52 Bicycles

I’m part of a mailing list discussion among software entreprepreneurs concerning business models to improve the viability of new ventures.

As part of this, it’s become apparent that there is a distinction that needs to be made between products and businesses.

Businesses are cash engines. It seems to me there are three ways for a software entrepreneur to build a cash engine:

1. Lease your brain. Consulting is a fine way to make money, especially when you can lease the brains of others. It is even a way to finance other businesses (similar to the “day job” financing method). Downside: others will usually own the ideas and intellectual property you create in the engagements that earn you the cash. (I avoid “sell your brain” because, aside from gruesome connotations, it means “get a job”)
2. Lease/sell your ideas: A research lab can create intellectual property to be licensed (in all sorts of permutations) to additional businesses. Again, lots of institutions make money this way, and holding the patent on the better mousetrap and having everyone else license it is a fantastic way to get very rich (for 25 years).
3. Build a self-sustaining institution: turn your attention to building a business that generates cash without your ongoing force of will. One in which your initial relationship may be doer, in the middle you are a manager, then at the end a shareholder, as the company evolves into a self-sustaining engine that converts the intellectual property into revenue through providing a product/service to customers, and you get a share of the profits.  

These are the types of businesses. There are many many different types of products that can fit into these molds. And I suspect that some who think they are doing “Build to Flip” are really creating a one-hit-wonder research lab, with their intent to sell all the IP (plus probably a multi-year contract for their own services), such that the lab will fold at the end.

Why does this matter? Because it is easy to get confused, and knowing which type of business you’re in informs decisions on how to best get wealthy:

1. Consulting practices should maximize the multiplier on their time. They should generally expect that they will spend about 50% of their time acquiring new/extended gigs. As such, they should seek out clients willing to pay at a higher hourly rate, as well as opportunities to sell the work of junior associates. Associates, who are paid a wage, can be billed at a higher multiple than your time, and the more associates you have, the more income they are generating over and above their own salaries, which goes straight to the owner - you.
2. Research labs should maximize the return on their ideas. That means anengine to generate ideas, develop them, drop the ones that don’t work, and license/sell/whatever those that do to interested parties. This model works best when you have multiple ideas (and ideally a stream of new ideas), and both the will and ability to license them out relatively early in the development cycle, rather than taking them all the way internally, so as to manage risk and continually generate income.
3. Product Companies should have a razor focus on a single idea, which is a combination of new technology and a way to (eventually) generate current income with it. VCs and other (rational) equity investors invest in product companies, and they do not invest in the others. (There are a few exceptions, but I wouldn’t bet on being one of them.) A product company is an all-or-nothing bet on the idea, so it’s best for the idea to have a high likelihood of success. Further, it’s about capital and time - the less time it takes for the enterprise to pay for itself (including fair market salary for senior management), and the less capital required for it to achieve that goal, the higher the likelihood of success.

Inside each of the three categories there are a number of variations on how to succeed. And nothing says that the enterprise needs to exist for all eternity to be successful, nor that it need to stay in the same form - witness the many consulting firms that have transformed into software product companies, and vice-versa.

And while these are early incarnations, it is possible to have crossover and multiple lines of business (a product company that has a research lab, and a consulting practice)… later on, when the company is sufficiently well established, and the question is how to put all this money to work. But that’s not the question in the early going.

We are a product company. I like this model. I think a lot of entrepreneurs do, especially since this is where a lot of them see their heroes - Gates, Dell, etc. But it’s not necessarily the best place to start, nor is it necessarily the way to maximize wealth. And if you really don’t have a clear idea on how to make money with an idea today, charging down the product company path is awfully dangerous .

But this last question is eminently answerable: there are a finite number of ways to generate revenue as a product company, particularly in software. But that’s a topic for another time.

And only now at the end am I mindful of my rule regarding pontification. Oh well.

This entry was posted on Friday, February 10th, 2006 at 10:01 pm and is filed under Technology Business. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed. Reddit This