If revenue is the key measure of success for a young company, why is it that so many young software companies are never able to generate enough repeatable revenue to become successful? One reason may be that young software companies in emerging markets often don’t manage to the right set of metrics as they pass through the critical early phases of their development. There are often two reasons for this. One, it is not always clear to the company what phase of development it is in. Two, it may not be focused on the appropriate milestones.
Over the past few years I have worked out a framework (Figure 1). It helps to characterize a company’s stage of development in order to help the company and its investors make better investment and hiring decisions and do a better job of planning and goal setting. Because this framework focuses primarily on the company’s stage of development, it can be used alongside the market adoption and product lifecycle models of Moore’s chasm.
While I don’t believe there is anything revolutionary about the framework, it is very effective at grouping the appropriate metrics by a company’s phase of development so that the management team can effectively work towards a common set of goals and effectively communicate with its employees and investors. You may want to add some of your own observations to enhance the matrix for your own use.
Phase II (or “Running Blind”) is often the most critical phase for a young technology company in an emerging market. If the management team does not understand what it really means to be in Phase II and what is truly required to exit from the phase, then it may overspend, focus on the wrong key metrics, make bad hiring decisions, raise money at the wrong time and never make it out of Phase II.
Many young technology companies in emerging markets fail during Phase II, often because they want to skip it and go right to Phase III. The Internet craze made this even clearer, as young companies often went from Phase I straight to Phase IV, and then died unhappy deaths.
You also will notice that there is little mention of revenue. Revenue does not necessarily indicate which phase of development you are in. Clearly, without revenue, no company can be successful. However, strong revenue does not necessarily mean that a company has exited from Phase II.
While the framework may have applicability to businesses other than software and technology companies, these businesses have the unique quality that they are frequently based upon new technologies, and management must figure out exactly how to build a successful company under a new set of conditions.
Phase I: Optimism
Phase I begins at the company’s inception and ends (by definition) when the company ships version 1.0 of its product. The company knows the market need, and it is working hard to get the first version of the product out the door. It is defining the product, refining the target customer and initial feature set, proposing a channel strategy, and building out skeleton organizations for sales, client services, and marketing. The exit criteria for Phase I is when the company ships version 1.0 of its product. Version 1.0 of most software products is usually not very robust and often does not work well. This is one of the reasons that Phase II is often protracted.
Phase II: Running Blind
The next phase of development is what I call “Running Blind,” because the management team truly doesn’t know exactly what it is doing yet. This is OK. The key to the second phase is for all parties (investors and management) to recognize they are in Phase II and lead the company appropriately. The trick in this phase is to figure out how to build a large business. In order to exit the second stage, the company must do the following:
* Nail the value proposition. Have a set of messages that clearly resonate with customers
* Get four to five reference customers. There must be more than one or two, as getting a couple of reference customers is much easier than obtaining four or five.
* Get one or two strategic relationships. These are not just “press release” relationships, but real partners who are helping to sell the company’s software. These types of relationships really help to validate the product in the market
* Achieve a predictable (not necessarily repeatable) sales model. The idea here is that once sales get to a certain point, the company is reasonably able to predict that they will close within a specified timeframe. The overall process may not be institutionalized, but the final phases of the process are fairly clear. Since much of Phase II is spent figuring out how to sell the new product, this exit criterion really says that the company has figured out how to close business and is predictable enough to begin spending more heavily on sales and marketing.
* Get the product over the bar. By “over the bar” I mean that the software has enough functionality, reliability and robustness that customers can purchase it, use it and get enough value out of it that they will purchase more. This is a key milestone for a software companies to exit Phase II. Since version 1.0 of the product is often prematurely delivered to the market, much of the time in Phase II is spent getting the product right.
Developing a clean software package isn’t enough to take you into Phase III. You also have to have your finance, sales and marketing departments in order.
From a finance perspective, you should be setting boundaries, not controls in Phase II. I once had a VP of finance that wanted to inspect every deal that sales brought in. He wanted the sales VP to justify every discount and proposal and was very concerned that sales was “sticking to the price list.”
As it turned out, the controls were actually cutting the legs out from under my sales VP. Typically you would find this desire for control in a CFO, so in the early phases it is better to hire a VP of finance who is often more comfortable with uncertainty.
It is important to remember that sales are unpredictable for much of Phase II. The sales team is working on selling to early customers, obtaining repeat business from early customers, defining a repeatable sales model and establishing the sales channel. The team should be a relatively small core team until the company moves out of Phase II.
Even if the sales team is having trouble selling version 1.0 of the product, it is critical that the sales VP establish clear metrics for the sales team. These metrics must contain more than just a number. The number is critical, but if no one is selling his or her quota, then other metrics must be established so that the bottom performers can be continually weeded out.
On the marketing front, most of the time in Phase II should be spent developing your value proposition, building a lead generation engine and creating a basic set of sales tools.
Phase III: Visibility
In the third phase, a company is working to make everything repeat. In order to exit from the repeatability phase, the sales division must have a repeatable sales model and the channel must be completely up and running. Marketing must have nailed the marketing messages and identified a repeatable way to generate leads. There must also be a full complement of developers for the product(s) and finance must have put the basic infrastructure (people and systems) in place. The services model must also be repeatable. Finally, the company must be profitable.
During this phase, the company is growing the sales team, spending more money on marketing to ramp sales, and focusing on finalizing a repeatable sales model and completing the set of sales tools. Finance is focusing on establishing internal control systems. Most companies will exit this phase when the sales model becomes repeatable.
Phase IV: Recruiting
This is the phase that requires a company to scale its business. The company is identifying new opportunities, adding new developers for new products and building infrastructure and growing headcount in all areas. There is (hopefully) no exit criteria for this phase.
Know the Framework
Each phase of development has a logical size (organization). This is important to watch so that the company does not over-hire, especially in Phase II. The framework can also be very useful if the company needs to downsize. Once it determines the phase that it’s in, it becomes much easier to determine the appropriate size for the functional organizations.
New products are always in Phase II for some period of time, even if the company itself is in Phase III or Phase IV. Similarly, if the company makes a major market shift, it automatically moves back into Phase II for a time. If the company is not adequately prepared, it can burn through a tremendous amount of cash in a short period of time because it may believe it’s in Phase III or IV when it is actually in Phase II.
Recognize that not every player on the management team will be able to grow with the changing needs of the company and that each phase requires different characteristics on management team. For example, companies often do not need a CFO until late in Phase II because CFOs tend to like order, controls and predictability – none of which exist until late in Phase II.
Similarly, a great Phase II sales VP is often very hard to find and may need to be replaced during Phase III. The great Phase II sales VP should not take this as a criticism of his or her abilities. Instead, he or she should take his or her stock in a company well on its way to success and move on to do it again. The same goes for CEOs. A CEO who is great during Phase I and II may not be the right CEO for Phase III and IV.
During the dot-com craze, many companies went straight from Phase I to Phase IV. Many of these companies either died or had to retrench into some form of Phase II in order to ultimately become successful. Ariba is a good example of this.
At my last company, I had to do a reduction in force and I was having difficulty working with my management team on exactly how to downsize the company. Using this framework, I was able to get the team to understand that the company was in Phase II. Prior to using this framework, my marketing team was spending as if the company was in Phase IV, and we were hiring as though we were in Phase III. After looking at the framework and comparing it to our progress, it became clear that we were actually in Phase II, so we could now discuss how to downsize the company and reduce expenses appropriately. Many of the previous arguments disappeared.
From a fund-raising perspective, it is very difficult to raise money in the early parts of Phase II, so entrepreneurs should raise enough in a Series A round to last through much of the Phase II. Or, they should do an early B round before the end of Phase I. If raising a B round in late Phase I is not possible, insiders may need to be willing to come to the table themselves if a B round is necessary in early Phase II, so that the CEO is not wasting time trying to raise money in a futile effort.
From an investing perspective, Phase II is a highly risky phase and it may help investors to identify which, if any, of the milestones the company has achieved in order to properly price the deal and assess the merits of the proposed business plan.
In summary, young technology companies in emerging markets must successfully pass through Phase II of their development. In order to do this, they must first recognize that they are in Phase II and then manage to the right set of goals or metrics. If the management team and board of directors both agree on the stage of a company’s development, it is much more likely they will make the right critical business decisions that will successfully lead the company into Phase III and eventually Phase IV.
Dan Slavin has over 20 years of technology startup experience and has been the CEO of three startups, including one that was venture-backed (Framework Technologies) and two that he founded and funded himself.He is currently consulting. He welcomes comments from people who have ideas for how to enhance/improve on the Four Phases FramEwork. You may email him at firstname.lastname@example.org.