How will entrepreneurs wanting to build value in software startups, and venture funders requiring both defensibility and eventual liquidity, respond to the rise of open standards, open source, and offshoring? As I've written before, these are all faces of the commoditization of information technology.
I think I see the shape of one response emerging from the fog. This is partially based on companies which have pitched to our team - and will remain nameless - and partially on a rather inchoate impression of chatter on blogs, tech sites, and open source sites. I'm not sure this is particularly unique or profound, but perhaps it's an early indicator of the shape of symbiosis between community and commercial processes.
Let's call this pattern the two-stage software startup. Unlike a two-staged rocket, the first stage is light and runs on little fuel, it's the second stage that has the big burn, if it ignites.
The first stage of the new model software venture builds a useful product as cheaply as possible. Actual engineering is focused ruthlessly on the unique value and differentiating features. In most cases, open standards are exploited to address as large a market as possible using off-the-shelf APIs and libraries. In many cases, the software is written on top of open source platforms, such as LAMP, to keep down development and initial customer costs. Code is usually written to published interfaces, rather than integrated into the open source itself, to avoid 'contamination' by GPL and other OS licenses. Often, a portion of the development will be sent offshore, particularly if the founders have prior experience or cultural connections with a reliable venue.
Build as little as possible, as fast and cheaply as possible, while demonstrating some unique value. From the classic VC view, many of these efforts will result in a product, or even a feature, rather than a sustainable company. But that may be OK for the first stage, because the development time and expense are small enough to be funded by the founders, friends and family, or a few angels. The go-to-market is similarly light. Rather than a sales channel, the venture will buy ad words on Google, promote itself via word of mouth on blogs and via user communities, and penetrate enterprises by pricing low enough to fall within the purchasing power of a department, or even an individual. Being in early and continuous touch with its market, the venture can course correct early and often.
Assuming this promotion strategy reaches interested buyers, the venture can go cash flow positive fairly quickly. This doesn't mean that it's a sustainable business: Barring some strong intellectual property defenses, the costs to an imitator may be equally low, and the venture's reward for proving a value proposition may be to draw competitors with greater sales and engineering resources. However, the time value of having a functioning product with newly proven value may be sufficient for a quick sale to a larger company which has sales channel synergy, or products in a touching function which can quickly integrate the new functionality. While the sale may result in only a few million dollars, that outcome may be quite profitable to the founders and the individual backers. This may even be true on a risk adjusted basis, and that may be a new thing.
The second choice after a successful first stage launch is to light the second stage, which will require venture funding. Second stage activities will consume cash in advance of the sales to fund them, as they must occur before imitators arrive. They may include adding functionality to meet customer requests, rebuilding parts of the product for greater efficiency and defensibility, adding the necessary sales force, scalability, and system integration to be able to sell to a higher end market, such as the CXO enterprise level, or carriers. At the point of making the second stage decision, the technology risks have been greatly reduced, and a portion of market risk eliminated. The company has already been learning from the market, though it will undoubtedly need to relearn some things as it shifts focus. Entrepreneurs who choose to enter this stage will receive valuations well above what they would have commanded before achieving a first stage takeoff, though perhaps not as much as they might hope: The VC will understand the business still requires significant investment to become sufficiently defensible for an eventual exit, and that the management team which succeeded in the first stage may need to be supplemented for the second phase.
Have we seen this pattern before? In a way, yes. Those of dating back to the beginning of the PC movement remember that a few coders, in less than a year, could knock out an acceptable product. The machines of the time had limited capabilities, customer expectations were modest, networking and enterprise integration were years away, and the early PCs provided embedded code for the machine-specific and performance critical input and output functions. Many of the early companies went the whole way without venture funding, and others bootstrapped their proof of concept stages. These options slowly eroded as the power of PCs grew, customer expectations for functionality and integration of software expanded, and the manpower and capital required to achieve initial release increased. Now we've taken a step back closer to those early days, as the combinations of open source and standards, and commoditization of hardware and software, once again make a low rent market entry feasible.