Software’s Valley of Death

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The early days of a software start-up are hard. You’ve got product that’s half-baked. Customer pilots that aren’t going well. Hiring engineers is brutal. You’ve got no one to sell your product. You’re running out of money and raising money requires a successful set of customer proof points. You know the playbook that consumer internet companies are following – don’t worry about monetization, just drive user value and grow. The money will come.

I’ve got bad news for you. If you’re in the software-as-a-service (SAAS) business, unless your business model is designed to ensure the money will come, the money won’t be there at the end of your journey.

In fact, few things are as important to the long-term viability of a SAAS business than the congruence of your price points with the market segment you are targeting. Lets do some simple math. Lets say you want to build a $100M recurring revenue SAAS business. There are really only two fundamental ways of doing it:

  1. Tackle the Enterprise: Sell 1000 companies @ least $100,000 per year deals with a market size of at least 5,000 companies
  2. Tackle the Small & Medium Business: Sell 100,000 companies @ least $1,000 per year deals with a market size of at least 500,000 companies

A company like Workday is a best in class example of No. 1, today worth $15 billion. They may have long sales cycles but it results in well over $400,000 per year deals. They went public with 325 customers and had a $135 million previous-year SAAS business. On the plus side: Deals are big; you can pay expensive sales teams their $250,000 on-target earnings; customers are sticky and contracts are typically multi-year so the business is enormously predictable. On the con side: I’m sure the business had greater customer-concentration in its early days than anyone liked; the early bookings must have been pretty lumpy and the sales/IT integration cycles must have been pretty long.

A company like Solarwinds is a terrific example of No. 2, today worth $3 billion. They built the business on small deals, typically less than $6,000 per transaction. Over 50,000 customers used the service at the time of the IPO to generate $62 million in revenue back in 2007. The model promotes that kind of velocity. It is inside-sales driven, with a downloadable version that reduces lead generation costs. Sales cycles are short because reps are often upselling a customer who has already downloaded the product. The market size is large in terms of number of companies, because almost any meaningful business can use the product. The deployment is quick. The pros are that when the flywheel is built, it can be a very cool business. The cons are that building that kind of high-velocity flywheel is super hard and not all market spaces lend themselves to this approach.

The valley of death is often in the middle. It’s the company with the long sales cycle (often because you are selling something that is pretty complicated to enterprises). You still require expensive sales people, have a limited market size and low price points (often $5,000 to $30,000 a year. ) Over time, the model simply doesn’t work. You can’t afford to sell or support large enterprises at these kinds of price points. There simply aren’t enough large enterprises to help you build a large business. Often it takes you a couple of years to discover this. You start off thinking “I will worry about building a great product first and worry about monetizing it later.” Then you convert your first customer into a paying one for $1,000 a month – thinking you can raise prices later once you’ve got customers to serve as references. Sometimes, you might even start with a higher price while targeting the Enterprise but start dropping it rapidly when you face competition, rather than fighting for value. You hire your first set of sales people and they keep closing low-price deals after long sales cycles. You assume that’s because you hired the wrong people or didn’t train the right people well. Your account-management costs are going through the roof and you’re wondering why you’re dealing with a bunch of custom requirements. You’re three years into your venture and you’ve landed in the valley of death. You’ve neither built the high price point, high value enterprise business nor the high velocity mid-market business. You’re simply stuck because neither outcome looks all that achievable.

The valley of death is totally avoidable, but only if you deal with it pretty early in the lifecycle of your start-up. Basically, you’ve got to pick your market segment in tandem with your product. You’re either enterprise, or you are mid-market (at least initially). You can’t be both. If you’ve picked the enterprise direction, somewhere in the first year – validate that someone will pay you at least $100,000 a year or iterate on your product till they do. If you’ve picked the mid-market direction, validate that you can address tens of thousands of companies and do so in a high-velocity manner early in your company’s evolution. If you are in the green zones, you’re set for greater things down the road. If you’re not, iterate till you are because the pain will be a lot worse down the road if you don’t. The great companies like Workday and Solarwinds design their entire business around their market segment – product, marketing, sales costs and competencies, account management and financial metrics.

A corollary strategy that many software entrepreneurs take is the “land and expand.” The idea is to sell a low price point, high-velocity product first – aiming to upsell later into a larger deal. That strategy (taken by companies like Dropbox or Box) can be a good one. But it doesn’t change the basic calculus of your market segment. Land and expand is a marketing/product strategy. If the net result is that you end up with small numbers of low-price-point customers, you’re screwed, whether you’ve landed and expanded or not.

Dealing with price can be particularly tough for product-oriented founders. The temptation is to keep iterating the product and deal with money later. Remember, this is B2B software and not the Consumer Internet space. Aim for the Enteprise or aim for the Small and Medium business, but at all costs, avoid the valley of death.

Image from Fire! by Eoghann Irving licensed under CC by 2.0

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