How you'll know when you have Product-Market Fit
Use payback periods to take the guesswork out out of PMF.
The most critical early milestone for a SaaS company is product-market fit (PMF). How do you get it? Many consider it a mystery, and a lot of people claim they just stumbled onto it.
A big reason it’s hard to tell someone how to find PMF is because it is hard to know when you have it. It’s not like you get an email notification one day congratulating you. Typically you’ll be able to point to a point in time many years ago when it started to kick in, but the exact moment is unclear.
This post introduces a methodological way to recognise PMF without needing a rear view mirror.
How people define product-market fit today
In preparing this post, we asked a bunch of people with different SaaS experience how they defined product market fit. We got a wide variety of answers. Here’s a sample:
“There’s a quote from someone whose name I forget that says ‘PMF is when you can’t sleep at night because you’re growing so fast to meet demand’.”
“We had PMF when people were willing to pay us.”
“I know I don’t have it right now. I know how it feels but not how to quantify it.”
“You have it if you do lots of things wrong but still win deals, if you have some customers in the same industry, if you have low churn, and if you’re winning customers consistently. VCs will rush you to find it. That’s like telling someone to find love really fast.”
“When you hear an audible sigh of relief during demos.”
A common thread is that people want a way of pinpointing product-market fit, but they don’t know of a clear metric or way of measuring it. In the absence of that, it’s common to hear “I know it when I see it” type definitions.
“I’ll know it when I see it”
“I’ll know it when I see it” actually works really well in the very early days. When the entire company is just a few people1 it's not too hard for everyone to agree if you have PMF or not. And if you don't, it's not too hard for everyone to agree on what to try next.
Where this approach gets difficult is when entering new markets or expanding existing ones (or when you grow the team). If in your company’s lifetime you only ever have one product, and are only ever in one market, then this is not a problem you’ll face. But most companies that have any success will eventually want to enter new markets or launch new products to existing ones.2
Since the company will probably be larger when this happens, it will be much harder to agree on if you have PMF. PMF in itself doesn’t mean anything; where this becomes a big problem is if take action based on incorrect belief that they have found PMF. A common quote we hear is “We have product-market fit, so it’s time to start scaling up the sales & marketing teams to really push this product in a new country!” We made this mistake when we first got to the US, and it was very costly (in dollars, and in time) to unwind it.
A measurable definition of product-market fit
The best way to agree on a subjective outcome is to have an objective metric act as a proxy for that outcome. If you have a metric that is highly correlated with the outcome, but is easily measurable, then you can just focus on the metric and assume that the outcome will follow.
Say you want a team to work towards product-market fit for a new product or market. As we’ve noted, it’s unlikely that everyone will subjectively agree they have PMF at the same time. It’s likely people will cut corners and declare PMF when they aren’t actually there yet. Luckily, there is an objective metric you can point the team towards. It’s called payback period.
The payback period tells you how long it will take to make back the money you spent to acquire new customers in a month. It’s easy to calculate. Over any period of time (typically a month):
For example, let’s say you spent $20,000 on go to market over the course of a month, you added $1200 MRR in new customers, and you lost $200 MRR in customers churning. Your payback period is 20:
You can use payback period to compare the efficiency of projects (lower is better). And thus you can use it to define product market fit. Just take the payback period of somewhere you have product-market fit, and make that the goal. Anywhere else that you achieve the same payback period, assume you have product-market fit.
The lower your payback period goes, the stronger your product-market fit.
For example, inside Workforce.com we think an okay payback period is anything below 24. So if a new product or market achieves a payback period of under 24 consistently, that’s a good sign that the product is working inside that market. Once the payback period gets below 12, we know we’ve really got that PMF locked in. We can then stress test that by increasing the investment in the market (increasing the numerator). If growth also increases, and the payback period stays the same, then that’s a good sign we have PMF and can keep investing more!
A common confusion about payback periods is that it’s not fair to compare mature and immature products or markets. One might argue that if you take the payback period of a market that’s performing very well, and compare it to a project that just started, then of course the new project will have a worse payback period. People will complain “We’re still figuring it out, don’t compare us to those who already have!”
The counterargument is that the numerator in the payback period equation is costs. When a project is new, and not yet generating quality revenue, don’t spend so much! If you keep spending so low that the payback period is good, you buy yourself a lot more time to find product-market fit and waste less money in the process. Then you can gradually increase expenses and see if the equation gives a different answer.
Implementing payback periods
There’s two parts to implementing payback periods:
Doing the calculations
Convincing everyone to embrace them
Part 1 is easy. You should already be tracking tracking the relevant expenses. Make a spreadsheet with them, and calculate the payback period next to them. Do this for each month, for each product/market.
Pay attention to significant changes, and to directional trends (positive or negative), and try to understand the why behind them. Make this easier for yourself by highlighting any payback period above 12 in orange, and anything above 24 in bright red.
Part 2 is hard.3 Or it was. Now you can just send people this post 😂
Frequently asked questions about payback periods
What’s a good payback period?
It depends on the business model, cost structure, etc. For SaaS, 24 months is okay, 12 months is good, 6 months is excellent.
What costs go into the payback period calculation?
All go-to-market costs. The idea is that all costs that aren’t generating new intellectual property should go into it, since the only purpose of those costs is to acquire or retain customers.
Why don’t costs of product development go into the payback period calculation?
Because they (broadly) generate intellectual property, which is valuable in the future. If you build a feature in February and it doesn’t win any new customers in February, you won’t delete the feature… it might become super valuable in April.
By that logic, shouldn’t marketing also be excluded? Since it’s generating content, etc.
No. Your customers pay you for your product, not your whitepapers.
Why does churn go into the payback period calculation?
Otherwise there would be a strong incentive to sell the product to customers who don’t want or need it. You want to incentivize selling a product that fits the market.
Don’t payback periods encourage short term thinking?
No. You can still do things that might not pay off for a while. But they do encourage you to do them much cheaper, in proportion to how much success you’ve had.
How should I compare payback periods between different countries?
Either do all your calculations in the same currency, or use a consistent currency. eg. if you record costs in EUR, you also should record growth and churn in EUR when calculating your payback period. If you do that, then it’s fine to compare that payback period to one that was calculated with all numbers in AUD.
But it’s probably a good idea (for lots of reasons, not just this) to do all your management reporting in a single currency.
Got a question? Leave a comment below and we’ll answer it here.
Let us know what you think
We’ve found payback periods to be a very helpful management tool. When used correctly they give you an objective way of saying if a product is succeeding in the market and providing real value to customers. This removes a lot of angst about which initiatives are working and which aren’t.
Try it out and let us know what you think!
When we say markets here it could mean new industries (“verticals”), new countries, or really any other set of prospective customers that isn’t identical to the current set.
The reason part 2 is hard is because it’s not fun to think about recurring costs as a lever you can adjust. It’s easy to think about growth (if we do more deals we’ll have better PMF!) and it’s easy to think about churn (if less customers cancel we’ll have better PMF!). But it’s very hard to look in the mirror and say “we’ve hired too many people for the outcomes we’re getting” (or we’ve spent too much on Adwords, or whatever your biggest expense is), and act accordingly.
Prevention is easier than medicine - if used right, payback periods encourage you to think about these issues ahead of time.
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Having a metric is nice.
How would you handle a company younger than a year that does year contracts? Just exclude the churn number? Or do some surveys to project churn?