Monday, July 20, 2009

Wanted: Small, No-Name Customers

Readers of my blog should be familiar with my deepening preference for software companies, especially those that exhibit a low cost structure and high margin sales (not all software companies do). However, increasingly I prefer to characterize my investment focus less by sector, and more by the sales and go-to-market strategy. Specifically, I find myself favoring companies that use the Internet to sell directly to small businesses and consumers, and skeptical of start-ups that build their strategy around selling to large, strategic customers. For a variety of reasons, it has simply become more expensive and less rewarding to sell to large customers, regardless of whether this is a Fortune 500 company, telecom operator or hardware OEM. At the same, new marketing and delivery methods have made focusing on small, no- name customers more capital efficient and scalable.

In the first decade of Israeli venture capital, entrepreneurs and venture capitalists had a natural bias towards start-ups that focused on large, marquee customers. Wins with such customers meant large deal sizes, the attention of strategic partners/acquirers, and a rush by other customers to emulate the early adopters and thought leaders. Always preferring a technical sale, Israeli start-ups preferred large customers with a strong understanding of technology. Conversely, we venture capitalists eschewed start-ups that focused on small businesses or consumers, mostly because there was no cost effective way to reach them from Israel. Even if you could reach them, it was widely felt that these small customers do not appreciate cutting edge technology and are partial only to established brand names. Furthermore, while the strength of Israeli high tech was generally built around product sophistication, performance and intellectual property, selling to small, no-name customers required a product that emphasized design, usability, simplicity and price.

Large Can Be Longer, High Touch, Expensive, Non-repeatable & Unrewarding

A lot has changed since then. First of all, post 2000 these large customers have grown wary of working with and relying on start-ups, hundreds of which have disappeared, changed direction or simply never reached scale. The result is that the sales and testing processes of large customers is longer and more arduous for start-ups than ever before. Additionally, the procurement process of these large customers is more stringent, built on the premise that they are always better off buying from a select group of large, established vendors(even with an inferior product). Even where they have no alternative, their reluctance to buy from start-ups persists with attempts to indentify a middle man, place the start-up’s IP in escrow(in the event of shut down), or extract a hard commitment to fulfill the product roadmap(rarely accompanied by any NRE dollars). And once an order is finally placed, the long coveted joint press release is blocked by the legal department.

Secondly, the established competition has become more proficient at thwarting start-ups’ efforts to penetrate their strategic customer base. The competition knows to take advantage of the customer’s preference for buying a full portfolio of products and related services by bundling products and offering their variant of your product for free or at cost. The weak start-up market bolsters the larger competitors’ attempts to sow doubt about start-ups’ long term viability. Even Oracle’s sudden shut down of Virtual Iron only a month after acquiring them can be seen as a message to enterprise customers that even M&A provides little assurance for product continuity. This systematic obstruction was always present, but has intensified with industry consolidation in networking, semiconductors and enterprise software.

Lastly, penetrating a couple large customers no longer provides the same currency it once did. Not so long ago, regardless of sales growth and profitability, a few big customers wins made you “acquisition material.” Such customer wins meant the company was turning a corner, and generally made the start-up “financeable” by fellow VCs. Investment bank research analysts would warn larger competitors of the upstart’s superior technology and growing traction, and the young start-up’s credibility would rise remarkably. Today, this connection has been severely weakened if not completely dislocated. This is partly due to the challenge of a repeatable sales process among more skeptical customers, but also due to the indifference of potential acquirers.

Small Can Be Quick, Low Touch, Repeatable & Inexpensive

With large customers no longer worth the effort, start-ups should consider focusing on smaller customers and/or consumers. Luckily, several trends play in favor of such a “no-name” customer strategy. Performance marketing including targeted online advertising and affiliate networks allows start-ups to reach a wide audience cost effectively and with minimum up-front investment ( see “When Marketing and Sales Becomes Scientific”). Similarly, advancements in delivery methods, including downloads, virtual appliances and software-as-as-service lower the cost of sales, deployment and maintenance. Of course, strategies focused on small customers and consumers do not preclude sales to large customers as mentioned in my previous blog post “A Preferable Route to Market.” The challenge for Israeli companies is to build a product that emphasizes usability and simplicity as much as technology and performance. I have little doubt that such skill sets exist in Israel, but the key is to make this a priority.

The start-up and venture world has undergone a flip over the past 10 years. Large customers, once thought to provide a short cut to success, are now seen as more demanding and less loyal than before. Fortunately, smaller customers scattered across the globe are now accessible and serviceable via the web. Telecom once has its version of “small” customers called CLECs, while the semiconductor companies focused on Original Design Manufacturers(ODMs). In both cases, the smaller customers proved to be short lived or unreliable. I believe software delivered over the Internet could be both long-term and successful, but in the very least it’s an inexpensive model to experiment with.

8 comments:

  1. It might be a successful business model for a company, but I do not see how VC can fit here. Such a company might need only $0.5M-$1M investment and the exit strategy is unknown. This might be good for angels building on nice dividends, but I do not see a place for VC here.

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  2. Dear Anonymous,
    I am specifically referring to the hundreds of profitable Internet and software companies out there enjoying freedom from financing. Most were backed by VCs. However, considering 85% of VCs have not turned a profit in the past decade, I don't think its entirely clear what a VC backed deal should look like. You are right that these companies don't look like aspiring Microsofts and Ciscos from day 1, but at least they can prove traction and avoid the perils of the venture funding dependency.
    Adam

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  3. re: they can prove traction and avoid the perils of the venture funding dependency.

    No doubt, internet startups serving small business and home users can become break even in a few months, if not weeks. I met few such entrepreneurs making a nice personal income on this. I just do not see a good model for VC joining such a venture: usually it's a small investment with unknown exit path. There are few notable exceptions, but too few to call this the way to go.

    For a traditional VC looking to invest $10M-$30M to get $100M-$300M back - I just do not see opportunities here. And I doubt that VC can invest 10 times by $1M instead, especially with unclear exit path.

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