Navigate the opportunities, challenges, and outcomes of service companies building their products.
Services companies traditionally have lower gross margins compared to technology companies, especially software companies. That’s because the service requires the human body to provide most of the value that the customer is paying for. Scaling a service company requires near-linear scaling of these organizations. In other words, to triple his annual sales, he would have to roughly triple the number of employees in his company. The lack of scalability leverage compared to technology companies causes a lack of investment interest on behalf of the venture funding industry.
the product is built
Some service companies end up building custom technology to make their revenue-generating human resources more efficient and/or more effective. MVP), and more sophisticated, could potentially be sold separately with high gross margins and attractive scalability leverage.
Building, selling, and supporting technology products at breakneck speed comes with many consequences and tradeoffs. These should be understood in advance.
deep domain knowledge
Let’s start with the biggest advantage of this scenario. The company’s executives and employees have deep knowledge of the industries they serve and the buyer personas they sell to. They learned how to run a company, preferably with a strong culture. They may even have developed a reputation and general perception of their industry presence. These are all things early stage tech startups hope to achieve.
Is it really a product?
In the early days, new technology was usually so focused on the needs of enterprise service delivery professionals that it didn’t make sense to sell it to others. To promote to that level, you need to define and create a real product. You can think of this in the same way as a research project working in a semi-controlled environment, as opposed to a commercial-grade product that is widely sold on the open market. There are big differences along multiple lines.
To create a real product, you have to go back to the very beginning of the startup idea development stage. You will need to create a business plan that includes a huge list of initial assumptions and aspirations. Unfortunately, most service companies do not do enough work on this plan and strategy. This is probably due to the gradual development and evolution of the technology within the company. It doesn’t seem like a ground-up business venture, and in many ways it isn’t. It is due to the way technology products were born.
A business plan for a new product shouldn’t just be in someone’s head. Instead, it should be documented and discussed with other company executives. While doing so, the team has to step away from the service company and pretend to be independent with only the technology product developed. How should we proceed from that new starting point? Even if ultimately cultivated inside a service company, such a mindset is perfect for developing a complete business plan for a new product oriented business.
The good news is that the company has many existing and former customers that can be approached for the necessary customer discovery related to new products. These customer relationships help us communicate our product feedback more honestly. A company’s knowledge of other aspects of its operations and priorities can also help you ask better questions and better achieve the much-desired “haha” moments sought during customer discovery.
competing priorities
Service companies in the positions described are often profitable and cash flow positive, but usually not profitable. This means that the investment required to further develop a technology product and prepare it for launch means draining valuable resources, both financial and human, from the core services business.
Service companies are very slow to develop their technology products because of this dilemma. It works as a double blow.
Profits are diverted and resources spend more time multitasking. Plus, if your product idea is great, other venture-funded startups may be working on something competitive, and you run the risk of being left behind.
Raising new funding for product-related ventures is an obvious option, but there are also some common challenges.
Potential Conflicts of Interest
New product sales may result in customers paying less for services, or none at all. Business strategy can actually call for cannibalization of service delivery as the business gradually evolves into just a product company over time. If not, you should consider the potential for cannibalization and decide whether to plan for cannibalization in your financial forecasts.
Other conflicts that may arise relate to other competing service providers. They can be the best customers for new technology products, especially in the early stages. Should you sell your product to them? Even if you don’t want the original developer to use your product, the sales model the product employs may not allow that level of control. This means that when a product is sold through distribution channels, you have no control over who buys it.
On paper, creating two entities to optimize opportunities may seem straightforward, but in practice there are problems and challenges to face.
Operating two businesses
Service and technology product companies, from how revenues and expenses are calculated, through the systems and processes used, sales and support models, pricing strategies, and business plans, over and over again. As new products are launched and that aspect of the company begins to mature, the company essentially becomes two different businesses under the same brand name.
For this reason, many service companies ultimately decide to split into two separate legal entities, one for services and one for technology products. This action often follows the validation of key aspects of the product-related business plan.
Relationships between two entities can take many forms, such as a parent company or a sister company. The term sisterhood is a rather layman’s term, but implies that there is some commercial and/or legal relationship between the entities. It may be the license of the technology created. It may be a reseller relationship. Or it might involve sharing resources. There can be significant sharing and duplication of resources in the early days after the split. If so, it will likely change over time until the new product company becomes self-sufficient, but retains a commercial or legal relationship with the original company.
On paper, creating two entities to optimize opportunities may seem straightforward, but in practice there are problems and challenges to face. Think of it basically like starting a new startup.
fundraising challenge
Venture-style investors tend to be hesitant to invest in service companies that build technology products. Especially if more than half of the company’s revenue comes from services.
Venture capitalists don’t like the hybrid business you’re trying to fund:
- Lack of unlimited scalability and potential for explosive revenue growth,
- the complexity of running two different businesses under the same brand and same leadership team, and
- There is a risk that the product-related aspects of the business will not be successful enough to either prey on the services business completely or dramatically reduce the services business to less than 20% of total revenue.
In many cases, the best solution to this funding challenge is to split the product business as a separate company. Investors demand that the new product company obtain an exclusive, perpetual and irrevocable license for intellectual property (IP) invented and developed within the service company. In fact, intellectual property ownership may be transferred entirely to the product company. Outside of IP ownership issues, investors should be able to consider investment opportunities like any other startup.
