Transitioning from a service business to a product-driven company

It has been awhile since my last post as I have been busy with board meetings. In addition, I met a number of interesting companies, a couple of which were service businesses in the process of transitioning their models to become product-driven software companies. It is a familiar formula to many out there. More often than not, the principals of a service business may have developed expertise and a network in a particular industry, developed a solution for a customer, and decided that they could resell it multiple times turning their business from a service one to a more scalable product-driven company. This makes a ton of sense as the entrepreneur gets to understand a particular market and pain point for customers. In addition, the early stage business gets the customer to pay for its initial product development. Having met with a couple of these types of companies this week, it reminds me to issue a few cautionary warnings for entrepreneurs:

1. Just because one customer wants it does not mean you have a big market opportunity-do your homework to make sure the customer’s pain is not unique and that this is not a custom development job

2. Have one version of your product, not one for each customer-I have seen a number of companies that claim they are a product-driven business with 5 customers when in reality they are still a service shop because their customers all have different versions of a product.

There is one company that my team met with a couple of years ago that had a marquee list of customers, all of whom had license deals greater than $300k. However when we did customer reference checks and deeper due dligence on the technology, we learned that all of the customers had different versions of the product. We ultimately passed on the deal as it was quite evident that the business had not made the full transition to a product company. I recently caught up with the former VP Engineering who was looking for a new job. In discussing why the company failed, this is what he basically had to say. While the company had great customers, the support costs associated with supporting 3 different versions of a product killed them. He had to spend too much of his team’s team fixing problems for the installed base rather than devote most of his resources developing the next generation product. Consequently, their product suffered and did not meet the demands of the wider market.

While turning yourself from a service company to a software business may be a good idea, be extremely careful about the customers you sign and remember to make sure that you really have one product not multiple, custom platforms because that can kill you in the long run.

Founder transition

There are a number of good posts about founder transition in light of the recent changes at Friendster and Plaxo. If you are an entrepreneur, I suggest reading Ross Mayfield’s words of wisdom on this topic. What makes it so interesting is that Ross is a founder, was replaced at a prior company, and is back again as CEO of another company, Socialtext. As Ross says,

Not a day goes by where I don’t brace myself for this change. As a CEO and Founder of an early stage company, I know new stages will come. I constantly question myself if I’m the best person for the job, because the company is more than just me. Its a source of livelihood, investor return and customer bliss — all of which improve over time. I am really darn good at this stage of the company and have proven it in the past. I hope to test my capabilities at latter stages, but also recognize that the day may come where regardless of my ability to lead, manage and deliver — environmental forces may call for the new.

As a VC, we always like to have an open and honest discussion pre-investment about what the entrepreneur expects from us, and what we expect from the founding team. When discussing the idea of transition and building the right team, we learn alot about the founders and what drives them. This does not necessarily mean we will replace the founder with a new CEO, but it is a great way to understand what motivates the founder and how committed they are to creating a successful company, not a one-man show. Some simply want to be CEO come hell or high water-we take a pass on those opportunities. Some tell us what we want to hear, but their body language tells us otherwise-they tense up and there is no positive feeling behind their words. Others like Ross tell us what we want to hear and internalize it. They know the drill and want to be given the opportunity to run the show and prove that they can do the job but at the same time understand that change may happen. These are the founders in which we like to invest.

What aisle/what shelf?

I met with an entrepreneur this week who had a fantastic background and great technology. However, it was a technology in search of a problem to solve. Why? Because he could not readily answer some fundamental questions like what problem are you solving, who is the buyer of the product, and what is the amount of pain the buyer has without your product or solution. This is a problem that I see time and time again. Additionally, many entrepreneurs cannot answer the question, “what aisle, what shelf?” When you go to a supermarket you know that you go to the condiment section to find ketchup, mustard or BBQ sauce. On those shelves, you will find different types of condiments and different brands organized in a way that makes sense. While on any given visit you may see new products on those shelves, they are still condiments. Similarly, your sales prospects need to know where your product fits to determine where you come out of the budget and who is responsible for evaluating new solutions. If you try to create a brand new market category that no one understands simply that will not work. Similarly you do not want to sound like everyone else.

Going back to our earlier analogy, while you want to find a large enough aisle to put yourself into, the struggle is expressing your uniqueness in the 30 second elevator pitch. You do not want to be a “me-too” product lumped in with 30 other companies. If not done correctly, you could end up being thrown into the general data integration, security, or performance management pile. 2 approaches I have seen include defining your own category (aisle) or your own sub-category (shelf). Doing the former is riskier and more expensive (defining a new market is not cheap), while offering the opportunity for outsized returns. More often than not, entrepreneurs with great technology feel like they have to create a distinct new category, and many times they end up creating a market that no one understands or cares about and one in which their dollars come out of the experimental IT budget-not a large bucket or great place to be. It takes time for a new category to become a budget line item. In my opinion, creating a subcategory is easier, gives a company the opportunity to express its uniqueness, allows the sales prospect to understand generally where your product fits in the budget, and still does not prevent you from creating your own category (aisle) in the future. While this may all sound very basic, I would not go pitch a customer or VC without having this nailed down.

Great business model

OK, so times have been tough in the IT market over the last couple of years. Luckily, it is starting to get better. For those of you who understand that selling IT software to enterprises is not easy, I thought you would enjoy this email from one of my portfolio companies regarding differentiation and “secret sauce.”

As X and I have been trekking around Sand Hill Road, and everywhere else venture funds are located, we’ve really paid attention to the issues of differentiation and “secret sauce”. As such, we’ve decided that our company needs a dramatic shift and we have found the answer. We worked on the plan at San Jose airport last night, watching the behavior of customers for this exciting new product. It was reconfirmed this morning as I left Starbucks.

Our company is going to get out of software and information technology completely. No, we are not mad, well, we may be, but that has nothing to do with this discussion. We are going to take the most plentiful resource on the planet, put it in handy plastic bottles and sell it for about $4 per bottle in airports and other convenient locations; but if you choose to buy it from your local grocery store by the case, it will only cost and $4 for a case of either 12 or 24 bottles – purely based on random decision making. This market has been validated by at least 50 other companies, who reap millions of dollars of profit from this market place each month. Our “secret sauce” will be the label – yes, it will be our company name and logo that will differentiate our product from Evian, Vasa, Fiji, San Pelegrino and those many other indistinct brands.

We look for your support at the next board meeting to make this dramatic shift in our company’s strategy!

Please scroll down for some final thoughts!

Can you imagine presenting the idea of bottled water to VC? We of course thought about it after X and I bought two frozen yogurts and 2 bottles of water for $12! Not only wouldn’t we consider drinking airport tap water, we bought bottled water with a name, Vasa, that would make one think it came from Germany – why would I buy water from Germany? I totally cracked up leaving Starbucks (there’s another one!) with my $3.60 non-refillable cup of coffee as I saw a case of water for $3.99 outside a grocery store!

Have a nice weekend everyone!

Thoughts from PC Forum-going into attack mode

Once again, I am not going to blog the panels at PC Forum, but you can find some good commentary on the conference via other bloggers from my post yesterday. Other good posts can be found from Dan Gillmor, Jason Calacanis, or the PC Forum Eventspace.

However, what I would like to share with you is some conversations I had with some VCs and entrepreneurs over the course of the day yesterday. While the panels are interesting and the speakers can stretch your mind, what is great about PC Forum is the high-level networking that occurs during the day. So what did we talk about? There were a number of attendees who were here during the past few years and their businesses raised a fair amount of capital and somehow they managed to survive the nuclear winter during the 2001-2002 period. What allowed them to do it? What are the challenges they face now? One observation that I discussed with some others is that the very principles that made companies successful during the bubble period are the very ones that would land you in bankruptcy court during any other business period. Some of these principles included growing revenue and headcount at all costs with no focus on profitability and spending tons of money on building a larger than life image-lots of money thrown at PR firms and advertising with no idea of who your target market was or what your customer really wanted. In other words, alot of these companies were based on cool technology and not on making customers happy. On top of this, VCs threw too much money at these companies and there was no need for entrepreneurs to be resourceful and creative in order to get things done.

Let’s fast forward to now. The companies that survived this downturn were excellent at cutting costs, repositioning their products for new markets, and being resourceful and creative to survive. While these are some of the business principles I want my companies to continue to adhere to, I also want to caution that there is a danger in being too cheap. Some of these companies were so shellshocked from what happened during the past couple of years that they have become too cautious. For anyone that has been through the tough years, the only thing I can say is congratulations for surviving but now it is time to take some calculated risks. It is time to get out of the bunker and go into attack mode. Go after your competition, take some calculated risks, and focus on creating some revenue growth. What is different now than before is that most companies that survived the nuclear winter know who their customer is, how much they will pay, and what features and functionalities they may want in future versions. While it may sound like idle VC talk, I encourage you to spend that extra $$$ now as long as you can see the real ROI behind a targeted marketing program, the hiring of a new engineer to finish a product faster, or a new sales person to manage more qualified leads. Once again, take it with a grain of salt, as some entrepreneurs may think this is another VC swinging for the fences, but the point is don’t be too cautious because the opportunity may just pass you by.

PC Forum 2004-Monday morning

PC Forum is off to a great start this year with an interview with Eric Schmidt from Google and a panel with the CEOs of AOL, Yahoo, and Google. I do not plan on taking detailed notes so I suggest you view Ross Mayfield’s blog and posts to stay current on the conference. I also suggest visiting David Weinberger and Brett Fausett for more notes.

With respect to the first panel, I took some interesting notes on spam. AOL and Yahoo are doing all that they can to stop spam, catching high 90% of it. The frightening aspect is that the high amount of spam that you do see is only the 4-5% that is not filtered. AOL gets 2.7 – 3 billion spam messages per day which is trying to get into their system. Not a surprise that spam is a huge issue, but these numbers are. No one claimed to have a silver bullet, but rather advocated the use of multiple ways to overcome this issue.

Bruce Schneier had some interesting comments on the security and risk panel. Specifically, Bruce said that security is social and not about technology. Yes, there are technical causes and solutions for security but it is irrelevant if the social and economic model are not fixed. For example, there are plenty of spam filters out there but we still get tons of spam. The economics work for spammers. For users, it comes down to balancing security with the cost to mitigate the risk. People will make decisions based on economic value and cost. I totally agree here.

Next up was the CIO panel (Dawn Lepore, former CIO of Schwab, Shai Agassi, SAP, and Rafael Sanchez, Burger King). Dawn Lepore said that software is one of the biggest issues for CIOs. It is complex and costs are excalating tremendously. Software vendors and customers are diametrically opposed as the software vendors want to lock-in customers and the customers want flexibility. How does seeing an architecture diagram where the vendor’s products are in 12 places in a stack solve her business problem? Given this tension between vendors and proprietary lock-in, it is no surprise that open-source and open-platform technology and new business models like the hosted or subscription sale are spreading rapidly. The more you hear the panel talk about technology and the job of the CIO as being a risk manager, you can clearly see why it is so hard for an early stage company to land a big customer. Who wants to take the risk of buying a new technology from a new vendor? Yes, it happens but it is not easy.

I guess it is not a coincidence that a number of companies floating around sell to/service consumers as the first target market-companies like Onfolio, Eurekster, and Datapod.

Staying close to your customers with blogs and RSS

As I have said a number of times, I am a big believer that companies should start looking at how to use new technology and standards like blogs, wikis, and RSS/Atom from a product perspective and not solely for news publishing and aggregation. What do I mean by that? In response to a post I wrote about why I blog as a VC and the benefits of it, Brandon Wirth sent me a link to a piece he wrote about the future of customer relationships. In it, he summarizes by saying:

In the very near future there will be a trend to use Social Networking to create product communities. This will replace focus groups, and market research trends of today with direct interaction with those most likely to buy a given product. This is the American Idol for big business. Instead of trying to pick what the best solution is and betting the farm on it, you let the market pick a winner for you and they will already love the product before they have it. The focus becomes on the end user. They feel ownership in the creation of the product, and already know they want it.

Not sure I agree on the “American Idol” for big business, but the point of staying close to the customer is an important concept. I certainly see a world where companies use new technology and standards like blogs, wikis, and RSS to build a relationship with its users and to empower them to participate in a company’s success. This conversational based approach to dealing with customers is a great and EASY way for companies to share information on new features and releases and get constructive feedback on their products, receive new ideas, and frankly hear about the gripes. All this should help companies build a better relationship with customers and gather real-world data. While the example Brandon uses is a consumer one, I also greatly believe that this applies to infrastructure software as well. As I mention in an earlier post, it is too easy for companies to get enamored about their technology and to forget that end users need a great experience. Building fanatical user communities is not a new idea, but the point is that new standards and technology make it easier for companies to create, manage, and leverage them in a frictionless and organized way.

Along these lines, Jeff Nolan just put up a new post on his LinkedIn experiment. And in it, he praises Reid Hoffman, CEO of LinkedIn, for paying attention to blogs and dealing with Jeff’s experiment in a highly positive way. I encourage reading this post as Jeff has some great comments on how companies can deal with bloggers and why it is another important source of information and feedback.

Hiring Talented Sales People

As you can see, I have been spending alot of time with my portfolio companies hiring in a number of functions to create growth. That is obviously a good sign. Hiring is such an important skill, there is no science to it, but research and common sense help. I am sure you remember the old adage, hire slow, fire fast. Anyway, when it comes to sales people, let me give you a rule of thumb-never hire sales people that have stuck around in a declining business for too long. Any sales person worth his weight wants to be where the action is, and if the company is not growing, the TALENTED PRODUCERS ALWAYS LEAVE FIRST. It may sound like I am being master of the obvious, but sometimes it is hard to remember this, especially since many sales people interview well. Do your research on their background and the companies at which they worked. Be extremely careful about the candidate that rode a company from $40 million of revenue down to $10 million because you can bet that if the guy was hungry and talented, he would be somewhere else!

Building your business around customers (continued)

Forgive me for being obsessed with customers, but after all, without them, how can you have a business. Anyway, I was interviewing a VP of Engineering candidate for one of my portfolio companies, and when I asked a question about the most significant lesson that he learned from one of his prior jobs, this was his thought-while the core technology is important, focus on providing the customer with an unbelievable user experience straight out of the box. What will the customer see and touch first. Start with the installation process. Make your product the easiest to install. If it goes smoothly and quickly, if you can do it plug and play or remotely, the customer will already begin to have a pleasant experience with your product. Make the GUI as user-friendly as possible. If it is as intuitive as using your email or browser, then it will make it easy for the customer to get the team using it with minimal training. Finally, make it easy to manage. Have a nice management console that allows an end user to administer the system, update it, and manage multiple licenses as simply as possible. So while having great underlying core technology is important, everyone will be selling technology and features and function. What many companies forget early on is that having a great customer experience can provide real differentiation and can often mean the difference between success and failure in competitive markets. As for the VP of Engineering candidate, he is on the shortlist as it nice to see someone with the experience to build product and manage teams but also think from a business-oriented perspective

Demo Day 2-@Home/Collaboration

The morning is off to a great start with a few home networking/digital media boxes for consumers. The battle for the home is in full swing between MSFT’s vision of the PC as the gateway to the home and companies like Akimbo, BravoBrava!, and Molino Networks bringing full digital media management to the set top box. It is truly quite amazing how much functionality continues to be added to these consumer devices, and how easy they make it for the consumer to view, listen and share their CDs, DVDs, downloaded video, and pictures. See Jeff Nolan’s blog for more information. If I were Microsoft and Tivo I would be worried.

One of the problems with collaboration via Webx and Placeware is that it is still not easy to use, the pricing is not friendly, and it requires users to schedule meetings in advance. Today’s companies, Convoq, Sightspeed, and GoToMeeting (Expertcity-a portfolio company) are all designed to allow users to take advantage of the daily, ad-hoc and spontaneous meetings that are not currently captured by the incumbents. Not only do they bring disruptive technology to the market making it incredibly simple to organize meetings and web video conferences but also disruptive pricing to increase usage. So if I were Webx and Placeware, I would keep an eye out for these companies which will allow users to host unlimited meetings for fixed monthly costs.