Friday, September 29, 2006

How Pure is Your Model

Rightnow Technologies is a leading provider of customer experience management solutions. Based in Bozeman, MT, the company boasts a $500m market cap, $100m in run-rate revenue, and a price to sales ratio of roughly 5x. The company provides software to its customers via multiple delivery models - on premise, on-demand single-tenant, and on-demand multi-tenant.

Salesforce, on the other hand, is a pure, read on-demand multi-tenant, SaaS play and enjoys a $4BN market cap, $472m in run rate revenue, and a 8.5x price/sales ratio.

As entrepreneurs architect start-up software companies, it is worth asking the following question: how much of Salesforce's 70% multiple premium is a function of the purity of their software delivery and pricing model?

When questioned why he supports so many delivery options, Rightnow's CEO, Greg Gianforte, answers that he sells the customers what they want. If they want on premise, fine. If they want their own instance of the application on-demand, fine. If the want multi-tenant on demand, fine.

While there is no question that being customer driven is a sound business trait, the complication arises when saying "yes" to customer demands introduces systematic weaknesses into your operating model. These weaknesses tend to frustrate the ability to realize economies in development, pricing, development, and sales force training.

Many of the bootstrapped start-ups that I meet with face this exact challenge - how can you say no to a customer when you need to make payroll? Why not agree to sell customer B what they want, even if it is inconsistent with what we sold customer A?

Where is the fine line between being customer driven and being a custom development shop building one-off products?

The economics of multi-tenant software are well understood:
  • lower research and development costs (eliminate the need to support multiple code bases, custom patches and the need to port the software across multiple hardware and O/S stacks)
  • lower support costs (eliminate on-premise one-off configuration complexities that complicate root cause analysis, eliminate need to support old versions of the product)
  • lower sales costs (standard pricing and delivery options vs complex pricing lists)
Complexity is hard to manage and impure models, while responsive to near-term customer demand, may in fact jeopardize long-term operating leverage. Dual tract models raise concerns about R&D, operations, support, and sales costs, with the model potentially increasing costs across the board relative to a pure play model. Dual tract models are also much harder for investors to understand and complexity and lack of transparency often lead to valuation dings.

At Hummer Winblad we are sympathetic to companies who perform "unnatural acts," ie deviations from their model, to win business. Teams, however, must be very careful that in pleasing customers they don't alienate investors who question the wisdom and sustainability of impure operating models.

All revenue is not created equally, and I posit that "good" revenue that reinforces efficiencies and the scalability trumps absolutely higher revenue. For start-ups, purity is a virtue worth aspiring to.

1 comment:

  1. Anonymous5:11 AM

    I'm a big fan of purity and and in the middle of an interesting natural experiment concerning it.

    Two years ago a moderately successful service business with two geographically diverse locations was sold as two separate enterprises- one unit was sold to me and the other was sold to someone else. The Fortune 500 company that was a partner in the venture had decided it was an opportunity no longer worth pursuing and the founder did not have the capital or credit to continue operations on his own.

    Since purchasing the business, we have pursued purity. There are four distinct customer types that can be served, we have chosen to only market to the one largest segment and have raised prices continually to the other segments in an effort to get paid well for serving them until they eventually drop off or we can sell those accounts.

    The purchaser of the other unit has done the opposite. He was previously the CFO of the combined company. He is actively pursuing 3 of the 4 segments and may begin pursuing the 4th as well.

    Right now he's winning as his sales are up about 20% since he took over. Our sales are down about 10% since we purchased the business, reflecting the loss of several large accounts that are not in the segment we are now targeting.

    However, when I speak with him, it seems like he is always involved in operational issues, probably reflecting the relative complexity of his business.

    Meanwhile, I have to spend very little time working in the business, as the management and employees can handle all routine matters. I'm free to work on the business and we will soon have the operations model sufficiently tuned to allow the marketing model to be turned up to 11 and, I believe, dominate our chosen segment of the industry locally and then begin our national expansion.

    After 25 years as an entrepreneur and involvement in 9 start-ups, I'm about as sure as I can be that in five years, when the results of this natural experiment can be evaluated, our single segment focus led by myself, who had very little prior experience in the industry, will have proven to be vastly more successful than the multi-segment approach of our peer- which is led by someone with years of industry experience.