intermediate steps, it’s not uncommon to still miss the mark when it comes to implementation.

This is okay. What isn’t okay is failing to commit to a cadence of rapid shipping in response to qualitative and quantitative feedback.

You have a limited amount of runway to figure things out. The longer you take to incorporate feedback and iterate on your solution, the less likely you are to achieve product-market fit before running out of money.

This speed of iteration is much more common with startups, partially because for them it’s life and death. In most internal innovation organizations or enterprise environments, speed isn’t as prized. 

It should be.

Make your product a closed beta.

This is a counter-intuitive one.

Many people think closed betas are little more than ways to manufacture scarcity and drum up interest in the product. I want to get behind the velvet rope because it makes me feel cooler. And there are plenty of startups who take this approach.

But a much less discussed but more important reason for doing it is you get to shape your audience. 

One reason why things like NPS and Sean Ellis’ question can backfire is your audience has commingled data. You have some % of people who reflect your ideal customer. But you have a bunch of other folks who are simply kicking the tires, or are competitors, or don’t have budget, or aren’t in the ideal job. 

The product isn’t designed specifically for them, so their feedback isn’t nearly as valuable. But it can be difficult to tease that out.

Enter the closed beta.

Gating your product, followed by some sort of survey or other instrument to qualify your customers, allows you to filter out the noise and maximize the feedback you get from your audience.

Some folks object that doing so artificially constrains growth. But growth in top line users who aren’t in your ideal customer profile and who churn doesn’t really do you any favors.

You can always open it up later.

Concierge your onboarding process.

One of the trickiest things in product design is architecting a good first time user experience. If you have a product that solves my problem, but it’s cumbersome or confusing to get to that point, I’m never going to get to the point where the light bulb goes on for me. 

One of the things that impressed people the most about Superhuman was their extremely hands-on approach to onboarding users. Critics argued that it doesn’t scale well.

But when you’re searching for product-market fit, scaling doesn’t matter. What matters is seeing your product in the hands of customers.

Walking them through it gives you a chance to see how easy or difficult it is to get started. It gives you a chance to find places that are confusing, to surface product improvement opportunities and identify ways to make your eventual first time UX better.

At the same time, you ensure customers get through that first time experience and experience the core of the product, maximizing the chances the light bulb goes on for them.

Concierge MVPs help you figure out whether the product itself sucks, or if it’s just the onboarding experience that needs work.

Product-market fit is hard to achieve. But it’s possible.

Make no mistake – legitimate product-market fit is elusive. But it is possible. By focusing on speed of iteration and staying very close to customers, you can increase your odds of success.

Whatever you do, avoid the temptation to prematurely scale. You will likely get pressure from your investors, or your CEO, or your growth board to scale whether you’re making legitimate progress or not. But it’s a trap, and typically ends poorly.

Stay disciplined. Move quickly. And when you’ve truly achieved product-market fit, you’ll know it.

It was 2016, and a Fortune 500 CIO sat in our offices describing how market changes were threatening the continued existence of his entire company.

“For us, innovation projects mean five years, fifteen million dollars, and nothing to show for it.”

How is it that even in the face of existential threats many organizations are unable to effect significant change?

One common reason is that established organizations tend to lump everything into one or two big swings since it’s what they’re most comfortable with. They’re used to succeeding—for the most part—with all of their major initiatives.

But that’s not how things work in meaningful innovation. And, in most cases you don’t even know if it’s going to work out until significant time has passed.

For most big companies that means throwing a lot of resources over an extended period of time to pursue something that, at least according to the odds, isn’t going to work.

• The three innovation portfolio mistakes.
• Why do these innovation mistakes happen?
• Why venture thinking is the solution to innovation portfolio management.
• Why not just do corporate venture investing?
• How can corporate innovation executives act like VCs?

The three innovation portfolio mistakes

Established organizations, particularly large ones, tend to make three key strategic errors in their approach to allocating resources to innovation:

• They pursue too few initiatives at a time relative to risk volatility
• They allocate resources inefficiently, often manifested as overallocation in any given initiative
• They fail to kill initiatives that are obviously not working

Why do these innovation mistakes happen?

Comfortable with big swings

Large organizations are used to taking big swings. After all, it’s much more efficient to put your muscle behind a few key initiatives than focus on lots of small ones.

Imagine going to your boss at GM with ideas for ten new types of jet engines, each more innovative than the next. She’s going to sit you down and tell you to focus—if she doesn’t throw you out of the building first.

Misunderstanding the risk curve

“Let’s see how this first one works,” is a common phrase we hear when leaders begin innovation initiatives. They tend to choose a very small number of innovation initiatives they think are good bets and put significant resources behind them.

That logic probably works in the normal course of business, where a thoughtful strategy and sufficient resources on average works well, and failure probably means an error in execution.

But that logic breaks down in the context of innovation, where failure is the norm, and only a small set of projects actually work out. Adding more resources, especially early on, quickly runs into diminishing returns territory.

Odds are, most or all of the innovation initiatives executives undertake will fail. But it’s hard for them to see it and even harder for them to admit it.

So, instead of reallocating capital and resources to better potential initiatives, they tend to double down on the few in front of them.

Throttling effects of risk mitigation systems

When you’re trying to protect a multi-billion dollar business from, for example, a data breach, it’s natural to implement rather draconian procedures to minimize the risks of a breach.

Most companies end up with a long list of checklists and approvals required for any new initiative. That friction greatly reduces the number of initiatives that can realistically launch in any given time period. And most initiatives are killed before they can even launch.

Maladapted resource allocation models

Resource allocation models at large organizations naturally evolve to accommodate evolutionary change, but tend to break down for more innovative projects. Project budgets tend to be at least annual, and often exist in the context of multi-year arcs. Finance teams employ repeatable tests for ROI (e.g., hurdle rates) to ensure capital is being allocated efficiently.

But real innovation involves significant uncertainty—after all, by definition you’re doing something new. In most cases you have few proxies or benchmarks to apply. It’s extremely difficult to predict how much money you’ll need, and when.

All of that makes it hard to comply with standard financial approval processes.

So instead of trying a lot of small things, it becomes easier to go to finance with an ask for a substantial capital allocation based on forceful assertions about how successful an innovation initiative is likely to be.

That naturally throttles the number of initiatives explored, and tends to filter out the riskier initiatives for which it’s harder to prove an ROI. It’s also a root cause for the frequent over-allocation that occurs, as well as the extended denial when things aren’t working out.

Internal sales friction

Executives at large organizations tend to be very aware of the difficulties inherent in pushing innovation initiatives through internal risk management and resource allocation systems.

That makes executives reluctant to undertake risky endeavors; even if they’re willing to risk their reputations on an initiative, they have to consider the sheer level of effort and political capital required to make them happen.

Furthermore, when executives have committed to an innovation initiative, it’s hard for them to admit defeat given all the trouble they have gone through—and the political capital they’ve deployed.

Corporate politics

The most fundamental reason for the development of internal politics derives from distributed organizational structures and disparate reward systems.

Take, for example, the IT department which is castigated when the CRM goes down, but sees the sale team get all the credit when sales beats targets. The IT team’s natural response is to block any changes that might threaten the stability of technology systems.

These structural conflicts of interest result in subtle, but powerful, forces against innovation. That tends to kill initiatives before they even start, and puts stress on the ones that do somehow launch.

Coordination challenges

The larger an organization, the harder it generally is to explain new initiatives sufficiently well to organize, energize, and coordinate the (often far-flung) teams required to implement innovation initiatives.

There are only so many initiatives that can reasonably be pushed through an existing organization at any given time. This also means that frequent changes can feel like whiplash, followed by the onset of fatigue and confusion.

As a result, larger organizations tend to be cautious about introducing too many innovations at a time, or in fact, over time.

Other antibodies to change

Operating an existing business model at scale requires tight coordination and reliable stability.

That often requires abstracting duties into subsystems governed by carefully prescribed expectations to enable safe interfacing with other subsystems. Six Sigma and other quality management systems are examples of ways organizations attempt to eliminate variance.

But innovation by its very nature involves trying new things that tend to disrupt multiple subsystems, pushing them outside of standard operating norms.

Even innovation that doesn’t trigger the risk mitigation and resource allocation filters mentioned above might fall prey to the constraints imposed by various systems designed to eliminate variance.

How can we do better?

For more disruptive innovation, it’s common for corporations to use startup entrepreneurs as a model.

After all, startups are designed from the ground up to disrupt. Shouldn’t large organizations look and act more like startups, at least when they’re trying to effect significant change?

Well, that’s probably true. But the root of the corporate innovation problems above derives from a very simple oversight.

Startups don’t exist in isolation; they thrive in a symbiotic relationship with venture capitalists.

By injecting the concepts of venture capital into the mix, large organizations can begin to realize the extraordinary potential offered by innovation.

Why venture thinking is the solution to innovation portfolio management

Startups exist in symbiosis with venture capitalists who assess, fund, and guide them towards maximum value creation.

It’s a model that has evolved over decades. But it’s very different from operating. Many of the corporate limitations described above derive from executives failing to understand the distinction between being a boss and being an investor.

But mention the words “venture capital” to a corporate executive and you’ll likely get a disdainful roll of the eyes. “That doesn’t work for us,” they’ll say. Or, “those VCs take too much risk.”

That latter part is probably true; as I have written elsewhere, the returns in the venture capital suggest something is broken in the industry.

But the former statement—that VC approaches don’t work for corporations—is probably inaccurate. The challenges in institutional (e.g., non corporate) venture investing are rooted in the “2 and 20” venture compensation structure, and generally don’t implicate the parts of VC that do work well.

Venture capital plays a critical role in the startup ecosystem; without it, the system simply wouldn’t work. Similarly for corporate innovation, if you don’t have a team playing the role of investor, things are likely to break down rather quickly.

Venture investing is meaningfully different from traditional investing, meaning that applying a traditional portfolio approach often fails in the context of disruptive innovation.

What breaks down without a venture mindset?

Taking a traditional approach to pursuing disruptive innovation usually results in:

• High outcome volatility
• Poor average results
• Deeply inefficient resource allocation
• High outcome volatility

Disruption projects often fail, but when they do work results can be extraordinary. In other words, outcomes are highly variable and difficult to predict.

Unless you’ve figured out a magic bullet to make your disruption efforts much more reliable, the only way to smooth this volatility is through a portfolio approach. Traditional approaches, as described above, often involve too few projects to smooth volatility.

Poor average results

The traditional approach also leads to poor results on average. But why?

For one thing, small innovation portfolios make it much harder to build an organizational innovation skill. Organizations often do a poor job the first several times—which in many cases are the only tries they make.

For another, investing is very different from operating. The skills, attitudes, and priorities are different.

Venture capital skill sets take years to hone, even for highly successful operators and entrepreneurs. Lacking these skills and attitudes usually leads to poor quality decisions that impact the average outcome.

Deeply inefficient resource allocation

Disruption projects have, as we discussed, very different risk and timing contours relative to traditional projects.

And it’s not just the resource allocation systems that tend to break down. The methodologies and skills employed by corporate innovators tend to result in suboptimal resource allocation.

Measuring success, for example, is often fundamentally different in the context of disruption. And the stages of risk and uncertainty reduction roll out very differently and can feel alien to corporate innovators.

This inefficient resource allocation further exacerbates both the volatility of outcomes and the average results relative to resources utilized.

Benefit from 60+ years of venture learnings

All of these are reasons why discarding the skills, methodologies, and learning of 60+ years of venture investing would be a mistake.

Venture capital is more than a way of investing in companies. It’s an approach to asset allocation and optimized value creation. And it’s just what corporations need to transform their approach to innovation—with some nuances in application of course.

Why not just do corporate venture investing?

CVC (Corporate VC) groups invest in startups, often alongside traditional VCs. In today’s increasingly fast-paced markets, corporate venture is an important innovation and value creation strategy. That’s probably why CVC now accounts for 25% of venture capital invested in the US.

But we think corporate venturing should be an additional strategy, not a replacement.

For one thing, CVC faces its own set of challenges:

• Coordinating with the mothership.
• Harmonizing financial and strategic imperatives.
• Overpaying for deals.
• Building and retaining a qualified team under the aegis of a corporation.

In many cases, corporate venture groups realize only a modest strategic return on their investments; most of the return tends to accrue to the founders and eventual acquirers (or public shareholders).

Successful corporate innovation, meanwhile, is much more likely to lead to significant strategic and financial benefits. That’s why internal innovation is critical, and probably more important than CVC in the larger scheme of things.

How can corporate innovation executives act like VCs?

Once you move past the misapprehensions about venture in the corporate context, the broad strokes of venture strategy are fairly accessible. Of course venture capital is a nuanced and complex field, and the devil (as usual) resides in the details. But that shouldn’t stop innovation executives from applying the most important parts of venture to their own activities.

So, what can we learn from venture capitalists?

Volume beats volatility

Corporate executives, like entrepreneurs, tend to have a small number of active areas of focus at any given time. As an operator, it’s just not feasible to do a good job of executing on too many things at once.

Venture capitalists, by contrast, seek to have a lot of active portfolio companies at any given time.

They know it’s very hard to predict outcomes and resource needs, so they smooth out the volatility with a large portfolio.

Don’t act like a boss

Corporate executives participate in execution—hence the name. They run teams and are by their very nature bosses.

The best tend to stay involved in (without micromanaging) their projects—in other words, they are operators.

Venture capitalists know better than to try to operate their portfolio companies. When you’re in charge of a team, it is harder to maintain the emotional distance necessary to make tough choices.

Being a venture capitalist is also a lot of work. Especially if you’re dealing with a broad portfolio (which you should), it’s nearly impossible to maintain the level of attention required to operate each company.

And for your innovation project leaders, it’s much harder to report to an executive than a board member. The level and frequency of reporting to a boss tends to be much greater, and often requires getting into the details.

That’s why good VCs act like board members instead of bosses.

They engage periodically with their startup teams for updates and to provide guidance, but they don’t try to manage them. They definitely don’t get caught in the weeds. If a VC is operating a portfolio company, that means that something has gone terribly wrong.

Your product is the portfolio

Corporate executives are accustomed to modeling each project, and justifying each individually to external parties (typically finance).

Venture capitalists know that they make money from the overall success of their portfolio, and act accordingly.

They assemble capital (raise funds) in large chunks based on planned investment and liquidity strategies designed to last 10+ years. They don’t model out 20 individual portfolio companies to their investors. They model out overall expected returns based on well-known proxies—other venture funds.

They also don’t justify each investment individually to their LPs. They have discretion about how to allocate the capital they raise.

So, act like a VC and raise a large pool of capital from your organization designed to be allocated over an extended period of time, and without having to go back each time to explain your needs to the finance department.

Justify it based on a portfolio of returns instead of trying to prove that any particular initiative is likely to be successful.

Focus on resource allocation, not individual outcomes

Corporate innovation executives tend to focus on ensuring that each project performs well. When an initiative struggles, it’s very tempting for people with an operator mindset to jump in and try to fix it.

But that’s a great way to waste a bunch of time and resources on something that’s destined to fail, and meanwhile starve more deserving projects.

Investors know that some of their investments are going to fail. Instead of focusing on fixing troubled projects, they focus on doing a good job of allocating resources.

They know that doing a great job of establishing rubrics for evaluating progress will enable them to make the tough decisions about when a project deserves additional resources or not. They know a fast no is better than a slow no.

Read here about how to handle failing innovation initiatives.

Milestones and stage-gate processes

Corporate innovators tend to focus on the viability of each individual initiative, using normative models derived from their corporate parent. That represents at least two key errors:

• Norms derived from the corporation are very unlikely to be effective for innovation initiatives.
• Individually justifying funding is very different from effectively allocating funds across a portfolio, and typically leads to inefficiency and overallocation.

Venture capitalists use carefully considered—and startup appropriate—milestones and stage-gate processes to understand the risk, potential, and value of each of their portfolio companies. They use these assessments to efficiently allocate their scarce capital resources.

This is perhaps the most challenging aspect of applying venture paradigms to corporate innovation, because it involves very different skills and approaches than are typically used in corporate environments. That’s why this area tends to be one where our corporate clients request the most assistance.

Treat the portfolio like a division

Corporate innovation leaders, as we mentioned above, tend to act like operators. That’s true for their bosses as well.

Tight organization and integration are the norm, with clear reporting structures and aligned strategies. But it’s really hard to act like a venture capitalist if you’re being managed like an executive.

Venture capital partners are called “General Partners” and their investors are called “Limited Partners.” The “Limited” part refers to the limited control and oversight investors have over the day-to-day operations of the General Partners.

That works, because the VCs need to be allowed to make their informed decisions without constantly having to explain things to investors who aren’t in a good position to understand what’s going on and how to act.

A similar approach works for innovation departments. Separation there is potentially even more important than it is in venture capital.

By keeping innovation teams and systems separate, you can avoid some of the systemic and procedural limitations that might otherwise constrain innovation efforts. This has implications for tracking and reporting systems, organizational design, and operations. It also can make it difficult to integrate successful projects back into the mothership, although there are ways to reduce this risk.

Founders are the key

Corporate executives understand how important people are to success.

However, the very nature and reality of modern corporate human capital means that process and role often have to supercede individual contributors. Short job tenures and the nature of job advancement in the modern corporate ecology are major contributors.

Venture capitalists know that the most important ingredient for startup success is the founding team. Even the best idea with a mediocre team is very likely to fail.

VCs also understand that the inherent complexity of innovation means it’s more about learning than execution, at least until the company finds product-market fit and begins sustainably scaling. And they know that small teams are more effective in the early phases requiring adaptability and learning.

That’s why it’s so critical to have an amazing and diverse early team. Unfortunately for most corporate innovators, some of those team members don’t exist in your organization. And the standard organizational human capital practices (e.g., recruiting, compensation, oversight) tend to align poorly with adding them.

Meaningful change takes time

Corporate executives are accustomed to working in a context where clear evidence of success or failure is visible within a year or two of launching a project, and often much earlier.

Venture capitalists have resigned themselves to the fact that the outcome is rarely clear until several years in to a startup. In some cases it can take a decade for success (or failure) to be a settled fact. That has implications for resource allocation, team organization, and management.

Conclusion

For structural reasons, corporate innovation groups have a strong tendency to focus on a small number of innovation initiatives at a time.

The inherent volatility and risk of meaningful innovation makes this a very risky bet. They often compensate by choosing incremental over disruptive innovations. And even in those circumstances they too often fail.

The result is a combination of a poor average return on investment and a failure to meet key strategic needs in our increasingly fast-paced economy.

We believe corporate innovators can dramatically improve results by borrowing from the 60+ years of learning embodied in the venture capital industry. From a high level, this means taking a portfolio approach to innovation, and acting as an investor (resource allocator) instead of an operator.

This has the benefit of enabling a significantly higher volume of innovation projects, which increases expected ROI. It also enables organizational behavior that is much more conducive to success for each initiative, further enhancing anticipated ROI.

If you’re interested in learning more about how DI helps organizations organize like VCs, we’d love to talk.

Design Thinking has become an essential part of how innovation teams surface ideas.

One specific tool has been the design sprint – typically a 5 day exercise using user-centered design methodologies to quickly arrive at a potential solution to a problem.

It’s fantastic tool – one we use ourselves and teach to our clients. But coming out of them, there’s often the problem of what to do next.

Getting Stuck

In our conversations with innovation teams, its extremely common to run a bunch of design sprints, identify a bunch of potential solutions, but then get stuck.

In many cases, the rough prototype and the small sample size of customer feedback, even if positive, isn’t enough to earn the resources internally to move to an MVP build.

And so instead of a stack of ideas piling up, there’s now a stack of somewhat validated prototypes piling up instead. You’ve moved the ball forward, but not by much.

Validating the rest of the Lean Canvas.

A great tool for summarizing a potential solution on a single sheet of paper is the Lean Canvas.

Underneath an idea is a set of assumptions:

• You’re assuming a certain stakeholder (or set of stakeholders) has a problem.
• That you have the solution to that problem.
• That the problem is solved in a way that creates value for the stakeholder – enough for them to either start paying for it or otherwise incorporate it into their lives.
• That there are enough of these stakeholders out there (and that you can get access to them easily enough) to make the time and effort worth it.
• That the cost to get them to use it is cheap enough relative to the value you extract from their use to make it worthwhile.
• That the solution is defensive enough to avoid being copied immediately.

Design sprints can help solve a subset of these, but obviously not all of them.

Assuming you are following the practices of user-centered design, you’ve done the work of validating stakeholders need before starting your design sprint. And through the sprint process you uncover at least to a degree that the solution could potentially solve the problem.

But just like a venture fund is unlikely to invest in a company on the basis of a clickable prototype and 6 conversations with end users, your growth board or other innovation governance team likely won’t consider that sufficient to green light the resources to build an MVP.

So how do you close that gap, improve your case and move the initiative forward? Here are 5 suggestions that have helped other clients break the logjam.

Polish the prototype and get more data points

You make something quick and dirty to capture user feedback during the sprint. Now it’s time to create high fidelity versions of that prototype.

This doesn’t need to be working software. It can still leverage tools like Invision. But it should have the look and feel of a finished product.

With that in hand, go outside the conference room and show it to more users. Capture their feedback around willingness to use and if necessary willingness to pay.

Don’t be surprised when you get lukewarm feedback or objections. Use those to improve the prototype, and go back out there.

Getting more data points can help build your case. And interestingly, simply having a highly designed version of your prototype can increase internal momentum as well. It gives the impression that there’s a “there” there.

Showing pretty screens can often generate more enthusiasm than talking about an idea in the abstract (or even showing lower fidelity versions of an idea, which signal that it’s half baked.)

Create a functional spec

Assuming the solution is a piece of software, a fantastic next step is to turn the prototype into a functional spec document. This typically includes:

• Writing out the user stories in detail.
• Outlining all of your assumptions around integration points and other data that needs to be captured.
• Creating a product roadmap, with the functionality you envision in the MVP and subsequent releases.
• Most importantly, using that information to get a timeline and budget estimate for the build.

Doing this gives your internal team the data they need to make the case from a level of effort perspective, which is obviously an essential part of your case.

It also helps you craft the message in a way that increases the likelihood of success. Too often teams try to pitch the grand vision. They ask for the budget to create the product as it will ultimately be. But this increases your cost and risk, both perceived and actual.

Instead, identify the “core experience” that belongs in the MVP. Focus your effort on nailing the first time UX and the core experience. Defer the rest.

This is a good practice anyway, as simpler, tighter products tend to result in higher user satisfaction and limit the amount of behavior change needed to adopt.

Getting timeline and budget numbers also help you identify potential trade offs, shaping what that core experience includes and doesn’t include. It helps you make a more modest ask for MVP development, while providing visibility into the costs of the potential long term roadmap as well.

We typically recommend getting an estimate from an external vendor at this phase, even if your internal team plans to build. This addresses two potential issues:

• It avoids the objection that the internal team has too many other things going on.
• Often the internal estimate is higher than the estimate from the vendor, both in terms of budget and time. Having a second data point is incredibly useful in making the case.

Create a growth model.

We’ve talked in detail about how we use growth models to put realistic assumptions around getting traction. We’ve found it to be an invaluable tool for making the MVP case.

The model makes a series of detailed assumptions at every layer of the customer or stakeholder funnel:

• • Acquisition: How will we get people to find out about the solution? From what channels? How much will those channels cost? What’s the audience size of those channels?
  • Activation: What are the steps necessary for a user to go from awareness to adoption? What are our estimates for conversion rates at each step of that onboarding process?
  • Retention: What do we think retention will look like over a 3/6/12 month period of time? (note that benchmarks are incredibly helpful here.)
  • Revenue: If these users are being monetized in some way, what are our assumptions around monetization? Number of ad impressions, % of free to paid subscribers, etc.
  • Referral: If there is a referral component, what does that loop look like? Number of invites sent per user, % who accept the invite, their onboading behavior (note that it’s often different than a user acquired cold because of the referral), etc.

These are obviously all assumptions. But they demonstrate to your team that you’ve given things way more thought. That you have a rational plan for how you will grow the product once it’s launched, and that your estimates for ROI are backed by a detailed breakdown of the levers that influence it.

Create a smoke test

To further validate some of the assumptions in your model, you can create a smoke test to test acquisition.

A smoke test can take many forms – often it looks like a landing page (with your pretty screens) with a call to action to sign up. Behind that is a page saying we’re not ready yet, asking for an email address to be notified when you launch. You supplement this with a tactical paid acquisition campaign to acquire potential customers.

This helps you validate a whole host of things:

• • Which channels are most cost-effective for generating traffic from our target users?
  • What value proposition and create treatment is most effective?
  • What percentage of people, once made aware of our product, are interested enough to click a sign up button?
  • Once they see that it’s not ready yet, what percentage still think it’s compelling enough to provide their contact information?

As an optional intermediate step, you can even add a pricing page (if relevant) in between the landing page and email collection. This lets you test various pricing models as well.

Conduct cold outreach

Finally, when dealing with b2b solutions, we often advocate for taking that smoke test and supplementing it with an aggressive cold outreach campaign.

You want the landing page up because it gives the idea credibility. You supplement the landing page with email addresses and linked profiles of people who “work” there. You build a list of targeted potential customers, and you craft a multi-modal outreach campaign to generate potential leads (typically some combination of email, phone and social selling.)

This again forces you to get outside of the building and test for value prop – customer fit.

While we believe in doing stakeholder research in other ways at the front end (validating pain through problem interviews, etc.), we do believe there is value in trying to sell the solution at this stage.

Getting meetings with potential customers who think the solution exists in some form is helpful because they’re no longer just giving you advice. They’re being sold, which increases resistance. As a result you get a ton of new useful information:

• • It surfaces objections you’ll eventually need to learn to overcome.
  • It begins to help you map the buying process by understanding who the decision makers might be for a solution like this.
  • If coupled with an signed offer letter when there is interest, you give your team the most compelling reason to move forward of all – a signed commitment to purchase the product once it’s live.

Design Sprints are important but insufficient

Please, continue to do design sprints. We know of no better tool to quickly make progress on a concept for a solution.

But realize it’s not a magic bullet. You still have to do the work of building your case to earn the right to move forward with it.

You can fundamentally de-risk an idea and earn the resources to build an MVP, in very little time and with very low cost. Consider baking the tools above into your process to increase your velocity of tested ideas.

DI has done all of the above for clients many times. We’d be happy to help you execute on any of them. To learn more, contact us.