Morettini on Management

General Management and Marketing Advice for Software and Tech Companies

Category: Financing

Health of the Tech Economy

I was reading an article recently about how the number of new tech startups in my local San Diego area has doubled, to 70 new companies, compared to the same quarter last year. More than half of those startups were in software, computer hardware or communications. The article included a number of other criteria useful in measuring the health of the local technology market.

The direction of these measuring criteria for technology market health was somewhat mixed: Local tech employment was up, patents up sharply and M&A activity was up as well. Total Venture Capital fundings, which is an extremely important factor in tech company formation, came in less than half the comparable quarter a year ago.

So are these results a good proxy for the state of the broader technology business overall? I think they represent a very good set of indicators. Let’s take a closer look at some of these factors in a broader geographic view, in addition to a couple of additional indicators that I’ve added to the mix:

TECH EMPLOYMENT

I’ve added tech employment as it’s obviously a very key indicator of the health of any sector. Challenger, Gray & Christmas stated that the number of planned layoffs in technology fields fell to just under 47,000 in 2010, the lowest yearly total for the sector since 2000. The firm says this signaled that technology is recovering more quickly from the economic downturn than employers in other sectors.

During the next 10 years, the tech sector is forecast to experience one of the fastest paces of job creation of any industry. There are many anecdotal reports of strong demand for tech talent, especially in the crucial Silicon Valley market. Nearly 150,000 tech jobs are expected to be added in the US in 2011, says Sophia Koropeckyj, an economist at Moody’s Analytics. In February, there were about 6.1 million tech jobs in the U.S., up 2.4 percent from a year ago.

Tech sector employment trends appear much more positive than in the overall economy.

VENTURE CAPITAL FUNDING

The estimated market value of venture capital-financed companies in the U.S. rose 19% in 2010’s fourth quarter and 23% for 2010, according to the Dow Jones U.S. Venture Capital Index. The bulk of this is technology, and past returns are a very good indicator of amount of VC capital that will be available going forward. When VC funds have good returns, more money pours into their new funds, creating greater amounts of capital available to new startups in the future.

CB Insights report on Venture Capital Fundings in Q1 2011 showed total invested capital rose to $7.5B, up from $6.5B in Q4 2010 and $5.9B in Q1 2010. While a bit choppy, the funding trend has been generally up since Q2 2009. Again, this is bullish for the tech sector, which relies more heavily than most industries sectors on VCs for capital formation. Venture capital is still harder to come by than before the recession. However, while still down significantly from the go-go days prior to the recession, Venture capital availability is still a positive indicator of the tech economy’s health going forward.

M&A

The best tech M&A data currently available is from the first quarter of this year, and it is very bullish indeed. Mergermarket’s report on global M&A activity, published in April 2011, paints a bullish picture for acquisition activity in the early part of this year. This report shows the total value of worldwide technology M&A deals rose to $27,872,000 in Q1 2011, up very strongly from $10,729,000 in Q1 2010, even though the total number of deals decreased by 3 in this period. The numbers for North America were comparable.

It should be noted that while Q1 2011 compared very well to the same quarter in 2010, in both North America and Worldwide the trend was down from Q4 2010. So while M&A activity has picked up very strongly since the recession officially ended, the short term trend of the last quarter wasn’t a positive indicator for the future. This means that M&A activity is a bit of a mixed bag with respect to measuring the health of the tech economy.

TECH CAPITAL SPENDING

Forrester Research predicts that IT spending will increase in 2011 by a healthy 7.5% in the US, and 7.1% worldwide.

InformationWeek conducted a survey which showed that 55% of information technology professionals said their companies will increase information technology spending in 2011, while only 19% expect it to fall and 26% expect it to remain unchanged.

“Technology executives clearly see a sustained recovery of relevant Products/Services and a strong appetite for technology-related purchases by U.S. companies and consumers, which helped raise the position of the U.S. market,” said Gary Matuszak, partner, global chair, and U.S. leader for KPMG’s technology practice. “Coupled with demand from emerging-market countries, this combined opportunity bodes well for the industry.”

Technology capital spending trends, particularly in the US, provide a positive sign for the health of the tech economy.

TECH STOCK MARKET VALUES

The Dow Jones US Technology Index is up almost 20% over the last 12 month period. Stock values are very volatile and are affected by many factors other than the overall health of the sector, particularly in the short term. But over time they are a very good indicator of the health of the sector.

What Does It All Mean?

The indicators that we’ve taken a look at offer a mixed bag of conflicting signals up and down. While it appears more of the signals are pointing up than down, we are in an economy with a lot of uncertainty, and no definitive direction that can be predicted with any confidence. However, the software and technology sector appears to be in much better shape in the near term than both the US and worldwide economies overall. Farther out, the prospects for the tech sector appear to be much more bullish, especially when considering very long-term timeframes such as the next decade. Every company needs to draw their own conclusions about the economic impact on their market segment and individual company prospects. But in a larger sense, the arrow for the tech economy is more likely point up than down. If I’m the CEO of a software or tech company, the overall tech economy would be a positive factor in my decision matrix going forward.

So where do you personally think we’re at? Have we recovered, in the process of recovering, or is the tech business still treading water or going backwards? Post a comment and let us know where your own company’s situation stands with respect to recovery and future prospects.

Follow Phil Morettini and Morettini on Management via Twitter, Facebook, LinkedIn, RSS, or the PJM Consulting Quarterly Newsletter. Contact Phil directly at info@pjmconsult.com

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3 Comments by admin on July 17, 2011
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Choosing an Advisory Board for your Tech Company

Advisory Boards have become a very chic addition to software and hardware companies over the last 5 or 10 years. So what are the key criteria you should use in putting together an advisory board? Well examine this issue below.

Prior to the 5-10 year period mentioned above, it was rare to hear of a company that had an advisory board. What’s driven this trend? For public companies, it’s mostly because desirable advisers who formerly would have served as on the Board of Directors may shy away, as a result of additional potential liability in that role. For private companies, I believe it was the recognition that those filling private company board seats primarily are there because of ownership (VCs, local angels, founders etc.), and may not have all key domain or technology expertise important to the company at the board level.

As a result, advisory boards are very much in vogue, sometimes to great effect–but often not. I’d compare this phenomenon to strategic partnerships. In strategic partnering, you’ll see everything from deals that greatly benefit both companies, to others which start and end with a vague press release. Similarly, many companies seem to put together an advisory board just because it’s the “thing to do”. This is just a waste of time, of course. Like most anything, if you put little thought and effort into it, very little usually comes back.

Let’s take a look at some criteria that could be useful in putting together your particular group of advisers:

Domain or technology expertise

This may appear obvious, but I see a lot of advisers on boards that are there just because they know someone, or maybe possess specific expertise that just isn’t core to the company’s success. I believe it is very important to use your advisory board to fill holes in your management team’s knowledge or experience.

Access to capital

This is a common reason that CEO’s will recruit an advisory board member, especially in early stage companies where capital needs are a critical strategic topic. But I’m not sure that this is always the best use of an advisory board seat; unless raising capital will be almost a constant need. I prefer to fill advisory boards with more scarce talents specific to the company’s market and technology.

Access to distribution channels

Distribution access is another common motivation in seeking advisory board members. I believe this is a very legitimate goal for your board, especially if the adviser truly has special access, or if distribution expertise is a real weakness within the company.

Honest and straightforward counsel

It’s very important to attract experts who aren’t afraid to challenge the management team’s view of the world and “common business sense”. Of course as advisers they need to be tactful in how they convey their viewpoints. But “Yes Man” panel that makes senior management feel good is of no real use, and can even be harmful by reinforcing a false sense of reality.

Available bandwidth

I believe this is a criterion that is very critical, and is often overlooked. I see companies rejoice when they are able to convince a high profile, “heavy hitter” to join their advisory board. While the name may look great on a company backgrounder or on your website, the reality is often that their time is spread too thin to be of real benefit to you. So make sure that you have a frank discussion, and reach agreement on what level of involvement they can actually have with your company.

Motivation

This is the most important criterion of all, in my opinion. Probably also the one on this list that is used the least in considering potential advisers. It’s easy to get excited about someone that fits perfectly what you need on paper. But you will find many folks that are interested strictly from a self-promotion viewpoint. It’s exposure for them, and looks good on their resume. There’s nothing wrong with this, as long as it’s not the sole or primary motivator. Others may think it will help them in getting to use their services in the future. Or they may have some more sinister reason for getting close to your company. So make sure that the candidate’s reasons for engaging are above board, and that your interests align. I’m not trying to create paranoia in anyone’s mind. But I believe that the adviser’s motivation is the single greatest indicator of success or failure in this role. Don’t ignore it.

So there’s some basic advice to consider when putting together your software or hardware company advisory board. Many of you have done this as well. Post your own advice, successes or horror stories in the comment section below so we can expand this discussion interactively.

Follow Phil Morettini and Morettini on Management via Twitter, Facebook, LinkedIn, RSS, or the PJM Consulting Quarterly Newsletter. Contact Phil directly at info@pjmconsult.com

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2 Comments by admin on December 7, 2010
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The Future of Venture Capital Funding in High Tech

Like almost every aspect of the current economy, Venture Capital Fundings of High Tech and Software startups are way down.

There is pressure on virtually every segment of our economy, and the worldwide financial system is in by far the greatest disarray of our lifetime. The preferred exit strategy for Venture Capitalists, the IPO, pretty much shut down quite a while back. Financial returns at Venture funds have taken a hit like everything else financial, and VCs are definitely not in good position to attract new capital in the near term–given the current frantic flight to quality by investors. Things look dire in the VC business. There are even suggestions by many people, including some prominent VCs, that the long running and revered Venture Capital business model is “broken”, and that it will cease to exist as we now know it.

So what really is going to happen? Is the end of the world near? (well…maybe, based on the news headlines every day). Will a software or technology entrepreneur be able to fund their company via the VC route in the future? Let’s take a look at some of the things I expect to see happen.

SHORT TERM AND LONG TERM IMPLICATIONS
First of all, I don’t believe the end of the world is near. Nor do I think that the Venture Capital business is going away. There is a fair bit of pain left to go in this very down economic cycle, and the VC business will be no exception. So in the short term, new VC funds will have a difficult time raising money, startup capital will remain very tight, valuations will be lower and the whole experience of raising money will be even more painful than normal (and it’s always painful). Many VC-backed startups which haven’t gotten sufficient traction have been told if they don’t have 12-18 months of cash in the bank, additional funds won’t be forthcoming. But make no mistake, there are software and tech companies closing funding rounds every day. VCs still have not deployed a very large amount funds they raised in better times–that money needs to be put to work. There is still money out there in the short term for deserving business plans. And in the long run, the economy will rebound and things will go back to “normal”. I do believe that the Venture Capital business needs to make some adjustments, however–so it will probably be a “new normal”.

HOME RUNS VS. SOLID SINGLES AND DOUBLES
One of the staples of the VC business model has been finding “home runs”, meaning those companies that can grow large enough for an IPO. These are few and far between. VCs have always said they would gladly invest in 5 to 10 failures to find that one big hit. The IPO market has essentially gone away for the time being, which puts a lot of pressure on the basic premise of how to make money as a VC. I’ve always thought the “big hit” model was lunacy, and akin to throwing darts at a board–it’s so hard trying to pick out who the huge winners are going to be a startup stage. There’s a lot of luck involved in a company getting to an IPO, and even more luck involved in picking them out at birth. This strategy seemed to work fine when the markets were consistently heading up and to the right, and quite a few companies could do an IPO and get a billion dollar market cap. But I’ve always thought the very basis of investing and company building is in finding those companies that can give you a return on your money, skillfully balancing risk and reward. Considering those companies that have truly developed a strategic advantage and a sound business plan, some of them may get very big, others not so much–depending upon the specifics of their target market and business. But VCs for years have been basing investment decisions almost solely upon huge markets and the potential for the big hit. I think it was lazy investing, and that part of the VC business model may need some adjustment.

VC COMPENSATION MODELS
As VC fund size and limited partner returns increased during this golden era of VC funds, so too did the compensation to the General Partners of the fund. When funds and returns were outsized, limited partners swallowed hard or looked the other way. It’s analgous to a mutual fund with a hefty management fee–when the returns are great, it’s no problem. But in times like today, the small fees associated with an index fund look pretty good compared to that underperform mutual fund with active, expensive management. VC fund Annual Management Fees which have typically been in the 2-3% range will likely be reduced, or maybe even go away entirely. The 20% carry standard will probably hold, and may even go up and bit if there is heavy pressure to reduce the management fees. LPs won’t mind the carry if they are realizing good returns. What does this mean for the software/tech entrepreneur? It may not mean much, on the surface. But I do think it will require VCs to do more homework on their potential investments, which possibly gives an edge to those entrepreneurs will less dramatic, smaller business plans, but better risk profiles.

THE OXYMORON OF “LATE STAGE VENTURE CAPITAL”
I’ve always thought that the idea of “late stage” venture capital was kind of a joke. However, the Venture Capital business has been moving this direction for quite a while. Part of the reason is that VC funds have gotten so big that it’s hard to deploy all of the money with “real” startup investing. And also it’s a less risky way to get to that big IPO payoff. But really, these late stage funds have gotten pretty similar to Private Equity firms, except their time horizon may be shorter. So maybe these investors should really just be re-classified–in many ways they don’t look anything like their early stage brethren. At this stage, there are usually many other potential sources of capital. I believe that this late stage segment of the venture capital business is one that is due to shrink the most in the near term.

CAPITAL-EFFICIENT BUSINESSES VS. KISSING FROGS TO FIND THE “BIG ONE”
I think that the Venture business will trend back to true startup investing, and will reduce it’s reliance on the long home run as its basic method of making money. This is where they really add value to the “business-creation value chain”. What I expect to see is a renewed search for businesses which are “capital efficient”. What I mean by this are companies that will turn an invested dollar into a high multiple of that investment, in terms of revenue, profits and valuation. You might say this has always been true. But the key difference, I believe, is that that venture funds will be smaller, and as a result will feel less pressure to fund high risk, high ceiling businesses where a lot of capital needs to be deployed. As I stated earlier, VCs with large funds have previously felt that the economics of their business demanded this approach. With smaller funds, I believe that capital efficient businesses in smaller markets will no longer be ignored. Solid singles and doubles may come back in vogue (for those of you that understand baseball analogies!).

IS MONEY REALLY “SMART’? OPERATIONAL EXPERTISE VS. FINANCIAL GUYS
I’ve always felt that the idea of “smart money” has always been a fallacy, or least one that was greatly overblown in the Venture Capital business. I know that there are A LOT of people that will disagree with me on this point. A lot of startup advisors will tell you that it’s imperative to raise money from investors who will provide much more than cash. I think it’s a bunch of malarkey. No doubt that there are some experienced, skilled and very well-connected VCs that can provide a strategic advantage to entrepreneurs, who are fortunate enough to attract them as investors. But with money being a commodity, this is mostly about a VC firm trying to differentiate and provide a value-add. Fundamentally, the need for capital and the need for advice and other business assistance aren’t tied at the hip. Both are o
ften needed, but they don’t need to come from the same place–they are important, but separate ingredients to the successful startup recipe. If you can get both in one package, that’s great. But too many VCs present themselves as experts in areas where they’ve really just been investors. This is especially true for those many VCs that come from a financial background, rather than from a high tech startup management background. Frankly, entrepreneurs need to be careful of utilizing faulty advice, regardless of whether it comes from someone who has put money in their company or not. Having money in a pocket should not be confused with operational knowledge or expertise. I’m not sure whether it will happen or not, but I’d like to see the Venture Capital business present a more realistic view of the value that they are adding–it’s not the same in all cases.

SUMMARY: WILL VC FUNDING GO AWAY?
The short answer is “definitely not”. I do think that the bubble excesses have highlighted some weaknesses in the Venture Capital model. There will be adjustments to it–just like there will be adjustments in many other businesses, as a result of our economic duress. I’ve offered some ideas to get everyone thinking–please feel free to disagree, or otherwise add to the discussion. I’d welcome everyone to post a comment, if you have an additional take on this always interesting topic.

Phil Morettini
PJM Consulting
www.pjmconsult.com

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No Comments by admin on March 2, 2009
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Competing with Entrenched Software & Technology Industry Giants

A few years ago I was reading an article in the business section of our local newspaper about a new Search Engine name CUIL (pronounced Cool). I already knew about CUIL, because I had noticed that it had just recently indexed the PJM Consulting website. One of their claimed differentiating factors was that they’ve their search index was twice as large as Google’s is. In addition, they believed that they had improved the ranking algorithms, and they also present the results in a different way. The results offered fewer results per page, but more comprehensive information on each site, and often included a photo or other graphic. The premise of the article was that it could have a chance to be a real competitor vs. Google, or at least Yahoo and Microsoft for market share in the huge search business. The founders had impressive pedigrees and came from Google on the technical side.

While the article gave credence to the possibility of CUIL being a potentially serious competitor to Google, Yahoo and MS, it also pointed out that quite a few companies have attempted to enter this fray, creating barely a blip in search engine market share to date.

I took a quick peek at CUIL at the time–the presentation was definitely different and possibly superior for some tastes. But in my quick look I wasn’t terribly impressed with the relevancy of the search results. No matter how you present the data, the relevancy of the results is paramount in search. I stuck with Google, as it appears just about everyone did.

Did CUIL meet with any success at all? Well, they’re no longer in business, closing up shop in September 2010. They were barely around for two years. They’re took on what is arguably the most powerful technology company in the world today, attempting to compete with them in their core area of strength. So you can’t say that the odds of success were high, which they rarely are for any startup. And this might be the ultimate tough market to enter at this point. Microsoft has continuously poured money into competing with Google with little success, most recently with BING and the partnership with Yahoo. But this IS the technology business; everyone gets at least a puncher’s chance. The key to survival (if not success) is usually how well the  execution is, and it didn’t appear that CUIL executed very well.

But execution aside, what’s the best way to go about competing in the software and hardware industries today? Should you just steer clear of the elephants of the industry? Many believe this is prudent, but I think it is not always necessary. Well, maybe going directly at Google’s search engine isn’t the best bet! But it wasn’t so very long ago that is was nearly impossible to get a venture capitalist to fund a company that was perceived to compete in a category with Microsoft (which could be viewed as MOST categories of the software business). Yet a short time later, Microsoft is considered in many ways a dinosaur, one that is quite beatable (don’t get the impression that I’m writing MS off–I’m not. Redmond is doing fine and could still rise again).

If it isn’t insane to compete with the giants, what are some best strategic practices that an early stage tech company can adopt to give it the best chance to survive and thrive, when entering market categories with large, entrenched competitors?. Let’s take a look at a few ideas:

Make sure that you can differentiate – This would seem obvious for any business, but when you are going up against a huge company with a good brand–well, don’t even try it without significant differentiating factors. They don’t need to be product related, necessarily–it could be free and outstanding support, better (cost-driven) price points, exceptional ease-of-use or many other things. But don’t kid yourself–you will need REAL differentiation.

Pick a niche, any niche–at least to start – It is important to pick a tight enough niche so that you can provide that true differentiation discussed above. Your investors may want you to attack a huge market, but if you don’t have that influence pushing you in that direction, pick a smaller area that you can have a better chance of dominating when you’re new. If you are successful in your initial niche, you can then broaden out into adjacent segments. Down the road, maybe you take on the giant “head-on”; but starting out is NOT the time for this.

Raise more money than you think you will need – Every once in a while a new company will “hit on all cylinders” from the very beginning. But in my consulting practice at PJM Consulting, I rarely see this. In fact, part of my practice is helping companies “pick up the pieces” after their initial business plan or execution has gone awry. No one likes to give up more equity than they need to, but things usually take longer to start working than you initially project. There are usually too many things that you don’t know until you really get into the marketplace. Plus, it’s generally easier (and cheaper!) to raise a bit more money at first than it is after that first misstep. A little extra funding in the bank can be a good insurance policy against a capital crisis early on.

DON’T try to be like them - A common mistake that I often see early stage companies make is trying to “be like the giant competitor”. Sometimes this comes from an inferiority complex, and sometimes because the founders come from one of the giant companies themselves. The last thing you want to do is create a big company bureaucracy. In most ways, you want to operate VERY DIFFERENTLY from you huge, slow-moving competitor. Resist the urge to create huge amounts of process before your company size dictates it as necessary. Be very careful about hiring away senior executives from you giant competitors, unless you are certain that they also have successfully operated in an early stage company before. Stay as fast and nimble for as long as you can–that is a primary advantage at this stage of a company’s development.

Recognize the giant’s execution weaknesses and beat them there – Analyze the large competitor’s business, and try to create your differentiation where they are weakest. It could be faster customer service, better channel relations, better ease-of-use, etc. If you concentrate your differentiation where they are doing the poorest job, it will accentuate the difference to the marketplace, and you will have a better chance of your advantage being recognized.

Focus, Focus, and Focus – This advice can be viewed as the culmination of the points above. Make sure that you don’t try to do any more than you can do EXCEPTIONALLY WELL at this stage. You can always expand your focus later. Remember, there is a good chance we would all be speaking German if Hitler hadn’t prematurely opened up a second front with Russia in World War II. The tech landscape is littered with companies that followed an analogous strategy, with similar disastrous results (Novell and Netscape are two former high-flyers that immediately come to mind).

SUMMARY

As an early stage company entering a market where a major company or two are the known leaders, make sure that you don’t “bite off more than you can chew”. You can always expand your focus after initial success. Contracting your focus later is usually quite a bit more painful, and many companies don’t make it through that transition. That’s my advice on how to attack a large, entrenched competitor. As usual, I’d be interested in seeing your comments–post them below.

Follow Phil Morettini and Morettini on Management via Twitter, Facebook, LinkedIn, RSS, or the PJM Consulting Quarterly Newsletter. Contact Phil directly at info@pjmconsult.com

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No Comments by admin on August 15, 2008
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Strategies for a Technology Market Slowdown

Is the world economy slowing down? What are the implications for technology companies?

Recently, technology stocks (along with the stock market in general) have tanked. There is a credit crunch that shows no signs of abating, and inflation is rearing its ugly head in some markets, and political gridlock seems to be the order of the day.  Is the economy headed for a “double dip” recession–taking technology businesses down the drain with it?

I don’t think so, but I’m not in the business of forecasting such things. Tech stocks are often affected more severely than average in an economic downturn, which affects technology industry investment and ultimately tech growth rates.

So what should you do if you’re the CEO of a software or hardware tech business?

Be Prudent, But Don’t Panic
Now’s certainly not the time to stick you head in the sand, and hope the economy doesn’t get any worse. It almost certainly will; but more importantly, how will it affect your company? That’s what you need to ponder. Is your product a “must have” or a “very nice to have”? Obviously the “nice-to-haves” will have a tougher time in a declining economy, and should plan accordingly. So take the time to analyze you situation, and make a forecast for your own business, based up the unique circumstances of your market and company. Remember, hope is not a strategy.

Look For Opportunities to Outflank Weaker Competitors
For strong players, declining economies can be a great time to pick up market share from weaker competitors. If you have the resources and can do it safely, now might be the time to run a promotion, or selectively increase your marketing. It’s counter-intuitive to most managers’ instincts. But weakening the competition during a downturn can lead to stronger growth when things turn back upward.

Slow Near-Term Expense Growth, But Don’t Compromise Long-Term Initiatives
In most cases, companies will want to carefully monitor, and possibly cut back on their spending. You want to make sure that you don’t put your company in jeopardy, by have expenses out of sync with flat or declining revenues. But try your best to keep intact the initiatives that are critical to long-term growth. You must continue to think long-term as well as short term, assuming you don’t get in a situation where your survival is at stake. Cut back on advertising and office space if you’re seeing a slowdown–but make sure you don’t cut the product development project which will lead to growth 18 months hence. These can be tough decisions, but they really separate the long-term successful CEOs from the flash-in-the-pans. Almost anyone can manage when times are good.

Limit The Growth Of Your Staff
While prudent spending can be wise during a downturn, aggressively increasing the size of you staff usually isn’t. There are always exceptions, of course, but adding too much staff can really bloat your fixed cost structure, in a manner that limits your management flexibility. Unfortunately, many companies are often most aggressively adding staff at the end of a growth cycle–just in time for the downturn. If this leads to layoffs, it can have a devastating effect on your company’s morale.

Although layoffs are sometimes necessary, they are always painful and hurtful to the company culture–unless the company culture is already of the “Attila the Hun”, cutthroat variety. The founders of one of my former employers, Bill Hewlett and David Packard, ran HP for many years with a rule of thumb that limited staff increases to 25% of revenue growth. This helped them avoid the natural inclination to hire someone new every time a new task was identified. I believe was an important factor in many years of smooth growth–without layoffs. This particular metric might not be right for your company, but something similar could prove to be a useful damper on excessive hiring.

Make Sure That You Have Money For A Rainy Day
While it’s no time to panic, it IS time to make sure that you have the financial resources necessary to comfortably cruise through a downturn.  Availability of funds and terms will only get worse if the  stock market heads down further and the credit crunch continues. Also, make sure that you have available the largest line of credit possible with your bank. It may cost you an extra few thousand dollars a year, but its excellent insurance, if you are surprised on the downside. If you’re in startup mode and financing yourself on credit cards and home equity lines–maximize your future access to these as well! Whatever your sources of funds, make sure now that you’re financially well prepared for whatever the future holds.

Be Poised For The Next Upturn, Whenever It Happens
I mentioned earlier that you should try your best to keep long-term initiatives alive. In that same vein, your thought processes should CONSTANTLY be focused on the next upturn, in all of your decision-making. Again, this assumes that your survival isn’t in question. For example, while massive hiring isn’t usually wise during a downturn, you want to always be open to unique opportunities that may not come along often. Say there is a talented executive available, only because of the downturn. If you can safely afford him or her, snap them up now, before a competitor grabs them. Or retain a talented consultant to position yourself with a new technology direction or market segment when growth inevitably climbs. Downturns often present opportunities to improve your business when the next growth cycle occurs. But you need to be “looking ahead” and making good decisions now, to take full advantage of the upturn when it finally does.

Summary
Once again, now is not the time to panic. But it is an important time to plan. Anyone that can predict what will happen with an economy should go to the nearest casino–no need to waste your time with a software or technology company! So I suggest that it might be wise to do a “best-most likely–worst” 2 year forecast now, and try to plan as best you can for the two extreme cases. Post a comment and let me know your thoughts on how the economy and the tech industry will fare in the coming months.

Phil Morettini
PJM Consulting
www.pjmconsult.com

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1 Comment by admin on January 14, 2008
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System Integration vs. Product Development

I’ve recently engaged on assignments with two new clients. Both of them have businesses selling to large, blue chip customers. Customers of the size that are used to “having it their way”.  As a result, for these clients to get deal with these customers often includes the need for a lot of customization.

The interesting thing about these two clients is how they perceive and approach that need to customize.

A Tale of Two Companies

Company A views customization somewhat as a pain and distraction, something to be controlled–I assisted them with creating a standard solution offering menu outlining the “Base” offering, with a list of options available at an added cost. They really want to discourage certain customizations, absolutely won’t do some things that will be asked, and want to make sure that they charge dearly for items that they find painful. They have the classic mentality of a product company; they want to do the minimum amount of customization necessary to make a large sale to this important type of customer–but NO more than they have to.

Company B, which also considers itself a product company, has a very different mentality about customization. They welcome it, pride themselves on it and position themselves to these potential large clients as someone that can quickly bring solutions to the client, customized to their desires. They want their reps to be scouring the big accounts for unique pain points or opportunities which might fall within the company’s core capabilities, enabling them to propose a customized solution. In fact, up till now, their product development approach has really been to find out what individual accounts want–and build it for them.

So which of these two business models is the best way for technology companies to go?

System Integration Business Models
Advantages:
*More flexible and able to change with shifts in the marketplace

*Not as capital-intensive due to less “betting” on upfront product development

*Easier to grow business organically with internally-generated capital than in a classic product business

*Less risk due to lower upfront investments

Disadvantages:
*More competition; System Integration is an “easier-entry” business

*Generally lower operating margins than a standard product business

*Growth is less scalable than a product-oriented company

Product-Focused Business Models
Advantages:
*Provides greater opportunity for strategic advantage and resulting fast growth

*Less competition if a strong product/brand/technology differential advantage is created

*Can scale much quicker if a hit product is developed

*Higher operating margins if product is successful

*Usually more marketing-driven and less labor-intensive

*If creating a very large company is the goal it’s much easier to raise outside capital

Disadvantages:
*Much greater risk of “crib death”, resulting in complete capital loss if first product has problems in development or marketing

*Harder to “get over the hump”; success is harder to come by and success often happens as a step function after a difficult startup period

I want to emphasize that there isn’t necessarily a “wrong” approach with either of these business models. You can make a lot of money pursuing either model. Both of the companies I have used as examples have managed to attract blue chip customer which would be the envy of any company. What we are really talking about here is the difference between a classic product-driven company and a system integrator.

Company A is that classic product-driven company. They customize when they have to, but also have a point where they will say “no”.

Company B also self-identifies itself as a product company, and in fact they have built their business around a small number of standard offerings. But as their core strategic advantage they really are utilizing relationships, the ability to customize beyond what standard product companies (especially larger ones) are willing to do, as well as to react very quickly to customer requests. They’ve built a very nice business doing this, but have some frustrations as well. They are highly dependent upon a small number of major accounts for virtually all of their revenue, and have the major revenue/profit swings that are associated with this type of business–up one year, back down the next. They also are in constant fear that a larger company will come along and “take away” their marketplace, because they’ve continuously failed to create strong new products to build upon a core offering which is very dated technologically. The core offering is long-in-tooth and appears very vulnerable. This company is very account-focused (and therefore reactive rather than proactive), and the lack of a market focus has kept them from being able to create additional, broadly marketable products which provide them with a strong proprietary advantage (and causes a lack of sleep at night!)

Company A understands who they are and what they want. That doesn’t guarantee success, but it makes it much easier to build a plan that everyone agrees on. At that point success or failure usually depends upon execution, unless the plan is awful. If failure is the end result in this scenario, more times than not, the problem is in execution. Company B’s biggest problem is that they are floating right in the middle between the two business models. They are trying to leverage both of these business models, and struggling with execution, in some ways with both.

SUMMARY

It isn’t impossible to combine these two business models successfully. I’m sure that many of you can point to several examples of such a very successful compromise. In fact, most technology companies combine both of these models to some extent with good success. But I find that usually a company identifies its business model primarily as a product company or a systems integrator. That identification is their strategic focus, and takes precedence when prioritizing the use of always scarce assets.

The secondary business model is usually utilized on an opportunistic basis. Product companies integrate and customize as needed to get a big deal. Integrators create “products” to fill the needs of a big account, and sometimes happily find they are salable to other accounts. Occasionally, these “products” prove so widely salable that they are spun off into a separate product company, or the integrator changes its focus into becoming a full-blown product company.

The most important thing in my opinion is to understand who you are, and what you are trying to accomplish strategically. It’s the companies that are trying to equally leverage both business models at once without one model taking the lead that gets itself in a heap of trouble. That’s my opinion on Systems Integration and Product Development–what’s yours?

Follow Phil Morettini and Morettini on Management via Twitter, Facebook, LinkedIn, RSS, or the PJM Consulting Quarterly Newsletter. Contact Phil directly at info@pjmconsult.com

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Will Web 2.0 Lead to a New Bubble?

So there’s a new “next big thing” happening in the high tech world–that’s feels very, very familiar. In fact, it seems a lot like “déjà vu all over again”, to quote one of my all time favorite philosophers–Yogi Berra. I’m talking about the Web 2.0 phenomenon. The question I present is–what’s the difference between Web 2.0 and 1.0? Although there are obvious differences technologically, and there are a few wildly successful companies following a Web 2.0 style model–my reply is “not a lot” is different.

SOCIAL NETWORKING IS THE BATTLEFIELD

The recent buyout of YouTube by Google for roughly $1.6 billion dollars is what finally set me off to write this article. You see, this is EXACTLY the type of transaction that was representative of the bubble years. An overnight success, with a lot of eyeballs (ok, TONS of eyeballs!) and essentially NO revenue turns it’s twenty-something founders into near billionaires, just months after starting the company. Ok, it was 2 years, but you get the point.

Now we haven’t seen a transaction quite like this in a long time, but they seem to be picking up steam. MySpace was snatched up similarly by Fox for about a half a billion, also with almost no revenue at the time. Facebook also looks like it will be sold soon, to one of the new or older media companies, for a big chunk of change.

What’s happening is the Internet market leaders such as Yahoo, Google, Amazon, Microsoft/MSN, and older media companies trying to keep up, like Fox and Time-Warner–are fighting to get and retain the lead in all the important mass market Internet categories. The hottest one at the moment is referred to as “Social Networking”. The idea is that in Web 2.0, the user is much more of a producer of content in addition to being a consumer of it, so that the idea of online users as passive consumers of content is now passé. This new wave is hitting big with sites that are getting huge growth in traffic, like YouTube and MySpace, which enable their users to produce and publish their own content. But how much money’s really in it?

All the big players are afraid of missing this wave, and like most big companies with respect to societal shifts–have missed the boat completely, or have fallen behind their more innovative startup competitors. And yes, I now categorize Google as one of those less innovative, bigger companies. As much as they’ve tried to avoid that fate, they’ve grown very big quickly–and haven’t had a home-grown hit for a while in “Internet time”.

EYEBALLS FIRST, PROFIT LATER

What strikes me as so familiar about all this is that social networking from Web 2.0 looks A LOT like the “Communities” phenomena of Web 1.0. Both represent an attempt to “get the eyeballs first” and “we’ll figure out how to monetize them later”. Both are based upon the idea of getting people together on a user-driven site, as opposed to selling a specific product or service. And both are driven by a business model where the main source of revenue is expected to be online advertising.

Now I happen to believe that YouTube and MySpace will end up being able to monetize those eyeballs. But does that mean that everyone will?

Some of you might say that the difference is that online advertising has been legitimatized by Google’s unbelievable success with contextual PPC adverting, with their search engine Ads and Adsense network. That success is irrefutable. But does that mean it will go on forever, and that the public will tolerate text ads (or something even MORE invasive) littering nearly every square inch of unused webspace? Personally, I don’t think so. There is definitely a place for online advertising, and I expect it to continue to grow robustly for the foreseeable future. But everyone seems to forget that online banner advertising was also highly successful at the beginning of Web 1.0–until the public got tired of it, and tuned it out. Advertising revenue online dropped like a rock, and many companies were destroyed in the process.

Google has done a great job of improving on the online advertising model so that Advertisers became successful, allowing Google to ride on that success by taking a nice cut of the take. But even today, it’s getting more difficult all the time to make PPC campaigns pay off. The days of easy direct conversions to sales are gone in most markets, and using PPC as a lead generation tool–while still good business for many–is far less compelling. Will the PPC market leaders continue to grow fast for a while longer? I’m sure. Will it flatten out at some point in the medium term? I’m sure of that also. Will most of those companies that are raising huge amounts of venture capital, with online Ad-centric business models, find the same level of success? I’ll bet you everything in my bank account against this. In fact, I think that there is room for surprisingly few additional big players who DEPEND upon online advertising for their success.

PUBLIC MARKET EXCESSES

The other aspect that seems to distinguishes the Web 2.0 wave from Web 1.0 history is the lack of overheating of IPOs. In fact, the IPO market for Tech companies overall still hasn’t really recovered from the Web 1.0 bubble. In addition to the burn marks that remain on Wall Street’s hands with respect to Tech companies, SARBOX has also made going public less attractive to all growth companies. Exit strategies are more often based upon a sale than an IPO these days. But two things here: just because it hasn’t happened yet–doesn’t mean these IPO excesses won’t reappear later in the cycle. I believe we are still early in this one. Secondly, I wouldn’t preclude some type of financial bubble, even without public IPOs of nearly no-revenue companies like in 2000. Anytime hype over-inflates the value of assets, the downstream consequences can be severe. If bidding wars by the established companies get too out of hand, it could still end up having a real negative impact on the stock market and the high tech business environment, down the road.

HISTORY HAS A WAY OF REPEATING ITSELF

My final thought on this topic is that in the High Tech world, there is almost always more money chasing the “next big thing” than can receive an adequate return. This inevitably leads to many excesses, including a level of hype that can only lead to disappointment, for those who get in late or with marginal business plans. The result is a boom-bust cycle that we see re-enact itself over and over again. My thesis is that “eyeballs first, figure out how to monetize later” has always been, and always will be a flawed approach, for all but the fortunate few. If you’re buying into Web 2.0 in a big way, Caveat Emptor–Let the Buyer Beware. A history lesson can sometimes be the most prolific forecaster of all.

Will there be a Web 2.0 bubble, much like the original dotcom bubble? It’s too early to tell. But as I’ve outlined above there are some hints in the news that a repeat might not be that far-fetched.

That’s my take on Web 2.0–what’s yours?

Phil Morettini
PJM Consulting
http://www.pjmconsult.com/

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3 Comments by admin on October 22, 2006
filed in B2C, Business Models, Financing, Mergers & Acquisitions, SaaS, Social media, Software/Product Development, Startup/Early Stage

Expense Controls for Early Stage Software and Tech Companies–Can You Overdo It?

You’ve seen it too many times before–the free-spending startup company which burns through their funds like a cocaine addict on vacation in Columbia. It’s ultimately a sad tale, with great potential often wasted, many jobs lost and multiple lives hurt. But it is sometimes hard to feel sorry for the management teams that put these companies in precarious positions with poor judgment and lack of self-control—they should know better, and end up getting what they deserve.

4 WAYS THAT STARTUP COMPANIES SPEND THEMSELVES OUT OF BUSINESS

  • Spend it almost as fast as it comes in, because the market is overheated. This was endemic during the Internet bubble years, when even formerly conservative VCs were imploring their portfolio companies to “spend money faster”, and “get the eyeballs now, we’ll figure out how to monetize them later”. A lot of that was going on back then. Crazy, as we all look back at it now.
  • A more common situation where money tends to get spent way too fast is when a startup management team is staffed primarily with “big hitters”, coming from big company backgrounds. I remember in particular a mesh networking company here in San Diego, which burned through over $60M in VC money, while creating almost no revenue along the way. They hired an almost endless list of VPs from name brand, blue chip companies, paying them well over the going rates at early stage companies. The CEO came from a big telecommunications company (with no startup experience). He was paid a SALARY of $750,000/year. Yes, you read that right–I’m not even counting his bonus and option grants. In a company that was barely past the pre-revenue stage, and nowhere near profitability. It still amazes me.
  • Another scenario I have seen quite a lot are pioneer companies that are developing a novel technology or product, attempting to create a truly new market. What happens often in this situation is what I’d call an “itchy trigger finger”. That’s when it’s still too early to create the critical mass needed in a market. Instead of being patient, marshaling their resources and continuing to develop their products while educating the market, these innovators get impatient. They blow through their investment capital with a premature, huge ramp-up in Sales and Marketing, well prior to their product or the market being ready for this expansionary phase. Their large expenditures in Marketing serve only to prime the market, to the great advantage of their fast-follower competitors.
  • The final situation that you often see leading to overspending is the company that has been bootstrapping successfully (but also painfully) for a very long time–then finally is able to attract a round of Institutional Capital. Every startup has a long list of “like-to-haves” that they would spend money on–if they only had it. So it’s ok to knock off the most important areas at the top of the list, when that initial funding finally comes through. But like a starving man let loose after hours at McDonalds, some of these formerly prudent managers gorge on the new-found capital–spending it like its ongoing cash flow–not the precious investment capital that it actually is. Not being miserly with investment capital is one of the cardinal sins indicative of bad startup management. In this particular situation, it is otherwise sound managers who undergo a bout of “temporary insanity”– a particularly sad story.

So that’s one side of the coin–overspending. We’ve all seen it, and when you’re not inside the eye of the hurricane that is a startup company, it’s pretty easy to recognize. There is no doubt that this free-spending behavior has killed many a promising startup.

But what about the flip side of the coin–when managements are TOO miserly, and spend too little? This is an area that I have not seen discussed very much lately in early stage tech circles.

Now please keep in mind, I’m not advocating spending funds that you simply don’t have. Borrowing is rarely a good idea for an early stage software or tech company. If you don’t have the money–please, don’t try to find a way to spend it anyway! Conservation of capital is one of the basic pillars of good startup management practice.

Yet, there are some places where an early stage company simply HAS to invest, or the outcome will be almost certain crib death. Below are a few important examples:

STAFFING WITH GOOD PEOPLE

Good companies are built with good people. Great companies are built with great people. Period. Even the company with great brand equity and outstanding IP are doomed for a fall without the continued benefit of committed, smart staff. In a startup, it’s even more critical, because you don’t have any of the built-in advantages that a big company has, which might allow the enterprise to coast for a bit before heading south. Without good people, startup companies will not thrive for long. Even if a profitable business can be built, it will soon hit a wall, as a result of lack of depth in the employee pool. The initial founders can only take it so far without a strong supporting cast–growth will eventually stall. I had a client, a young CEO, who did a great job building a strongly profitable, multi-million dollar business in a large and competitive market. But his growth stalled because he viewed much of his staff like desk chairs, or any other overhead line item–an expense item to be minimized. Don’t make this mistake. Your staff is your lifeblood, not a ball & chain to be jettisoned at every opportunity.

CREATING A GOOD PRODUCT

Almost important as good people to a software or high tech startup is a killer product. Although there are many, many things that are important to a successful startup tech business, by their very nature, tech companies are almost always driven by a great product. There are exceptions, no doubt–but this is a pretty good rule. It makes little sense to cut expenses in product development (assuming that you’re spending the money wisely!), until you have created a product that can lead to winning in the marketplace. With a startup, that almost certainly means something that’s not “me too”–it needs to be faster, cheaper, more capable. I was at one point VP- Sales & Marketing for a small public company that was still in development of its primary product (a PUBLIC company that is pre-product is the subject for another interesting article…). The company was still losing money due to high development costs, and a small revenue stream. Because it was a public company, there was a strong reluctance on the CEO’s part to raise money due to the resulting stockholder dilution. He was also always threatening to cut costs to make the quarterly numbers look better. INSANITY. There’s nothing more than I can say–cutting product development until you have a product to sell is suicide. Worrying about quarterly profits until you have made the company a going concern from a product perspective is stupid. You have to do what you have to survive, of course, but this was a company with access to the public capital markets. A strong product is the muscle that allows you to break though the barrier of embedded competitors with strong positions and brands. Don’t kid yourself and save your money for other uses until you’ve hurdled this bar.

BUILDING A CRITICAL MASS OF UNIT SALES

Lastly, you’ve built a killer product and have a savvy staff pushing it out into the market. With whatever you’ve got left in your tank–use it. Stomp on the gas peddle, spend whatever you can muster on outbound sales and marketing programs. This is where the proverbial “crossing the chasm” really takes place. There are a certain number of successful customers you need to sell before you get over the peak of that initially steep sales curve–and things start to get easier. Once that happens, people know your company name and product. Enough happy clients are out there so that word of mouth marketing kicks in. Instead of fighting for every new customer, they start coming to you in increasing numbers–without much effort at all. Your product is now showing up in the market share figures. The press and analyst community start to call you, instead of you leaving endless unanswered messages in their voice mail boxes. Yes, at some point believe it or not, it really does get easier! But this happens only if you are able to close the number of initial sales necessary to reach critical mass in your specific market. Until you reach this point–SPEND WHATEVER MONEY IT TAKES–AS LONG AS YOU HAVE IT.

I’m sure there are more very important situations that you can list, where spending too much or too little can cause big problems for startups. Let me know what your examples are–post a comment or send me an email.

Follow Phil Morettini and Morettini on Management via Twitter, Facebook, LinkedIn, RSS, or the PJM Consulting Quarterly Newsletter. Contact Phil directly at info@pjmconsult.com

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Is Advertising the Future of Software Revenue?

There is a strong movement toward Internet-based software applications. Of this, there is little doubt. I have written on the SaaS trend in the past, and believe it is real. But sometimes market trends such as the move toward SaaS are overstated, both in terms of the speed of change, and also how much change the trend will ultimately affect a market. We have a word for this overstatement of a trend: “hype”. So, is traditional software revenue model of licensing dead? Will all software eventually be “given away” to the end user, and supported solely by advertising revenue?

If you believe many of the pundits in the computer trade press, the answer is a resounding “yes”.

What do I believe? It’s a bunch of hooey.

I’ve got a few gray hairs, and have been in the technology business for a while. In technology, this type of hype is neither unusual nor infrequent. For background purposes, let’s backtrack a bit, to few recent, major “trends”, which were heralded as the “next big thing” by the mainstream technology trade press and associated analysts.

Java
What was predicted: Java was going to take over the world, it was a Microsoft killer. Sun Microsystems was to ascend to the position of King of the technology world.

What actually happened: There was tremendous PR hype far in advance of mature, usable technology and products. This was followed by headlines detailing the dismal failure of Java in the market, and the beginning of yet another down cycle for Sun. Java technology eventually matured and found a nice market space, although not a dominant one, and one that Sun seems to have failed to capitalize on directly. The most recent estimate I’ve seen of Java revenues for Sun is $10M annually.

Bluetooth
What was predicted: Bluetooth was going to be the next great wireless standard, blowing past the expensive and inferior 802.l1 standard. It would extend from cable replacement all the way to “smart networking”.

What actually happened: Unlike Java, which people saw as proprietary to Sun (with good reason), no one company “owned” Bluetooth. It was backed by a large consortium and standards committee. Unfortunately, like Java, it was grossly oversold very early on, both on its maturity and its ultimate potential. The trade press once again declared this new technology a failure—far before the development cycle was even able to deliver stable, useful products. 802.11 became the dominant wireless networking standard. Bluetooth has found a small niche in short cable replacement, primarily in the market for hands-free devices attached to mobile phones. Newer emerging standards such as UWB threaten to usurp in many of the market niches that Bluetooth has been able to establish, and is the new challenger to 802.11 for the wireless networking space.

Pen and Voice Computing (take your pick):
What was predicted: Many times over the years, tech industry pundits have proclaimed that by year xxxx, Pens and or Voice Recognition technologies will have rendered the trusty keyboard and mouse obsolete. We will be able to engage our computing platforms in a more natural manner, much like we do in “real world” interactions. The Apple Newton was to be only the first generation of soon to be ubiquitous pen-based computers, which would dominate our everyday computing world. Later, Bill Gates told us during a stage introduction in 2001, that he was “already using a tablet PC as his everyday computer.” Certainly all the experts, over the years, expected these technologies to mature and become mainstream, long before the year 2006.

What actually happened: We’re still waiting. I’m guessing that Bill G.’s clunky Tablet PC is sitting somewhere in the corner of his office—gathering dust. I haven’t tried to add it up, but I’m sure that many billions of dollars have gone down the drain (along with a bunch of high profile startups, and careers), trying to bring these technologies to the mass market. In the meantime, the technologies have continued to mature, and have found important niches. Pens have become useful in mobile computing, although keyboards have recently mounted a comeback in that area. Voice recognition continues to mature and has become very useful in the market for people with disabilities. The maturation of voice recognition can also be seen when you call a company using one of the newer automated attendants, as entry points to their call centers. They are much smarter and quite a bit less frustrating to use than the earlier attempts in the market, which helped coin the phrase “voice mail hell”.

WEB or DOT COM 1.0
What was predicted: All software was going to be Internet-based, free to end users, and supported by advertising revenue. Traditional licensing of software was old-fashioned and passé. Try getting an emerging software company with a traditional licensing model funded in the year 2000. If you weren’t laughed at by potential investors, you were at least viewed as a dinosaur.

What actually happened: I doubt if I need to spend too much time reviewing what happened, unless any of you were living in a cave in 2001.

So here we sit in 2006, in an era that the press been dubbed “Web 2.0”. Google is the hottest company on the planet, supported almost exclusively by advertising revenues. They are buying software companies left and right with inflated stock, eliminating license fees, and rolling the acquired products into their wildly successful advertising-supported model.

Once again I’ll pose the questions: So, is traditional software revenue via licensing dead? Will all software eventually be “given away” to the end user and supported by advertising?

Doesn’t Web 2.0 sound a lot like Web 1.0? My thesis is that it does, with a few obvious exceptions. Google has shown that in some cases, the advertising-supported model for software can work EXTREMELY well. And people aren’t in quite the crazy mood that they were in the late 90’s, when otherwise perfectly sane, experienced VCs and other business people appeared to lose their collective minds. Statements like “it’s not about the revenue, it’s about attracting the most eyeballs”, and “we’ll figure out how to monetize it later” were NORMAL. And let’s not forget my all time favorite “Your not spending money fast enough”.

I’m not suggesting that craziness is returning; because not enough time has past to forget the resulting pain wrought on the high tech industry. But I do believe, that in terms of ultimate effect and rate of change, the pundits once again are viewing a molehill, and proclaiming a mountain. Google is hugely successful. They’ve hit on a great formula that works for the Search Engine software business. The formula that they’ve created has allowed a great many people to build websites with excellent, useful content, and monetize that content, in whole or in part, with online advertising.

But I strongly disagree that this is the future of all—or even most—software applications. If you look at the Google phenomena closely, I believe it is a special case. The Search Engine business is a mass market; nearly everyone uses one these days. It is also a large market with almost an infinite number of identifiable submarkets of customers, which is what allows Google to sell so much advertising, to so many different customers. When you do a search in Google, you are essentially joining one of those submarkets, making you identifiable to the vendors in that space. There is also the wonderful fact for Google that their version of online advertising looks a lot like their “free product”—the search results, and their ads are reasonable direct replacement alongside those results. In fact, a large number of (even sophisti
cated) people don’t even realize they are responding to advertising when they click on a “Sponsored Link” result. There are probably a number of other mass market applications that will provide a similar opportunity, for using an advertising-only revenue model.

But for most software applications, I don’t believe that this model will be work. Most software applications are focused on a smaller market. In many cases, the ongoing R&D; to support these important—but not universally needed—applications, may be nearly as high as developing a Search Engine. There may be advertising opportunities available to online version of these applications, but the revenue in most cases may be far less than what is required to fund R&D;, marketing and sales—while still make a reasonable profit. I also don’t believe that clicking on advertising will be nearly as “natural” while working on a spreadsheet, writing a letter, or doing your online banking. I think that even Google is making a mistake by eliminating license fees for many of the applications they are acquiring, in their recent M&A; frenzy. Everyone gives them a pass on their strategy, because of the wave they are currently riding. But that doesn’t mean that it’s the right one. Only time will tell for sure. I remember a similar point in the development of Netscape (one of the Google’s of the past) where everyone thought Netscape could do no wrong. In the end, their strategy looked very flawed, and of course they failed to execute—which is generally even more important to success.

Certainly advertising form factors and technology may adapt to these newer online applications—but that’s a big if, and counts on innovation. I’m sure many software companies with advertising-only business models are being funded TODAY. Sounds a lot like “we’ll figure out how to monetize it later”, to me.

Another interesting point to consider that in other forms of media, advertising as a revenue source is taking a beating vs. user fees. High Profile examples include television (cable & pay per view vs. traditional free networks with advertising), and the emerging Satellite radio.

My expectation is that there will be a few major successes, like Google, that rely exclusively on Advertising for revenue. There will also be a larger number of companies that augment their licensing revenue with advertising. But for the foreseeable future, I see licensing revenue remaining as the backbone of software business models.

The moral of this story is, don’t always believe what you hear. It’s very hard to predict what will really happen in High Tech. Sometimes what is shouted the loudest in the technology business, turns out to be laughably wrong, in hindsight.

That’s my unvarnished opinion—go ahead and shoot holes in it! I’m curious to hear other opinions and supporting facts.

Phil Morettini
PJM Consulting
www.pjmconsult.com

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No Comments by admin on June 21, 2006
filed in B2C, Business Models, Corporate Strategy, Financing, General Management, Online Marketing, SaaS, Startup/Early Stage

Software vs. Hardware

Much of my consulting practice centers on working with software-based companies. But I have substantial hardware market experience in my background, and I do take on consulting assignments with hardware companies.

So what are the differences and similarities between successful software and hardware businesses?

Capital Requirements
One of the larger differences is that software companies generally require much lower capital to reach profitability and continued growth. This is primarily because of the lack of need to invest in expensive semiconductor development tools and  semiconductor masks for semi companies, manufacturing plants/equipment, manufacturing engineering personnel, unfinished goods inventory, higher cost of finished goods inventory, etc. So except for startups backed by substantial institutional capital, it’s much easier for typical  startup software companies compared to their hardware and semiconductor counterparts.

Margins
Another important area where software companies have an advantage is in margins—both in the area of typical gross margins, as well as the potential for higher net margins. This is primarily due to the negligible cost-of-goods-sold for most software companies.As a result, it easier for software companies to get to profitability, and if a large market is found, sustain profitability. Remember, throughout this article I am talking “on average”. There are hardware businesses with excellent gross margins (dominant semiconductor companies come to mind) as well. But in general, this is an area where the advantage goes to software.

Pricing
The big difference here also is related to costs. The major difference comes down to product cost, which in the long run creates a floor for anyone who would actually like to make a profit. Optimal pricing of hardware or software should be based upon a value-based approach—with market segmentation as the key. However, I rarely find this to be the case in my consulting practice—whether the company markets a software or hardware product.

In the hardware business, you tend to see a lot of simple pricing models that are cost-based. For software businesses, the negligible product cost can be the other end of the proverbial double-edge sward when it comes to pricing. In a competitive market, you often see competitors in software markets literally “give away” the initial product, and rely on the upgrade stream or advertising to make a profit downstream. This can strain the profitability of the entire segment, and in severe circumstances, can suck all the profit from the market. You see this scenario most often started by weaker competitors, or in markets where switching costs are high. While hardware pricing can be even more competitive generally, it is less likely for a weaker competitor in a hardware market to introduce a “zero-margin” program. This is because it is often tougher to hang onto a customer in the second generation (if the market has commoditized), and the market leader often has a gross margin advantage—making it an ill advised maneuver other than as an attention-getting, short-term promotion.

Distribution
The advent of the Internet has created a major difference in distribution between software and hardware companies, where there was very little difference in the past. It has made direct distribution much more practical for small software companies, in markets where a simple download or a SaaS-based model is practical. Of course hardware companies sell directly over the Internet as well, but the cost advantages aren’t the same due to shipping, inventory, etc. For those companies which aren’t direct-only, distribution is similar for hardware and software companies. Traditional distribution through third parties tends to be very similar, although higher inventory costs are still a burden that hardware companies need to manage more closely, both for in-house finished goods and in-process inventory as well as finished goods held by the channel.

Defensible Strategic Advantage
This is an area in which software and hardware markets have both similarities and large differences. Both hardware and software companies value patents as a form of providing a sustainable competitive advantage. But in my opinion, the inherent malleability of software makes patent protection less useful in software than in hardware. It is easier to “find another way” of accomplishing the same end result when you are dealing strictly in software code. It’s also easier to segment in software markets, creating a targeted, niche version of a software product for a specific segment, nipping at a market leader without drawing their fire. It’s much harder for a small hardware company to differentiate itself this way. On the other hand, the hardware market leader that establishes itself and creates a large volume business gains the important competitive advantages—cost efficiencies and brand recognition are the huge, defensible advantages. So I believe this point comes down to scale—in software markets, it’s easier for a small competitor to overcome the scale of larger competitors, and develop a niche strategic advantage. While in hardware, the large competitors can use scale to create the ultimate competitive advantage.

Localization Requirements
This is an area in which hardware companies normally have an advantage. They usually have simpler user interfaces, and sometimes utilize symbols extensively in their interfaces, greatly reducing translation requirements into local languages. Hardware companies do have to deal with some physical differences in standards, such as electrical—but these have stabilized over time, and are often handled in the standard product.

Conversely, software user interfaces are usually language intensive and more complex, with thicker user manuals. This requires software companies to live with higher localization costs and longer lead times to market worldwide. The exception to this is complex software sold to highly technical users, where English is often used as the standard language.

Potential for Dominance
I’m going by mostly by empirical evidence here. It seems that there have been a lot more hardware companies who have dominated their respective businesses for a longer period of time than in software. For every Microsoft (and there’s really only one of those!) it seems there are many more examples like Intel, Cisco, IBM, HP, Dell, etc. Hardware markets tend to commoditize more easily, but with standardization on a couple of leading brands. It’s harder to make money in the long run in hardware unless you are one of the top two or three players. Large hardware markets are also relatively larger in revenue than large software markets, allowing market leaders to more fully utilize their profit and cost advantages over competitors by spreading marketing costs over large product volumes. So if you’re looking to build a truly dominant company from scratch, the odds are greater in hardware—although you probably are still better off heading to Las Vegas, and putting your life savings on roulette red!

There are many more ways to contrast and compare hardware and software companies, but I will end it here. What other points would you add? As usual, post a comment or send me an email message to further the discussion.

Follow Phil Morettini and Morettini on Management via Twitter, Facebook, LinkedIn, RSS, or the PJM Consulting Quarterly Newsletter. Contact Phil directly at info@pjmconsult.com

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2 Comments by admin on February 9, 2006
filed in B2C, Business Models, Corporate Strategy, Distribution Channels, Financing, General Management, Operations, Pricing, Product Marketing/Management, SaaS, Software/Product Development, Startup/Early Stage, enterprise software, hardware
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