Fixing Internet and Software Companies

Contact information: Eclicktick Corporation, 1560 Sand Hill Road, Suite 304, Palo Alto, CA 94304

Phone: 650-322-8880. Cell: 415-225-8610. Web site. www.eclicktick.com

The Internet does not change the fundamental task of software development whether you are a software company selling a tool or an Internet company for whom software is a way of manufacturing a service.

Companies developing software for the Internet still make the same mistakes that software companies have made for years. They still fail to specify their projects properly. They still fail to do usability testing. They still make poor tool choices. They still get their pricing and business model wrongs.

What the Internet does do, in a sense, is give you more room to make mistakes. The cynics would say that the Internet software developers made the same mistakes that personal computer software developers had made, who made the same mistakes that mini-computer software vendors had made who made the same mistakes that mainframe software developers had made.

But the major difference with the Internet comes from a fundamental law of economic geography.

“Small markets support few niches.”

The corollary of this law is that:

“Large markets support many niches.”

The Internet is in a distribution sense, the largest market in the world. It allows highly specialized companies to economically reach thin markets that would otherwise not be sustainable.

The consequence of this sustainability of thin niches is that software companies are exposed to more competition than they could ever have dreamed of before. Software is one of those products that is relatively easily sold over the Internet.

The Economics of Software and the Internet

Fundamentally, the ability of software companies to reach more customers around the world means that segmentation is increasingly more refined. What might have been a legitimate software business strategy prior to the explosion in the Internet may no longer be defensible.

Achieving market leadership in your category is increasingly important to economic success. If you are not the category leader that everyone points to, you will not be found by search engines, reviewed in magazines or discussed in chat groups.

The economics of software development have two components.

The learning curve that you descend in order to solve the problem first for one customer and then to generalize about it.
The number of customers over which you can allocate your development costs.

In general, software should be a scale game, where vendors with more customers have the ability to allocate costs over a larger number of customers and hence have higher profitability and more marketing resources.

But talent does make a difference. There is wide variation in the quality of the architectures developed by firms and the rate at which they can learn from their customers. In the long run, the truly successful vendor must learn more, learn faster, market more and gain more customers.

Learning from customers means learning what they will pay for. And equally as importantly, a firm must learn which sales channels are most cost effective (viral marketing, web site, direct mail, e-mail, seminars, trade-shows, telemarketing, direct sales, resellers, OEMs, VARs). For a tool vendor like Oracle, it could be the raw tool, or it could be the value added consulting services. Or it can be services with higher value added such as applications.

Relationships and Pricing

Over the years, I have found that the costs of sales, marketing and support tend not be hugely influenced by the cost of the software product. Selling a $2,000 product seems to be as much work as selling a $20,000 product. And there is really not a huge difference between selling a $20,000 product and a $200,000 product. So, unless you are in the impulse purchase price range, typically under $100, you might as well focus your efforts on larger more profitable relationship opportunities.

I use the term “relationship opportunities” because fundamentally selling software is about creating a relationship with a customer. Any great piece of software should be used by a customer over a multi-year period. The upfront sale of software is only part of the relationship. It also includes training, support, upgrades and related products and services.

A Useful Sales Framework

Category 1:

Those who know they have got a problem and have some idea of what the solution is.

Category 2:

Those who know they have got a problem and don’t know how to solve it.

Category 3:

Those who don’t know they have a problem, and so would not be interested in a solution if it fell from heaven.

With limited sales resources, you have to focus your sales efforts on Category 1 customers. If a Category 2 customer approaches you, you can sell to them. But, under no circumstances should you bother to sell to Category 3 customers.

What is problematic for the sales person is that within a Category 3 company, there may well be a Category 1 or 2 manager, but unless he has a great deal of authority, the Category 3 company will be unlikely to buy.

Managing For Value

The basic theory of company valuation states that a company value is driven by its free operating cash flow. Free operating cash flow represents the cash that is spun off after reinvestment necessary to sustain the business. Discounting the free operating cash flow after reinvestment to sustain the business (FCF) is the major component of typical valuation models used by financial analysts.

At the early stages of a company, the focus is upon product completion, launch and reaching a positive cash flow. But a positive cash flow in the software business is not necessarily a sign of good health. If stable sales require continuing investment in R&D just to maintain the state of the business relative to competitors, then the FCF may be negative.

Measuring Free Cash Flow

For the early stage company, where buyers are leading edge adopters, the strategic objectives are typically to meet the specialized needs of leading edge adopters in order to build a productized product that will be acceptable to the mass market as the product category emerges and the market switches to a growth market.

For the growth market stage company, the strategic goals are typically to build a brand so that in an uncertain world, buyers will select the software over less appropriately or well branded software. During this period of rapid revenue growth, the objective is to drive down the cost of delivery while improving product/service performance and enhancing the brand.

In the mature phase of the market, the strategic goals is typically to gain a low cost position with a superior value product and high market share, reaping the benefits of the learning curve descended, and building a scale barrier to entry.

At each stage, the FCF Steady State will be different. If you are not investing sufficiently in R&D, working capital, staffing and infrastructure to maintain what we might call the Strategic Steady State, then cash flow will overestimate the value of the business by taking into account the need for transforming one Steady State into another.

In other words, the Steady State for an early stage market will not normally create a sustainable position of competitive advantage without additional investment.

Modeling Value Creation

Even within a single product company, there exists a portfolio of investment choices. Every company has a value chain consisting of activities. Activities are done on behalf of a segment targeted by the company. Each activity can be driven by six major classes of cost drivers:

Learning or experience curves.
Scale cost drivers.
Capacity utilization cost impacts.
Complexity and focus effects.
Yield and quality drivers.
Time and coordination cost drivers.

Senior executives play a key role in software/Internet companies by choosing which activities and which cost driver improvement merit investment by the company. And of course, the importance of cost drivers will vary as the market matures.

In some cases, mergers and acquisitions are useful tools for acquiring expertise, knowledge, improved processes or changing the cost drivers of a business.

One of the challenges of software company cash flow forecasting occurs over multiple period forecasts. Because good businesses, whether software or Internet, must rely upon repeat sales and customer multi-period profitability, the major uncertainty for companies is ensuring that they are paying attention to retention. Focusing upon customer acquisition cost, without putting in place programs for measuring customer satisfaction will inevitably cause customer defections. Judgment about the value of a company is often predicated upon assumptions about customer retention rate. Amazon.com is an obvious example. It will fail if it cannot make multi-period relationships profitable and its value will rise or fall on its success in managing customer relationships and repeat purchase.

In early stage companies, learning and experience curves are typically very important.

Technical developers are learning how to build an effective product and begin the process of engineering the software development process.
A new management team is learning how to work together, make decisions and put in processes that are appropriate for the company’s current complexity.
Determining how to hire, train, motivate and manage staff that are a fit with the company’s mission, values and value add requires experimentation.
Marketing is experimenting with different marketing programs, pricing schemes and distribution approaches.
Sales staff are experimenting with different classes of prospects.
Customer support is learning where the users are having problems and where costs are being incurred.

In growth stage companies, additional elements come into play. Some of the lessons from the early stage market need to be unlearned to “cross the chasm” and become successful with the mass market. New areas of focus now include:

Growing the scale of business.
Changing the culture of the business towards a more marketing, test oriented, empirical culture that relies less on intuitions.
Internationalization of the product.
Launching the product in new market segments.
Launching the product in new countries.
Increasing the breadth of the functionality or services.
Adding additional value to the product or service offering.
Developing new channels of distribution, strategic alliances, major account sales and installed base marketing programs.
Improving business processes and reengineering work-flows.
Development of improved infrastructure for decision-making, budgeting, planning and control.

In the growth stage, companies need to ensure that the complexity of their business has not rise too high. Complexity generally leads to higher costs and a key objective at this point in the market is to keep improving the cost structure of the firm. Firms that become too complex such as IBM had to go through a process of shedding 90% of its business lines in order to be able to focus on the growth areas of its business.

In the mature phase of the market, a certain rigidity typically sets in and the company frequently has difficulty simultaneously driving down its cost structure, and simultaneously investing in the next generation or family of innovative products. Organizational restructuring is common at this stage to ensure that over- or under-investment in old and new products respectively does not occur.

Running Out of Money

Most software companies fail. The primary reason for failure is under-capitalization. Software companies are easy to start, but product completion, testing, launch and achievement of cash flow are typically an order of magnitude more expensive and more difficult to achieve. And many software companies gambled that, if they could complete the product, more dollars can be raised.

There are no easy solutions to starting and making an under-funded business successful, but the following guidelines may help reduce the amount of loss and risk and maximize your chance of killing bad software businesses earlier.

First, it is essential not to spend 100% of your available capital on product development. Software without marketing dollars to support it rarely succeeds. The rule of thumb is to spend no more than 10-20% of your capital on bringing your first product to market.

Second, it’s important to remember that for most companies, the first generation of software will at best be limited in functionality and at worst totally mis-targeted and mis-architected. You will not achieve the margins you expect on your first generation product because of the learning curve you will have descended and the need for the development of the second and third generation product.

Third, selling software is generally hard. Don’t believe your spreadsheet. Probably the only strong indicator of easy sales will be shown if customers are beating a path to your door because they cannot find an equivalent solution to your software product.

Fourth, if your product is innovative, you need even more cash flow to support a long educational process.

The Magic of Success

There is a certain magic to businesses that work. Events seem to flow naturally into other events. The product was simple to build. Customers had a big need for the product. Adoption and demonstration of success was fast. Little customization was required. Customers moved to purchase more product quickly. Good software businesses, like any good business, are highly leveraged. Small amounts of effort create large pay-off.

If You Are In Trouble…

But these insights may not be helpful if you are already in trouble. Suppose, you have built your product, or it is close to completion, and you have 3-6 months of cash flow available. The first thing that you have to do is cut back. This will be painful. It will go against all the things I have written earlier about the value of retention, the value of being an employer of choice, but if the company is going to survive, cut early rather than late.

Your objective should be to stretch the cash flow, even if means delaying product launch. Yes, it is a costly approach, but raising money is costly too and very time consuming.

Reducing your costs means getting rid of anyone but critical developers. Putting full time staff on part time contracts or eliminating them. Some managers may be prepared to work for equity for a short period of time. Office space is probably optional in this financial situation.

And it may make sense to consider strategic alliances, distribution relationships or mergers to reduce the capital necessary to bring the product to market.

But if you put together all the numbers and it won’t fly, the ultimate solution is to sell the code or bring the code to the point where it can be sold. And if you can’t agree on price, there are many ways of structuring a sale including royalties and earn-outs where the price is based upon the eventual commercial success of your transferred product.

Is Your Business a Dog?

Rating Your Business

Factor	Assessment	Comments
	Rate each answer on a ten point scale from 1-10 where 10 is best performance, 5 is adequate performance and 1 is awful or non-existent.
Management
1. Does your CEO have the respect of the management team?	1-2-3-4-5-6-7-8-9-10
2. Is there a management team?	1-2-3-4-5-6-7-8-9-10
3. Does the management team work well together?	1-2-3-4-5-6-7-8-9-10
4. Has the management team avoided becoming burned out or emotional?	1-2-3-4-5-6-7-8-9-10
5. Has the management broad experience with this type of product/service?	1-2-3-4-5-6-7-8-9-10
6. Has the management deep experience with this class of customer?	1-2-3-4-5-6-7-8-9-10
7. Is there passion in the management team for the business and product?	1-2-3-4-5-6-7-8-9-10
		TOTAL AVAILABLE MANAGEMENT POINTS 70

Strategy
1. Does the firm have an explicit strategy?	1-2-3-4-5-6-7-8-9-10
2. Is the strategy being implemented?	1-2-3-4-5-6-7-8-9-10
3. Is the execution of the strategy excellent?	1-2-3-4-5-6-7-8-9-10
4. Does the firm care about quality and the customer?	1-2-3-4-5-6-7-8-9-10
5. Does the firm project the resource consequences of proposed projects to ensure success?	1-2-3-4-5-6-7-8-9-10
		TOTAL AVAILABLE STRATEGY POINTS 50

Financing
1. How many months of burn rate can be paid for out of capital and high probability projected cash flows?	1-2-3-4-5-6-7-8-9-10	Scale: One point for each month that the company can survive to a maximum of 10. Assume a ramp up of expenses for product launch.
Is there an ongoing cash flow management forecasting and management process?	1-2-3-4-5-6-7-8-9-10
Are the figures on which management is basing its decisions reliable?	1-2-3-4-5-6-7-8-9-10
Are the volume assumptions for success realistic?	1-2-3-4-5-6-7-8-9-10
Is the working capital trend getting better?	1-2-3-4-5-6-7-8-9-10	In other words, it is taking less working capital to grow the business based upon incremental working capital per incremental dollar of sales?
Is the company backed by investors with deep pockets who are interested in participating in subsequent rounds of financing? Or is the company spinning off cash and is not in need of financing?	1-2-3-4-5-6-7-8-9-10
		TOTAL AVAILABLE FINANCIAL POINTS 60

Competition
1. Does the firm have adequate knowledge about its competition?	1-2-3-4-5-6-7-8-9-10
Does the company have a superior value proposition to its major competitors or alternative solution providers?	1-2-3-4-5-6-7-8-9-10
Does the company have a sufficient marketing budget to make a significant impression on its target audience?	1-2-3-4-5-6-7-8-9-10
Does the company have a large competitor with a higher priced offering?	1-2-3-4-5-6-7-8-9-10	Surprisingly, having a large competitor is a good predictor of success for smaller companies. It allow them to price under the large company’s pricing umbrella.
		TOTAL AVAILABLE COMPETITION POINTS 40

Product
Does the product work?	1-2-3-4-5-6-7-8-9-10
Do buyers actually use the product?	1-2-3-4-5-6-7-8-9-10
Are buyers sufficiently involved with the product that they use it frequently?	1-2-3-4-5-6-7-8-9-10
Are the customers happy with the product?	1-2-3-4-5-6-7-8-9-10
Are the customers delighted with the product?	1-2-3-4-5-6-7-8-9-10
Is repeat purchase a consistent pattern?	1-2-3-4-5-6-7-8-9-10
		TOTAL AVAILABLE PRODUCT POINTS 60

Marketing
1. Is the product being sold based upon a clear benefit message?	1-2-3-4-5-6-7-8-9-10
Has the company understood the segments in its market?	1-2-3-4-5-6-7-8-9-10
Has the company consciously decided not to market to certain audiences?	1-2-3-4-5-6-7-8-9-10
Is the company seen as the number one or two player in its segment?	1-2-3-4-5-6-7-8-9-10
Is the market growing in unit terms?	1-2-3-4-5-6-7-8-9-10
Is the market growing in dollar terms?	1-2-3-4-5-6-7-8-9-10
		TOTAL AVAILABLE MARKETING POINTS 60

Sales
1. Is the sales cycles short?	1-2-3-4-5-6-7-8-9-10
Is the speed of sale improving?	1-2-3-4-5-6-7-8-9-10
Is the ability of a buyer to use the product improving dramatically with new releases?	1-2-3-4-5-6-7-8-9-10
Are customers accepting the price level of the product?	1-2-3-4-5-6-7-8-9-10
5. Can the product be sold by ordinary mortals rather than the founders of the company?	1-2-3-4-5-6-7-8-9-10
Does the company have effective sales literature?	1-2-3-4-5-6-7-8-9-10
Does the company have an effective web site?	1-2-3-4-5-6-7-8-9-10
		TOTAL AVAILABLE SALES POINTS 70

Technical team
1. Is the architecture robust?	1-2-3-4-5-6-7-8-9-10
Is there a clear distinction between the tasks of CTO, VP Engineering, and Chief Architect?	1-2-3-4-5-6-7-8-9-10