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How to measure product-market fit

Written By

Matthew Speiser

How to measure product-market fit
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When Open AI launched ChatGPT in November 2022, product-market fit (PMF) was unmistakable. Within days, millions of people were signing up for the free beta test, sharing responses the chatbot had generated for them on social media, and developing new use cases for the software.

While swift traction and product adoption like this are exciting to see, it also tends to be an anomaly. For most companies, the journey to achieving product-market fit — essentially a strong pull from their target market — is gradual, with many ups and downs along the way. For this reason, it’s important to be able to measure product-market fit to ensure you’re moving in the right direction. Read on to learn about the right metrics to help quantify your company’s product-market fit — pre-launch, post-launch, and as you scale.

Metrics for product-market fit

While there’s no singular metric for measuring PMF, most startups will look at a handful of numbers to get an idea of product traction. Here are some metrics your startup might consider to gauge PMF.

Total addressable market

Total addressable market (TAM) is the size of a product’s potential user base. Achieving PMF requires capturing a large enough share of a product’s TAM so the business can grow and expand. A company that’s achieving PMF is growing the share of TAM that it serves.

There are a few ways to analyze TAM. The “top-down” analysis entails using a credible source (e.g., government census data) to reference the size of the market you want to reach. A more scientific approach would be the “bottom-up” analysis, which leverages existing sales and pricing data for a product category (e.g., high-end watches, lawn furniture, etc.) to understand how large the TAM is.

A third method is the value theory. This method requires understanding what value your product or service provides beyond what your competitors offer and then determining how much more the market would be willing to pay for that value. From there, you can gauge how large the TAM would need to be to make it worth it to enter the market.

By assessing TAM and determining the revenue opportunity available, companies can tinker with their product offering or business model to enable them to grow their potential market share within the available market segment.

Obtainable market

No company will ever acquire 100% of its TAM — but companies can scope down to determine how much of the addressable market needs to be captured to make a business case for the product or service.

To start, determine the TAM within the company’s geographic reach (also known as the “addressable market”). From there, consider how much of this market the product can realistically capture given its current limitations (e.g., sales and marketing spend, competition, macro market conditions, etc.). This number is the obtainable market.

While this number can be something of a guesstimate, it’s a much more realistic goal for the company to work towards than TAM. As the business grows, the obtainable market should grow with it to encompass a larger share of TAM and reflect the additional levers an expanding business can pull to bring in new customers (e.g., more sales reps or a larger marketing budget).

Growth and profit

Growth rate and profit margin are metrics that can help determine if a product is capturing an increasing share of its obtainable market. In SaaS, a common rule of thumb is that products with a combined growth rate and profit margin that meet or exceed 40% are achieving PMF (known as the “SaaS Rule of 40”).

While anything above 40% is good, it’s important to note that both growth rate and profit margin will change over time. In the early days of a startup, the growth rate is usually quite high given the obtainable market being large for new products. However, this tends to level out over time. A new product with a low growth rate indicates a lack of PMF.

Conversely, larger businesses typically have lower growth rates because they’re already selling to a large share of their TAM. These businesses want stronger profit margins to sustain growth. A startup with a low profit margin isn’t necessarily a bad thing, as there’s still time to test pricing and adjust expenses as the business moves toward PMF.

Customer acquisition cost

Increasing growth rate requires increasing spend on marketing and sales. To do so strategically, it’s important to understand a product’s customer acquisition cost (CAC) — the lower the CAC, the more effective a product’s sales and marketing. To calculate CAC over a given period of time, use the following formula:

CAC = (Marketing Costs + Sales Expenses) / # of New Customers Acquired

Like growth rate, CAC generally increases as a product soaks up more of its TAM. This is because once a product acquires early adopters who intuitively understand its value, it needs to be marketed and sold to buyers that require more convincing (and that are more likely to churn). This means more spend on sales and marketing to convert potential customers and stave off competition.

LTV:CAC ratio

Once you have CAC, you can plot it against the lifetime value (LTV) of your customer to determine if you have a strong foundation for growth. To calculate LTV, use the following formula:

LTV = Avg. Purchase Value x Avg. Number of Purchases x Avg. Customer Lifespan

Generally, an LTV:CAC ratio above 3:1 is considered good. This means the lifetime value of your product’s customers is significantly higher than the amount it costs to acquire them, indicating you’re achieving PMF.

Did you know?

When you’re in the thick of building your business, the term “unit economics” may either 1) feel too granular to be important, or 2) sound too complicated to tackle when your bandwidth is already limited. The truth is: a unit economics analysis is critical in determining whether or not you have a sustainable business model, and can provide unrivaled insights into your company’s successes and shortcomings — regardless of its size or stage.

Why Unit Economics Matter To Your Startup

Retention rate

Existing customer retention data can provide insight into PMF. If the share of a product’s active users remains consistent (i.e., plateaus) over time, it’s a good signal that users find the product necessary. If the share of active users never plateaus, but instead continues to fall, the product has yet to find PMF.

A “good” retention rate will vary by product and by market. According to Mixpanel, the average eight-week retention rate for most industries is somewhere between 6% and 20%. For media or finance, an eight-week retention rate above 25% is considered “elite,” whereas a SaaS or ecommerce company would have to achieve an eight-week retention rate of 35% to earn the same label.

Organic growth

The last metric on the list — while valuable — is a bit less scientific. If a product is showing a steady increase in active users without any additional inputs (i.e., sales and marketing), this is a good indicator it’s achieving PMF. In these instances, growth is typically happening via word of mouth referrals and internet virality — as was the case with ChatGPT.

How to source PMF data

For profit margin, growth rate, CAC, LTV, and retention rate, the metrics needed to understand PMF can be tracked internally using a third-party product analytics tool like Mixpanel or Heap.

To proactively source PMF data, companies can also send out surveys to their existing customers. There are two types of surveys organizations typically rely on when measuring PMF. The first is known as the “PMF survey,” and utilizes the “Sean Ellis Method” of asking customers their level of disappointment if the product ceased to exist. Respondents who say they’d be “disappointed” or “very disappointed” are customers with whom you’ve achieved PMF. According to this method, if more than 40% of respondents say they’d be disappointed, the product has a good chance of achieving broad PMF).

The second type of survey is the Net Promoter Score (NPS) survey. An NPS survey asks recipients how likely they’d be to recommend the product to a friend or colleague on a scale of 1–10. Respondents who answer with a 9 or 10 are considered “promoters,” and respondents who answer between 1–6 are considered “detractors” (7–8 is passive). The NPS is the product’s percentage of promoters minus its percentage of detractors. A score between 30–70 is considered good and indicates PMF.

In both survey approaches, companies can also ask open-ended questions to get more nuanced feedback to improve PMF. However, it’s important to note that surveys can be biased, so feedback received shouldn’t be a company’s only input in determining PMF.

PMF is always changing

Achieving and maintaining PMF requires continuous iteration. TAM and retention rate should be revisited with every major product development. LTV and CAC should reflect quarterly sales and marketing expenditures. As a company grows larger, the product’s target obtainable market, growth rate, and profit margin should naturally adjust with it.

To ensure the product is iterating in ways that increase PMF, it’s important to set periodic goals that roll up to PMF. Examples include:

  • Bi-annual or quarterly reviews of your TAM and obtainable market
  • Quarterly reviews of growth rate and profit margin to see if they meet the SaaS Rule of 40
  • A quarterly LTV:CAC ratio of at least 3:1
  • A quarterly retention rate goal north of 6%

In short, PMF is reached via continuous research, customer guidance, effort, and smart measurement that utilizes multiple inputs to generate a holistic view of how the market is receiving your product. If the metrics aren’t indicating PMF, keep iterating on the product until they do.

Notes
Written by

Matthew Speiser

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