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Month: November 2018

Productised Services

This article was originally published in 3 parts on swombat.com in December 2011.

One of the most fundamental decisions when deciding to start a company is whether you will sell a product or a service. Most people will immediately pipe up that products are the best, but that’s not so clear. It’s not even clear that the devision is so binary. There is a third alternative: productised services.

In this series, I’ll explore the difference between products, services, and productised services, and offer some tips for how to productise a service (or service-ize – sorry for the butchery – a product).

Product companies

Classic product startups are things like Basecamp. Sure, it’s sold under the moniker “Software as a Service”, which muddies the discussion a little, but the key product property of a product has is that additional sales require a minimal amount of additional skilled time to deliver. There are support costs, server setup costs, etc, but those are marginal compared to a specific sale. On average, each sale has a fixed delivery cost associated with it and requires no human interaction to deliver the benefit to the customer (though the sales process maybe very time-consuming, but that’s another discussion).

The benefit of selling products is that if you build the right kind of product, and particularly the right kind of technology product, it scales tremendously well. If 37signals gets demand for a million new basecamp accounts at once, they should be able to ramp up the server infrastructure pretty quickly and capture that business, rather than turn them away. Services companies can’t do that. A services company with business than they can handle will either turn away customers, or ask them to wait, or raise their prices (same as turning away customers), or even just take the business on and deliver a poor service.

Another benefit is what I call the “making money while you sleep” paradigm. Since there’s little or no human element in the delivery of the product, you can go to sleep, wake up, and find that you earned money while you were sleeping. That’s a great feeling, not to be underestimated as a feature of products – although in theory, once a services company gets big enough, you will essentially arrive at the same point: others work and earn you money while you sleep.

The big downside of product companies is that it can be very hard to validate demand for your product, and until you’ve done that, you don’t know whether the product is worth building. Many people skip the validation step (because it’s hard) and end up building worthless products that don’t sell. Others take too long to build the product (can especially be the case for web startups), or fail to build it quite right, or are beaten by strong competition. Many of the best product markets are winner(s)-take-all markets, where one or a few large successes will reap most of the business, and the rest will be left with crumbs.

Another big problem with products, particularly intangible products like your typical SaaS app or music track, is that people don’t value those very highly compared to physical products. App developers rightly bemoan the fact that people will spend hours deciding which of three 99 cent apps they will buy, and then walk into a Starbucks and spend $5 without even thinking about it. So another problem with intangible products is that it’s hard to get people to pay a high price for them, so you need to sell to lots of customers to make a profit. These two factors rule out direct sales methods and mean that you need to be able to market your product to large numbers of people cost-effectively to stand a chance. By comparison, a high-price item only needs a few sales a month (or even a year) to be profitable, at least when the business is small.

So, basically, products have a lot of uncertainty in terms of whether anyone will want to buy them, and can have a fair bit of upfront expense before you find out whether your effort so far was a waste of time and money (even with lean methodologies, there will be some waste and dead-ends).

Services companies

Services companies are much better and much worse than product companies, depending on how you look at them.

The classic example of a service company is a consulting, web development or design agency (like, oh, 37signals – but before they built Basecamp). Essentially, a services company trades skilled time for money in a mostly linear way.

There are great benefits to services. First, you can often ask for a significant chunk of the money upfront. That’s great for cash flow, and not to be underestimated. It means that services companies very rarely require investment to take off.

Secondly, you know pretty much right away whether anyone wants to buy your time, so you’re not sitting for years waiting to find out if you have a business. It can take a few months, or even years for sales to ramp up to a level where the business can be called “alive”, but sometime in the first few months you should start to see significant amounts of cash coming in. If you don’t, you’re probably selling the wrong service, or selling it very, very badly.

Another good thing about services is that people instinctively understand that skilled time is worth money, so whereas convincing even a 10-people company to spend $200/m on a web product might be a tough sell, they will not hesitate to spend a few thousand dollars on the right service. And before you say “but the $200/m comes in every month forever”, first of all, that’s ignoring inevitable churn, and secondly, most businesses would (and should) rather have $3000 upfront than $200/m for 18 months, even if the latter is slightly more.

Finally, one last benefit of services is that services markets are often very fragmented, so it’s much easier to build a moderately successful company in that kind of market. There are very few winner-takes-all services markets. Most of them look a lot like accountancy and consulting: a handful of huge mega-firms, a bunch of very large firms, quite a few large firms, and lots and lots of small firms. It’s much easier to get a foot in the door and build a sustainable business in this type of market.

On the downside, services are very hard to scale. Since you’re selling skilled time, and you only have so much of that yourself, you need to hire other skilled people in order to scale. The maths for that just doesn’t work in your favour until you get really big (see this article by Jason Cohen for details), and getting really big is really hard, because you need a lot of smart people, and smart people are rare and expensive and hard to recruit.

Another problem is that services have much lower gross margins, because part of your variable cost (i.e. the cost that is attached to delivering the service) is skilled people’s salaries. As long as you’re the only person working in your company, the margins look great because it’s all profit for you, but as soon as you have to pay someone else, suddenly you find those margins dwindling rapidly. By comparison, with a product, your gross margin can and should be extremely high – 80, 90, or even 95% in some cases.

Finally, services kind of suck because they take constant effort. Most services are not recurring, so you have to keep selling. People leave your company, so you have to keep recruiting. New people don’t know what they’re doing, so you have to keep teaching and training. If you stop doing any of those things, your company can develop deadly problems very quickly, like a diminishing sales pipeline, running out of people at a given skill level, or even running out of cash. Those things are hard to delegate until you get bigger. And getting bigger is really hard.

The third alternative: productised services

First of all, what is a productised service? It’s a service which you’ve systematised and supported by tools, automation, processes, etc, so that you’ve decoupled the benefit given to the client from the amount of time spent on your side. In other words, whereas in a services company the ratio of X units of time for Y units of income is relatively fixed, in a productised service, X/Y can be all over the place. Some clients will be extremely profitable, and others less so (but still worth serving – otherwise, turn them away, of course).

Accounting services are a great example of productised services. Though many accountants will charge for time above and beyond their “standard service”, most of them have packaged things like “yearly accounts” or “VAT returns” into a fixed price deal. This leaves them free to optimise the delivery of those services so that they take a minimum amount of time, while still charging the client the same amount.

Even large consulting companies, like Accenture, try to productise their services. Back when I was there, Accenture was very keen to sell what they called “Managed services”, where they would take over an entire function of the business and deliver it for a fixed price, enabling them to manage the costs internally and deliver the service in an efficient way without undercutting their own revenues.

Productised services don’t have to, and in many cases, shouldn’t, be marketed as such, or else clients may try and push down your prices if they think it doesn’t take you that long to deliver (conveniently forgetting the time it’s taken you to systematise the service so it can be delivered more efficiently). “But you’re getting a lot of value out of our service” doesn’t always work, especially not with smaller companies, so think carefully before marketing your productised service as such.

Productised services have a number of advantages. Similarly to products, they can scale much more easily than services. Once a service is properly systematised, it is easier to actually carry out, which makes recruitment much easier, since you don’t need your people to be as highly skilled. You won’t be able to deal with a sudden million orders, but you can ramp up capacity pretty damn quickly if you need to.

Like products, the margins can also be quite high, because most of the time-consuming parts of the service have been automated or simplified so that the human time spent is small compared to the return. Unlike products, however, the process doesn’t move along without human involvement, which means you have to keep working on it – but you can structure productised services so that there is a recurring component, which provides similar benefits.

Since this is a service (and perceived as such), people naturally understand the value of it and are willing to pay real amounts of money (in the thousands or tens of thousands) which they would not be likely to throw into a product by a small company.

Because it is a service, unfortunately, you must do the sales directly – it is difficult to sell services without any salespeople. However, the advantage is that you can tailor your pricing to the type of client, and how much value your productised service brings them. If your service will provide £100k of value to one client and £1m of value to another, it stands to reason that your proposal for the second client will have a markedly higher price tag than the first (which might be based on a percentage, or some other calculation method). This is difficult to achieve with most typical startup products, since you often don’t know who you’re selling to until too late.

Finally, another advantage of productised services over both products and services is that they can be taken in either direction if needed. If customers start to require a lot of bespoke work, you can evolve towards a normal service model. If, on the contrary, the customer base just keeps growing, you can automate more and more of the service until it becomes self-service. This makes productised services a great way to kick off a product business, by generating these product-related revenues early on and using them to continue building out the self-service aspects of the product (in effect cannibalising your own service with your product).

Productised services are not good at all stages of a company. Google could not and should not run AdWords as a productised service, for example. At that scale, you need maximum automation. But they could have done so in the early days of AdWords. Nor are they always possible in the very early stages, before you have any idea what your market wants (but then, why are you starting a business in that industry?).

I’ll address the paths to a productised service, from either a product or a service, in later articles, but hopefully in this article I’ve made the case for why there is a third model, which sits in between products and services, and which should be worthy of your consideration when trying to figure out how the hell you’ll get your company off the ground, particularly if you’re a new entrepreneur and are taking my advice to stay away from investment until you have your basic business skills figured out.

Thoughts from 2018:

This article still makes a lot of sense today. The fundamental business forces have not changed. The benefits of each kind of business are still the same.

Investment as a cushion or a springboard

This article was originally published on swombat.com in December 2011.

I believe new entrepreneurs should not take investment. Here’s why.

There are two primary types of investment that I’ve observed being taken: investment as a cushion, to protect the company from having to focus on short-term revenue generation right away, and investment as a springboard, to help the company grow faster or enable a cash-intensive business model. These can be loosely matched with the Seed and Series A stages of funding, though some Series A are cushion funding, and some Seed funding is used as a springboard.

One might expect me to launch into a tirade about how one is better than the other, but that’s not really the case. Both uses are valid. However, cushion funding is dangerous for inexperienced founders.

A cushion from reality

Starting a business with zero revenues and zero funds, you have to do what’s called “bootstrapping”. As UK entrepreneur Iqbal Gandham (who contributed this swombat.com article) argued on TechCrunch, bootstrapping from zero funds is impossible:

The harsh reality for startups is that you need someone somewhere to pick up a tab for around £50k, which of course could be split over two people, i.e £25k a piece, but still that is just £300 or so pounds less than the average salary in the UK.

However, many people commonly raise this initial £50k (though it’s often much less) from their own savings (saving £50k is hard, but hardly impossible, when you’re an IT contractor earning £50-100k/year). Bootstrapping, then, is creating a business without taking external investment. When it’s your own savings dripping through the hourglass, when every expense matters, you end up, hopefully, being very focused on reaching revenues as soon as possible. Lack of funds creates an extreme awareness of the need for more funds.

However, if you have a nice £100-200k cushion provided by someone else, you don’t feel the bite quite so much. Sure, you still have a runway, and it is diminishing, and it is something you need to “think about”, but it is far more theoretical than seeing the biggest number in your bank account steadily approaching zero.

One of the biggest things that new entrepreneurs (at least in most of the world outside of Silicon Valley) need to learn is not how to build a product or deliver technical work, but how to run a business profitably. It’s all these ancillary tasks, from sales to accounting, finance, legal, marketing, and general business management, that take three years to learn (give or take). That learning is one of the most important forms of progress for the new entrepreneur.

In that context, any cushion which slows down the learning, which delays it, makes it more distant and theoretical, is potentially harmful. Most successful entrepreneurs are the kind of people who thrive in sink-or-swim situations, and investment-as-a-cushion can turn this into a delayed sink-or-swim, and even set things up for a sink: having funds makes you more likely to take on fixed expenses start relying on your ability to spend, which you shouldn’t – not until you have a functioning business and/or know what you’re doing.

So, my advice to new entrepreneurs is: don’t take funding, and if you do, take a minimal amount and spend as little of it as humanly possible.

A cushion from short-term focus

The proposition is considerably different for experienced entrepreneurs. Managing your cash flow, your runway, your fixed expenses, etc, is a very hard lesson to forget. Once you learn how to sell a product that doesn’t exist based on a reputation that’s only in your head, that’s a skill acquired for life.

Many experienced entrepreneurs who could fund themselves take seed funding anyway. However, they don’t take it “because they couldn’t afford to do a startup otherwise”, they take the seed funding because it enables them to put aside the short-term revenue focus for a little while and aim for something bigger and riskier. Once you’ve learned how much the short-term focus matters to your survival, it’s very hard to ignore it. The cushion of external investment enables an experienced entrepreneur to temporarily ignore that pressure.

In this situation, I think it makes a lot of sense to take external investment as a cushion.

A springboard to greatness

Finally, the third case almost exclusively applies to experienced entrepreneurs, since, at least in the sane world outside of the Valley, VCs will pretty much never invest in a business that doesn’t have either a proven founder or proven revenues (both of which add up to an experienced entrepreneur).

In this case, funding is required to enable the business to grow much faster than by organic growth alone. This is particularly important in winner-takes-all and first-mover-advantage types of markets. Paypal and eBay are great examples of the first: most people will have only one online payment account, and they’ll pick whoever has the most popular platform. This winner-takes-all advantage paradigm is so strong that even with all their misbehaviours, both of those players are still firmly lodged at the top of their respective markets. Worth taking investment to get there first? You bet.

For the second case, looking in the enterprise market, many pieces of software like SAP have huge installation costs. A large SAP installation might cost $200m: $20m in software licences, and $180m in consulting fees to set it up. In a market like this, being the first to make the sale is pretty important, because customers are very rarely going to change platform if it costs that much.

In these contexts, taking growth investment makes sense, because otherwise a competitor who does take that investment will beat you to the post. This type of investment is not at all a cushion – in fact, it makes the fall much harder if you miss, turning a moderate success into a complete failure – it is a springboard, an amplifier of your efforts.

If you know what you’re doing and are willing to take the risk, springboard investment does of course make sense.

Conclusion

So, in summary, taking investment can be seen as either a cushion from reality (often the case with new entrepreneurs), a cushion from short-term focus, or a springboard to greatness.

Only the latter two are good uses for investment. If you don’t yet know what you’re doing, if you feel you need the cushion just to survive, then you probably should not take it.

To conclude, it’s worth noting that these arguments apply mostly to the 99% of the world outside of Silicon Valley, where spending tens of millions to build a company with zero revenues for years is not an option.

Thoughts from 2018

Even as the amount of money available to entrepreneurs has moved up and down with the times, I don’t think the core point of this article has changed at all. If anything, I’d expand it to larger, more mature companies, where my observation is that money without a clear sense of purpose to direct it is itself toxic, as it tends to lead to investing that money in distracting side-ventures that eventually impact the success of the core business.

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