Chapter 10: Sustainable Growth

10.0 Where does growth arise?

The engine of growth is the mechanism that startups adopt to achieve sustainable growth. According to Eric Ries, sustainable growth is based on a straightforward principle – “New customers come from the actions of past customers.” Accordingly, there are four main ways past customers drive sustainable growth:

1. Word of mouth

2. As a side effect of product usage – luxury goods drive awareness whenever they are used. For example, if you see someone driving in the latest BMW or wearing the latest Prada jacket, you might be influenced to buy those products. This also applies to viral products like Facebook and PayPal. For example, if someone used PayPal to transfer money to a friend, the friend is automatically exposed to using PayPal.

3. Funded advertising – most businesses use advertising to attract new customers to use their products. To drive sustainable growth, the advertising should be paid for profit and not as a one-time source like investment capital. As long as the cost of gaining customers is less than the revenue generated by customers, the excess profit can be used to gain more customers.

4. Repeat purchase or use – certain products are made to be purchased repeatedly through a subscription basis (cable company) or by voluntary repurchases (groceries).

These four sources of driving sustainable growth power the engines of growth. Each engine has an intrinsic set of metrics that decide how fast a company can grow when using it.

10.1 The three engines of growth

The engines of growth are built to give startups a small set of metrics on which to focus their energies. Startups must focus on the big experiments that lead to validated learning, and the engines of growth help them focus on the important metrics.

1. The sticky engine of growth

There are two examples Eric Ries used for the sticky engine of growth. One was a startup developing a market to help traders of collectibles connect with the other. These individuals were fans of movies, anime and comics who collected complete collections of toys and other merchandise based on their favourite characters. The startup wanted to compete with eBay and other physical markets related to conventions and fan gatherings.

The second startup sold database software to enterprise customers. They had the next-generation database technology that could supplement or replace offerings from large companies like Oracle, IBM and SAP. Their customers were CIOs, IT managers and engineers from some of the world’s largest organizations. Both startups had early customers and early revenue. They had validated and invalidated many hypothesis in the business models and were executing against their product and road maps. Their customers had shared positive feedback and suggestions for improvements, and both startups had used their early success to raise money from outside investors.

It turns out that both companies were using the same engine of growth, although they were from different industries. The two products were designed to allure and maintain customers for the long run. The basic mechanisms for the maintenance of the customers were different in both cases. Nevertheless, both companies depended on having a high customer retention rate. They expected that once customers used their product, they would continue doing it. Therefore, companies adopting the sticky engine of growth track their attrition rate or churn rate carefully. The churn rate is the fraction of customers at any time who fails to remain engaged in a company’s product.

Simple rules govern the sticky engine of growth. The product will grow if the new customer acquisition rate exceeds the churn rate. Eric Ries states that the speed of growth is decided by the rate of compounding, which is the natural growth rate minus the churn rate. Unfortunately, both startups were tracking their progress based on generic indicators like the total number of customers. Even the actionable metrics they were using, like the activation rate and revenue per customer, were unhelpful because these variables had less impact on growth in the sticky engine of growth. After meeting Eric Ries regarding their growth problems, one of the startups relied on his advice to model its customer behaviour using the sticky engine of growth as a template. The results were impressive – 61% retention and 39% customer growth rates. This can usually be seen in companies in the engagement business that are struggling to find growth. The way to find growth is to pay attention to existing customers of the product, which is more engaging to them. For example, the company could focus on getting more and good listings as it would incentivize customers to check back a lot. On the other hand, the company could message customers about limited-time offers or special offers. Either way, its focus should be based on improving customer retention. This goes against the usual intuition that if a company lacks growth, it should invest more in sales and marketing.

2. The viral engine of growth

Social network sites are where customers do most of the marketing. Product awareness spreads quickly from person to person on social networks like a virus. This is different from the word of mouth marketing. Products that show viral growth depend on person-to-person communication as an essential requirement of normal product use. Customers don’t intentionally behave as evangelists as they are not deliberately trying to promote the product. Instead, growth happens as a side effect of customers using the product.

Just like the other engines of growth, the viral engine is powered by a feedback loop that can be quantified. It’s known as the viral loop, and its speed is based on a single mathematical term called the viral coefficient. The higher the coefficient, the faster the product will spread. The viral coefficient measures how many new customers will use a product because of each new customer who signs up for it. That is, how many friends will each customer bring with them? As each friend is also a new customer, they have a chance of bringing in more friends.

If a product with a viral coefficient is 0.1, one in every ten customers will recruit one of their friends. This isn’t a sustainable loop. Assume 100 customers sign up, and they will cause 10 friends to sign up. Those 10 friends will cause an additional friend to sign up, but the loop will fail. However, a viral loop with a coefficient of more than 1.0 will grow because each person who signs up will bring an average of more than one friend. Companies that adopt the viral engine of growth should focus on increasing the viral coefficient as minor changes in this number can cause considerable changes in their prospects. Therefore, many viral products don’t charge customers directly but depend on indirect sources of revenue like advertising. This happens because viral products cannot afford to have any friction ruin the process of customers signing up and recruiting their friends. This can cause testing the value hypothesis for viral products challenging.

The actual test of value hypothesis is a voluntary exchange of value between customers and the startup that serves them. Monetary exchange doesn’t drive new growth, but it’s helpful to indicate that customers value the product to pay for it. If Facebook had charged customers in their early days, it wouldn’t have grown. By investing their time and attention on Facebook, customers make the product valuable to advertisers. Companies that sell advertising serve it to two types of customers – consumers and advertisers and exchange a different currency of value with each.

3. The paid engine of growth

Let’s assume that one business makes 1 dollar for every customer that signs up. The second makes 100,000 dollars from each customer that signs up. To predict which company will grow faster, one extra thing should be understood – how much it costs to sign up a new customer.

Assume that the first business uses Google AdWords to discover new customers online and pays an average of 80 cents each time a new customer joins in. The second business sells heavy goods to large companies. Each sale needs a considerable time investment from a salesperson and on-site sales engineering to help install the product. These hard costs will total up to 80,000 USD per new customer. Yet, both companies will grow at the same rate. Each company has 20% of revenue available to reinvest in new customer acquisitions. If each company wants to increase its growth rate, it can do it in two ways either increasing the revenue from each customer or driving down the cost of acquiring a new customer.

Like the other engines of growth, the paid engine of growth is powered by a feedback loop. Each customer pays a particular amount for the product over their lifetime as a customer. Once the variable costs are deducted, this is called the customer lifetime value. This revenue can be invested in growth by buying advertising. Startups employing an outbound sales force are also using the paid engine of growth, and so are retail companies. All these costs should be factored into the cost per acquisition. Most sources of customer acquisition are exposed to competition. Prime retail storefronts have more foot traffic and are thus more valuable. Advertising targeted to more reputed customers costs more than advertising that reaches the public. What decides these prices is the aggregate value earned by the companies competing for any given customer’s attention. Wealthy customers cost more to reach as they become more profitable customers.

Eventually, any source of customer acquisition will have its CPA bid up by this competition. If everyone in an industry makes a similar income for each sale, they will all wind up paying most of their marginal profit to the source of acquisition. Thus, the ability to grow in the long run by using the paid engine demands a different ability to monetize particular customers.

Eric Ries recommends startups focus on one engine at a time. Most entrepreneurs have a strong leap of faith hypothesis on which engine will most probably work for their business. If they do not, communicating with customers will quickly recommend which engine seems profitable. After thoroughly pursuing one engine, a startup should consider pivoting to the others.

10.2 The engines of growth decide the product/ market fit

Marc Andreessen used the term ‘product/market fit’ to describe the moment when a startup finally finds a broad set of customers that resonate with its product. Unfortunately, most startups misunderstand the concept of the product/market fit. Some think that pivot is a failure event or that once their product has achieved the product/market fit, they don’t have to pivot anymore.

Eric Ries believes that the engine of growth can clear this misunderstanding. As each engine of growth can be defined quantitatively, each has a unique set of metrics to evaluate if a startup is on the verge of achieving a product/market fit. For example, a startup with a viral coefficient of 0.9 or more is on the brink of success. By using innovation accounting, a startup can measure if it’s getting closer to the product/market fit as it tunes its engine by studying each trip through the Build-Measure-Learn feedback loop. The direction and degree of progress are important, not vanity metrics or raw numbers.

For example, assume two startups are trying to tune the sticky engine of growth. Company A has a compounding growth rate of 5%, and Company B is 10%. It might seem like the larger growth rate is better, but what if the company’s innovation accounting dashboard shows that Company A’s compounding growth rate has been improving for the past six 6 months as 0.1%, 0.5%. 2.0%, 3.2%, 4.5% and finally 5.0% whereas Company B was 9.8%, 9.6%, 9.9%, 9.8%, 9.7% and now 10.0%. It’s obvious that Company A is making real progress, not Company B, although Company B is growing faster than Company A.

10.3 When engines run out

Every engine is tied to a set of customers, their habits, choices, advertising channels and relationships. However, at some point, those customers will get tired. In Chapter 6 we explored the importance of building an MVP so that it doesn’t contain more features than what early adopters need. Following this strategy successfully will unlock the engine of growth that can reach the target audience. However, transitioning to mainstream customers will need a lot of additional work. Once you have a product growing among early adopters, you could, in theory, stop work in product development completely. The product would continue growing until it reached that early market’s limit. Then the growth would become steady or completely stop.

Some companies accidentally finish following this strategy. Since they are using vanity metrics and traditional accounting, they think they are making progress when they see their numbers growing. They mistakenly think they are making a better product when they have no impact on customer behaviour. The growth comes from a working engine of growth running efficiently to bring in new customers and not from improvements driven by product development.

Conclusion

Regardless of any size, companies can suffer when their engines run out. They need to manage various activities while tuning their engine of growth and developing new sources of growth for when that engine automatically stops. How to do this will be explored in Chapter 12, but before that, you need an organizational structure, culture and discipline that can manage these quick and unexpected changes. This is known as an adaptive organization per Eric Ries, which is the next chapter’s subject.