Product-Market Fit (PMF)

Finding Product-Market Fit is essential - a fantastic team with a perfect product in a small and shrinking market will fail. Identifying the correct market is step one for many founders, and this cannot be overstated. Our guide explains everything you need to know to reach and measure Product-Market Fit

Updated 16 March 2022

There are three key buckets that startups need to get right to succeed: Product, Team and Market. Many startups focus on really nailing the product or ensuring they're surrounded by a confident, intelligent and energetic team. However, it's typically the last of the three that is overlooked and can become the biggest challenge for founders.

Following on from this, one of the earliest challenges for startup founders is trying to identify Product Market-Fit (PMF). There are many moving parts to a product offering that make it notoriously difficult to establish. Not only that, but business and consumer preferences are changing more rapidly than ever, meaning a PMF established 12 months ago may no longer apply in today's rapidly changing world.

One of the essential checklists investors look for is a clear PMF between a company's offering and its target market. Just saying "we have achieved PMF" is not enough. If you're raising capital, VCs have clear cut ways they test PMF.

Why does PMF matter?

PMF is a clear signal to founders (and investors) that the problem you've identified is valid and the solution you're proposing solves this problem. As a startup founder, viewing your world through PMF allows you to see the world differently, inspire new ways to create value for consumers and grow your business.

This guide explains what PMF is, how startup founders can achieve this, and the fundamental ways VCs analyse PMF in an investment context. We cover:

What is Product Market-Fit?

In its simplest form, PMF is where you have a product and a market that wants it. PMF is one of the central concepts in the startup world. At any given time, a startup will have a product that it provides to customers. How well your product aligns with customers is the key to running a successful business.

However, not all startups know when they have achieved PMF. For example:

Google didn't know it had PMF with its first search browser as no one used it.
Apple didn't know it had PMF until it released the Apple II with the first-ever colour graphics (the Apple I came with no monitor, keyboard or casing and was a commercial flop).
Amazon didn't have PMF when it first started selling books until Jeff Bezos realised that the world was much wider than books and branched out into e-commerce.

Know This: Countless startup founders have worked on one idea, only to pivot into another vertical or completely overhaul the existing product offering. There are clear strategies that founders can use to continuously test PMF until they have a product that customers can't get enough of.

Many startups worldwide have spent years perfecting PMF, which can reap huge benefits if they are successful. For example:

Spotify has built a product that customers are likely to stay with for decades.
Apple has created an ecosystem of products that work seamlessly, tying in consumers.
Amazon has created the largest network effect globally, with a marketplace penetrating >82% of American households through its Amazon Prime service.

These are examples of companies that have gone above and beyond to establish clear PMF.

Defining Product Market-Fit

VC investor Marc Andreesen coined PMF as "being in a good market with a product that can satisfy that market".

New Zealand-Specific Example of PMF:

You can think of PMF as the Luna Rossa from the America's Cup challenge, where the product is the sail and demand as the wind.
For the vessel to move fast, you have to build a sail and find the wind to power it. If you have one without the other, the boat will go nowhere.
If you have a great product with no market, you won't sell anything.
If you have a massive target market with a critical problem but no product that addresses that problem, you won't have any traction.
For your company to grow, you need to build a product where the value proposition directly satisfies customers' needs in a particular market.

When Product Market is (and isn't) established

Situation 1: Where Product Market-Fit isn't established
It can become quite clear when PMF isn't established in a startup. The common feedback you'll get from customers includes:

No sense of connectivity or smoothness to the experience.
Customers don't see the value in the product – your product may still not solve the problem, or it may solve a different problem that consumers weren't that bothered about.#
Lack of "network effect" – customers use your product, but it isn't significant or aligned enough for customers to go out and tell all their friends about it.
Sales cycles are long and getting longer.
High churn rate on existing and new customers.

Situation 2: When Product Market-Fit is established.
It is very clear when PMF is established. Common characteristics include:

Customers are adopting the product faster than you can innovate.
Word of Mouth will take over, and customers will effectively sell for you.
Usage is growing faster than you can add servers.
Customers are shovelling money at your offerings faster than you know what to do with it.
Hiring takes on an exponential growth trajectory.
There's a "buzz" about your startup, and the media start to get interested (e.g. Facebook, Vine and Clubhouse in the early days of inception).

Where Do I Find Product Market-Fit?

"The Value Hypothesis", and how it applies to Product Market-Fit
A value hypothesis is the ability to explain the key assumption that underlies why a customer is likely to use your product. A value hypothesis addresses both the features and the business model required to entice a customer to buy your product.

Take Uber, for example - the key assumption may be that Uber has the highest number of drivers on its network, meaning the availability of taking an Uber will be the highest among ride-sharing services. Features that needed to be built out to establish the value hypothesis could have been the ability to schedule rides.

Another example is Jetstar - the key assumption may be that Jetstar's low-cost pricing model will undercut any other competitor in the Australia and New Zealand market, leading to the lowest prices for consumers.

The three key things you need to achieve PMF

Product
Pricing
Business Model

Adjusting and Testing Everything to Achieve PMF
In the quest for PMF, startups tend to isolate and look for specific cohorts of customers to identify whether they have aligned and stuck to the product. In the quest for PMF, the three levers you can change are:

Market
People
Product

Everything else is irrelevant. If you've identified the right market, targeted the right people and built the right product – you'll achieve PMF. Talking to your customers is the fastest and easiest way to optimise your product (and understand whether there is a need at all, giving hints at whether the current market is appropriate).

Achieving Product-Market Fit in Four Steps:

1. Determine your target customer
Once you've identified the right market, segment the customers in that market and adapt your approach to clearly identify which segment would be most suitable for this product. Clearly defining the buyer's characteristics and likely mindset is essential here.

2. Gather information
Understanding customers pain points and getting feedback within the market is the next essential step. This can be used to formulate, improve and iterate your product. The Sales and Marketing team can be instrumental here in building relationships with customers and finding their problems' root cause.

3. Focus on a vertical
Finding the niche and establishing PMF in that niche is far cheaper and more effective than casting your net wide. The larger the market, the more resources it will take to accurately identify PMF. Larger markets lead to wider customer feedback discrepancies, meaning you'll need to spend more time gathering information. The faster you can get actionable insights from target customers, the better.

4. Specify Value Proposition
Identify which portion of the customer's pain points your product can target and how you can provide this better than competitors. Understanding what differentiating factor your product has over others is the key to winning in a competitive market.

How Do I Know When I've Hit Product Market-Fit?

The easiest way to explain when a startup hits PMF is when they get "on your wavelength". Assume your company is on a "wavelength", and customers are also on their own "wavelength" about a topic, issue or problem.

Resonating with your customers at the same "wavelength" is the key to PMF. This can either come from the startup changing their "wavelength" (through changing the product or changing the target customer).

Changing your wavelength takes time and is a continuous process. Like how a wave will not move in zig-zags, a wavelength is likely to oscillate and increase amplitude gradually with no sharp turns. Since both your product and the customer constantly shift around, it can be challenging to know when you've achieved PMF, and it's easy to get out of sync with each respective "wavelength".

Other startups can also align their wavelengths with your own (leading to duplicate, undifferentiated or "copycat" startups) or to the customer's wavelength (meaning they can reach PMF before you).

The Disappearance Test: A common way to know whether you've hit PMF is to ask if the majority of customers that are currently using your product would be disappointed if your product disappeared from the market. If so, it's likely you've created an essential product for your industry and have achieved PMF.

Why Do I Want Product Market-Fit?

Product Market-Fit is essential to progress any business - without it, your sales and traction will stall and you'll never be able to scale your business.

Word of Mouth

When people start to understand the product and the value it creates, they're likely to share that positive experience with their friends and family. A strong PMF will replicate this positive experience in every new user that adopts it, and the cycle continues. In this sense, you're left with a brand and product that scales in a power-law fashion (non-linear growth).

VCs look for PMF before investing

Aside from bankrolling the startup, VCs are great at adding value through strategy, key hires and introducing prospective customers. However, all these points are only relevant once a company has established a core market and developed a product to capture that market.

A startup that hasn't established PMF signals to a VC that significant product development and market validation are necessary, making the value of the business much lower.

PMF isn't Linear

PMF is everyone in the team's job – and it won't be simple to find. A lot of time will be spent trawling through data and feedback to understand the evidence behind why people stay and why people churn out of the product. The product you start with will inevitably change as you scale, and PMF will be a constant process for everyone to work on.

All Markets are Not Created Equal

Some markets will be easier to find PMF than others. In general, a market with many potential users, high expected growth in those numbers and users that are easy to acquire will find it much easier to find PMF. With a larger and clearer market, it becomes easier to switch out customers, get feedback fast and find PMF more quickly.

Finding user-centric attributes is much easier to do in a market with a wide variety of customers. It will typically be one or two differentiating factors in your product that make customers choose you over other products (stickiness); everything else could be the default/the same as competitors. Finding PMF is ensuring those key differentiating factors are in your product.

How do VCs Analyse Product-Market Fit?

There are several ways potential investors analyse Product Market-Fit, as we outline below:

Net Dollar Retention (NDR)

NDR is a metric used to compare fluctuations within the existing revenue base. NDR identifies recurring revenue over time and is closely linked to churn. It is calculated as:

(Revenue at the Start + Upgrades) - (Downgrades and Churn) / Revenue at the Start

Upgrades are existing customers who spend more in the current period than the previous one (e.g. moving from silver tier membership to premium tier membership). Downgrades are the opposite of upgrades (customers who spend less in the current period than the previous period – e.g. moving gold to silver memberships).
Churn are those current customers that stop subscription of the product entirely.
Net Dollar Retention > 100% show that customers that use the product typically increase usage and spend on the product while keeping churn relatively low. This is a good sign for startups and likely a clear example of PMF.

Churn Rates

A typical churn rate for a consumer tech company is ~3% monthly. For B2B or enterprise plays, it's typically lower (<2%). Where PMF is achieved, churn rates become extremely low (sub-1%) as customers find the product serves their needs exactly, and it becomes a "must-have", resulting in extremely low churn out of the product.

The churn rate is a key sign for VCs and one they'll look to understand if they're looking to invest. Key advice for founders would be to get your churn metrics in order first before hitting the pitch deck roadshows.

Pricing increases, product changes and market shifts will all impact your churn numbers, and being able to tell a narrative about this concerning churn when raising capital is essential.

Annual Recurring Revenue (ARR) Growth

When PMF is established, word-of-mouth takes over, and you typically see a frenzy of new consumers in your market segment adopt the product. It's not uncommon to see this as a "hockey stick" like growth where revenue ramps exponentially every month due to a key product shift or pivot to a new customer segment.

Net Promoter Score (NPS)

Running NPS on your products is a fast and easy way to gauge how well you're doing versus peers and industry. NPS is a quantitative metric that you're able to peg targets to and provides the team with an overall hard metric they can work towards. You can download NPS benchmarks for New Zealand businesses here, and this Stuff.co.nz article explains NPS in more detail.

Product-Market Fit Case Study: Spotify

Daniel Ek realised that the music-sharing market had some of the fundamentals necessary for PMF following Napster's exit in 2001.
Music content was present, and distribution platforms existed through increased mobile phone adoption in the early 2000s.
Daniel thought the existing users on Napster may still be willing to pay a small fee for access to the music, and Spotify was created on this value hypothesis.
It turned out Daniel was right, and the streaming subscription model was born.
Spotify now leads the market in music streaming, ahead of peers like Apple and Tidal, with over 200 million monthly active users.

Product Market-Fit Frequently Asked Questions

Product Market Fit isn't an easy process, and for any founder there are a number of uncertainties. We anticipate two common queries below:

If my competitors and I both have Product Market-Fit, what happens?

Your competitors can hit PMF at the same time your startup does. Suppose the market is large enough, and the niche you operate in is different to the niche they operate in. In such a situation, there may be instances where the market as a whole is growing and developing fast enough to sustain multiple startups in it (examples include Uber and Lyft in the early days, Alibaba, Pinduoduo and JD.com, or Spotify and Apple Music).

However, as markets become saturated and customers become used to using products, consumer preferences can start to stick. People who use Uber will continue using Uber; new customers may not be as easy to convince, or most of the market may have already been serviced. In such instances, price-cutting and other marketing tactics may come into play in the fight for market share.

Typically, PMF starts to slide for startups as consumer preferences (and competitor actions) change. This is why PMF is important to track, and once you've established it, you continuously listen to feedback and test your target market.

Are there misconceptions around Product Market-Fit?

Yes - there are two common misconceptions:

Firstly, there is a misconception that PMF is always a massive event, and your whole team will celebrate it as a 'moment'. In reality, PMF may be quietly achieved when everyone is still tinkering away on product development or slow implementation. PMF is an iterative process and will come about due to hard work, listening to your customers, thinking logically about the market and drawing insights from cohort after cohort.
Secondly, there is a misconception that once you achieve PMF, you're on your way to becoming a unicorn. Whilst PMF is a huge milestone and something to applaud, it's just as easy to lose sight of the problem and have PMF slip right out from under you.

Markets are more competitive than ever, and there are going to be similar products looking to replicate what you have done. Not only that, but technology has changed the modern consumer into a rapidly changing demographic – with tastes and preferences that sway like trees in the wind. Keeping a close eye on your customers, the market and your product are all essential habits, even once PMF has been found. As you grow, listening to your customers is essential.

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