Service companies traditionally have low gross profit margins as compared to tech companies, especially software. That’s because services require human bodies to deliver most of what the customers are paying for. Scaling a service company requires a mostly-linear scaling of those bodies. That lack of scalability leverage as compared to tech companies, causes lack of investment interest on behalf of the venture funding industry – with one potential exception, if executed correctly.
A Product Gets Built
Many service companies end up building custom technology to make their revenue-generating human resources more efficient and/or more effective. Over time, the technology matures to the point of resembling a minimum viable product (MVP) that, with further refinement, could possibly be sold separately at high gross margins and with scalability leverage.
This article explores the issues and opportunities presented to service companies that decide to build a technology product.
Deep Domain Knowledge
Let’s start with the biggest benefit of this scenario. The company’s executives and employees have deep knowledge of the industry they serve and the buyer persona they sell to. They’ve learned how to manage a company and hopefully with a strong culture. And they might have even developed a reputation and general awareness of their existence in their industry. All of those things are the same things an early stage tech startup would love to have already accomplished.
Is it Really a Product?
In the early days, the technology is so specific to the needs of the company’s service-delivery professionals that it couldn’t reasonably be sold to others and supported separately. Elevating to that level requires actually defining and creating a real product. You might think of it in a similar way as research projects that work in a semi-controlled environment versus commercial-grade products that are widely sold on the open market. Big difference along multiple dimensions.
Creating a real product requires going all the way back to the beginning of the startup idea development stage. A business plan that includes a huge list of assumptions should be created (read my article titled “Your First Business Plan is a Huge List of Assumptions”). Unfortunately, most service companies don’t do near enough of this planning and strategy work. I assume it’s due to the way the technology was gradually developed and evolved inside the company. It doesn’t really seem like a near start-from-scratch venture, and in many ways it’s not.
But even if you feel like you have a great business plan in your heard, document it and debate it with the other company execs. While doing so, pretend you’ve separated from the service company and are on your own with only the technology that was developed. How would you proceed from that new starting point? I hope you would develop a full business plan for the new product-oriented business.
The good news is that you’ve got lots of existing and prior customers that you can approach for the required customer discovery related to the new product. Your rapport with these customers should help them be more honest with their feedback on the product. Your knowledge of other aspects of their operations and priorities will arm you with better questions and better enable you to achieve the highly-desired “aha moments” that are sought during customer discovery.
Service companies in the position I’m describing here are often profitable and cash flow positive, but usually not highly profitable. That means the needed investment to further develop the product and gear up for its launch drains valuable resources, both financial and human, from the core services business.
I see lots of service companies make very slow progress on developing their tech product due to this dilemma. That serves as a double-whammy. The length of time that profits are diverted and resources are multi-tasked lengthens. Additionally, if the product idea is a good one, there are probably other venture-funded startups working on something competitive, which means you might end up getting left behind.
Raising new funding for the product-related venture is an obvious alternative, but later in this article I’ll describe some common challenges there too.
Potential Conflicts of Interest
The sale of your new product might cause your customers to pay less, or none, for your services. It is possible that your business strategy actually calls for cannibalization of your service offerings as you progressively evolve into just a product company over time. If not, think about the likelihood of cannibalization and decide if you should plan for it in your financial projections.
The other conflict that can arise relates to other service companies you currently compete with. They could be the best possible customers for your new technology product, especially in the early days. Will you sell them the product you’ve developed? Even if you don’t want them to buy your product and use it against you, the sales model you employ for the product might not give you that level of control. In other words, if you sell through a distribution channel, you won’t fully be able to dictate who they can and can’t sell the product to.
Running Two Different Businesses
A service company and a tech product company couldn’t be more different in the way they’re run. Everything from the way revenue and expenses are accounted for, to the systems and processes that are used, the sales and support model, the pricing strategy, and on and on throughout the business plan. As the new product gets launched and that aspect of your company starts to mature, you will realize that you’re basically running two different businesses under the same brand name.
Yikes! Does your CEO have experience running both types of companies? What about other members of the executive team?
Because of this, many service companies eventually decide to split into two different legal entities – one for services and one for the tech product. Often, this action follows the validation of important aspects of the product-related business plan.
The relationship between the two entities can take on different forms, including parent/subsidiary or sister companies of sorts. The word “sister” is more of a layman’s term, but implies there is some commercial and/or legal relationship between the entities. Maybe it’s a license to the technology that was created, maybe it’s a reseller relationship, or maybe it involves the sharing of resources. In the early days after the split, there might be lots of sharing and resource overlap. If so, that probably changes over time until the new product company is self-sufficient, but still with a commercial or legal relationship with the original company.
On paper, creating two entities to best optimize the opportunity might seem easy. But in practice, there will be plenty of issues and challenges to face. Basically, think of it like starting a new startup, but just with a couple of jump starts in a certain areas.
It might be obvious why venture-style investors shy away from investing in service companies that are building a tech product. Even having the product launched with paying customers might not be enough to excite them, especially if half or more of the company’s revenue still comes from services.
Venture investors won’t like the following things about the combo business you’re trying to get funded:
- Lack of untethered scalability and possibility for explosive revenue growth
- Complexities of running two different businesses under the same brand
- Risk that the product-related aspect of the business doesn’t succeed enough to either completely cannibalize the service business or dramatically reduce it to a 20% or less mix of total revenue
Often, the best remedy for this fundraising challenge is to split off the product business as a separate company. Investors will require that the new product company has an exclusive, perpetual, and irrevocable license for the intellectual property that was invented and developed inside the service company. In fact, maybe the IP ownership fully transfers to the product company. Outside of the IP ownership issue, investors should be able to review the investment opportunity just like they do with any other startup.
Nothing about this article is intended to scare you away from your product-related aspirations. Rather, I want you to go into the venture with eyes wide open and with an understanding of the most common issues to overcome.