Consequences and Trade-offs

 Consequences and Trade-offs

Navigating the opportunities, challenges, and outcomes when a service company builds a product.

Service companies traditionally have low gross profit margins as compared to tech companies, especially software. That is because services require human bodies to deliver most of the value for which their customers are paying. Scaling a service company requires a mostly linear scaling of those bodies. In other words, tripling annual revenues requires roughly tripling the number of company employees. That lack of scalability leverage, as compared to tech companies, causes lack of investment interest on behalf of the venture funding industry.

A Product Gets Built

Some 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 attractive scalability leverage.
Taking the leap to build, sell, and support the technology product comes with a variety of consequences and trade-offs that should be understood in advance

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 to which they sell. They’ve learned how to operate a company, hopefully with a strong culture. They might have even developed a reputation and general awareness of their existence in their industry. All of those are things an early-stage tech startup would love to have already accomplished.

Is it Really a Product?

In the early days, the new technology is usually so specific to the needs of the company’s service-delivery professionals that it couldn’t reasonably be sold to others. Elevating to that level requires 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. There are big differences along multiple lines.

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 initial assumptions and aspirations should be created. Unfortunately, most service companies don’t do enough of this planning and strategy work, perhaps due to the way the technology was gradually developed and evolved inside the company. It doesn’t seem like a start-from-scratch business venture, and in many ways it’s not. That’s due to the way the tech product came into being.

The business plan for the new product should not just be in someone’s head. Instead, it should be documented and debated with the other company execs. While doing so, the team should pretend they’ve separated from the service company and are on their own with only the technology product that was developed. How should they proceed from that new starting point? That mindset will best enable them to develop a full business plan for the new product-oriented business, even if it is ultimately incubated inside the service company.

The good news is that the company has lots of existing and prior customers that can be approached for the required customer discovery, related to the new product. The rapport with those customers should help them be more honest with their feedback on the product. And the company’s knowledge of other aspects of their operations and priorities will arm them with better questions and better enable them to achieve the highly desired “aha” moments that are sought during customer discovery.

Competing Priorities

Service companies in the position being described are often profitable and cash-flow positive, but usually not highly profitable. That means the investment needed to further develop the tech product and prepare for its launch drains valuable resources, both financial and human, from the core services business.

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 introduces the risk of getting left behind.
Raising new funding for the product-related venture is an obvious alternative, but there are some common challenges there, too.

Potential Conflicts of Interest

The sale of the new product might cause customers to pay less, or nothing, for services. It is possible that the business strategy actually calls for cannibalization of service offerings as the business progressively evolves into just a product company over time. If not, the likelihood of cannibalization should be considered, and decisions should be made whether to plan for it in financial projections.

The other conflict that can arise relates to other competitive service companies. They could be the best possible customers for a new technology product, especially in the early days. Should the product be sold to them? Even if the desire is to not have a product used against its original developer, the sales model employed for the product might not allow for that level of control. In other words, if the product is sold through a distribution channel, who purchases it cannot be controlled.

On paper, creating two entities to best optimize the opportunity might seem easy, but in practice, there will be issues and challenges to face.

Running Two Businesses

A service company and a tech product company couldn’t be more different in the way they are 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 the company starts to mature, the company basically becomes two different businesses under the same brand name.

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 significant 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 issues and challenges to face. Basically, think of it like starting a new startup, but with a couple of jump starts in certain areas.

Fundraising Challenges

Venture-style investors tend to 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 hybrid business you’re trying to get funded:

  • lack of uninhibited scalability and possibility for explosive revenue growth,
  • complexities of running two different businesses under the same brand and same leadership team, and
  • 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 percent 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 the new product company to have an exclusive, perpetual, and irrevocable license for the intellectual property (IP) 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 like they do with any other startup.

Gordon Daugherty

Gordon Daugherty is a seasoned business executive, entrepreneur, startup advisor, investor, and the best-selling author of Startup Success: Funding the Early Stages of Your Venture. A proud native Texan, Daugherty graduated from Baylor University. He has vast experience with early-stage fundraising from both sides of the table, making more than 350 investments and raising more than $100 million in growth and venture capital as a company executive, fund manager, board director, and active advisor.

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