In last week’s blog, I discussed one of the many questions that investors often ask: “What is your market size?” Surprisingly, many companies cannot properly answer this question. This week I want to consider the deceptively simple question, “Are you a product company or a services company?” Or to state the question out in more detail, “Does the company obtain its revenue principally from the sale or license of a product, whether tangible or intangible, or from providing services to customers?” This is an issue in which most investors will be deeply interested.
Why is this a key distinction? The answer can be summarized in a single word: scalability. Scalability is the ability of the company to rapidly increase product and sales if warranted by customer demand. True product companies typically scale quickly and easily. Production facilities can go to overtime, add a shift, outsource some elements of production, etc. For software companies, scaling production is inherently even easier since there is no physical product to manufacture. In contrast, true services companies are inherently difficult to scale. The company can grow only as fast as it can expand the staff to provide the services. The more technical the nature of the services, then the greater the challenge of expanding the customer delivery staff, based on issues of staff recruiting, hiring, and training.
Investors who consider early stage companies want to find companies with the ability to grow quickly. In most cases this means product companies not services companies. So the preferred answer to this question is to be able to answer (honestly!) is “we are a product company.”
The situation is often complicated when a company began as a service company but in the course of delivering services identified a need and developed a product to meet the demand. In that case, the accurate answer is, “We began as a service company but are now adding a product component [or transitioning into a product company].” In either case, it is vital to present financial statements for past performance and pro forma projections that draw a clear distinction between the costs and revenue related to the service portion of the business versus the costs and revenues from the product-related operations.
Based on the above discussion, it should be clear that there are at least three ways for a company to lose credibility over their response to the question, “Are you a product or services company?”:
- Not having a clear answer of any sort;
- Trying to present your company as a pure product company when in fact it is a services company attempting to make the transition to a product company; and
- Presenting financial statements, whether regarding past performance or projected future performance, that create a false impression of revenue being product-based when in fact it is services based.
Two factors make this question more complex to answer for many tech companies. First, many technology companies generate significant revenue from services that are tied closely to the product – typically implementation services at the front end, followed by maintenance and support services for the product. This type of service is different in nature from web development, app development, etc., in that the company may be the only business qualified to implement or service the product, so there is much less competition. A second factor is the shift to SaaS business models. A software company that has transitioned from traditional licenses to SaaS arguably has transitioned from a product to a service company. However, SaaS is the exception to the general rule disfavoring services companies – a SaaS company is a service company that has all the scalability of a product company, along with that most precious of acronyms – RRR (regularly recurring revenue).
As a result of these factors, the revenue of a technology company may fall into as many as five categories, as follows:
- Hardware sales;
- Traditional licensing of software;
- SaaS licensing;
- Services such as implementation, maintenance, and support of the company’s proprietary software; and
- Services that are not based primarily around the company’s proprietary software (for example, a company that specializes in app development for third parties).
So before you get in front of investors, be sure that you have fully considered the type of company you are, and be sure that you can present financial statements for past performance and projections of future results that clearly distinguish among the various categories. These steps all take time, but is definitely time well spent.