That’s the zillion dollar question. And no one knows the answer definitively.
Even the most successful VCs have major duds in their portfolios. But every startup that becomes a large profitable company has the following two elements in common.
1) Product/service people really want or need
A “product/service people want” is the starting point for any successful startup and part of the reason that I love working with Y Combinator startups. They drill the mantra “make something people want” into hackers’ heads who are actually capable of executing the vision.
MBAs often spend way too much time obsessing over the business model before they’ve figured out how to create a useful product. A great business model can never make up for a product that doesn’t meet a want or need.
I don’t really consider myself an expert on creating useful products. In fact, I’m not sure anyone is an expert. Steve Jobs may be considered the world’s best product visionary, but NeXT Computer was hardly a smash hit. And the executive behind Microsoft’s lucrative Xbox business has added much less value with the Zune.
I was lucky in my first two startups to work with great products — the original founder’s vision really resonated with users. I helped both companies reach their potential, but I didn’t create that potential. Luck of stumbling into great products can’t last forever, so I now obsess over finding better ways to figure out if a product has potential before committing to take it to market. Every launch program starts with a discovery phase where we dig into how well the product is resonating with users, who really needs it, and why it’s resonating. Then we decide a timeline for going to market.
The only way to know if a product will resonate is to get actual users on it — and the sooner the better. If the product isn’t striking a nerve, it’s better to delay an aggressive go to market push. Many startups succeed with a refined vision rather than their original product.
2) Business model that works
Ultimately startups get VC funding based on their potential to create a thriving business. This requires combining a needed product with a business model that pays the costs of building a lucrative business. There is as much art in creating a strong business model as there is in creating the perfect product. It is a thing of beauty when all the pieces fit together in a perfectly tuned economic engine. Each ingredient is relatively simple, but making them work together at scale is extremely difficult.
These are the key variables to consider when developing a business model that supports profitable, scalable user acquisition channels:
- Lifetime value of a user
- Cost of acquiring a user
- Marginal costs (besides acquisition cost)
The lifetime value of a user must exceed the cost of acquiring the user and any marginal material/service costs (costs that increase incrementally with each customer). This is generally pretty easy to achieve if you have low marginal costs. Most traditional software has zero marginal cost, which is why freeware is possible (it may not be profitable, but it is sustainable). If you’re lucky, the lifetime value of each user is significantly higher than the marginal cost. In this case you have a lot left over to spend on profitable customer acquisition. On the other hand, if you have marginal costs that exceed the lifetime value, then this is a non-starter, no matter how useful the product is.
If your product is useful and the basic business economics work, then the next part of the business model puzzle is figuring out “customer acquisition channels.” VC funded businesses must have very scalable customer acquisition opportunities. No VC is interested in funding a business that maxes out at $1 million/year in revenue — even if it has 90% profit margins.
Once you have a basic engine that works, keep tuning all pieces to make it work better (improve conversion rates, bring marginal costs down, find ways to increase LTV…). This will open additional profitable customer acquisition channels. And obsessively tuning all these areas has been a major factor in my ability to attract 10’s of millions of users for startups that ultimately filed for NASDAQ IPOs.
The Ultimate Startup
The ultimate startup would be one where the product meets a critical need for a huge addressable market, users have a very high average lifetime value, there are no marginal costs and there are very scalable user acquisition channels that are completely free (ie viral). Unfortunately I don’t know any businesses like this. Facebook comes close, which helps explain their valuation of $50 billion (who knows what it is now??)… The only piece they are missing is a high lifetime value per user.
The science behind viral marketing has rapidly evolved in recent years, so I’m anxiously waiting for this ultimate startup to launch. Hope I can get some of the early equity in it.