Friday, September 02, 2005

Scale Free Profitability

Morgan Stanley's high-tech investment banking team present a wonderful chart that examines the effect of scale on software profitability. The chart powerfully illustrates that scale is increasingly necessary to achieve competitive operating leverage in the software industry.

For example, the distribution of LTM operating margin by revenue size is as follows:
  • $75-300m in revenue = 7% operating margins
  • $300-500m in revenue = 11% operating margins
  • $500m-$1bn = 12% operating margins
  • $1bn-$5bn = 18% operating margins
  • >$5bn = 33% operating margins

The scale effect, as noted by Larry Ellison and Barron's, is driving rapid consolidation of the industry as vendors seeks to consolidate capacity, drive volumes, and get to minimum efficient scale. Consolidation, while good for exits in the near term, has troubling long-term implications wrt the market's expectations for future small cap software company growth, profitability, and viability.

Start-up companies and VCs, by definition, cannot rely on scale to help us achieve profitability. Rather, start-up companies must innovate their business models and strategies in order to reach attractive profitability metrics independent of scale.

As important as technical innovation, successful start-ups must innovate how we do business and prosecute R&D, marketing, sales, and operations.

If we simply innovate technically and rely on traditional business practices, we will suffer from the fate illustrated in the table above.

How we rip costs out of the software model while delivering value will be critical.

I would enjoy hearing from start-ups and investors on novel, optimized business practices that are helping to realize scale-free profitability. While open source software, offshore development, and channel based selling are well-known strategies, any fundamentally novel approaches would be great to share.

10 comments:

  1. Anonymous12:03 PM

    How do you do it?! Great post, keep up the good work.

    Best Wishes,
    Ken
    Fastest Reader in the World

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  2. I've got one!

    Minimizing costs....scale free profitability....ummm..

    Marketing is expensive. 30% of sales is not unusual.

    Viral marketing, or enabling your customers to advertise your product as they are using it, cuts out a large chunk of that.

    Sure...the benefits of viral marketing accrue with scale, but nonetheless, it's a significant reduction in variable expenses.

    Great post by the way. Keep’em coming Will- you’re doing pretty well. Thanks.

    - Yeehaaa

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  3. Seems to me there are two drivers that one can work without scale.

    First, you need to reduce marketing and sales as a percentage of first-year client revenue. Too many firms geared for growth spend gigantic bucks to bring in new business in the name of "hypergrowth". One does not have to be a "duck" (in the BCG product-portfolio matrix sense) for very long, if at all. On the sales side, there is often bloat from keeping ineffective sales staff, or having an overreliance on outside sales for smaller prospects. On the other, technology to measure marketing impact is getting very good, and should be applied to aggressive pruning of ineffective marketing or sales efforts.

    Second, you need to increase the contribution of recurring revenue. A lot of software firms are driven by one-time sales with small recurring maintenance revenue. This latter component needs to be increased, as it is the source of long-term relationships, and is paid for through providing top upgrades and customer service, which is much cheaper on the main than penetration sales.

    Of course, aggressive cost containment combined with a focus on follow-on revenue is not a recipe for 1000% annual sales growth, but it does help increase the profit margins significantly, allowing the growth that does occur to be profitable, and opening the door for a high profit growth, even without a major increase in sales (as the higher-margin recurring revenue kicks in).

    But that's just my bootstrapper's perspective.

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  4. To extend the meme of lowering sales & marketing expenses: I think this is part of the opportunity that "Web 2.0" offers. W2.0 is not only a new way to combine evolving Internet technologies, it also incorporates the leveragability of the Blogosphere (feel free to shoot me for using cliches). If you create a product that follows the amorphous value set of the B'sphere and the timing is right, they'll elevate the profile and distribution of your product far beyond expectations. Look at all of the recent mash-ups and beta sites that receive promotion because of the substantial growth and rabid appetite of bloggers (del.icio.us, flickr, etc...).
    The hard part is that you can't just buy your way into this venue and receive the benefits. They have to select you. Now, I'm sure that spending some time thinking about B'sphere's value-set and analyzing other successes could improve a company/product's chances and I'm sure that some have already exploited this channel.
    Another channel that uses innovative effects to broaden adoption is Open Source. Part of the success of Open Source is that because involvement in the development of a product is distributed, the promotion/evangelization is also distributed - often in unexpected and positive ways.
    Of course both of these options require a model that gives to get. But ain't that the way it often goes.

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  5. One other comment - the chart may really tell a story about movement through the profitability cycle. If the smaller firms are all targeted toward growth, they will spend more on customer acquisition than the large firm, which has saturated it's market and is shifting to generating the returns it has been promising.

    Of course, this would be blown away by data showing that the large firms are exhibiting larger % growth than the smaller ones.

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  6. An anomoly that comes to mind in regards to the scalability model is Salesforce.com. They clearly have a scalable software model, but they continue (and have since the very beginning) to pour 40% and 50% of their revenues back into Sales & Marketing, thus eroding their margins. How successful would SF.com had they not invested so heavily into sales & marketing? One could look to SugarCRM as an example, or even RightNow.

    One could argue that there is still tremendous scale left in SF.com, but it comes at a very, very high cost of sales & marketing.

    Where is the balance?

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  7. Having a horizontally focused product that can be OEM'able through a vertical, in my opinion, is one of the easiest ways to sell software. Give them a robust API with healthy margins and you're on the right track. I've seen it work well.

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  8. Anonymous3:52 PM

    How much does the Microsoft monopoly distort the numbers?

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  9. Anonymous4:18 AM

    This comment has been removed by a blog administrator.

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  10. Anonymous1:26 AM

    Can you please post the report from Morgan Stanley or atleast give us some pointers to the source.

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