When faced with the challenge of funding and launching their startup, entrepreneurs frequently look to gain early market validation, product definition, and revenue through consulting engagements with one or more customers. This arrangement allows the entrepreneur to leverage existing relationship and expertise to launch their business prior to investing heavily in infrastructure. If the engagement is successful, others will follow, either through a more broad relationship with the existing customer, or through engagements with new customers. If those engagements are, in turn, successful, the entrepreneur can continue to hire more people, extend the project to further build out the feature set, sign more engagements following the same model, and voilà, a company is born!!

After a period of time, however, the entrepreneur may be faced with the inevitable question of, “who are we, a consulting company which leverages a core technology or a product company with a repeatable selling model?” This key question may mark a turning point in the growth of the company, and requires serious, careful thought. While there is no correct answer, this article will focus on the specific challenges of this decision, summarize the options, highlight common pitfalls, and offer advice on how to navigate.

Strategy & Model

Which business model to choose is, of course, the core issue. Many factors go into the analysis, including: size of the opportunity, scope of the offering, skill set of management & employees, relationships with existing customers & vendors, and availability & requirements of investors.

The key difference between a product company and a consulting company is leverage. Ideally in a product company, you design, build, market and sell a single widget to hundreds, thousands or million of customers. This “build it once, sell it many times” model allows you to invest in a single design and manufacturing process, market one offering and narrowing define the hiring and training of your sales and support teams. It implies that the market is large enough, and the offering broad enough to be attractive to a large number of customers without significant alteration. When executed properly, this model can produce very large, highly profitable companies. Microsoft, for example, generates about $650,000 of annual revenue per employee with a gross margin in excess of 82%. The growing acceptance of web-based offerings has taken that model even one step further. Consider the example of Google, which, at the time of their initial public offering, was producing more than $1,000,000 of annual revenue per employee! The entire computer software and programming sector produces almost $900,000 of revenue per employee at an average gross margin of 63%. The computer services sector, by comparison, produces about $860,000 of revenue per employee with an average gross margin of 49%.

While the average numbers certainly can argue for the primacy of the software model over services, the challenge is that this leverage can be just as powerful when used against you. In the most extreme case, a large upfront investment will be required to research, design, building, test and market the product before a single dollar of revenue is realized. That, of course, can spell trouble should the company’s initial offering assumptions require revision or the development fall behind, and the company’s cash begins to run out.

A consulting company, on the other hand, requires much less capital to start, gets to revenue more quickly, can change their offering with every customer conversation, and, if managed properly, will be able to scale up or down based on the forward looking pipeline of engagements. These companies, particularly smaller consulting companies, are much more nimble than comparably sized product companies. As one of our portfolio CEO’s likes to say, “there is no reason for a services business ever to be unprofitable.”

Offering

Before tackling the transition from a services company to a product company, all the elements of the new and old offering must be considered. From the product company’s perspective, is the available market large enough, and the offering general and compelling enough to warrant a fundamental change in the business? The offering must be carefully thought out and clearly defined. The process is similar to launching any new product company; except that the services company has an existing infrastructure of customers, relevant domain expertise, and technology. This analysis forms the core of the transition and cannot be taken lightly. Many companies fail in this transition because they confused a single, strong, successful client engagement with a broad market opportunity.

Should a large product opportunity emerge, the specifics of the offering need to be defined to best take advantage of the existing assets of people, clients and technology. Some of the elements to be considered include: specific client to generalized product release feature sets and schedule, and the mix of product and services.

Finally, the impact of any transition on the existing clients must be considered carefully. In some cases, the company must be able to go through its transition without any impact on the level of service delivered to its existing clients. This is usually the case where the clients are strategic, the prior relationships formed the basis for the future product offering, and the clients' support (revenue or reference) going forward is important to the future success of the product company. In other cases, the transition is so fundamental that some or all of the existing services clients will be considered legacy and a drain on future business. Those clients should be transitioned away from the company as quickly and painlessly as is feasible in order to prevent any drain on revenue and distraction. In either case, open and early communication with clients is important to maintaining great relationships and reputations.

Personnel, Culture & Training

Many believe that a company is really nothing more that the sum of the people who work there. As companies get built, employees are hired because they possess a specific set of skills that match the needs of the company. The challenge during any major transition is that the skills and mindset needed to develop, deliver, sell and support commercial off-the-shelf (COTS) offerings are vastly different than those needed to successfully spec, sell and deploy one-off consulting engagements. This challenge extends to all employees, including management and founders.

Ideally, a company would like to build up the product team slowly as they are scaling down the services organization. One common approach is to hire a small product “SWAT” team – a mini version of what the larger organization will be complete with leadership, product management, development, marketing, sales and support – and scale that organization to match customer driven demand. The existing services organization may play an important role in product definition and delivery as the business grows.

Hiring, employee training, and ultimately the corporate culture will need to undergo a major transformation to match the changing needs of the company. In this area, clear vision and strong leadership will be key.

Finances

The reason many consulting organizations strive to evolve to product companies can be summed up in one word: leverage. Why exert the effort and expense to sell one custom engagement after another when you can build it once and sell it over and over again? A consulting business may be very profitable, but its revenues and margins are fundamentally capped by the number and costs of the available man-hours.

While either model will work, the transition from consulting to product company will almost certainly bring with it a revenue gap as the product team expands beyond the level supportable by the services revenue. A software sales executive should generate 5 times or more their own costs in revenue – thereby providing funding for engineers and others. Most services delivery people, by comparison, will delivery 2 times or less their own costs in revenue. While there may be no shortage of work for hire if you have good relationships with your customers and can sell creatively, the development and support of technology products brings additional costs that may not be supportable solely from services revenues.

This is often one of the most painful challenges for companies that have gotten accustomed to a steady stream of revenue derived from selling new or incremental projects. To effectively make the transition, the company will need to plan for a probable downturn in revenue and increase in costs as its internal resources are moved away from generating immediate revenue by deploying projects, and into investing in development and building software.

Investors

Finally, the entrepreneur must always be aware of the particular requirements of existing and potential investors. The existing investors made their decision to support a particular company and business model, and must be considered and consulted in any major business shift – particularly if they may be asked to support the company again during the transition. Different types of investors will have different incentives and motivations when considering a shift. “Friends & Family” investors may be motivated by personal loyalty to the entrepreneur, financial investors will be seeking maximum returns, and strategic investors may be motivated by synergies to their own business initiatives. In any case, understanding the unique desires and motivations of each investor, and open communication and transparency will help smooth any bumps.

Conclusion

As the post-bubble technology market continues to evolve, companies are more frequently seeking to hedge their market entry risk by developing early services relationships with key clients. This strategy, largely replacing the “first mover” strategy popular in the 90’s, brings many advantages for entrepreneurs, customers and investors, including lower up front cash requirements and early market validation. The strategy of transitioning from a services company to a product company is not without risk however. As the entrepreneur develops their plan, they must take into account how this fundamental shift in business will affect their key stakeholders, and create a plan to maximize the value of the transition, and minimize distraction to the team and disruption to their customers.

-Jon Goldstein