False Positives Distort the Path to PMF
Beware of customers who love you for the wrong reasons
Achieving tight product-market-fit (PMF) is the holy grail for seed stage startups. Some never get close to PMF, unfortunately. But it’s arguably worse for a startup that thinks it’s found PMF and then, later, realizes it was a “false positive.” This typically involves raising significant VC, building a team, and then enduring a brutal series of setbacks.
False positive PMF happens most often when founders & investors that double down on false positive demand signals - that is, customer demand is very strong, but it turns out the startup’s underlying business model has been built on shaky ground.
False positives can occur across the gamut of tech startup business models. How can they be avoided? Early detection offers the best hope. Here are some examples of various categories of false positives, accompanying “failure mode” scenarios, and mitigation strategies:
Lending
False Positive: happy users & efficient customer acquisition (driven by adverse selection)
Failure Mode: new customers come in droves and the LTV/CAC ratio looks great - what could go wrong? Lots. A lending startup could be a ticking time bomb of credit risk. Even if they avoid credit risk, money is the ultimate commodity - a successful startup lender will be swamped by competition, which will pressure the LTV to go down and the CAC to go up.
Mitigation Strategies:
Make sure to have access to experienced risk managers to vet underwriting models
Build proprietary software to enable compelling benefits for users that are not merely from taking on credit risks that other lenders want to avoid
Ecommerce
False Positive: happy users & efficient customer acquisition (driven by underwater unit economics)
Failure Mode: happy customers acquired via low gross margins are notoriously fickle, making the challenge of raising gross margins a perilous journey.
Mitigation Strategies:
Focus on high gross margins from day one by vertically integrating
This will entail building a core competency that will enable a startup to offer a non-commodity product ie one that is highly defensible
Hardware
False Positive: strong early customer inbound interest from tinkerers (not users with a desperate need solved by the product)
Failure Mode: for hardware models targeting both B2C and B2B, early users are often more interested in playing with a new toy than actually solving a persistent problem. Not only does this inflate a startup’s perception of demand, it also creates a distortion because it can be very hard to target the right ideal customer profile amidst a throng of tinkerers.
Mitigation Strategy:
Target a product with a persistent use case & a recurring revenue model
Ship product in small volume early on to keep close to early users - and avoid crowdfunding platforms as they attract tinkerers like moths to a flame
Enterprise Software
False Positive: a founder’s charisma (not product execution) drives early customer sales
Failure Mode: a charismatic founder can be a rainmaker even if with a barely-developed product and a sub-par engineering team, so this can lead to 10-20 customers and 1-2m in revenue before customer disappointment begins to mushroom.
Mitigation strategies:
Discount the demand signal from customers that are in-network & sold by the charismatic founder
PMF is not achieved unless non-founders can effectively sell the product
Bottom Up/PLG SaaS
False Positive: strong growth in users & revenue, but churn is high (3-4%+ monthly)
Failure Mode: a SaaS startup can grow rapidly without realizing there is a big leak in the bucket. By 4-5m, high churn will hit like a ton of bricks, making growth very challenging from that point onwards.
Mitigation Strategies:
If churn is high, avoid spending on outbound sales or marketing even if the LTV:CAC ratio seems positive
Instead, focus resources on product development for user segments with highest retention & most persistent jobs-to-be-done
Each of these categories has its pitfalls as well as its opportunities. Personally, I think the category with the most attractive structure for achieving tight PMF is bottom-up SaaS:
Software has the most attractive unit economics
Software sold bottom-up entails no risk of charisma-driven-demand-inflation
Tinkerers that can kill a hardware startup are actually quite useful for quality assurance
Of course, bottom-up SaaS still must fend off the pernicious risk of churn - finding PMF is a challenge for any business model!