Capitalizing and Operating a Software Business

pre-Prohibition Acme Beer label

“As I have noted in the past, this is why the venture capital model that was developed to support silicon so seamlessly switched to supporting software: both entail huge up-front costs to produce zero marginal cost goods, which means capped downside and theoretically infinite upside.” That Ben Thompson quote is from a non-public newsletter, but here’s a similar public post.

“The most common high level concepts associated with lean product development are: 1, Creation of re-usable knowledge. Knowledge is created and maintained so that it can be leveraged for successive products or iterations.” Lean product development – Wikipedia 

I particularly like the table on that page which, breaks products into needed, wanted, and wished for.

  1. A needed product has a broad requirement which is stable and commoditized
  2. A wanted product has a specialist requirement with future potential for a wider range of markets
  3. A wished for product has an unrealized requirement, needing to be introduced to market 

The concept of a modern, lean software business is to iterate development and improve product market fit until you have satisficed every market you can reach. 

Customers are trained to expect this as well. When you buy subscription model access to a software thing, you expect that thing to evolve and improve, right? Even if it’s commoditized, if you’re paying monthly you expect benefit for that recurring bite. Even if your vendor seems to follow a model closer to that of a car lease, there are still new models every couple of quarters and strong pressures to upgrade into those releases.

With the possible exception of accidental outcomes from failed acquisitions or private equity conversions, there are few places where enterprise software truly reaches “finished” and stops development. If people are still assigned to the product and people are still using it, which is to say if the product matters at all: then developers are receiving customer input and itching to fix things. Even if feature development does completely stop, bugs are impossible to prevent or detect perfectly. Additionally, the complexity of real world usage makes bug discovery and resulting impacts unpredictable. Therefore, any software thing a vendor is still taking support subscription money for has some level of ongoing maintenance requirement. A vendor that ignores this requirement is taking a risk.

This means the pivot from value creation to value extraction which the VC driven portion of the software industry (e.g. all of it) expects is sort of broken, right? Well, not exactly… but the model is not perfect either. The key is to think about that chip factory. It isn’t actually free to operate: regardless of the mystic processes that go into making sand into computational power, there are all the obvious inputs of any physical plant. Electricity, water, materials, people and their safety and comfort requirements, not to mention salaries. So there are ongoing costs, of course, it’s just that those costs are dwarfed by the profits of providing in-demand chips. Cost-benefit ratio is so good that OpEx might as well be zero once the plant’s spin up costs are recovered. Similarly, the cost of keeping Milton in the basement working on ancient product maintenance is negligible if the recurring revenue is high enough.

The goal is to keep costs linear while making revenues exponential. If you can do that, you fit the venture capital model and are a good bet. If you look like you can do that for a while, but can’t, you may still fit the bubble economy model because there’s a sucker born every minute. If you can’t do either, you probably won’t get funded by a VC.

%d bloggers like this: