Advice for Growth

• I recently had two startups seek my advice on the same day. The first is developing a marketplace to help traders of collectibles connect with one another. The second startup sells database software to enterprise customers.
• These two companies have absolutely nothing in common, yet both came to me with the exact same problem. Each one had early customers and promising early revenue.
• Each engine of growth is like a combustion engine, turning over and over. The faster the loop turns, the faster the company will grow. Each engine has an intrinsic set of metrics that determine how fast a company can grow when using it.

Where Does Growth Come From? The engine of growth is the mechanism that startups use to achieve sustainable growth. I use the word sustainable to exclude all one-time activities that generate a surge of customers but have no long-term impact, such as a single advertisement or a publicity stunt that might be used to jump-start growth but could not sustain that growth for the long term.

1. Word of Mouth ◦ Embedded in most products is a natural level of growth that is caused by satisfied customers’ enthusiasm for the product.
2. As a Side Effect of Product Usage ◦ Fashion or status, such as luxury goods products, drive awareness of themselves whenever they are used. When you see someone dressed in the latest clothes or driving a certain car, you may be influenced to buy that product.
3. Through Funded Advertising ◦ Most businesses employ advertising to entice new customers to use their products. For this to be a source of sustainable growth, the advertising must be paid for out of revenue, not one-time sources such as investment capital. As long as the cost of acquiring a new customer (the so-called marginal cost) is less than the revenue that customer generates (the marginal revenue), the excess (the marginal profit) can be used to acquire more customers.
4. Through Repeat Purchase of Use ◦ Some products are designed to be purchased repeatedly either through a subscription plan (a cable company) or through voluntary repurchases (groceries or lightbulbs).

The Three Engines of Growth

• We saw in Part Two how important it is for startups to use the right kind of metrics, actionable metrics, to evaluate their progress. However, this leaves a large amount of variety in terms of which numbers one should measure and engines of growth are designed to give startups a relatively small set of metrics on which to focus their energies.
• Startups have to focus on the big experiments that lead to validated learning. The engines of growth framework helps them stay focused on the metrics that matter.

1. The Sticky Engine of Growth
   • Thus, both businesses rely on having a high customer retention rate. They have an expectation that once you start using their product, you will continue to do so.Therefore, companies using the sticky engine of growth track their attrition rate or churn rate very carefully.
   • The rules that govern the sticky engine of growth are pretty simple: if the rate of new customer acquisition exceeds the churn rate, the product will grow.
   • The speed of growth is determined by what I call the rate of compounding, which is simply the natural growth rate minus the churn rate.
   • This goes against the standard intuition in that if a company lacks growth, it should invest more insales and marketing. This counterintuitive result is hard to infer from standard vanity metrics.
2. The Viral Engine of Growth
   • Online social networks and Tupperware are examples of products for which customers do the lion’s share of the marketing. Awareness of the product spreads rapidly from person to person similarly to the way a virus becomes an epidemic.
   • This is distinct from the simple word-of-mouth growth discussed above. Instead, products that exhibit viral growth depend on person-to-person transmission as a necessary consequence of normal product use. Customers are not intentionally acting as evangelists; they are not necessarily trying to spread the word about the product. Growth happens automatically as a side effect of customers using the product. Viruses are not optional.
   • Like the other engines of growth, the viral engine is powered by a feedback loop that can be quantified. It is called the viral loop, and its speed is determined by a single mathematical term called the viral coefficient. The higher this coefficient is, the faster the product will spread. The viral coefficient measures how many new customers will use aproduct as a consequence of each new customer who signs up. Put another way, how many friends will each customer bring with him or her?
   • For a product with a viral coefficient of 0.1, one in every ten customers will recruit one of his or her friends. This is not a sustainable loop. By contrast, a viral loop with a coefficient that is greater than 1.0 will grow exponentially, because each person who signs up will bring, on average, more than one other person with him or her.
   • Companies that rely on the viral engine of growth must focus on increasing the viral coefficient more than anything else, because even tiny changes in this number will cause dramatic changes in their future prospects.
   • A consequence of this is that many viral products do not charge customers directly but rely on indirect sources of revenue such as advertising. This is the case because viral products cannot afford to have any friction impede the process of signing customers up and recruiting their friends.
   • In the viral engine of growth, monetary exchange does not drive new growth; it is useful only as an indicator that customers value the product enough to pay for it.
   • However, it is not true that customers do not give these companies something of value: by investing their time and attention in the product, they make the product valuable to advertisers. Companies that sell advertising actually serve two different groups of customers consumers and advertisers and exchange a different currency of value with each.
3. The Paid Engine of Growth
   • Imagine another pair of businesses. The first makes $1 on each customer it signs up; the second makes $100,000 from each customer it signs up. To predict which company will grow faster, you need to know only one additional thing: how much it costs to sign up a new customer.
   • If either company wants to increase its rate of growth, it can do so in one of two ways: increase the revenue from each customer or drive down the cost of acquiring a new customer.
   • Like the other engines, the paid engine of growth is powered by a feedback loop. Each customer pays a certain amount of money for the product over his or her “lifetime” as a customer. Once variable costs are deducted, this usually is called the customer lifetime value (LTV). This revenue can be invested in growth by buying advertising.
   • Suppose an advertisement costs $100 and causes fifty new customers to sign up for the service. This ad has a cost per acquisition (CPA) of $2.00. In this example, if the product has an LTV that is greater than $2, the product will grow. The margin between the LTV and the CPA determines how fast the paid engine of growth will turn (this is called the marginal profit).
   • Although I have explained the paid engine of growth in terms of advertising, it is far broader than that. Startups that employ an outbound sales force are also using this engine, as are retail companies that rely on foot traffic. All these costs should be factored into the cost per acquisition.
   • Over time, any source of customer acquisition will tend to have its CPA bid up by this competition. If everyone in an industry makes the same amount of money on each sale, they all will wind up paying most of their marginal profit to the source of acquisition. Thus, the ability to grow in the long term by using the paid engine requires a differentiated ability to monetize a certain set of customers.

A Technical Caveat

• Technically, more than one engine of growth can operate in a business at a time. For example, there are products that have extremely fast viral growth as well as extremely low customer churn rates.
• Companies that attempt to build a dashboard that includes all three engines tend to cause a lot of confusion because the operations expertise required to model all these effects simultaneously is quite complicated. Therefore, I strongly recommend that startups focus on one engine at a time.
• Most entrepreneurs already have a strong leap-of-faith hypothesis about which engine is most likely to work. If they do not, time spent out of the building with customers will quickly suggest one that seems profitable.

Determine Product/Market Fit

• Marc Andreessen, the legendary entrepreneur and investor, coined the term product/market fit to describe the moment when a startup finally finds a widespread set of customers that resonate with its product. When you see a startup that has found a fit with a large market, it’s exhilarating. It leaves no room for doubt.
• Startups occasionally ask me to help them evaluate whether they have achieved product/market fit. It’s easy to answer: if you are asking, you’re not there yet. Unfortunately, this doesn’t help companies figure out how to get closer to product/market fit.
• Since each engine of growth can be defined quantitatively, each has a unique set of metrics that can be used to evaluate whether a startup is on the verge of achieving product/market fit.