JULY 1991
From time to time, the Technology Law Bulletin has analyzed the software industry, and the ways in which software developers can best seek financing in light, or in spite, of various unique attributes of their business. Among other things, we have sought to show how certain commonly perceived deficits in the typical company profile may be turned into advantages. The recent release of the annual “Software Industry Business Practices Survey” by the Massachusetts Software Council and Price Waterhouse provides the occasion to once again highlight where opportunity lies for the software entrepreneur.
This year’s Survey is a wealth of information derived from 466 respondents nationwide, and should be required reading for every type of participant in the software field. For example, it reveals that 68% of those responding had self-financed their businesses; only 19% had obtained venture capital, and just 4% expected to obtain venture capital financing in 1990 (the year of the survey).
Is this good news or bad? On the one hand, these figures could be read to indicate that the software industry is starved for capital, in part because the majority of software developers do not present the appropriate profile to attract venture capital investment. However, before leaping to that conclusion, note the following Survey responses as well:
- 56% of those responding spent less than $100,000 for all purposes from the date of founding their companies until the date of first non-beta sales; 81% spent less than $500,000.
- 64% of those responding shipped their first non-beta product copy within 12 months of founding the company.
- 68% had participated in some sort of strategic partnership, and 63% of this group had received some sort of direct or indirect financing as a result (e.g., equity financing or equipment loans or discounts). The vast majority of these respondents rated their strategic relationships as “satisfactory” or better.
- 86% of the respondents had had only 1 or 2 CEOs in their history, and 88% still had founders in the most senior management positions.
- 64% of those responding indicated self-financing as the method they would choose to launch a new company.
This data provides a far different picture – one of successful businesses launched with internally generated revenues and strategic partner assistance, and still controlled by their founders.
For too many entrepreneurs, venture capital still is automatically viewed as essential to the launching of a start-up venture. And, for ambitious, high capital requirement enterprises, it usually is. However, a VC funded enterprise must necessarily drive itself towards rapid growth and an eventual sale or public offering – a “bet the ranch” strategy which may pass over alternatives for comfortable, safer, sustained (though more modest) growth, and which may or may not accommodate the retention of the founders in the key management positions.
This institutional investor preoccupation with fast growth and public offerings is a historical anomaly: we are surrounded by a legion of privately held, low-profile businesses in many industries with sales of under $10,000,000, where the owners’ annual compensation and profit taking rival those of the officers of many Fortune 500 companies – and where the founders (or their heirs) remain in full control of the businesses which they have created. Most of these enterprises were financed with founders’ or family funds and bank loans.
We submit that software development (and for that matter, software publishing and other related enterprises) represents one of the premier opportunities to return to this time-honored success model. The business of software development is characterized by unusually high profit margins (after the costs of development have been recovered), and, as demonstrated by the Survey responses, can have comparatively low barriers to entry. Moreover, for many types of products, there are ample third-party distribution channels available for products (thus dramatically reducing, or even eliminating, the overhead of a sales force), as well as good prospects to receive development funding from other industry participants.
The lesson to be learned from this is that shrewd entrepreneurs have an extraordinary opportunity in the software area, but one which can only be fully exploited by taking advantage of those aspects of the business which are unique to the software industry.
The ideal foundation for a successful self-financed start-up is therefore a product which has a short development cycle, minimum capital requirements, and known and likely distributors, or some other means of ready and efficient access to the intended market. Although the criteria just listed may seem self-evident, it is too often the case that they are ignored by entrepreneurs when founding a company. This may be due in part to the fact that the most frequent founders of software companies have technical backgrounds (for example, 45% of those responding to the Survey were technical in training; only 31% of those responding had marketing or sales training). As a result, founders too often are snared by the allure of a particularly intriguing technical challenge, and embark upon projects with development budgets which exceed reasonably obtainable resources, and which may generate a product for which there is no developed market or for which no means of efficiently delivering that product to market exists.
To follow this latter course of action is to turn one’s back on an opportunity which is too compelling to ignore. In the vast and burgeoning market for software, there are simply too many product opportunities which meet the ideal criteria. To step outside these criteria, no matter how elegant and beguiling the challenge of the product which may be envisioned, is to embark on a needlessly risky and difficult struggle.