Tuesday, May 8, 2012

Four Things I’ve Learned from Founders

The best part of working in VC is the opportunity to learn from the amazing entrepreneurs you meet (includes the ones we ultimately pass on). For me at least, that's why I got into the business in the first place. This will hopefully be the first in a series of posts on what I’ve learned from the many entrepreneurs whose companies I've looked at, some of whose identities I hope to be able to reveal soon (wink, wink). Four of the best insights I've gotten from some great founders follow:

1.    Budget-Based Pricing:
This is my favorite. I’ve seen a few startups take an approach to enterprise sales that I call “budget-based pricing.” The idea, roughly, is to calculate how much can I charge while staying under the expense limit of the individual that I am selling to within the organization. If you are selling to Dell, you are not selling to Dell the corporation. You are selling to the marketing office, shareholder relations, production, etc. You are probably selling to an even smaller part of that organization: the marketing department of a particular product line, perhaps even in a particular geography. Once you’ve drilled down to the discrete level at which you are selling, there’s one individual who is your ultimate customer. Ask yourself: how much can that individual authorize for a single purchase without having to get approval at a higher level, and/or having to go through procurement? This is her budget authority. Price at or below this, and she can make a unilateral decision. Price above this, and maybe you can get more money per sale, but your sales cycle will lengthen in proportion to the number of corporate layers you have to go through – as will the risk that someone higher up who is less excited about your product than your end buyer will cancel the sale altogether.

The most elegant use of this tactic is what I call “credit card pricing.” If you can set your price to a level at which the buyer can simply pull out his credit card, charge it and expense it later, not only have you eliminated bureaucratic delays in your sale, but you’ve eliminated the entire order-to-cash (OTC) cycle. This is the fastest way to close an enterprise sale. When you are a large, mature company, with dozens of customers and stable cash flow or financing to support long sales and OTC cycles, you can afford to optimize for long-term income. When you are a startup, you have to optimize for speed and cash.

If you don’t know your end buyer’s expense level, ask them! Many of them will happily tell you, as if they really want your product it’s in their interest to get their hands on it as soon as possible.

2.    Tiered vs Transaction Pricing:
Transaction pricing based on an appropriate unit of measure makes sense when the marginal costs associated with each unit of sale are significant (e.g. cloud services or CPX advertising). The downside of transaction pricing is that your customer will try to limit or game the number of transactions they need, in order to keep their costs down. For example, if you provide a fraud detection service, they will try to minimize the size of the sample they test. This leads to lower revenue for you and a worse customer experience for them. A flat-rate model with multiple tiers avoids this.

3.    Competitive Dynamics of an App or Platform Strategy:
The revenue appeal of an app strategy, or a platform upon which others can build apps, is relatively easy to see (although harder to execute). Recently one founder explained the strategic value of an app platform, namely how it shifts competitive market dynamics in two important ways: many would be competitors will become app partners; while direct competitors are forced to decide between going big or going home. This also points to the risk inherent in the app platform strategy: you need to be ready to go big as well if needed to maintain your app platform lead; nobody wants to build for the number-two platform; while on the downside a platform with few apps not worth much (see under: RIM).

4.    Avoid Long-Term Contracts
It’s natural to get excited when you’re offered a long-term contract. What great validation of demand for your product! There is an advantage in fundraising to be able to point to recurring revenue, but from an operating perspective it’s better to sign a one-year contract and then renegotiate for higher prices once the year is out. Your negotiating leverage as an early stage company will be dramatically higher then. Yes, this introduces some risk that they won’t renew, but they wouldn’t be offering you a three-year contract if they didn’t really like your product. To use the fundraising analogy, giving a discount to your earliest customers make sense, but letting them keep that discount for three years would be like giving your seed investors the right to participate in the A and B rounds, but at the seed valuation.

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