Investing in Sales and Marketing Too Early
Know When to Spend—and When Not To

Many companies move to a high burn rate too quickly, and it’s hard to go back. Sometimes even frugal entrepreneurs wind up spending too much either because they don’t manage the money or are tempted by having money in the bank. This often happens when a startup raises too much money too early. It also happens with entrepreneurs who are accustomed to having lots of resources—for example, if they’ve spent time at big companies. Frequently it happens when entrepreneurs haven’t found product-market fit and believe that it’s just a matter of spending money to reach the right customers or users.

The Real Cost of Spending Too Early

For every venture dollar invested, I estimate that more than two-thirds goes into sales and marketing costs and only a third into product development. Spending on sales and marketing too early means there is no return if customers don’t bite. These dollars, unlike those invested in product, can’t be leveraged if a company is trying to sell product consumers, or customers simply don’t want to buy. Once you up the burn rate, there’s no easy way back.

Many startups ramp up sales before the product is ready. Of course, a lot of work is required to get sales early on. But a product with a truly great value proposition that delivers in a measurable way practically sells itself.

The right time to invest heavily in sales and marketing is when you’ve determined that you have product-market fit. When you’ve reached that inflection point, then—and only then—should you spend aggressively on sales and marketing to drive growth. Companies that ramp sales and marketing too soon waste a lot of money. That problem compounds itself, leading to wasted financing rounds, dilution of equity, and, often, loss of your own job.

Sometimes, even when you have a great product, you don’t understand the sales process well enough to scale it. You need to know who you’re selling to, how much they will really spend, and what kind of salesperson the company needs to hire who can succeed at selling that particular product to those people. All of this must be understood before sales can efficiently scale.

Of course, some startups don’t need to spend heavily on sales and marketing—their products are designed to market themselves. The next two chapters get into that in more detail.

CEO X, an incredible promoter, naturally got investors excited about his company. In two years, he raised three rounds of funding with just a few million dollars in annual revenue—most of which came at a loss. That is, he was spending so heavily on acquiring new customers that the company was far from profitable. Both he and his investors interpreted the revenue as an indicator of having found product-market fit and concluded that if they spent more on marketing, they could drive a lot more revenue.

No one wanted to believe, given the amount of capital raised and the associated valuation, that the company was still pre-product-market fit. Moreover, CEO X’s investors weren’t on the same page. The early investors helped convince the later ones that the company was ready for a growth round; the later investors—having invested on the belief that the company was ready to grow quickly and having promised that to their partners and their own investors—didn’t want to admit that the company wasn’t ready to scale. This is another reason not to raise too much capital too early: not only does doing so create a lack of alignment, but it’s also very hard to live up to the expectations that come with that capital and the associated valuation.

When the company failed to achieve its projected sales two quarters in a row, the board gave CEO X feedback that he should replace the head of sales. He did. The new head of sales turned over the entire sales team but told the board it would take as much as two full quarters for each new sales representative to become fully productive.

With the burn still incredibly high and sales limping along, the board and management team finally concluded that the company hadn’t found product-market fit. Total time consumed (or, more accurately, wasted): four quarters.

The real measure of whether a startup is ready to invest in growth is if it’s clear that the company can acquire users or customers in a repeatable and efficient manner. Ultimately, of course, that acquisition has to be both efficient and profitable.

Ratcheting Up the Burn Is Easy—Bringing It Down Is Difficult

It’s easy to spend money on marketing quickly. Open a Google AdWords account, put in your credit card, and set the budget to a few thousand dollars per day. Combine that with hiring like there’s no tomorrow, and you’re off to the races. If the condition of the United States economy is any indicator, it’s easy to spend money—but not so easy to save it.

In an ideal world, companies would be able to scale their organizations up and down just as they do their computing resources. The difference is, there is a hidden cost to scaling down organizations. The negative impact on the organization is expensive.

As anyone who has managed an organization can attest, organizations don’t operate one person at a time. There are teams and groups. It may be easy for investors to tell a company to “cut the burn,” but the human beings that make up organizations are slow to recover from these sorts of cost-cutting exercises.

The cost also affects founders/employees disproportionately as compared to investors. Professional investors can keep writing checks to buy more equity, but founders and employees can’t create more equity. Thus, burning through capital unnecessarily tends to hurt founders and employees more than it hurts investors.

But if you’ve scaled your company prematurely, you must cut the burn. These cuts take a long time to heal. We’ve all heard stories of companies making repeated cuts. Company leadership is trying to “do the right thing” by keeping people in their jobs, yet employees live in fear that they may be the next to go. Better to cut too deep than too shallow.

Investors may seem schizophrenic, sometimes encouraging you to cut the burn while at other times suggesting you spend aggressively. This is because investors have very few levers once they have invested. They can push you to spend less, they can invest more, or they can fire you and hire someone else.

Of course, investors perform many other activities: making introductions to customers, potential employees, and other investors. They can also help you make strategic decisions and, of course, ensure a company’s ultimate liquidity. But when it comes to day-to-day operations, there is very little they can do. At the same time, they may feel intense pressure to do something when a company appears not to be working.

When a company hits its growth inflection point, it should raise as much capital as it can and grow as quickly and aggressively as possible. Scaling pre-maturely, however, is incredibly costly—not just in terms of capital but in terms of organizational health as well.

Don’t Mistake a Lack of Product-Market Fit for Poor Execution

All too often, people confuse a lack of product-market fit with a failure to execute. Experienced operating executives often believe that if they can get the right team in place—in particular, the right lead-generation and sales operations—they can solve what appears to be an execution issue.

They get things running smoothly, only to discover that the product still isn’t selling. Perhaps customers seem interested, but they just aren’t buying.

Common refrains include, “We need a different go-to-market strategy,” “We’ll get a new VP of sales with a team who can actually sell,” and “We haven’t been trying this approach long enough to know if it works.” Or, in the case of consumer startups, “We just need to get this in front of more users.”

Management and board members alike simply don’t want to believe—especially after ratcheting up the burn rate—that the product doesn’t meet a market need. Or, if it does meet a market need, they don’t want to accept that it has too much friction to gain adoption—it’s too difficult for people to use or buy.

How can you tell which problem you have? Find out how happy your existing customers are. If they’re happy, and a lot of other potential customers could derive the same value, then you have a go-to-market/execution problem. If they’re happy, but it’s because of something unique to their business, you have a product-market fit problem. If they’re unhappy, you have a product problem.

Granted, it’s not a question of product-market fit or execution. Great startups get both right. What’s critical is not to confuse a lack of one for a lack of the other.

Understand the Traction Curve

How do you know when you’re ready to invest aggressively in sales and marketing? Mark Leslie, former CEO of storage-management company Veritas Software and now a lecturer at the Stanford Graduate School of Business, first introduced me to the Sales Learning Curve (SLC) when I took his sales operations course at Stanford. Although it’s primarily business (not consumer) focused, it’s one of the best tools available for figuring out when you’re ready to invest in scale.

In the past, one of the biggest questions startup founders faced was whether they could build the product. That is still an open question outside of information technology. For example, biotechnology companies face fundamental science risks, and clean-tech companies face questions about whether they can convert from prototype scale to production scale. But for the vast majority of business and consumer software companies, the question isn’t whether they can build the product but whether people will use it once it’s built—and whether the companies can develop an efficient approach for reaching their potential customers.

Many companies can now rely on open source software and cloud-based infrastructure like Amazon Web Services to provide the basic building blocks for their products. Even today’s hardware companies are in large part software. As a result, startups can and must spend more of their time and capital engineering efficient customer adoption into their products and honing their go-to-market strategies.

Leslie describes three distinct phases of the SLC:

• Initiation phase: A startup is trying to get customers. The company is still very much in a period of discovery and learning, refining both its product and its approach to selling that product.
• Transition phase: Sales are beginning to accelerate. The company has real market traction.
• Execution phase: The company is ready to invest aggressively.

One key insight from the SLC is that the slope of the customer-adoption curve steepens rapidly as companies move through the transition phase. Thus, before you start spending aggressively on marketing and hiring lots of sales people, ask yourself whether your adoption curve is really steepening. If it’s not, you’re still in the initiation phase.

Company X hired an extremely experienced VP of sales who then hired a complete team of sales reps to sell the company’s product. But the company—which had very complex technology at its core—hadn’t yet figured out how to package its offering so that customers could see a clear value proposition that was easy to buy into.

Although customers expressed a lot of interest in solving the pain point that Company X’s product addressed, few actually purchased the product. All the while, the company kept burning through cash and missing its numbers. It was another year before the company figured out how to package its product in such a way that it was easy for customers to buy. In reality, the company was still in the initiation phase. It shouldn’t have ramped up sales until it figured this it out.

Where business startups must prove a repeatable sales model, consumer startups must prove a repeatable user-acquisition model—and they must continue to maintain their growth. Yet the principles of the SLD still apply: the slope of the net adoption curve—the number of new users minus those who leave—must steepen aggressively to justify spending aggressively on sales and marketing.

I emphasize net adoption curve because many consumer startups have been known to spend aggressively on acquisition in support of growth only to have a large percentage of their users churn out and the curve eventually flatten. It doesn’t help to acquire a lot of users if your product isn’t sticky enough to get them to continue using it.

Create Unique Value

There are examples of creating value without following the SLC, of course. Some companies spend aggressively on sales and marketing before they have figured out how to make those sales profitable—and their founders and investors make lots of money in the process.

But these companies require very unique market and capital environments to support their growth. Daily deal site Groupon is one example. The company has seen incredible sales growth, going from $30 million in 2009 to $313 million in 2010 to $430.2 million for the third quarter of 2011. Yet during that same record third quarter, the company accrued expenses and payables of $622 million to merchants.

The company’s recent IPO valued it at more than $17 billion. Whether the company’s model is sustainable is an open question. But the founders made a lot of money in the process, and so did investors. The founders took hundreds of millions of dollars off the table as part of a previous (private) round of funding. And on paper, at least, the ownership positions of both the founders and investors are now worth billions. Clearly, value was created—but again, it required a very unique market and capital environment.

A key question to ask yourself is what kind of company you want to build. Many companies lose money for years; some are even unprofitable after they go public. Although investors may claim to want to build stand-alone companies that will be around for a long, long time, the primary goal of most is to make large amounts of money for themselves and their investors.

Founders often put a lot of emphasis on reaching break-even. I commend this goal. It’s an absolute necessity in tight capital markets or if you don’t want to rely on outside capital. But reaching break-even by itself doesn’t make for a high-growth company; as a result, it doesn’t, by itself, make a company a venture-worthy investment.

If your aspiration is to raise venture capital, the primary question for new investors isn’t when you can reach break-even. The primary questions are whether you’re in a big market and how you can ramp growth (be it revenue or users) more aggressively to capture that market. Don’t confuse the desire to raise money with the ability to spend it effectively.

Too Late for Hope, Too Early for Traction

At their core, investments are about opportunity and risk. How big is the opportunity, and how well is the company set up to capture it? What are the risks to capturing that opportunity, and how can they be mitigated? And, in the case of follow-on financings—those financings other than the first one—how much risk has been taken out since the previous financing?

Companies may ultimately raise numerous rounds of funding, both private and public. These rounds fall into three buckets, roughly paralleling the three stages of the Sales Learning Curve. If you find yourself stuck going more or less sideways a few years into building your company, understanding how startups are valued is key to understanding where you need to focus if you’re to raise capital to grow your business. It’s also an important consideration should you decide to sell instead, so you know how potential acquirers are likely to value your company.

People often bitterly complain about how seemingly arbitrary company valuations are. The markets reward consumer companies for user growth without meaningful revenue, while they typically measure business companies on revenue. Why is this the case? The simple answer is that the market values consumer and business startups very differently. Moreover, when it comes to acquisitions, external dynamics—such as an acquirer’s need for a particular technology to fill a gap in their product line or strategy—can have a huge impact on a company’s valuation.

Startups begin life with their value based on a combination of market demand for the deal, the pedigree of the team, and the potential market opportunity. Their founders sell the dream, and the companies are valued on hope. I recall the very first time I raised venture capital—I asked a potential investor how his firm had decided on the valuation for our company. Only half joking, he told me that because there were three of us, he estimated our individual values at about a million and a half dollars each and then threw in another half million because we were working together.

After the initial phase, companies go through a period of indeterminate value. They have some product and market traction, but they haven’t taken out significant adoption risk. For the potential investor, the price of the investment may be significantly higher (based on management team expectations or market interest) but not priced commensurately with the lack of risk taken out of the investment.

Many have just enough traction that potential investors would rather wait until that traction is proven (and the associated risk taken out) than invest when no significant adoption risk has been removed. These startups are too late for hope but too early for traction.

Some companies go through repeated rounds of funding in this stage. Their traction curve is steepening, but the actual numbers are still too small or the curve too flat to change investor perception.

In the second stage, startups are valued on traction. For consumer companies, that means their ability to attract users, the number of those users, and the rate at which that number is growing. For the vast majority of business startups, it’s the total size of the market opportunity and their revenue growth numbers in that market.

Consumer companies are valued differently because of the three M’s:

• Mass market: Their markets are huge because potentially everyone on Earth could use their product.
• Monetization: All those users can consume ads, pay directly, or do both.
• Main Street: Many people have first-hand experience with the company’s products or know about the company and are therefore more likely to want to buy the company’s equity.

What’s more, investors, from individuals to professionals, want to say they’re in well-known, celebrity deals—they want hotness by association. The only question for these companies is whether they can get millions of consumers to use, and keep using, their product. When they can, they are, by definition, valuable, because relatively few companies are able to build something that millions of people want.

When it comes to getting out of the transition phase, your entire focus should be on changing the steepness of your traction curve. If you’re building a consumer company, that means figuring out how to add users more quickly, and ideally reaching an exponential growth curve. If you’re building a business-to-business company, it means changing the slope of your revenue curve— demonstrating that you can sell efficiently.

Are You Ready to Throw Gas on the Fire?

The Net Promoter Score¹ (NPS) measures the answer to the question: “How likely is it that you would recommend a company to a colleague or friend?” This is a great indicator of whether you’re ready to throw gas on the fire.

The answer is given on a scale of one to ten, with respondents grouped into promoters, passives, and detractors. Companies with higher Net Promoter Scores have been shown to have faster, more efficient growth. Improving your score boils down to having more promoters and fewer detractors.

Companies with higher NPS values have more efficient growth engines because their customers are more likely to recommend their products to new customers. Not only is a high NPS a great indicator that customers like your product, but it also means they’re providing you with free marketing! In addition to any marketing you do directly, a high NPS means you’re leveraging your customers to help you acquire new ones—making your growth engine highly efficient.

Asking people whether they’d recommend your business to someone else is a lot different than simply asking them if they like your product. For one thing, people are often embarrassed to admit they don’t like a product they bought—it makes them appear to have bad judgment. But to recommend that product to a friend, they really have to love it; few people want to be known to their friends or colleagues for recommending a bad product.

Putting NPS to work at your company doesn’t mean you have to hire expensive consultants or spend a lot of money on surveys. It’s easy to use tools like SurveyMonkey to ask your users or customers questions and tabulate the answers. And having a single metric like NPS is very useful—it’s a straightforward measure you can watch over time.

A corollary to NPS is tracking how new customers find out about you. That way, you can invest more time and money in the channels that are working—and less in those that aren’t. Tools like Google Analytics are important for tracking, but so is asking new users and customers, “How did you find out about us?”

If your NPS is high and you believe you have a big market opportunity—that is, the market is big, and a lot of other users or customers can derive the same value as your existing base—then it’s time to throw gas on the fire. Raise as much capital as you can, and invest in growth.

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Get Out There and Sell

Even introverts who don’t think of themselves as promoters are promoters. If you’ve ever raised a dime from someone else—be it a family member, a friend, or a professional investor—convinced a customer to buy your product or hear your pitch, or gotten someone to invest time working on your product in their off hours, you’ve been a promoter.

I used to think of sales in a very negative light. It was something other people did. I held onto that belief until I had to get out there and sell in order for my company to survive. I had to meet with customers, pitch investors, and recruit employees. It was humbling and exhilarating. Having had to sell my ideas, products, and companies over and over again, I now believe promotion is fundamental to the survival of any business—and you should, too.

When it comes to startups, you are just as much the product as your web site, software, or hardware. Potential users, customers, employees, and investors aren’t just deciding to use your product—they’re deciding to make an investment in you.

Some entrepreneurs mistakenly think that getting out there and promoting their products is something only non-tech-based companies need to do. After all, in an age where technology is everywhere, why would you need to have humans involved? This is a mistake.

There may have been a time when the Web was all about technology, but today’s Web is all about being social—just look at Facebook and Twitter if you have any doubt. That means you need to be visible. As much as it might be nice if they did, products don’t speak for themselves—entrepreneurs do. And with all the media available today—blogs, tweets, posts, not to mention numerous startup conferences that are always looking for entrepreneurs as speakers—there’s no excuse not to be out there.

Being visible is no substitute for having a great product that people want to use and spend money on, or for working your way up the traction curve. But in an age when brand matters more than ever, raising your profile—if you do it in a positive way—can have innumerable benefits, from helping get you more users to helping you recruit employees and attract investment. Plus, being visible is incredibly cost-effective. It’s a form of sales and marketing you can invest in without spending any financial capital.

Summary

Investing in sales and marketing too early can kill your company. It can burn up your hard-won cash. Yet not investing when you’ve got serious market traction can have equally disastrous effects. Although figuring out when you have the right amount of traction to invest more aggressively is very much an art, the tools presented in this chapter can add a little more science to your decision.

Failure comes from

• Investing in sales and marketing before you have product-market fit
• Insufficient experimentation
• Investing too late

It’s time to spend on sales and marketing when

• You’ve found product-market fit.
• Users or customers are referring you to other customers.
• You’re rapidly, measurably moving up the traction curve.