🤝 This week’s edition is sponsored by Alto

Alto helps angels and founders invest in startups and other alternatives through self-directed IRAs. Read our article where we break down how angel investing via SDIRAs works, including key rules, risks, and tax advantages to know before investing.

📰 Today's topic: Does that startup actually have Product-Market Fit? (Probably not.)

Let’s play out a common scenario for VCs:

You see a startup hitting $1M in annual revenue. They're raising a round. The deck looks sharp.

So you think: they've clearly figured something out.

And that might be true…for the time being. But there is a lot of game left to be played.

What is PMF?

Before we go further, let's get specific about what the term “product-market fit” means.

It's one of those terms everyone throws around but few people define clearly. 3 things must all be true for PMF:

1. You've built a product people are willing to pay for.

2. You can acquire those people for less than what they're worth to you.

3. You can do it repeatedly.

That's it. That's product-market fit.

The problem is most founders who claim they have PMF have some combination of those three, but not all of them.

PMF isn't a finish line. It's a treadmill.

Product-market fit happens in stages. 

Because, the channels that got a startup to their Series A run rate may completely stall out before their Series B. The company has to find product-market fit again at each stage.

Take the company Heroku as a great example. They started as a platform for Ruby developers - customer acquisition was easy, and they grew so fast that they actually saturated the Ruby developer market. 

To avoid stagnation, Heroku did a complete expansion to support other programming languages - essentially re-finding PMF at a higher level.

Sounds easy. But that transition is far from guaranteed, and it's where a lot of companies die.

An uncomfortable truth

Raising money doesn't prove product-market fit. At all.

There are companies that have gone public without true PMF. (I.e. Uber, who was unprofitable on a per-ride basis.) 

To call a spade a spade: their entire financing was built on selling the dream. Self-driving cars would cut costs, and Uber Eats would drastically increase customer lifetime value.

But that's not product-market fit. That's a fundraising story.

True PMF means you can acquire customers profitably and repeatably, such that the unit economics actually work. That's it.

The upsell escape hatch

When a startup can't make customer acquisition profitable on its own, there's a common pivot: upsell.

Some of the top softwares (you probably use) do this constantly:

• GoDaddy sells you hosting, then domains, then email, then security

• Expedia sells flights, then car rentals, then hotel bookings

• SaaS companies like Slack start free, then charge for history, then expand with seats as your team grows

It's often easier to increase what each customer is worth than to reduce what it costs to get them.

This matters even more when you consider that customer acquisition costs almost always go up over time. The low-hanging fruit converts first, channels saturate, competitors crowd in - so if CAC is climbing, the company needs to be making more per customer just to stay in the same place.

So when a founder tells you they're "not profitable yet but have a clear path," ask specifically: what's the upsell? 

One more thing worth noting

Next time a founder tells you they've found product-market fit, ask yourself: which part?

The product people want, the acquisition costs that work, or the repeatability? Because "we're growing" and "we have PMF" are very different statements. 

Once you start asking that question, you'll never look at a pitch deck the same way.

– Brian from Angel Squad

📕 Startup term you should know

Ever heard of Internal Rate of Return (IRR)?

Think of IRR as your investment's "annual report card" - it tells you what percent return your portfolio company or fund is earning each year over the life of the investment. Higher IRR = investment is killing it. VCs love this metric because it lets them compare their fund against others from different years (aka "vintage years") like a fine wine competition, but make it finance.

My insider scoop: The Angel Capital Association reports that angel groups achieve median IRRs of 15-25%, with top performers reaching 30%+ IRR. However, angel investor Chris Sacca warns that "IRR can be misleading in early-stage investing because it's heavily skewed by timing—a company that exits in year 2 will show much higher IRR than one that exits in year 8, even with similar multiple returns." Many angels focus more on cash-on-cash multiples than IRR for this reason.

Overheard in SF…probably

“We're not employees, we're a family. A family that works 80-hour weeks and pays in equity and kombucha on tap.”