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.

Thoughts During Freakish Weather

Freakishly cold weather meant waking up to no electricity this morning. Having to break two early appointments due to temperatures in the teens gave me time to think, and I remembered that it was exactly a year ago when I filed the papers establishing 20/20 Outlook LLC.

Moving beyond 30 years of mostly C-level jobs has been exciting, challenging, and gratifying. The exciting part is meeting many fascinating and gutsy people who are willing to take chances in order to follow their dreams. The past year’s challenge has been building a personal brand around what I do. Gratification comes from seeing how the 20/20 Outlook process resonates with CEOs and others who hear about it.

I’m thankful for having experienced a wide variety of responsibilities over the years. Most of the time I knew I had the best job in the company. While I was building strategic partnerships at the world’s fastest-growing networking company, the CEO’s verbal job description was “go make good things happen and keep me posted.” I learned from experts how to formulate business plans and implement integration plans successfully from arguably the most successful software acquisition company ever. A billion-dollar company recruited me to lead product direction for their 100+ software products and help transition from independent product lines to solutions. In between, I helped grow business for half a dozen startups.

Now I’m given the opportunity to apply what I’ve learned and draw on the wisdom of people I know by advising CEOs of small- and medium-size companies on new growth strategies. Helping them move beyond the “CEO dilemma” and into new levels of business activity is the dream. Working with truly courageous people every day and seeing them succeed in moving to the next level is more a gift than a job.

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?

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.

Attacking “Business Entropy”

Not long ago, I wrote a post on how clarity affects the bottom line. It emphasized the importance of a sharing a common vision among a company’s management team and laments how often it’s inadequate. “The lack of this understanding is so common among $10-50M companies that I’ve stopped being surprised when they can’t articulate a clear positioning statement.” The point has since arisen in several CEO discussions, and as I continued to ponder how it happens, a relevant term suggested itself from the fields of physics and cosmology.

Entropy. According to Merriam-Webster’s Online Dictionary, entropy is defined as “the degradation of the matter and energy in the universe to an ultimate state of inert uniformity” and as “a process of degradation or running down or a trend to disorder.” These words could also describe how the purpose, meaning, and direction underlying a successful business can lose strength over time.

When brand new ventures pursue funding, investors want to understand the business and seek answers to questions like:

  • What category of business is this?
  • What is its primary offering?
  • Who are its competitors?
  • What are the competitors’ weaknesses that can be exploited?
  • What makes the company’s offering unique in the market?
  • How will it gain advantage in the market and keep it?

and so forth.  In a well developed business plan, these questions are answered clearly and formulate the company’s strategic positioning.

As a business grows, it naturally changes, causing the strategic positioning to evolve. New competitors enter the market. The product strategy and product mix react to external economic forces. Customer requirements result in development of new products and services. Acquisitions occur. Partnerships are struck.

Such changes affect the strategic positioning of the company and also the shared management vision. If the company positioning is ignored as these changes occur, the business equivalent of entropy can begin and proliferate. The previous “uniformity” of vision gradually erodes. A “degradation” of the company’s messaging about itself, its products, and its services follows a “trend to disorder.” The lack of shared vision within the management team causes inertia and delays in execution.

Thankfully, the remedy to this “business entropy” doesn’t involve a comprehension of cosmology.  All it requires is foresight and a willingness to take action. Periodically, especially during and after significant game-changing events, the company’s strategic positioning must be reviewed and revised. Senior management and other key players should reach a consensus vision about the company, its market, its competitors, and its direction. And of course, outside assistance can facilitate the process.

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.

Clarity Affects the Bottom Line

Last week I spent a morning leading a management team through a strategic positioning session to achieve more clarity about their business. The next day I read an article containing this quote by the leader of a technology incubator:

My team and I probably saw, heard or read more than 200 business pitches last year. And after about 75 percent of them, we didn’t understand the businesses. I’m convinced that this is a primary cause of entrepreneurial failure. Every entrepreneur needs to be able to clearly and succinctly communicate the essence of his or her business to an intelligent stranger.

While it’s important for startups to have an elevator pitch, it’s equally important for the management team of an existing business to share a clear vision that provides a context for making business decisions. The lack of this understanding is so common among $10-50M companies that I’ve stopped being surprised when they can’t articulate a clear positioning statement. Why do you think so many companies have trouble with something so basic and so important? I have a theory.

Recently a CEO friend in Dallas shared the “PerformanceManagement” matrix below. While the origin is unclear, it’s a useful framework for examining issues, and it offers a clue as to why so many companies lack the clarity they need to operate efficiently.

Urgent Important Matrix

For many CEOs, sustaining an up-to-date picture of the company’s value in the market is either neglected or delegated to Marketing because it lacks urgency compared to operation issues and cost management. This falls under the heading of “Poor Planning.” The CEO’s number one priority is growing shareholder value, and clear strategic thinking contributes directly by enhancing the quality of important decisions affecting future value.

If you’re a CEO, do you stay on top of your company’s value in the eyes of players that matter, especially potential acquirers? Or will you leave this non-urgent critical issue unaddressed until the day you’re shocked to read that your closest competitor was just acquired by a company with whom they’d partnered?

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