While startups may claim that they have found product-market fit, how can investors actually tell if good product-market fit has been found? How can investors differentiate genuine need from a temporary spike in viral interest from a founder’s well-intentioned optimism? In this blog, learn more about assessing product-market fit and how to understand if product-market fit has been found.

Assessing Product-Market Fit

At its core, product-market fit is the degree to which a product satisfies market demand. It represents alignment between a startup’s value proposition and the underserved needs of its target customers. Typically when product-market fit has been found, customers enthusiastically purchase, use, and even become evangelists for the product.

Assessing product-market fit can be important for private market investors conducting due diligence. Products or services that do not have strong product-market fit may have a harder time acquiring, retaining, and benefitting customers, which can also hinder future growth.

The following are some methods investors can use in order to assess product-market fit.

The Sean Ellis Test

When a company has an active user base already, one tool investors can use is the Sean Ellis survey method. In this test, users are asked on simple question: how would you feel if you could no longer use this product/service? Those conducting the survey are measuring the percentage of users who answer “very disappointed”. Ellis’ research suggests that if 40% or more of surveyed users report they would be “very disappointed” to not be able to use the product anymore, that can be a strong indicator of product-market fit. This also can represent that users view the product as a “must-have”, not just a “nice-to-have”.

Cohort Retention Rate Analysis

While surveys can capture customer sentiment, data can reveal true behavior. Strong product-market fit is typically reflected in well-retained customers. Investors can take a look at the percentage of customers who continue to use the product over time. A “hockey stick” shape in a customer retention curve showing an initial decrease flatlining above zero can represent the percentage of users that are retained instead of fully dropping off.

Net Promoter Score

As mentioned previously, satisfied customers can become viral marketers as they make recommendations to friends and family about a product or service. A Net Promoter Score (NPS) can help put a number to the satisfaction and how likely a customer is to “promote” the product or service. This is typically measured in survey form by asking “How likely is it that you would recommend this company/product/service to a friend or colleague”, oftentimes represented on a 0-10 scale. Higher numbers on the scale represent promotors who love the product enough to make recommendations to others on becoming customers.

Lifetime Value / Customer Acquisition Cost

Additionally, taking a look at Lifetime Value and Customer Acquisition Cost can provide some insight into the financial viability of the startup. Lifetime Value calculates how much revenue a customer generates over their lifetime compared to the cost of acquiring the customer (Customer Acquisition Cost).

• Lifetime Value = (Gross Margin % * Average Revenue Per User) / Churn Rate
• Customer Acquisition Cost = Total Sales & Market Spend / Number of New Customers Acquired
• Churn Rate = (Lost Customers/Total Customers at the Start of a Specific Time Period) * 100

A lifetime value:customer acquisition cost ratio of 3:1 or higher may be considered an indicator of a startup with product-market fit.

Spotting Product-Market Fit at the Earliest Stages

For startups that are at their earliest stages and don’t have a sellable product, large number of users, or even revenue data yet, evaluation may want to shift from measuring outcomes to assessing the quality of processes and understanding of the problem.

Assess Market Research

Has the team clearly identified an underserved customer need? Investors may want to look for evidence of deep market research and a clear understanding of the market the startup plans to operate in.

Evaluate the Minimum Viable Product (MVP)

Even without a final product, investors may still be able to assess a prototype or an MVP. How is the startup using the MVP? Are they Alpha or Beta testing it with potential customers and iterating based on feedback? How far along are they in the process and what are the go-to-market plans and timeline for the MVP?

Final Thoughts

Determining product-market fit is not a one-size-fits-all metric. Investors may want to take the information obtained from the startup and make decisions based on active user base, customer retention, and MVP status in order to help determine if the startup has found product-market fit.

Are you ready to invest in startups? Sign up for a MicroVentures account to start investing!

Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:

• Assessing Startup Market Size: TAM, SAM, and SOM
• Understanding Tender Offers
• Understanding Valuation Caps
• Calculating a Startup’s True Runway

*****

The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.