Defining Product versus Services Businesses

The genesis of this post is a comment I made about product companies at a large networking event earlier this week in Houston:

“If you think you’re a product company and you haven’t developed a repeatable sales model, then you’re a services company.”

In other words, if every deal closed is in a different vertical market and/or solves a different problem, then the transition from a services company to a product company is incomplete. What is the effect on the value of your company?

How to grow a company’s value is a topic I spend a great deal of time thinking about, and the 20/20 Outlook process focuses on aligning a company with others in the industry to grow a private company’s valuation. While that’s a vital driver of any corporate strategy, let’s consider how the form of a company’s offerings (specifically, products versus services) impacts its market value.

One attraction of starting a product company is the relatively rapid growth in valuation possible in comparison to that of a pure services company. To see why this is a critical issue, go to Yahoo Finance and compare the ratio of revenue to enterprise value for half a dozen public companies that derive most of their revenue from either products or services. For example, the well-run government services company Raytheon’s trailing twelve months’ revenue is $25 billion yet their enterprise value is only $18 billion, a ratio of 0.7. Compare that with your favorite products companies and you’ll find much higher ratios for well-run products companies.

Of course, customers demand varying amounts of service to accompany product purchases, thus few so-called product companies are successful without offering services as well. The percentage mix of product and services revenue can determine profitability and valuation, so it’s important to characterize the difference between products and services.  Products and services both solve problems, but in their purest form, they do it differently. The chart below depicts these differences.

Cost – Any problem can be solved with enough services, but the cost may not attract any customers. Creating a product to solve the problem is an alternative, and the gap for customers who want more customization than the product offers can be filled with services.

Fit – Services by their nature enable delivery of customized solutions. Products exist because enough problems of a certain class can be solved well enough to satisfy most needs with a generalized solution.

EBITDA – Earnings vary widely, yet as a general rule, the EBITDA of a well-run product company can easily double that of a well-run services company of similar size.

In the software industry, for example, it’s fairly common for a services company to evolve into a product company over time. Consider the continuum below that depicts such an evolution, starting on the left with totally service-based solutions (“Custom Services”) and incorporating product-like characteristics as we move to the right and end with Product/Service solutions.

To the right of Custom Services is “Packaged Services.” Once you’ve solved the same problem several times, you can package a partial solution (60%? 80%?) that can be customized for each customer. Basing the price of the solution on value rather than level of effort (hours), profitability increases.

Continuing to the right, next to Packaged Services is “Product-Related Services.” If your staff becomes expert at designing, implementing, integrating, and managing solutions using highly desirable but complex products, the result is a scarce resource that can be sold at a premium and that raises your margins. The classic historical example is a services company that became a leading expert at implementing SAP systems.

If yours is a well-run product business or is evolving into one, the benefits include higher EBITDA and a higher valuation than those of a similarly-sized services business (“product only”). And finally, the highest valued companies are often those that have desirable products with an abundance of product-related services available, whether supplied internally or by partners.

As the line between products and services blurs with the introduction of new types of products delivered in new ways, it’s important to understand how value is derived. Does the statement about claiming to be a product company without developing a repeatable sales process ring true?

I ask forgiveness for some sweeping generalizations. Certainly, exceptions to this high-level look at valuation abound. Feel free to point them out and elaborate or disagree.

Top IT Trends for 2011

Cascadia Capital LLC is a Seattle-based independent investment bank founded in 2000. They recently announced their top information technology predictions for 2011, based on insights from their work with private and public growth companies.

The six trends are:

  1. Increased competition between growth equity and strategic acquirers
  2. M&A, not IPOs, drive shareholder liquidity
  3. Web content management, analytics, marketing automation and customer
    relationship management (CRM) convergence
  4. SMB adoption of cloud services will drive consolidation of cloud vendors
  5. HIPPA compliance drives M&A for healthcare IT sector
  6. Technology enabled services companies become acquisition targets

Do you agree with their predictions? What would you add?

Choose Your Diet Carefully

A good friend shared an analogy. He described a scientific study of bears where one group of bears ate a diet of nuts and berries while a second group ate marshmallows. All seemed content with their diet, and both groups increased their weight. The result? Bears eating nuts and berries successfully survived the long winter, while those on a marshmallow diet couldn’t make it.

Marshmallows represent business activities that make us feel good, like a calendar full of meetings. They trick us into thinking that we’re doing something worthwhile, when in fact they are wasting time.

For many companies, the current economy equates to a long, hard winter. To survive and thrive, focus on the nuts and berries, i.e. focus on tasks that move you toward your business goals – and skip the marshmallows!

Every Portfolio Has (at least) One

Every private equity and venture capitalist investor I talk to has at least one portfolio company that stalls out. The company survives the original investment rounds to become an “established” business. Soon thereafter, the management team opts to focus on a single aspect of the business, e.g., “we’re going to focus on growing the customer base.” The monthly mantra becomes “keep the pedal down on sales, manage operational issues, and carefully manage cash.”

These activities are crucial to survival, yet the danger is that the CEO and management team can get comfortable working in the business and forget to work on the business. Neglecting to put a rational plan and adequate resources in place to enhance company value (including growing revenue) often leads to an abrupt plateauing of valuation that takes months and even years to recover from.

Initiating and maintaining productive relationships with relevant organizations at the right time establishes a decision-making context that maximizes the valuation of technology businesses. Created specifically to increase shareholder value, the 20/20 Outlook process enables a CEO to:

  1. view company value through the lens of potential acquirers,
  2. adjust market strategy and offerings accordingly, and
  3. initiate and maintain strong ties with key companies that can drive valuations ever higher.

The key is to intervene well in advance of a slowdown and put an enlightened process in place. Not doing so risks the ultimate loss of mega dollars and significant market share.

Surprise: Clients Tell It Best

It’s been awhile since the last post was published. Client deliverables, non-profit activities, and family priorities, as well as continual business development, have made it a hectic time.

The 20/20 elevator pitch is that “it is a process that helps a company get ready and stay ready for an exit,” but it’s more than that. While helping shoot some videos during that non-profit work, we were close to Infoglide’s offices, so I asked CEO Mike Shultz to stand in front of the camera and share his thoughts on his use of the 20/20 process.

Mike has started and sold several companies, which enables him to speak with authority in this 2:47 of unedited footage. With just one take, Mike captures the essence of the process better than any marketing firm I could have hired. Enjoy.

Acquisition Activity? Up, According to Corum’s Nat Burgess

Corum Group is a leading provider of merger and acquisition services to software and information technology companies. Because of their heavy involvement in  M&A, they are an excellent source of data about high tech transactions. Their president Nat Burgess was recently interviewed on CNBC about the current level of acquisition activity.

The Mystery of a Disciplined Process

“Mystery” and “process” aren’t often used together. A process is commonly thought of as a way to replace mysterious methods of accomplishing a goal with a well-documented, step-by-step procedure that, if followed precisely, always produces the desired result.

CEOs can be mystified when a competitor with seemingly inferior products and services is acquired by a larger company.  The response is, “Why not my company?” The answer often isn’t self-evident.

In his book A Whole New Mind, Daniel Pink proposes the need to combine left-brain analytical thinking with right-brain creative thinking for those who aspire to succeed in the 21st Century. They must combine both modes of thought in order to “connect the dots” faster than their competitors.  The 20/20 Outlook process demands right-brain and left-brain thinking from management teams who implement it.

A client CEO commented not long ago about how the process has precisely positioned his company for an exit. “At first we just wanted to determine where we fit in the marketplace. During the process, we identified twenty potential acquirers and then narrowed our focus to two industry groups. What we noticed over time was that a market for our products developed around those two groups as though the market was mysteriously growing toward us.”

The CEO came to realize that the illusion of the market coming to his company was the result of decisions he and his team made to follow the decision framework they had put in place. Now those decisions have put them in a position to achieve significant payoffs from relationships created using 20/20 Outlook thinking.

A Milestone for 20/20 Outlook

Exactly six months ago, 20/20 Outlook LLC officially opened for business. If it seems longer than six months, you’re right – planning started over 18 months ago. I felt “nudged” in a new direction and began exploring how to deliver value to CEOs of private companies. The answer ultimately lay in combining an unusual (some might say “weird”) combination of C-level experience in partnerships, acquisitions, and product strategy for startups through billion dollar companies to create the 20/20 Outlook process.

In February, I set a goal to achieve a certain level of business in six months, and we’re on track to surpass that goal this month. Experienced friends in the consulting business say it takes a year to get it off the ground, so it’s exciting to reach this milestone in the middle of what no one but Washington would call a booming economy.

Most new businesses move in different directions once launched, and this one is no exception. Connecting with great clients was planned, and working with some great CEOs to help them achieve their goals is exciting. What was unanticipated is how many people have said “you should write a book” (more on that soon).

No one could be surrounded with a more supportive group of industry friends, comprising serial CEOs, C-level execs, VPs, VCs, private investors, consultants, and other computing industry leaders. Thanks to each of you for being so open and helpful with your advice and encouragement.

Finally, a special note of thanks goes to Mike Shultz, Infoglide Software CEO. His willingness to be a sounding board and continual idea source for 20/20 Outlook is deeply appreciated.

Important Indicators are Up

Because I help companies define an exit strategy and grow value accordingly, I’m always seeking better sources of data that capture the current state of the investment world. Pitchbook is one source that publishes particularly useful information about fundraising, investments, and exits. A recent Pitchbook presentation suggests that we’re on the verge of significant growth in private equity investment during the next year, and that’s good news companies moving toward an exit.

One factor mentioned in the Pitchbook prez is that capital overhang is high and growing. When that happens, valuations tend to increase because so much money is looking for a place to land and produce a return.

Additionally, chart below depicts that the number of quarterly private equity exits through corporate acquisitions, initial public offerings, and secondary sales is on the upswing after reaching a low in early 2009.

Finally, one of the best analysts in the business, Richard Davis of Needham and Company, commented in his newsletter that it’s been 25 years since he’s seen so many companies in a great position for an IPO.

Taken together, all these indicators suggest that, despite the continuing malaise in the broader economy, a CEO who keeps his/her company’s partnerships, product strategy, services, and partnerships aligned with potential acquirers can expect to see greater opportunity this year and through the next.

Little Mistakes Illustrate Important Principles

No one likes to see their stupid mistake to be plastered on the internet, me included. That said, it’s hard to pass up writing about a personal blunder that illustrates important principles.

A week and a half ago my supply of business cards was getting low and a business trip was nearing. It made sense to make the new business cards consistent with my web site’s newly redesigned graphic theme, so I redesigned them. When the card publisher’s web site refused to accept my design file, I called their 800 number.

For the next 15 minutes, a very competent customer service rep somewhere in the world explained why the format wouldn’t work and rebuilt the card using my graphic elements. He’d show me a new version online, I’d ask for a tweak, he’d respond, then I’d refresh the page to see the changes. We repeated the cycle until it was done, and I approved and ordered the cards.

The cards arrived on my doorstep the Wednesday night before I left early for the two-day trip, and I was very pleased with the graphic appeal of the cards. Happy to have my original idea for the design implemented, I packed a supply of new cards before crashing for the night.

During several meetings on Thursday, I handed out a few of the new cards. Friday morning while handing one to a friend, I noticed something wrong. In front of my twitter address “@2020outlook” it was supposed to read “twitter:” but instead it said “tweeter:”, and also the blog URL had an embedded “@” sign. For a few seconds I wondered why the service rep made those silly mistakes, and then quickly shifted the blame where it really belonged – me.

I have a few old cards left, and the corrected ones will be here in a few days. Still, it’s valuable to learn (or relearn) the general lessons apparent from this mistake:

Recognize when details need your full attention. In a rush to get to other tasks after I completed the order, I let my focus on getting the new design right distract me from the more important job of making sure the textual details were correct. The lesson: leaders need to continually and accurately evaluate how much time to devote to details versus the big picture.

Don’t waste time beating yourself up for mistakes. After a mistake is made, focus on correcting it and then move to your next task. If you tend toward perfectionism as I do, this can be difficult. The lesson: when a leader makes a mistake, it’s fine to do a post mortem to determine what could have been done differently. Once you’re done, however, move on without regrets and refocus on growing your business.

In my case, I devoted the trip home to self-flagellation. It didn’t take the whole trip so I used the rest of the time to do something productive – outlining this post.

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