VCs Want to See Product-Market Fit: Here's How to Prove…

For the world of venture capital, fall arrived long ago — a fall in funding. In the first quarter of 2016, U.S. venture investment dropped 30 percent from its $17.3 billion peak in the second quarter of 2015. Venture capitalists are now focused on protecting their investments; and with $5 billion less up for grabs, competition for the remaining funds is fierce.

Related: Elite Venture Capital Firm Andreessen Horowitz Looks for These 3 Things in Startups

With lower funding, entrepreneurs who want a slice of the (shrunken pie) must prove to VCs that they’re worth the dough. Here are some suggestions how.

Product-market fit wins investments.

In today’s cash-strapped funding climate, investors are looking for one thing above all else: product-market fit. According to Marc Andreessen, founder of Silicon Valley venture firm Andreessen Horowitz, that means being in a strong market with a product that can satisfy.

To be clear, you don’t have to provide the best solution for that particular market — every product has room for improvement. But, product-market fit requires your product to solve user needs as well as, or better than, the products of your competitors do.

Sometimes it’s clear when your product has found its market match: Demand outpaces production, the web raves about your “hot new thing” and sales can’t hire staff quickly enough. Other times, though, it’s not so obvious. To remove the guesswork, web analytics firm Kissmetrics recently debuted Survey.io. The survey’s key question for measurng product-market fit is, “How would you feel if you could no longer use [X product]?”

If at least 40 percent of respondents representative of your market answer “very disappointed,” then you can bet your product has found a fit. So, be sure to survey at least 250 accurate users, especially if you’re seeking $1 million or more in seed money.

If users tell you they will miss your product, then you’re ready to meet VCs, right? Well, not quite. Your next task is to prove product-market fit to VCs with the four following metrics.

Related: 3 Ways to Monitor Customer Churn

1. Ever-growing monthly recurring revenue

A growing MRR (monthly recurring revenue) means your startup’s product is gaining traction, so be sure to share it with interested VCs. Use a 90-day snapshot to show an upward trend. For startups seeking $1 million or more, my firm looks for at least $20,000 in MRR with 20 percent month-over-month MRR growth. To really impress VCs, shoot for a 7 percent week-over-week gain.

2. High gross margin

Put simply, gross margin is the difference between your revenue and what’s required to keep the power running. A high gross margin indicates a healthy company with a profitable product, so most VCs look for a gross margin of at least 60 percent before investing.

How does gross margin impact company valuation? Let’s say your startup is growing by 20 percent month-over-month growth. If you brought in $20,000 the first month, then you’d finish the year with $791,600, and the next year with approximately $7 million. With a 60 percent gross margin, the company would likely sell for about four times the next year’s revenue. But if the company’s gross margin is lower, then it might sell for only twice next year’s projected revenue.

3. Low churn

A startup’s margins might be great, but if four of every five new accounts leave in the first 90 days, then the startup is headed for the graveyard. Before investing, my company looks for a churn rate below 6 percent. A churn value higher than that can indicate a product problem or a weak market.

4. Strong lifetime value 

The lifetime value of a customer describes how much one customer is worth. If, for example, a customer pays $100 per month on a 12-month contract, then the average customer is worth $1,200. Be sure to take churn into account, though. If your churn rate is 10 percent, then subtract that from the customer’s lifetime value, which drops it to $1,080. A high lifetime value indicates a strong market that’s satisfied with your product.

Related: 4 Steps to Building Lifetime Value From Expensive First-Time Customers

What happens if, after reviewing your metrics, you spot product-market misalignment? Before visiting VCs, you need to fix the problem.

Put your target user under the microscope. For instance, if you’re selling a SaaS diagnostic tool, then “doctors” is not a hyper-defined target audience. Instead, you might choose to target primary care physicians aged 30 to 40 who own their own practices.

Then use A/B testing to perfect the user experience. Over the course of 90 days you might test different packages or pricing options to maximize conversion rates and gross margins while minimizing churn. To master this, I recommend the Nielsen Norman Group user experience certification.

With VCs bracing for winter, you’ll need to work harder than ever to win their investment. But even for experienced entrepreneurs, product-market fit can be elusive. If you can prove to venture capitalists that you’ve found product-market fit, you’ll have earned your ticket to a more prosperous spring.