Business Fundamentals for Product Managers

Background

Understanding “business fundamentals” may seem like an obvious requirement for product managers, however I see too many PMs disconnected from the business side of the company they are working for, primarily focusing on “building features.” I think this is in part because product management has always had such a close relationship with engineering, and historically other functions (e.g. Sales, marketing, finance, etc) were responsible for “running the business.” Luckily, this has started to change in the last five years with standalone product functions becoming true business leaders. However many companies, and more importantly, individuals, have never seen product people operate as business leaders outside of the sphere of engineering work.

In a modern company building technology products there is likely already is a product function and it should be cross-functionally leading the business, not simply defining features. When running well, product is the glue that keeps all other teams within the company aligned and executing on the same strategy at every level. To have the understanding and credibility to a cross functional leader it’s critical that as a PM you fully understand what every other function is doing, why they are doing it, the key metrics for each, and how all of those play together in the company’s business model. Without this understanding you are making decisions with incomplete information.

Another big gap I see out there is between traditional business education curriculum and the metrics that a lot of modern software and/or subscription based companies use to manage and run their business. I will fully admit it’s been 15 years since I started my MBA program, so things may be changing now, but based on the newer PMs I interact with I get the sense there are still some things missing. College and grad school curriculums teach you the basics of accounting (income statement, cash flow, revenue, etc) some marketing metrics around ROI and funnels and that’s about it. These things are of course foundational and you need to know them, but they are about 15% of what you need to be successful working at modern subscription-based business.

Finally, the reason I call this out is because it’s an important mindset shift for a lot of product managers. You need to approach your job as a problem solver for the business. Yes, you are a customer champion, and you solve customer problems day in and day out, however if you are not doing those things in service of driving business outcomes you are missing the mark. Many PMs fall into a trap of wanting to add “new stuff” to the product, to put their stamp on it, and because of a historical paradigm of valuing output and shipping software over a focus on business outcomes. Furthermore, understanding the entire business model helps you to ensure problems are being framed the right way. If someone asks you “how do we improve trial conversion by 25%?” you can go run with that or ask “Does it have to be trial conversion or can we get there with a combination of more trial starts and an improvement in trial conversion?” You need to understand the individual elements in your company’s business model and how they work together to ensure you are solving the right problem with the full range of possible solutions.

Where Things Start to Diverge from the Textbook

This is the part where your accounting class actually pays off. A deeper understanding of an income statement, balance sheet, and cash flow will of course help, but outside of funding conversations, the things that really get used every day are revenue (and bookings), and gross margin. What gets left out of the business school curriculum is how revenue, bookings, and gross margin actually extend out to a ton of subcomponents that are the actual levers your co-workers spend every day trying to manipulate.

Cash flow is important, but exactly where it fits is typically an operational issue for finance and other functions, rather than something product gets directly involved with insofar as we are talking “cash management”. Gross margin is obviously a large determinant of free cash flow, but the cash throw off from gross margin is deployed across many other functions in the business. If you have a capital intensive business (e.g. buying servers to offer a hosting service) then it really matters if you have enough money from new customers to keep buying what you need ahead of growth. For a pure software company, the biggest draw on cash flow is typically headcount or marketing spend. Each of those could be adjusted over time with product changes, but those are fairly big strategic shifts.

In a software company context, the divergence between “book learning” business fundamentals and what people in software companies use every day has happened in part because because of the growth in subscription based models. Up until the last 15 years, hardware and software were effectively sold once to each customer and that was it. As subscription models started to grow in popularity, new measures were required to better track the dynamic nature of a recurring business.

A quick glossary:

• Subscription: a pricing model where a user purchases access to a product or service for a recurring price (usually monthly or annually)

• Usage-Based Pricing - a more recent trend where SaaS products have a partial or fully variable pricing component tied to how much the customer use the product (check out Zapier’s model)

A lot of people say “SaaS” and they mean “subscription.” SaaS or “Software-as-a-Service” is a deployment model where an application is provided to customers without the need for them to host the infrastructure to run the application. In prehistoric days, you would buy software, and the server to run it on, and run it all yourself in your own data center. If you interchange “SaaS” and “subscription” most people know what you mean, but as newer pricing models come and go it’s helpful to know exactly what you are talking about. For the purposes of this article I’ll mostly show how a subscription-based company runs as I feel it’s still the most common and illustrates why a basic understanding of account principles is not enough.

Revenue

Basic Setup & Context

Revenue is the income to the business for the sale of goods and services. Bookings gives you a future-looking view at your revenue by summarizing the value of the contracts you have signed with your customers. Think of it like your revenue backlog - it’s more or less locked in and will convert to revenue at a stable rate. Revenue is “recognized” on the accounting books as real when value or services are delivered. For subscription-based businesses you may sign a year long contract and even receive the full year value up front (you get all of the cash day 1), but the revenue is typically recognized monthly, with the logic that your customer has not received all of the value of the service on day 1, and that they continue to receive that value evenly over the duration of the contract. This is distinctly different from hardware products (or going to the grocery store) where you typically have all of the value as soon as you pay for it and have it in your hands.

Here are a few simple examples assuming:

• $15/mo subscription price, paid monthly

• $12/mo subscription price, paid annually

• $8/mo subscription price, paid annually for a 3 year commit (20% discount for 3 year)

Good news! Revenue is still what they teach in school which is effectively price * quantity. In a subscription business however, you constantly get to re-sell the product to your existing customers every month or year depending on the renewal cycle. As a result, revenue really breaks down like this:

Revenue = (New Subs * Price) + (Renewing Subs * Price) + (Expanding Subs * Incremental Price Difference) - (Contracting Subs * Incremental Price Difference) - (Churned Subs * Price)

You will notice that sales to brand new customers, which often gets a lot of the airtime in conversations historically, is only one of 5 components. New sales are always important, but in a lot of subscription based businesses, once you are a year or two in, a lot more of your opportunity to grow revenue comes from better monetizing your base of existing customers than from selling to net new. There’s also reasons we’ll get into later as to why it’s much cheaper to get more revenue from existing subs than trying to find new ones. As you hit scale, keeping more of your existing customers should be a top priority.

This is why understanding your goals and metrics at a very specific level matter so much. Are you trying to show:

• Total revenue growth - new + renew + net expansion goes up, and you don’t care as much why

• New customer revenue growth - specifically revenue from net new sales has increased

• New subscriber growth (count) - the count of new subscribers has gone up, which typically matters more in freemium or delayed monetization models

I’ve seen many people talk past each other describing one of the three above when they actually meant different things. Which one your business cares most about depends a lot on the investors, the board, and the leadership team, but regardless of which ones matter and how much, it’s up to you to understand what is important and why.

Selling to New New Customers

I will say up front that there are hours of content available out there on each topic below. I want to expose existing and aspirational product managers to the baseline content, but fully expect you should go do additional research and dig in more on each of these to really understand them. I found this site to be a really great guide if you want more detail on some of the metrics discussed in this post.

Acquisition

Before you can actually sell someone a product, you need to acquire them. There are entire courses on customer acquisition and I’m not attempting to do the topic full justice here, other than to point out the fact that A) PMs need to understand and care about this topic, B) it ties into the new customer revenue C) the lack of it in renewals helps illustrate the economics of upsells and retention.

One way or the other your customer needs to hear about your product and get to the point where they are able to make a purchase decision. Typically this is done via some combination of marketing activities and outbound sales (”business development” done by business development reps “BDRs”). The cost of all of these activities to find and get customers to the point of making a purchase decision is an important input to the entire model and is referred to as the Cost of Acquisition or “CAC.”

Historically, the dominate measure of acquisition efficiency has been something called “LTV to CAC” which is effectively the average value of a customer over their time with you vs the cost to acquire them. Think of it like a discounted cashflow model for an individual subscriber because that’s basically what it is . It does force you to ask the question - should we keep making this (sales and marketing) investment to get this level of return out of each customer?

For a complete explanation, see this.

Understanding this metric and the dynamics of the various inputs relative to where your company is in its growth lifecycle is key for product managers, primarily because some of biggest levers for accelerating growth may not be “new features.” Many consider the milestone of achieving a good LTV:CAC ratio (let’s say 3:1 or greater), is a true measure of the elusive product market fit. Product/customer fit is proven when people are actually willing to pay for your product as individuals, effectively demonstrating willingness to pay. Product/market fit is when you’ve proven you can find a lot of customers (efficiently) and they are all paying you. Now you’ve proven you have a business and not a hobby. It’s worth mentioning LTV:CAC is one way to measure but not the single standard. Here’s an interesting article with an alternative take.

Unfortunately too many product people fall prey to the old saying “to a hammer, everything looks like a nail.” If your primary orientation is to build new stuff, you’re going to miss the mark. You need to set your primary orientation to be “how can I optimize the company business model to achieve our objectives.” The product might be absolutely fine for your existing segment and the best way to accelerate growth is to reduce the cost of acquisition so that you can acquire more customers with the same spend level.

This is not to say that focusing on LTV is wrong or should get less attention. I emphasize acquisition because the factors that drive LTV (average value of the annual subscription * average number of years a customer stays with you) are where most of the traditional PM focus goes. Improving the existing product to improve retention and adding new capabilities to be upsold will have positive effects on LTV and you should try to optimize this as much as possible. Looking at the full equation helps the business figure out how to manage cash and accelerate growth if possible.

Conversion

Once people are aware that your product exists you need to get them over the line to actually pay for it, which is typically referred to as conversion. Exactly how this happens varies widely depending on the product, the customer base, the price point, and many other factors. For more complex products and in general in the past, sales teams would often be responsible for getting customers to close. For less complicated products that are more self-service, many companies focus on getting the customer to convert without any human interaction via a freemium model, free trial, or just a direct purchase on the website.

Regardless of the model, the important thing for product managers to note is that you want to be sure you have appropriate instrumentation and metrics so you can adjust and improve as necessary. For self-service flows, this is where you hear about traditional conversion funnel metrics that show you exactly how many people make it from one step to the next as they land on your website, sign up for a trial, start using, etc. Again, entire courses are taught on optimizing conversion funnels on web and mobile. Go invest the time to learn more about each to increase your awareness and set of solutions you bring to the table and also learn about modern product analytics platforms like Pendo and Amplitude.

If you have sales team that is heavily involved in closing a majority of your customers, then you want to make sure you have visibility into metrics that typically live with your Sales Ops leader or head of sales. Understanding these metrics will help you isolate selling challenges from true product or experience shortcomings. A few examples:

• Sales per rep

• Conversion rate per rep

• % of deals that were “competitive,” in that you were truly head to head with someone else vs selling against “do nothing”

• Win / Loss rate per rep and overall, vs specific competitors

• Win / Loss reason

• Revenue / bookings / gross margin trade offs - depending on the sales comp plans you will see some “innovation” to optimize whichever metric pays the best, sometimes inadvertently causing a negative effect in some other metric

Quick side rant on Win/Loss data: you get out what you put in here. If you invest in spending time with the reps to train them on what the reason codes mean and what the actual competitor capabilities are and aren’t, then you might get usable data. Most of the time the reps are in a hurry as they are measured on productivity and unless it’s super clear, they’ll pick something in that field and move on. A month later a PM is trying to make roadmap decisions based on an inconsistently chosen trash pile. If you want win/loss data to be usable, take ownership, work with sales to get the codes and fields formatted the way you want and spend the time to train them yourself on what they mean. Grab 30min at lunch once a month to talk through the data with them and ensure they are coding things correctly, otherwise you might as well ignore it.

Remember, when there are people involved, they are unlikely to tell you that they themselves are the problem. If you have a sales team, make sure you have some way to evaluate if the selling / conversion experience itself is too cumbersome and the reason people are converting. You will always get a list of new features that would have closed the last 5 lost deals. As a product manager try to do sales call ride alongs, interview sellers, and customers who recently converted to probe for possible points of friction in the sales process that can be solved by product or process improvements.

Retention

Typically if you have a subscription based model and a decent sized existing base you’ll hear the term “MRR,” or monthly recurring revenue, come up quite often. MRR is a measure of how much (predictable) revenue is coming in every month and appears to still be the gold standard high level metric for measuring revenue of existing subscriber bases. While you may be watching renewals, churns, expansions, and contractions on a daily basis in any given month, you typically don’t know “how you did” until the month is over. MRR therefore provides a decent “sweet spot” metric that irons out week on week irregularities and is “often enough” to see real trends. Perhaps not surprisingly you are trying to grow MRR each month, so let’s examine what’s at play:

• New subs coming in (ignore for this part of the discussion)

• Existing subs renewing (continuing to pay the same amount)

• Existing subs churning (cancelations)

• Existing subs upgrading or expanding usage (paying you more per month)

• Existing subs downgrading or contracting usage (paying you less per month)

A lot of product people miss this as do a surprising number of business leaders. Most of the customers you are “selling” to are the existing subscribers who renew every year, not the new customers coming in and onboarding. This is why you continue to invest in existing features, why you come back and do v2 and v3 instead of “V1 and done.” It’s easy to get complacent and think “most of them are auto-renew” and they are happy, so let’s focus on adding features that let us target new customers. It’s always a balance, but your resource allocation are balanced appropriately to the mix of net new and renewing customer revenue you are looking to drive.

Technically there are two types of retention metrics to talk about. First is customer retention rate, which is percent of subscribers that renewed from this period to the last. Revenue retention rate is what % of last month’s existing customer MRR did you keep this month? Both are important and they can move in opposite directions at the same time. You can be losing customers (customer retention rate drops) while getting more money out of the ones you keep to the point it “fills in the hole” and net revenue retention is actually up for the same period. Neither is “bad,” you should just be mindful and watching both. Is this particular example, while in the short term it’s great as revenue is up, if you keep churning customers you’ll eventually run out of people to upsell and the revenue retention numbers will swing back the other way.

Just as with conversion, you should have a ton of instrumentation to provide leading indicators to retention issues and show you opportunities for growth. Traditional measures like NPS and CSAT are great and do correlate with renewal rates, but typically are not super actionable. Whether the scores are high or low there’s no obvious answer to “ok, so we’re doing what then?” This is where product instrumentation platforms like Pendo and Amplitude become super helpful. With solid analytics you can see things like:

• Who purchased but hasn’t really done anything with the product

• Who is using the product, but only a narrow slice of the capabilities they are paying for

• Who has a one or two active users, but 100s of inactive users

• Which parts of the product people come back to over and over again to use (habits)

• Which parts of the product people view once and never return to (usability issues?)

• Which parts of the product people never seem to find (navigation and awareness issues?)

Understanding all of these proxy metrics will start to give you a picture of the behaviors that predict customer “health” and thereby are likely to renew or expand usage. Similarly you can start to spot customers that are on troubling trends and try to course correct early before a churn happens. More and more companies are building complex machine learning models that use these and many more metrics like customer support contact events to build very accurate predictive churn models that drive automation for customer success, customer support, and even targeted upsells and offers.

The importance of all of these health metrics within subscription businesses has also led to the rise of relatively new function, Customer Success. Exact structure varies a bit, but for the most part once a deal is closed, a separate team that is responsible for renewals ensures the customer is appropriately onboarded, understands all of the features, and closely monitors the same usage metrics to ensure successful renewals. There has always been someone that owns renewals, but the big shift in recent years is the rise of customer success as a proactive function driving positive outcomes vs a historical “renewal manager” who was there to ensure payment or try to do a last minute save if the customer tells them they intend to cancel.

If you are a product manager in a subscription business and you don’t have a customer success function, strongly advocate for starting one. If there is one, they should be your most frequent touch point. Sales will give you a limited but important view of what’s missing to close new deals. Customer support will give you a limited but important view of what’s broken. Customer success is in the unique position to see ALL OF IT and give you something approximating a balanced view of what’s working and what’s not.

Expansion

Expansion is another way of saying “sell your existing customers more stuff” or sell them a higher priced offering. To the extent you are a subscription business with multiple pricing tiers, a customer may be able to expand (go up to a higher price point) or contract (go down to a loer price point) without renewing or canceling pretty much at any time. Obviously you want them expanding more than contracting and many businesses have rules in place to allow customes to move up whenever they want but contractions can only happen at renewal or by contacting support, etc. Other businesses let people move freely month to month.

The important take away for product managers is that introducing a net new capability to your existing customers that gets them to pay more can be huge, and in some cases is a much easier path to growth than building things to go after new customer in new segments as you don’t need to adjust all of the go to market elements. You already have your existing customer’s attention, you can send them emails and in-product messages, start a trial with a click and convert them with the card they have on file.

Side Note: Monetization and Pricing Strategy

In general, most businesses are not iterating on their pricing structure and price points as often as they probably should be. Many PMs can go a good part of their career and get very little exposure to pricing projects, let alone constant iteration. This is in part because ownership of pricing decisions within companies is either distributed among many groups or it is unclear. Sometimes product owns it, sometimes marketing, sometimes it’s a multi-function pricing committee that includes sales and finance as well. Regardless, a lot of companies spend a ton of time optimizing every other element of their business but refuse to engage in price experimentation, potentially leaving money on the table.

As a product manager the best you can do is expose yourself to as much content as you can find about pricing models and the different ways companies play with monetizing their customers. A great starting resource is the book Monetizing Innovation. Written by two pricing consultants, they give a great overview of common failure modes as well as pushing the idea that you should be testing pricing all the way through initial discovery, not just when the product is “done.” Also there are many videos out there that talk through the various monetization strategies such as trials, freemium, etc and how those interplay with acquisition models.

Side Note: Product Led Growth (PLG)

It’s hard to open up LinkedIn or Twitter or wherever you get your product management content these days and not see the phrase Product Led Growth (PLG) come up, and likely the name Elena Verna at the same time. Elena has done an amazing job distilling what she’s learned in her career and cranking out super helpful frameworks that layout options for PLG, when PLG will work or not, and how it intersects with monetization strategy. There are many videos out there and I’ll link to a few below, but in this interview from Lenny’s Podcast, Elena gives a brief description of what PLG actually is and some common misconceptions. In many ways PLG is the leading edge of what this entire post is trying to capture. The product itself is being used to solve acquisition, retention and monetization problems.

Additional PLG resources:

• Building Growth Teams (Reforge)

• What is PLG (Elena Verna)

Gross Margin

Gross Margin is the profit remaining from revenue (new and renew) less the cost of goods sold, which for physical product means the cost of the materials used to build the product. The cost of the batteries, metal, plastic, chips, etc to build an electric car are $30,000 and we sell it for $60,000.

In a SaaS/Subscription model, cost of goods sold typically includes:

• Operations costs - data center or costs of running the service on AWS or other hosting cloud

• Customer support costs - the costs of running a customer support organization (headcount, tools, etc)

• Any people you are paying to manually provide some part of the service behind the scenes

• Licensed software or services that are integrated in your product

For a SaaS business with a subscription business model, it’s not uncommon to see gross margin values near 80% to 90%. 30 years ago, the only way you could get to those type of numbers was by licensing IP (with no COGS). While it’s not the thing you are going to probably worry about as often as something to do with revenue or growth, as a product manager you certainly need to understand the key drivers of COGS for your product and be on the lookout for opportunities to reduce them.

I’ve written previously that while product manager don’t necessarily need to have a development background, being fully aware of the technical tradeoffs the team is making is a must. The engineering team owns “how” but there are often many different options available that have short and long term impacts on operational costs and therefore COGS. Most engineering teams are on top of this, but sometimes they are missing a piece of context that may push a decision one way or the other. Be respectful of people’s roles, but make sure you are aware of any and all COGS impacting decisions being made by the technical team you work with.

Summary

The role of product manager requires you not only to be extremely well versed on the details of your customers and their pain points, but also on the financial mechanics of your business and how it operates. Without a full understanding of both, you will be making suboptimal decisions and run the risk of becoming a “feature factory,” shoveling out new capabilities without regard how they positively impact the business. Ensure the you understand the key financial metrics of your company, and how they map to the work you are doing and your customer’s pain points. Leverage tools like an opportunity solution tree to show how customer pain points map to proxy metrics that map to financial metrics and always keep that duality in front of you. Remember, you are there to be a problem solver for the business, and you want to leverage your knowledge of the customer to come up with the best solutions.