2016 is going to be a very different year for startups.
For several years, the mantra of early-stage companies has been to grow the number of engaged customers at almost all costs. YCombinator uses growth as a bellwether: if you aren’t seeing 6-8 percent growth each week in either users or revenues, then you’re doing something wrong, and haven’t found the product/market fit you’re after.
Growth in engaged users is a good metric to focus on if certain assumptions are true:
- You’ll be able to raise more money to fund that acquisition at better and better terms the bigger you get.
- There are strong first-mover advantages in the market that make it a land-grab.
- Engaged users will eventually bring in more revenue than they cost to acquire and service.
These assumptions are increasingly inaccurate.
You might not get more money cheaper
With a tightening public market and a reduction in acquisitions, investors aren’t sure they’ll get their money back. Just look at deals like Square.
Furthermore, traditional venture capitalists are being squeezed out—accelerators like YCombinator and angel funds like AngelList are closing their own funding ($700M and $400M respectively), allowing them to continue to fund early-stage companies; and private exit tools like Exitround are eliminating the network of investment bankers that engineered exits.
Remember that VC firms have to return money to their own investors (usually called Limited Partners) at a rate that beats the market. Because the VCs expect many of their deals to fail, the ones that do succeed have to return a large multiple on their initial investment. Deals that grow with accelerator backing, or exit to an acquirer through a private exit, don’t usually give venture capitalists the return on their investment that their limited partners demand.
So first: Raising more money at a better rate than you have in the past is unlikely.
First movers don’t always win
Sometimes, it’s good to be first. But that only happens under specific conditions:
There needs to be a tremendous stickiness to the market. That means the costs of a user switching to a competitor are high. As technology becomes more commonplace, however, it’s harder to lock in consumers in ethical ways. DRM, long-term contracts, and making it hard to cancel are shady approaches to reducing churn, and consumers are getting wise to them. With the pace of consumer technology changing more and more rapidly, a particular tech stack gets old: we had PCs for 20 years, phones for 10, tablets for 5, wearables for 3—we get bored fast.
You need to be able to defend your position by innovating as fast as smaller competitors who have less to lose. This doesn’t mean doing more things than your competitors; in fact, it may even mean doing fewer things, better. Evernote’s Phil Libin laments the fact that his users don’t use 95% of the product—and yet, the company has to support those features now that they’ve been developed. As companies get bigger they lose focus on the 80/20 rule of new features, and try to please everyone.
You need barriers to entry. Unfortunately, technology barriers to entry tend to erode over time. Netflix pioneered reliable online streaming, so when it came time to license content they were the only real game in town. Now any broadcaster or creator can stream their content reliably, and publishers are squeezing Netflix, forcing it to respect regional licensing and stop turning a blind eye to users who use VPNs to access content in other countries. Netflix has responded admirably by becoming a content producer in its own right, but their fortunes aren’t as rosy as they once were.
So second: Just because you got there first doesn’t mean you’ll stay there.
Users are no guarantee of contribution
Unless your company starts with a real business model, users don’t mean revenues. Snapchat has a hard time monetizing its users; plenty of startups addicted to the mantra of growth haven’t properly figured out how to extract money from what they do. When you do try to monetize your users, it can undermine the benefits they saw from the platform. You’ve broken the “free” pact, and you’ll find out that they didn’t value what you made as much as you thought.
Even if you do manage to make money from those users, it’s unclear you can do so profitably. Revenue isn’t profit, so unless you can get costs under control, you’ll still die. If your cost of acquiring new customers is high, you need cash to fund the acquisition, even if the customers pay off in the long term.
So third: It’s hard to pivot to profitability if free was your initial value proposition.
In other words, the days of growth at all costs are over. The magical metric of “Active Users” isn’t king any more.
The new metric: Margin
Redpoint Ventures’ Tomasz Tunguz has written prolifically about the metrics that businesses need to track. He believes the new metric is unit economics: How much does it cost to produce a unit of something, and how much does the company get as a result?
Unit economics is marginal revenue (what someone pays for the next unit you sell) minus the cost of producing that unit. It’s a measurement of how well you scale, and getting it right helps a company grow even in adverse conditions. For example, a product that sells itself—with its own demo, trial, onboarding, and upselling—doesn’t have a cost of sales associated to it. There’s no salesperson to feed, no commission to pay. That’s good economics.
But costs can only go down so far. Competing purely on cost is a bad game, one that involves cutting corners, offshoring, and lousy customer experience. Sure, startups need to look at the cost of the product.
Revenues, on the other hand, can go up a lot. Coca-Cola can charge more for what it makes than, say, generic sugar water because of Coca-Cola’s brand. When someone orders a Rum & Coke, they’re demonstrating the value of strong brand awareness. In 2013, marketing agency Interbrand estimated that Coca-Cola’s brand is worth $79.2 billion, second only to Apple’s brand at $98.3 billion.
Positioning is king
Branding is a function of having properly framed a customer’s understanding of the marketplace, and having occupied the strongest, most desirable place in that market. Slack, for example, is a group chat productivity tool. But by framing the company as a platform for organizational change, Slack changed how people thought about the tool set. Then it made its product more—fun with emoji upvotes, easy logins, and cheeky chatbots—which worked in the new frame.
Good positioning makes the cost of sales decrease, because prospects already understand the value of what you’re offering, and because you know who to target. It also makes revenues increase, because customers are confident that your higher price is justified.
To switch from growth to unit economics, startups will have to work on automation and scaling to keep costs low. But they’ll also need to get much, much better at reframing the minds of their intended customers, and positioning themselves as the best choice within that new frame.
In 2016, smart startups will focus on the cost and revenue of individual unit sales. And then they’ll need to prove that these economics will hold as their business grows. Growth will only matter once positioning and margin are working properly.
So my advice is to focus on positioning to a degree that would seem pathological otherwise.