After talking about Pivot or Persevere regarding to Eric Ries´ book “The Lean Startup” today´s topics are Batch and Grow
By the way: At the end of this week I´ll probably be done with the studies of the book. There are 3 chapters to go after Batch and Grow: Adapt, Innovate and a conclusion/epilogue.
Small batches in entrepreneurship
When Eric Ries teaches entrepreneurs this method of small batches, he oftenbegins with stories about lean manufacturing (e.g. Toyota). Before long, he can see the questioning looks: what does this have to do with a startup? The theory that is the foundation of Toyota´s success can be used to dramatically improve the speed at which startups find validated learning.
Toyota discovered that small batches (instead of inflexible mass production) made their factories more efficient. In contrast, in the Lean Startup the goal is not to produce more stuff efficiently. It is to – as quickly as possible – learn how to build a sustainable business and to get through the Build-Measure-Learn feedback loop more quickly than our competitors can. The ability to learn faster from customers is the essential competitive advantage that startups must possess.
The large-batch death spiral
Small batches pose a challenge to managers steeped in traditional notions of productivity and progress, because they believe that functional specialization is more efficient for expert workers.
Imagine you are a product designer overseeing a new product and you need to product 30 individual design drawings. It probably seems that the most efficient way to work is in seclusion, by yourself, producing the designs one by one. Then, when you are done with all of them, you pass the drawings on to the engineering team and let them work – in other words, you work in batches.
From the point of view of individual efficiency, working in large batches makes sense. It also has other benefits: it promotes skill building, makes it easier to hold individual contributors accountable, and, most important, allows experts to work without interruption. At least that´s the theory.
Consider our hypothetical example. After passing thirty design drawings to engineering, the designer is free to turn his or her attention to the next project. But what happens when engineering has questions about how the drawings are supposed to work? What if some of the drawings are unclear? What if something goes wrong when engineering attempts to use the drawings?
These problems inevitably turn into interruptions for the designer, and now those interruptions are interfering with the next large batch the designer is supposed to be working on. If the drawings need to be redone, the engineers may become idle while they wait for the rework to be completed. If the designer is not available, the engineers may have to redo the designs themselves. This is why so few products are actually built the way they are designed.
Large batches tend to grow over time. Because moving the batch forward often results in additional work, rework, delays, and interruptions, everyone has an incentive to do work in ever-larger batches, trying to minimize this overhead. This is called the large-batch death spiral because, unlike in manufacturing, there are no physical limits on the maximum size of a batch.
Eric Ries gives an example of a company he worked for. The longer they worked, the more afraid they became of how customers would react when they finally saw the new version. As their plans became more ambitious, so too did the number of bugs, conflicts and problems they had to deal with. Pretty soon they got into a situation in which they could not ship anything. The more work they got done, the more work they had to do. Who knows this situation? I do.
Where does growth come from?
The engine of growth is the mechanism that startups use to achieve sustainable growth. Eric Ries uses the word sustainable to exclude all one-time activities that generate a surge of customers but have not longterm impact, such as single advertisement or a publicity stunt that might be used to jump-start growth but could not sustain that growth for the long term.
Sustainable growth is characterized by one simple rule:
New customers come from the actions of past customers
There are four primary ways past customers drive sustainable growth:
- Word of mouth
- As a side effect of product usage (When you see someone dressed in the latest clothes or driving a certain care, you may be influenced to buy that product. This is also true for viral products such as Facebook and PayPal)
- Through funded advertising (Advertising must be paid for out of revenue – as long as the cost of acquiring a new customer is less than the revenue that customer generates, the excess can be used to acquire more customers.
- Through repeat purchase or use
The three engines of growth
1. The sticky engine of growth
An example for a sticky engine of growth is the mobile telephone service provider branch. When a customer cancels his or her service, it generally means that he or she is extremely dissatisfied or is switching to a competitor´s product. This is in contrast to, say, groceries on a store aisle. In the grocery retail business, customers fluctuate, and if a customer buys a Pepsi this week instead of Coke, it is not necessarily a big deal.
Therefore, companies using the sticky engine of growth track their attrition rate or churn rate very carefully. The churn rate is defined as the fraction of customers in any period who fail to remain engaged with the company´s product.
The rules that govern the sticky engine of growth are pretty simple: If the rate of new customers acquisition exceeds the churn rate, the product will grow. The speed of growth is determined by what Eric Ries calls the rate of compounding, which is simply the natural growth rate minus the churn rate.
(By the way: Eric Ries talks about the reasons why in the sticky engine of growth it is ESSENTIAL to use the value hypothesis (such as cohort analysis) – as discussed earlier)
We should try to focus on existing customers, to hold them and give them incentives. Because even though we are successful in acquiring new customers – when existing customers are leaving at the same time, there will be no growth.
2. The viral engine of growth
Online social networks and Tupperware are examples of products for which customers do the lion´s share of the marketing. Products that exhibit viral growth depend on person-to-person transmission as a necessary consequence of normal product use. Customers are not intentionally acting as evangelists; they are not necessarily trying to spread the word about the product. Growth happens automatically as a side effect of customers using the product.
Like the other engines of growth, the viral engine is powered by a feedback loop that can be quantified. It is called the viral loop, and its speed is determined by a single mathematical term called the viral coefficient. The higher this coefficient is, the faster the product will spread. It measures how many new customers will use a product as a consequence of each new customer who signs up. For a product with a viral coefficient of 0.1, one in every ten customers will recruit one of his or her friends. By contrast, a viral loop with a coefficient that is greater than 1.0 will grow exponentially, because each person who signs up will bring, on average, more than one other person with him or her.
Companies that rely on the viral engine of growth must focus on increasing the viral coefficient more than anything else, because even tiny changes in this number will cause dramatic changes in their future prospects.
A consequence of this is that many viral products do not charge customers directly but rely on indirect sources of revenue such as advertising. If Facebook or Hotmail had started charging customers in their early days, it would have been foolish, as it would have impeded their ability to grow. It is not true that customers do not give these companies something of value: by investing their time and attention in the product, they make the product valuable to advertisers.
This is markedly different from companies that actively use money to fuel their expansion, such as a retail chain that can grow as fast as it can fund the opening of new stores at suitable locations. These companies are using a different engine of growth altogether
3. The paid engine of growth
Imagine another pair of businesses. The first makes $1 on each customer it signs up; the second makes $100.000 from each who signs up. To predict which company will grow faster, you need to know only one additional thing: how much it costs to sign up a new customer.
Imagine that the first company uses Google AdWords to find new customers online and pays an average of 80 cents each time. The second company sells heavy goods to large companies. Each sale requires a significant time investment from a salesperson and on-site sales engineering to help install the product; these hard costs total up to $80.000 per new customer. Both companies will grow at the exact same rate. Each has the same proportion of revenue (20 %) available to reinvest in new customer acquisition. If either company wants to increase its rate of growth, it can do so in one of two ways:
Increase the revenue from each customer or drive down the cost of acquiring a new customer. That is the paid engine of growth to work.
Like the other engines, it is powered by feedback loop. Each customer pays a certain amount of money for the product over his or her “lifetime” as a customer. Once variable costs are deducted, this usually is called the customer lifetime value (LTV). This revenue can be invested in growth by buying advertising.
Suppose an advertisement costs $100 and causes fifty new customers to sign up. This ad has a cost per acquisition of $2. In this example, if the product has a LTV value that is greater than $2, the product will grow. The margin between the LTV and the CPA determines how fast the paid engine of growth will turn.
Even though more than one engine of growth can operate in a business at a time, Eric Ries strongly recommends to focus on one engine at a time. Most entrepreneurs already have a strong leap-of-faith hypothesis about which engine is most likely to work. If they do not, time spent out of the building with customers will quickly suggest one that seems profitable.
Principles of a lean startup: