One of the words that came from the dot-com era was "business model." I think this phrase arose because venture capitalists were hearing entrepreneurs talk about how many eyeballs their websites would attract--but not how those eyeballs would translate into revenue.
But the dot-com collapse slammed venture firms’ investment returns--making capital scarce and causing founders to adopt a hungry business model in which a start-up learns fast before it runs out of scarce resources.
The hungry business model does this in three stages and your start-up must know which stage it’s in and how it will get to the next one. Moreover, capital providers are generally different for each stage. For example, in Stage 1, you can usually forget about getting a check from a big name venture capital firm.
Stage 1: Getting Your First Customer
When you start your venture, you have to be thinking about who your first customer will be. And if you hope to get that customer to use--and eventually pay for--your product, you will face challenges.
People naturally shun products from start-ups. After all, most start-ups fail and if someone gets dependent on that product and its maker goes up in smoke, the customer has to find replacement.
To overcome this hurdle, you must find a customer who has "pain" that no other company is even trying to cure. One example of the 180 companies I interviewed for my new book, Hungry Start-up Strategy, is Phil Libin who told me that he is very disorganized and needed a place to store all the articles, pictures, videos, and documents that he found useful in one easy-to-access place. No service existed to solve that problem so he started Evernote.
Simply put, one way to get your first customer is to make yourself the first customer. This is a great idea--particularly if there are lots more people like you. Of course, there is an important distinction between getting someone who uses your product and someone who pays for it. But at Stage 1, what you really want is to get a customer who uses your product so enthusiastically that he will urge, say, 20 of his colleagues to use it too.
At Stage 1, the way to keep the lights on is usually by investing the founders’ savings--and in Libin’s case, he had some since he had achieved start-up success before Evernote. The virtue of living off of Ramen noodles is that your hunger pushes you to build ever-better versions of your product fast, so you earn your way into your first customer’s good graces faster.
Stage 2: Attracting More Customers and Tracking Their Behavior
Stage 2 is where you try to find more customers like your first one. The best way to do that is through so-called viral growth. This means that if you have designed your product right, your first customer urges 20 of his friends to use your product and they do. And each of those 20 turn into enthusiastic evangelists for the product--who in turn recommend it to 20 of their friends.
This sounds easy. But it almost never works without a feedback loop. This means that you have to measure the virality coefficient of your product--the ratio that tracks whether new customers outnumber ones that drop out. If that coefficient is rising, you’ve got it right. If not, you need to find out why by talking to those customers and retool the product until those customers are thrilled to recommend it.
By the way, this is the point where you need to get customers to start paying for your product. While you might initially give it away for free, once those customers get dependent on the product, some may want a version of it that does more than the basic one. And for such a premium version, a fraction of your customer base will be willing to pay.
Once you can demonstrate that customers are paying for your product, you can raise capital from friends, family, and angel investors.
Stage 3: Expand
If you are among the small number of start-ups that has made it to Stage 3, you are in a great position to persuade venture capitalists to write big checks that will allow your venture to expand from Stage 2. You may have sold to most of the customers you’re likely to get within a particular region and you want to expand into new pockets of similar customers who live in other countries.
For such global expansion, and for the funds needed to develop new products, venture capitalists who are enthusiastic about your previous progress will want to chip in. And by waiting to raise the biggest bucks until you have demonstrated your venture’s ability to succeed without their money, you are in a far stronger negotiating position to take it.
As Steve Jobs said in a 2005 speech at Stanford, referencing the last issue of the Whole Earth Catalog, “Stay hungry, stay foolish.” A hungry business model, will keep you there.