Many of the statements and metrics small technology companies highlight may appear to be positive on the surface, but don’t tell the full story. Since investors, both public and private, seek out companies that are meeting key milestones, management teams position their companies to fit the mold and continue to spew the same messages. Both executives and investors end up believing that the company is on a solid path to conquering the market. A deeper look into these common misconceptions, however, can reveal some of the dark spots between the bright lines.
What follows are five statements that should set off a red flag for investors:
“Our won/loss rate is 90%.”
The Misconception: Wow, these guys never lose. Let’s just extrapolate this as their market share increases and their sales force expands. Their products and service must be blowing away the competition.
The Reality: A small technology company has to be winning at this rate just to exist. If it is in a new market space, then it has little or no competition so by definition it has a high win rate. More often, this statistic is used to show a company’s prowess when it is competing against an established gorilla, say an SAP, an Oracle, or a Cisco. In these instances win rates should be extremely high, and if they aren’t, something is horribly wrong.
Here’s why. The company’s rejections are dealt out early in the sales/marketing process, usually at the initial query. Therefore, an account that has rejected the company after the first dialogue is never listed as a prospect in the pipeline reports. The company lost this one forever, but it is never recorded as a loss.
Moreover, for those accounts where the company got past the initial query, it is allowed in for a reason. The account does not want SAP, Oracle or Gorilla X. It is therefore the small company’s account to lose. It should win it almost every time.
“We have a 90%-plus customer retention rate.”
The Misconception: This company has loyal customers, and its products are essential to the customer base.
The Reality: This number is usually used in conjunction with the annual continuation of maintenance and support plans or subscriptions. At 90%, the company is, at best, testing the boundaries of being a long-term player.
One out of every 10 customers has dropped the product because it is dissatisfied with it or doesn’t need it. For a young company that is purportedly supplying the demand of a fledgling market, this is huge leakage. In fact, it may mean that customer disappointment is greater than one out of 10, since many companies continue to subscribe to ongoing support plans for several years even after struggling with a product, hoping that one day the product will perform as desired and they’ll be able to realize a return on the capital outlay.
“Our installed base is huge.”
The Misconception: Not only do these customers represent an ongoing income stream for the company, but they are also a fertile market for all the new products that the company has on its PowerPoint slides.
The Reality: A large account base is what it is a large account base for a particular product. On its own, it represents nothing more. If the installed product is perceived as a good product, then the customer will be very willing to consider the next offering from the company, but only to the extent that the competition doesn’t offer a superior product, and the company has the distribution network to deliver the new message and the new product to the customer. The value, therefore, doesn’t lie in the installed base, but in the lack of a competitive offering and/or the strengths of the company’s existing distribution network. By itself, the installed base is meaningless for the growth equation.
On the other hand, the installed base may very well be part of the decline equation. If the product or the service the company delivers is perceived as poor, or a tired legacy product, then it represents the foundation for an eventual decline in revenue. A company that is perceived as producing weak products will have a severe obstacle to overcome when it introduces a new product, and over time its installed base will decline. Likewise, a company with a reputation for legacy products will not be perceived as an innovator, and its installed base is vulnerable as competitors introduce new products into the account.
The exception to this rule is when the new products being introduced into the installed base have been carefully designed to provide technical or data linkages such that the installed base is locked in as it moves to the next wave of innovation. In this case, the installed base does play into the growth equation, but the necessary and essential variable is the technical or data linkage itself.
Finally, the installed base may have value if it is profitable. Those profits can be used to grow the business in other ways, such as introducing new products or expanding distribution. The corollary is also true, however; a large installed base that generates losses will drain investment away from new product development and expanded distribution. Put simply, if the installed base makes money, then it has a positive attribute. If it loses money, it is negative. And if it is the negative, the larger the installed base, the worse the situation.
Just take a look at the graveyard of huge installed bases: Digital Equipment Corp. (DEC), Borland, Ashton Tate, Lotus, BAAN, Sybase, Prime, Wang, 3Com, and on and on. Then consider those who have leveraged their installed base: Oracle and Microsoft have always had superior technical migration strategies and dominant distribution systems. These successes are few and far between.
In summary, the installed base has value if it is or can be a positive source of cash. Otherwise, it is neutral at best. The critical variables are the competition, the distribution, and the technical lock-in. More than likely, a large installed base will be a drag on growth, which is contrary to the implications frequently made in company road show presentations.
“Our software was developed in partnership with Marqee Company X.”
The Misconception: If a company as prestigious as GM, Boeing or Wal-Mart has partnered with the company, then its product must be well suited for a broader market.
The Reality: There is rarely even a neutral position to this perceived badge of honor. Ultimately partnership means, “I want you to develop features and functions specifically for me at a discounted price.”
The promises of the partnership are that the marquee customer will help guide the small technology company’s products in the right direction and that it will lend the prestige of its name to the marketing of the product to the broader market Unfortunately, what usually occurs is that the product developed is specific to the marquee customer. Additional development costs are required to craft products for the broader commercial market, putting a drain on financial and other resources.
In addition, by the time the company is finally set to launch a product broadly, a competitor may already have started penetrating the market. Any prestige that the marquee company’s name may have held is more or less irrelevant at this point.
“We have marquee customers. Many of the Fortune 100 have purchased our products.”
The Misconception: Since they have sold to GM, Boeing and Wal-Mart, they must have passed a rigorous sales process. Clearly these guys have established products and a strong sales force. It will be a piece of cake for their products to be adopted among the horde of smaller companies.
The Reality: The brand name company on the obligatory slide entitled “Marquee Customers” is generally meaningless. While not quite Noah’s ark, large companies tend to have at least one of everything. In such massive organizations, it is likely that a department or a branch will acquire or experiment with new technology that may improve operations. Moreover, while these companies are extremely well managed, the impact of a company of this size parting with $100,000 here or there is relatively insignificant, so getting that single purchase order is not that difficult. Almost any startup will get its first order or two from a large company.
Nowhere is this truer than in vertical markets dominated by a few companies. Take the pharmaceutical market. It is downright hilarious for a company targeting this sector to claim a presence within the top 10 companies. The response from the audience should be loud and clear: “You better have, because there isn’t anyone else!”
There is an exception to this rule of thumb regarding marquee companies. If a GM, Boeing or Wal-Mart has actually standardized corporate wide on a company’s products, then the company has every right to brag about it and may well deserve your investment dollars.
On balance, it is more meaningful for a company to list multiple mid-tier companies as its customers. Mid-tier customers usually place the same demands on the technology as the Fortune 100, but they are more selective and rigorous in making initial buying decisions. These smaller companies cannot afford to have one of everything, so they select more carefully and implement only the best solutions.
Before I close, I want to make sure you’re not misinterpreting what I’m saying. For example, do the arguments I’ve made mean that the best companies to invest in are those that have low win rates, miniscule customer bases with unfamiliar client names or no customer partnerships? Of course not. My point is that you need to dig deeper into the claims mentioned above, since many of the proof points that are promoted as evidence of success may well be leading indicators of soon-to-come failure. If a company’s entire positioning is based on misconceptions such as these, it is likely that the company has covered its market potential with veneer.
A strong management team will be prepared with true indicators of growth, and it will be able to communicate a deep understanding of the market it’s addressing along with the challenges and opportunities that lie ahead.
Dean Goodermote is a venture partner for ABS Capital Partners. He has spent 20 years in operating roles in the tech and biotech sectors. His last post was CEO of ABS portfolio company Clinsoft.