Many high tech firms-software, hardware and Internet-make a consistent pattern of mistakes that reduce their ability to grow and increase their need for funding and management consulting. The recent NASDAQ meltdown is challenging the abilities of technically oriented management teams and forcing them to step away from their business models. It is key for turnaround managers and consultants to educate management teams about their choices in this tenuous industry.

As a consultant to and former CEO of software, consulting, hardware and Internet firms, I have learned over the years that management teams of many technical businesses fail to understand the economics of the selling process. Managing sales costs and sales cycles is one of the glaring weaknesses of these types of companies. Fixing the business model of the company typically requires changing its sales strategy.

Almost by definition, a high tech product is one with a short life cycle. While there are some high tech industries, such as pharmaceuticals, where patents offer protection and barriers to entry exist, most high tech firms have to deal with rapid life cycles and a need for rapid learning. In the computer laptop business, for example, product life cycles are approximately six months. And, in the software business, annual product upgrades are common. In Internet businesses, product improvement is frequently continual.

What this translates to is that there is an optimal period in which sales activities are most productive and where the value of the product is at its highest. This short window requires that companies effectively manage the cycle to obtain the most sales during that window.

In most markets there are three types of customers. Level 1 customers know they have a problem and have defined the solution. Level 2 customers have identified a problem but have not yet figured out a solution. Level 3 customers do not even realize they have a problem. Capital starved businesses need to focus exclusively on Level 1 customers. Among Level 1 customers, they must discard those with lengthy purchase cycles as prospects.

Segmentation choices affect the length of the sales cycle. One of the hardest lessons for entrepreneurs to learn is that segmentation does count. While in theory, many high tech products or services can be sold to many different types of buyers, selecting the right segment has dramatic consequences on the cost of sales, the need for working capital and the rapidity with which a company can improve its product and grow.

For example, assume that a company has one salesperson and that it takes about one month of effort to close a sale. Make the simplifying assumption that the salesperson's closing rate is a very high 50 percent. In theory, he or she should generate an average of six sales per year. If instead the company was trying to sell a product with a six-month sales cycle, the salesperson could only generate one sale per year. Under the second scenario, the amount of sale would have to be at least six times greater to compensate for the smaller number of customers and a higher need for working capital to finance the selling process. Clearly this points out that there are some dramatic performance benefits to having more customers.

First, a company can learn more from six customers than it can from one customer. At the end of the year, it will have on average, one customer with 10.5 months of operating experience, one customer with 9.5 months of operating experience, one customer with 8.5 months of operating experience and so on.

In addition, assuming it takes two to three months to get useful feedback from the early customers, the company has the opportunity to improve its sales, training and support processes with the early customers, thereby increasing sales and usage experience for later customers.

Most high tech firms expend too much managerial focus upon the closing cycle. Reaching profitability requires a broader view of supporting customers with an emphasis upon repeat sales and gaining customer confidence. The six components of the sales cycle are:

1. Time to Qualify. Many high tech firms with leading edge products confuse interest in their product with intent to buy. Qualification of a prospective customer's ability to buy quickly is critical. Without this capability, no leading edge firm will survive.

2. Time to Close. Focusing upon only the rapidly closing customers is clearly insufficient. The more high tech products I work with the more obvious it becomes that many categories of high tech products are so complicated that selling is only the first stage in a value-creating relationship.

3. Time to Competence. Getting the users to use what has been bought is the next and equally important challenge. In areas such as software and Internet businesses, making sure that usage occurs is a critical activity. In the case of a software tool, it may require actually providing professional services to make sure that the client has a quick and early success. In other businesses, usage may require training and customer support programs.

4. Time to Productivity. In many high tech businesses, trial and usage may be obtainable, but it is the repeat sale that is the source of profitability. Many high tech suppliers fail to manage this next step by not making sure that they assist the client in understanding the benefits of using the product. This “time to productivity” requires that the client understands that the initial product has paid off and there is now strong evidence for purchasing more products or services. This can mean creating cost benefit measurement models, white papers, business cases or actually doing measurement work on the customer business.

5. Time to Repeat Sales. Recognition of productivity is not very useful unless it can be converted into repeat sales. The data is very clear that repeat sales are less expensive and more profitable.

6. Time to Reputation. The final stage in any high tech business is what I call “time to reputation.” At a certain point, a high tech supplier has demonstrated its ability to reliably create value and service the customer. At such point, buying decisions start to be predicated far more on the business consequences of the usage and less on the more tactical issues of features and price. Reaching this stage is the objective for all product launch and sales strategies.

In the late 1990s, many Internet businesses built their user bases by giving away software. Some, such as Netscape, were fortunate enough to be bought before they monetized the relationships (converted users into paying customers). In the harsher light of the NASDAQ meltdown, companies are now faced with a more traditional requirement of building self-funding businesses.

In sales terms, discounting or giving away software to create a standard has the enormous benefit of reducing the effort required to create a standard. However, in a world of competitive giveaways, the giveaway is not a business, it is only a sales tactic for the profitable or optimized sale of something to be purchased later. With the exception of unusual market segments, putting a great deal of effort into giveaways makes little sense without an upgrade strategy.

In effect, the trade-off is the following: The cost of getting the giveaway into the hands of customers and the upgrade sales, marketing and customer relationship management costs offset by the revenue from the upgrade and future multi-period revenue opportunities versus the working capital and capital investment required for a more selective sales process where the company is charging for its services.

Another way of looking at the same problem is to express it as a single period profitability goal versus a multi-period profitability goal. Clearly, in looking at the behavior of Microsoft versus Netscape, Microsoft had the advantage of deep pockets, which allowed it to take a multi-period view of browser-customer profitability.

In other words, in a specialty product where learning from each customer is very high (contributing in the table to a 10 percent improvement in value over launch value) the difference between having no customers and one customer is a ten percent improvement in value, but the difference between launch value and having ten customers is a value rating of 270 percent or 160 percent improvement.

At a certain point in time, learning from customers drops off and mathematically the above model runs into an exponential growth problem. But interestingly, an alternative view might be that with enough customers, new learnings emerge about the value requirements of a segment or on a personalized marketing basis. Businesses based upon customer intimacy can, with enough purchase frequency, experience a similar value enhancement on a per customer basis.

The same effect holds true for mass markets where each new customer contributes proportionately less learning about overall value creation. What is particularly interesting here is the mathematics of value improvement-for product categories that require extensive customer learning or where customer needs are evolving quickly, rapid learning can lead to disproportionate creation of value if enough customers are acquired quickly. And, if capital investment is required, for example, in data mining or customization software, size may be a requirement for affording the analytical and delivery capabilities.

Some managers may feel uncomfortable with this analysis, but if we think about the change in value perception of customers, we are not talking merely about features improvement or bug fixes. Value to a customer covers many different areas such as the benefits of a using a product that is becoming a standard; the ability to exchange information with other users and customers; the existence of knowledge, support and print material focused on the high tech product; the availability of complementary products; certainty about the survival of the product due to market share; the ability to provide support and the ability to personalize products and services based upon customer intimacy.

The ability to increase value and stay ahead of the competition is a key issue in sales, because as every salesperson knows, a superior value proposition is easier to sell. The data on new product development is unequivocal-a high level of differentiated value causes a 98 percent likelihood of product launch success. In other words, a superior value offering means higher sales.

Having demonstrated that learning from customers can help companies improve their value proposition in terms of products/service performance, segment value or personalized value, the question arises: How does a company capture these opportunities for improvement?

There are no simple answers. Every company is going to be different, and with varying resources, prioritization will be critical in selecting the methods to use. Approaches could include the following:

One of the most commonly made mistakes at high tech firms today, particularly the ones I have consulted in Silicon Valley, is to focus only on the technical side of the business. One company with whom I worked was so obsessed by the building of a piece of software that it did not notice for eight months that it had been walking away from major service revenues that would have obviated the need to raise funds-a big plus in a difficult funding environment. This company is not alone in the blind spot.

The fact is that engineers and programmers like to build things. However, customers want solutions. Often they do not care about the mix of the solution - whether it is all self-service or whether it is a mix of products and services. By missing this simple fact - that services represent significant revenue opportunities-many high tech firms make raising money much more difficult than necessary. By changing their sales process, they have the ability to solve multiple problems at the same time. First, the sales cycles can be shorter. Second, companies can gain a more intimate understanding of customer needs and perceptions of value. Third, companies can reduce their need for fund raising.

Another common misconception in Silicon Valley that is prevalent among venture capitalists and those companies seeking venture capital is that the only leveragable business model is a “high R&D” software or hardware business. The logic goes as follows. In software, for example, margins typically run very high. Depending how costs are allocated, software has an incremental margin of 85 to 99 percent. Each incremental sale greatly contributes to cash flow.

However, what this analysis ignores is that R&D, sales and marketing expenses must be allocated over the volume of the product sold. If the sales cycles are too long, the company will not have enough time to close the required number of sales to amortize fixed costs. In effect, it will not make money on any sales.

The apparently high margins of many high tech businesses will only materialize in the event of success. It is noted that success is difficult in a market where multiple competitors are being funded by multiple venture capital firms or where marketing resources are weak because funding has dried up.

For such reasons, I would argue that companies that take a less theoretical view of solving customer problems are more likely to be self-funding, to develop good knowledge of their customers and to succeed.

As Treacy and Wiersema point out in their book, The Discipline of Market Leaders,[2] there are three ways of seeking leadership: technology leadership, process leadership and customer intimacy leadership.

Technology leadership is the default bias in Silicon Valley. However, when I point out to clients that Dell is arguably the most successful personal computer company ever, they realize that process leadership can build a huge business.

In the future, it is my belief that customer intimacy leadership will be perceived as increasingly attractive. The explosion in technology has caused technology indigestion in many prospects. They cannot keep up with all the technologies required for their business. A straight “technology sell” will in many cases be inferior to a services, ASP, out-tasking or solution sell.

Customer intimacy not only translates into improved products and services, but also a better ability to target the right product and increases the probability of repeat purchase. (See Table 2.)

Clearly, the more customer education that is required or long approval processes are experienced, the less profitable pioneering sales efforts will be. Another implication of these figures is that many high tech firms underestimate the synergy of selling additional and complementary products and services to existing customer bases. In a customer intimacy leadership strategy, owning the relationship allows a different procurement strategy for resale.

Managing the relationship with existing users and customers leads rather naturally into the next issue of customer relationship management (CRM), because existing customers are more likely to visit and use lower cost forms of interaction with a high tech firm. Identifying when high cost human interactions are necessary is a critical activity in maintaining customer intimacy leadership.

Other costs that are typically ignored in sales strategies are the costs of developing the customer relationship management process. Companies typically discover that if you analyze the cost of CRM prior to launching products and services, it changes the profitability of proposed new products. To model this problem for one start-up, I worked with Primary Matters, Inc., a management consulting and software development company focused exclusively on customer contact center discipline. Our projections determined that the company would need 300 support staff by the end of year three due to the variety of services that the initial founders sought to provide. With better costing information, the strategy had to change.

Another misconception about CRM costs is that they are costs. For many companies, the variety of CRM interactions actually represent part of the sales force, have different cost structures than expensive direct sales activities and need to be modeled as a revenue rather than a cost center.

I work with several business incubators. A typical problem for these firms is that their experience of sales management is very limited. It seems that very few high tech firms have sales and business development experience. A common question plaguing high tech start-ups is how much commission they should be paying their salespeople. This turns out to be a difficult question to answer unless the company has a costed sales and business development strategy. Far more choices in sales strategy exist that most founders realize, including:

When costs of the different approaches are modeled, it quickly becomes clear that measurement of sales costs is a far more complex task than it used to be. The strategic choices of what to do in house versus what to outsource, strategic alliances and commissioned sales representatives can only be addressed by modeling the choices and tracking the data on an ongoing basis.

There are some basic conclusions that seem to be true, however. Of these, the primary conclusion is that selling mid-priced products in the $1,000 to $25,000 range is typically unprofitable. Smaller items don't require extensive budget approval; larger items can support a sales process.

Many small innovative high tech companies believe that the cost of a direct sales force is prohibitive. They turn instead to indirect sales and strategic alliances. Perhaps the most important lesson in negotiating and developing such distribution strategies is that many inexperienced start-ups do not anticipate that the sales and sales support costs for such relationships are exceptionally high. I have frequently seen small companies accept distribution deals, development contracts or alliance deals with large firms, but not be able to exploit such relationships because they cannot manage the large investment needed to make the typically large alliance partner effective. Again, these costs and opportunities can and should be modeled in advance.

In the mid-1990s, I spent a great deal of time training telecom managements to deal with competitive environments. There were several consistent errors made in the simulation we created that I see time and again with high tech firms. First, most managers are reluctant to use price as a marketing weapon or to regulate demand for their product if they have bottlenecks or capacity constraints.

Given the emphasis upon short life cycles and unpredictable buying patterns for novel or disruptive technologies, measuring the impact of price (and other aspects of the marketing mix) takes on new importance. In many cases, management teams have been overly influenced by strategic theory and their vision of the company and insist upon excluding revenue opportunities from segments of the market that are not in “their mental model.”

Another frequent error is to fail to consider different pricing models. When you have a bundled product and service, you have the choice of charging for the product and giving away the service, charging for the service and giving away the product, or charging for both product and service.

From a sales and customer purchase perspective, these approaches have different effects upon the closing cycle. Experimentation makes sense. If you sell your hardware as a service, it may be purchasable immediately. If it is a capital expense, it may be subject to different rules, pools of capital and buying processes.

The data on new product development success says quite clearly that early marketing homework makes a difference. I believe this is just as true with a high tech product whose features are evolving quickly. Rapid and early crisp product definition helps everyone in the organization sell the product. Monitoring the market will evolve that specification, but market research, usability analysis, “living with” the customer, focus groups and attempts to understand the different features, services and levels of service can only help improve performance. And, in most markets, segmented pricing will also produce a higher rate of success. One size does not fit all.

The action steps that come from these prescriptions will vary based upon the situation of the high tech firm. But as a general rule, the following steps will prove useful:

• Review the sales performance of the firm by type of customer. In particular, focus on whether or not the company is making it simple for customers to do business with it.

• Model the cost of servicing customers, distributors and strategic alliance partners. Consider either refocusing efforts and dropping customers or testing different sales approaches including selling distributed products or targeting other segments.

• Develop improved training materials for customers, improved white papers and cost-benefit analyses, or consider offering more professional services.

Alistair Davidson is the founder and managing partner of Eclicktick Corporation, a technology strategy firm based in Palo Alto, Calif. He is also the former CEO of IPARK Venture Campus, a San Jose business incubator. His career includes founding three software and consulting firms. In addition, Davidson is the author of three books, including the free e-book Turn Around! A Brief Guide to Starting, Growing and Turning Around your Software or Internet Company, available at www.eclicktick.com. Davidson also has an MBA from Harvard and has developed and launched numerous software products. He may be reached at alistair@eclicktick.com.