Traversing the Traction Gap

by Bruce Cleveland

  If the company has a land-and-expand business model, is there consistent proof that the “expand” part is taking place? How large have the initial purchases (land) been and the next follow-on purchase (expand)? How quickly does the customer come back for more, and how often? Because the data set is still lean leading up to MVR, it’s very common for investors to call customers and ask them specifically about their expansion plans regarding the product, and not just their satisfaction with the current state of the product. They will also delve into whether expansion is contingent on new features or other changes or improvements to the product.

  Note, at MVR, CAC is typically still much higher than long-term projections, so it’s not a key decision criterion, as long as it’s not crazy high or way out of balance with revenue or user acquisition: if you are buying customers at any cost, that will be apparent, and usually a big negative. On the other hand, a declining CAC trend is certainly encouraging to investors. For B2C companies, the scrutiny may be higher even at this early stage.

  Stable churn—In most business models, keeping current customers is just as important as adding new customers. Prior to MVR, since there is typically a limited number of customers, there won’t be a lot of churn (loss of customers) data. As a result, any churn is concerning, especially for B2B companies. Expect potential investors to dig into the causes behind churn, which customers are churning, and how much the churned-out customers were contributing to revenue.

  Market size validation—Market size determines the ultimate value of the business being created. Investors will look for signals in the previous metrics to help them understand how large the market can be, and/or to validate your assessment of the market size. These clues can include types and distribution of customers (industry, size, etc.); initial, current, and estimated future account value (percentage of account penetration); or the Lifetime Value (LTV) of a business or consumer.

  One last and often-discussed point: at MVR, you have likely only penetrated one market, geography, or user segment. At this point, you’ve been focused on proving that you can successfully acquire target customers or users. If you can do it once, it’s reasonably likely you can do it again (but certainly not guaranteed). Initial forays into a new market area aren’t the worst idea, as long as these ventures are not at the expense of success in your primary focus area. Focus, based on a strong fact-based view on which markets to develop when, is also often an investment criterion!

  Many VCs won’t invest at MVR, and in fact won’t invest until you reach the MVT stage or later, partly because of a lack of early-stage expertise, and partly because a number often have to put larger sums of capital to work, which is easier to justify as the risks decrease and the valuations increase. Fortunately, a group of true early-stage investors are still looking for opportunities, and if you nail the points above and prove you have reached MVR, you should be in a good position to raise the necessary capital to reach MVT.

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  SYSTEMS ARCHITECTURE

  Systems Architecture has not played a pivotal role in your journey across the Traction Gap—until now. From MVR to MVT, however, Systems Architecture takes a more prominent role. And Systems Architecture involves more than just technology, although technology is a key factor. It includes the business processes you establish and will affect every functional area of your startup.

  Through MVR, your startup has remained “lean” in terms of the number of people it employs. Now, however, you must bring new people into the company to support newly required functions, including sales operations and customer support.

  Your new folks, by definition, weren’t there in the beginning with you. They don’t know why certain decisions were made before they became team members. They don’t know how those decisions were made. They bring their prior work experience into your startup in the form of opinions and bias of “what works best.” These opinions can create friction and discord.

  Your challenge is to quickly harness your new workforce to accomplish your startup’s mission to reach MVT in 12 to 18 months. You don’t have time for miscommunication, poor collaboration, suboptimal data capturing and mining processes, or adjudicating squabbles related to differing opinions about what is “best” for the startup.

  Therefore, you must set up systems and processes that enable you to hire the right people, communicate and coordinate effectively with them, and implement solutions that enable you to capture and retain users as fast as possible at the lowest possible cost.

  From Ideation to MVR, you were primarily focused on creating a market-first product with enough users to validate a market.

  Now you must turn your attention to building a scaling machine. Your scaling machine must be optimized to produce your product, customers/users, and revenue. This machine consists of humans, technology, and process—and the systems to power and empower them.

  At this point, you don’t need more strategists, you need what I call “executionists.” And you need to put processes in place across the company so that your executionists can collaborate and operate as fast and effectively as possible without “the wheels coming off.”

  For many early-stage CEOs, building a scaling machine is not their forte. Many—most—are typically great product and market visionaries. Operations? Not as much. If operations isn’t their specialty, now is the time to invest in a few people who are great operators and can help to build the scaling machine.

  These are people who have experience setting up and running business application software and the processes to drive them. They need to understand how marketing and sales and back-office operations work together and how to connect and integrate your website, marketing automation, CRM, and back-office systems, such as order management, billing, customer success, and support. They have demonstrated excellence in setting up and helping other startups at your stage. This is no time for on-the-job training. You need people who know what to do and how to do it.

  Before reaching MVR, these people were unnecessary overhead. Now they are essential. Without them, you will fail to reach MVT.

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  REVENUE ARCHITECTURE

  “Don’t be desperate for revenue. Focus on adding value to the customer and the revenue will follow.”

  AMY PRESSMAN, Cofounder, Medallia

  Through this point in the book, I have been focused on showing you what it will take for your startup to make it from Ideation to MVT. Now it is time to discuss how this process fits into an overall strategy to become a category king.

  The metrics vary depending on the type of business model, but since this book is focused on early-stage B2B software startups, I’m going to show you the growth rates you must attain if you hope to become a market leader.

  Several years ago, Neeraj Agrawal, a GP with Battery Ventures and many successful SaaS investments to his credit, released an analysis of eight of the top SaaS companies and the ARR growth they achieved over their first five years. He began with a uniform starting point, which was when each company was generating about $2M ARR, not Day 0 or company formation.

  Neeraj stresses how important it is to get to $2M ARR and that the management team should be the primary “revenue engine” to get there. This is consistent with the information I gave you in Chapter 6 regarding the initial marketing and sales processes.

  T2D3 Path to $100M

  FIGURE 281

  Neeraj created the above chart, which shows how seven public SaaS companies—Marketo [which was taken private and acquired by Adobe since this chart was created], NetSuite, Omniture, Salesforce, ServiceNow, Workday, and Zendesk—each managed to triple revenue twice and double three times after reaching $2M ARR.

  The challenge is to triple from $2M ARR to $6M ARR within 1 year, then triple again to $18M ARR, and then double to $36M ARR, $72M ARR, and $144M ARR.

  I didn’t know Neeraj was putting this data together as I was independently working on Traction Gap Framework metrics. We came to similar conclusions be
cause we were working from a similar set of data. He has a much tidier name—T2D3—where I had been calling this particular revenue growth model the “Fibonacci Series of SaaS,” a reflection of my science training in college.

  Although Neeraj and I arrived at our conclusions independently, my findings and advice to early-stage teams are consistent with his. The T2D3 model correlates with the Traction Gap Framework value inflection points; this is why reaching these points in the time I’ve outlined in the Traction Gap Framework is so important. All investors know about the T2D3 model, so you will be measured against it.

  The “Fibonacci Series of SaaS” operates against a slightly offset time period from the T2D3, but follows a similar growth pattern of $1M ending ARR 1 year after MVP, then $3M, $10M, $25M, and $50M. I don’t take the Traction Gap Framework out as far as the T2D3 model primarily because the issues the Traction Gap Framework addresses are constrained to early-stage startups. After $10M, quite frankly, the problems you will face are very different and beyond the scope of the Traction Gap Framework.

  In 2017, OpenView Partners performed a survey of 300 enterprise software companies. These companies ranged from pre-revenue to more than $20M ARR across all software categories.

  From their survey and from the data of all venture-backed SaaS companies, they determined that the likelihood of your SaaS startup achieving $100M ARR in 5 years is about 0.1 percent.

  From their report, “In the boardroom, you’ve probably been told that after you hit your first $1M in ARR, you should triple twice, then double three times (known popularly as T2D3), ultimately reaching $100M ARR about 5 years later. But, of the ten most recent enterprise SaaS IPOs, only two—Nutanix and Cloudera (they collectively burned about $1.4 billion)—managed to actually grow at this breakneck speed. A handful of others were close behind, but half of them took eight or more years.” [Note from Bruce—Battery actually states that the T2D3 model begins around $2M ARR.]

  So, what are the actual median growth rates of all venture-backed SaaS companies? OpenView Partners produced this great chart:

  Growth Rate by ARR

  FIGURE 292

  How do the findings of the OpenView Partners survey reconcile with the T2D3 model, the Traction Gap Framework, and their associated growth rates? Simple. The achievements of the companies in the T2D3 model represent some of the “very best-in-class” SaaS companies. I believe these are the growth rates you should aim for if you want to maximize the likelihood and the amount of financing you need with the minimum amount of equity dilution. It doesn’t mean you can’t secure financing from the venture community if you don’t hit T2D3 metrics, but you may not be able to raise as much as you’d like or you may have to give up more equity ownership for any given investment.

  Finally, a personal observation: The data in the OpenView Partners survey comes from the entire market of venture-backed SaaS companies. And, as I stated in the beginning of this book, the facts show that more than 80 percent of all startups fail, which means that many of the companies that make up the OpenView Partners survey dataset, statistically, will fail as well. So you may grow slower than T2D3, but you may not survive if you do.

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  DEALING WITH CHURN

  You’ve been in market with your product for a year or longer. At this point, many companies with subscription business models begin to experience churn, the loss of customers.

  I began thinking about churn a few years ago and developed a metric that is as important as the ones I advised you to watch at IPR, MVP, and MVR, because one of the biggest drains on your business model at this stage, especially if you are a SaaS business, is losing customers.

  On a quiet Sunday, I was reading through some board decks as I prepared for upcoming board meetings.

  This material usually has a section on churn and highlights the impact it has—both positively and negatively—on my portfolio companies.

  Some of the board decks I was reviewing, fortunately, identified the fact that the startups were experiencing negative churn as their customers increased the footprint of the portfolio company’s technology.

  I got to thinking about this issue.

  You have a significant number of metrics you can use to measure top-of-the-funnel health for companies that use a SaaS business model: Customer Acquisition Cost Ratio (CAC Ratio), Customer Lifetime Value (CLTV), etc.; Bessemer Ventures did a great job introducing these concepts and terms to the market more than a decade ago.

  These are tried, tested, and proven metrics that management teams and investors use to evaluate how well a company with a recurring revenue model is performing.

  However, churn is also a critical component of the SaaS model. I asked myself, “Why don’t we have a common metric to measure the health of the bottom of the funnel?”

  Key questions are:

  Shouldn’t we know how much we are spending to retain a customer?

  At what point should we “fire” a customer, if ever?

  Should that point vary by industry or type of customer?

  When should we parachute in our “customer success” teams to prevent loss of a customer?

  It seemed to me that if we have a Customer Acquisition Cost metric, shouldn’t we have a Customer Retention Cost (CRC) metric—the cost to “save” a customer—and what elements we would use to measure the CRC and CRC ratio?

  So I put together a bunch of thoughts on what should go into the calculation of such a metric and sent that over to Totango, one of my portfolio companies.

  Totango provides a customer success platform. Software companies and others use Totango’s platform to help determine whether or not a customer is deriving value from a software product. This information enables customer success teams to “parachute in” and help a customer derive value from their software product, thereby mitigating a key issue associated with churn.

  Given that Totango is “in the business of reducing churn,” it seemed to me only natural that they would take these initial concepts and launch the CRC and CRC ratio metrics into the industry as a whole.

  They did this with a fantastic white paper on CRC, titled The Missing SaaS Metric—Customer Retention Cost.3 Here is an excerpt that shows you how to calculate this metric:

  Customer Retention Cost (CRC) Per Customer

  To calculate the average annual cost to retain a customer, divide annualized customer retention cost (e.g., CRC for the last quarter x 4) by the total number of active customers.

  Annual CRC per Customer = Annualized CRC /

  # Active Customers

  CRC Ratio

  The CRC ratio should attempt to answer the question: how much are we investing to make sure we can retain and renew every dollar of revenue from our existing customers? The point is that in a SaaS business, you are always trying to protect all of your revenue, not just the revenue that is up for renewal in the next month or quarter. In its simplest form, the CRC ratio can be calculated as follows:

  CRC Ratio = Annual CRC / Annual Revenue or ARR

  I would encourage anyone dealing with churn/retention to do a simple web search and read the entire white paper.

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  SOCIAL PROOFING THROUGH

  ADVOCACY MARKETING

  Once upon a time, we learned that to successfully scale a business we needed reference customers and consumers. Geoffrey Moore taught us that the majority of any given market didn’t want to be the first to try a new product; they wanted to be sure that others had tried it first and had success with it.

  Today, that is still very much the case, perhaps even more so. Why? We are so heavily bombarded with advertising from every corner that it’s hard to wade through the cacophony. More than ever, perhaps, we rely on what our friends and peers have to say regarding business or consumer products; most of us simply don’t have the time to sort out every option and claim. In the last century, we called it “word of mouth” and considered it an important, if imprecise, selling tool.
Today we’ve got social media to help us through the noise. The terms you need to keep in mind are referral marketing, or social proofing. It can be managed more skillfully than “word of mouth” and can make or break your product and your company.

  “I’ll just buy from a brand I already know and trust.” This attitude may not be stated verbally, but it is very much the behavior businesses and consumers exhibit when faced with too many choices and too little time/too many facts to sort through. This attitude can kill your startup; you’re not a trusted brand, you’re just another screaming voice adding to the noise. You’re part of the problem, not the cure.

  Who can help you break through the noise so you can tell your story or, more importantly, get the market to listen? That would be trusted advisers, respected industry experts, other professionals in companies admired by your prospects, or, in the case of consumer products, friends and known celebrities.

  This is what social proofing is all about: acquiring and using references in digital form—using advocacy marketing technology—so your message and your brand are easily accessible anywhere, anytime, and your customers can access these references as needed and at their convenience.

  Greg Ciotti, in a Neil Patel Digital blog post, wrote that there are seven concepts you must understand about social proofing in order for it to be successful.4 In summary:

  Don’t use negative social proofing: that is, don’t suggest that “bad things will happen” if someone doesn’t use your product. This tactic has been shown to turn people off and is not effective.

  Do use positive social proofing. Refer to the benefits other notable companies or people are getting from your products, rather than your product’s potential cost savings to the customer. Use this benefits language on your home and landing pages.

  Use pictures with all your social proofing. Photos of smiling people are the most successful kind. Humans relate to happy humans.

  As we learned from Geoffrey Moore’s Crossing the Chasm years ago, people are influenced by other people like themselves. It is critically important to understand the personas of your buyers: you need to use people with a particular persona to market to others with similar personas.