Validating

Startups must exhibit economies of scale. If you’re doing a startup, you want to go to the moon rather than build a small business. Your first step is to do a simple calculation to determine whether the business is capable of getting there.

Suppose we have a startup that sells units for $1,000 each, and the per-unit cost to produce your product decreases as more units are sold (economy of scale).

Let’s assume an upfront cost of $50,000 for software development to handle the first 100 orders [($1,200–$700) *[1]  100] and then another $247,500 [($975–$700) * 900] in fixed costs for design/manufacturing upgrades to support 1,000 customers. After those two fixed expenditures, the startup is paying only per-unit costs like customer service and the cost of materials.

This simple calculation illustrates many things about the startup world. First, we see immediately how important it is to shift per-unit costs into fixed costs (like software) and why what seems like expensive upfront software development can pay off in the long run.

Second, we can see how much capital is needed before the business breaks even.

Third, we realize how important pricing is. If you are not constrained by competition, you want to charge the highest possible price at the beginning to get profitable as soon as possible. A price change from $1,000 up to $1,200 would completely change the economics of this business and make it unnecessary to take on more outside capital. Free or heavily discounted customers generally don’t value the product as much and are counterintuitively the most troublesome. Paying customers often are more tolerant of bugs. They feel invested in the product.

Fourth, we understand why achieving $199 or $99 price points without massive scale is so difficult. A real product has dozens or hundreds of cost components, each with its own economy-of-scale function. Each of those costs need to be driven down (via robotics, supply chain optimizations, negotiation, etc.) to decrease the overall price of the product. It’s hard to make a profit!

Everyone's boss is the CEO other than the CEO. The CEO's boss is the market.

This is why startups must pursue large markets. Even if you can build a product with economies of scale, you need to ensure the market is large enough to reach those economies.

The annual market size is the total number of people who will buy the product per year multiplied by the price point. To get to a billion dollars in annual revenue ($1B), you need either a high price point or a large number of customers. A few different ways to achieve that magic $1B in different industries is to sell the product at:

●      $1 to 1 billion: Coca Cola (cans of soda)

●      $10 to 100 million: Johnson & Johnson (household products)

●      $100 to 10 million: Blizzard (World of Warcraft games)

●      $1,000 to 1 million: Lenovo (laptops)

●      $10,000 to 100,000: Toyota (cars)

●      $100,000 to 10,000: Oracle (enterprise software)

●      $1,000,000 to 1,000: Countrywide (high-end mortgages)

Now, some of these markets are actually much larger than $1B. There are many more than 100,000 customers for $10,000 cars in the world. The number is more like 100,000,000 annual customers for $10,000 cars. So the annual automobile market for new cars is near $1T, not $1B.

Low price points require incredible levels of automation and industrial efficiency to make profits. You can’t tolerate many returns or lawsuits for $1 cans of Coke. On the other side, high price points allow for investment in sales. Selling a house does not require 100,000 times more sales effort than selling a can of Coke, but it generates 100,000 times more revenue.

Do market sizing calculations early and often. Market size determines how much money you can raise, which determines how many employees you can support. Assume the average startup employee costs $100,000 “all in,” including salary, health insurance, parking spaces, computers, etc.

Suppose you need five employees for three years to come up with the cure for a rare disease. To support five employees per year is $500,000 per year, not including other business expenses. If your market size is only $50M, you have a problem. Finding someone to invest $1.5M to pursue such a small market is going to be very difficult. That $1.5M is more likely to get invested in something with a chance at a $1B+ market.

The best market size estimates are both surprising and convincing. To be surprising is the art of the presentation. To be convincing, you want to estimate your market size in at least two different ways.

First, use Fermi estimates to determine the number of people who will buy your product (top-down market sizing). This requires general stats like 300 million Americans, 8 billion world population, 30 million US businesses, and domain-specific stats like 6 million annual pregnancies.

Second, use SEC filings of comparable companies in the industry to get empirical revenue figures and sum these up (bottom-up market sizing). Bottom-up is generally more reliable. Be sure you are not drawing boundaries too big or optimistic. “If we get only 1% of China…” is a bad start. One of the most convincing things you can do with a bottoms-up estimate is to link or screenshot an invoice with a high price point.

In theory, the ultimate market research is a table with 7 billion rows (one for each human), columns for their attributes (e.g. location, profession), and columns for each possible version of your product, with each entry showing the amount people will pay for those features. Of course, you can’t survey 7 billion people, but you can sample a few hundred. This gives you a framework for how to set up your product tiers and roadmap.

Say the first five people want your product so much that they will pay $1,000 for version 1 with features x and y. (Remember, the vast majority of people will pay $0 no matter how many features you add.) You want to earn enough money on version 1 to pay for version 2. If this is not the case, you should rearrange the order of features until it is true, at least on paper.

If you are seriously considering starting a business, consider paying for a demographically targeted survey with 500 responses. It will save you money, time, and energy in the long run. Even spending $1,000 to seriously evaluate four ideas will be well worth it in time/energy savings.

If you genuinely can’t afford this, ask ten to twenty potential customers how much they’d pay for different versions of your product or run a poll on social media. You will find early feedback on pricing and features (even biased feedback) superior to none at all.

The 6 Ps are a useful checklist.

Product—What are you selling?

Person—To whom?

Purpose—Why are they buying it?

Pricing—At what price?

Priority—Why now?

Prestige—And why from you?

Seems obvious, but many companies (especially in healthcare) can’t easily answer these.