By: Andrew Neitlich

October 22nd, 2004

Reader Rating: 9.5

If you run a Web development or design business, you should consider developing products. There are a number of reasons why.

The Fundamental Flaw of Service Businesses

First, service business models suffer from a fundamental flaw: in a service business, you have to trade your time for dollars. People pay you for a service, and this service requires some involvement by yourself, employees, or contractors, all of which costs money and cuts into your profit. Even if you know how to price based on value instead of time, you still face the problem of having to use resources re-create a service experience with every project and new client.

Meanwhile, you can sell a product over and over again. Once developed, products can generate an ongoing, passive revenue stream for you. Your costs shift to product development and marketing, but the economics can be quite impressive once your product achieves acceptance.

The Value of a Proprietary Product that Can be Sold Again and Again

Second, products are proprietary, and add to your company's enterprise value. In today's market, it is very difficult to sell a service-based firm. Research shows that, even when it's done well, the acquisition of a service firm usually results in the turnover of 75% of the original employees after a year. While there may be value in a service firm's brand, customer list, and methodology, the true value of a service firm lies with its talent.

So why should an acquiring pay a premium to acquire or invest in a firm that only provides services? Why should they buy a company that provides what has become a commodity around the world, namely services? The answer is that they won't, which is why most service-based firms only sell for 1-2 times revenues -- if they sell at all.

Meanwhile, companies with products, especially proprietary products, are much more attractive to acquiring companies and investors. Among publicly traded technology companies, those with proprietary software products sell for 5 to 10 times revenues -- often more. They earn this premium because margins are higher with proprietary products, and because they have developed something tangible that they own.

Case Study: Provide Both Services and a Product

I recently worked with a start-up that was two businesses in one. They ran a regional software development business, and also owned the license to a proprietary technology. They were looking to raise about a million dollars to grow both. Half was for the software development business (to hire and pay salespeople, technical support staff, marketing expenses), and half was to be used to bring their proprietary technology to market.

Their development business was stable and growing. They had hired some of the best managers in the area -- people with a proven track record of growing $50 million firms. And they had market data and a solid plan to prove that they could achieve impressive revenue numbers over a 3-year period.

Meanwhile, the proprietary technology was basically a lottery ticket: unproven, early stage, and high risk. The company had no track record or management expertise in bringing a product like this to market. They did have market data showing that this product had enormous financial potential -- after about three years of development.

To this company's credit, they were able to get meetings with extremely wealthy investors. And guess what? None of these investors wanted to touch the software development business, even though it was stable, had excellent management, and the market opportunity was solid. But a few of them wanted to invest in their proprietary technology, even though it was high risk and unproven!

This case study is one of many examples suggesting that products can increase the value of, and investor interest in, your company.

Four Basic Product Strategies

Convinced that it makes sense to develop and market products? Now you have to think about the best way to position your product in the market. You have four choices, all of which have advantages and disadvantages:

1. Develop a product with a significant advantage over the competition (also know as "faster, better, cheaper").

   If you want to truly differentiate your product from the competition, you need to have a significant edge that matters to your market. Examples include: lower total cost of ownership, faster deployment, greater usability, and operating speed.

   For instance, before Microsoft Office, people bought their word processing software (e.g. Word Perfect), spreadsheet software (Lotus 1-2-3), and presentation software separately. Then Microsoft bundled all of these solutions (and more) into a single suite of products that cost about the same as any single previous solution used to cost. This significant cost advantage essentially wiped out the competition.

   Salesforce.com is another example of a product with a significant advantage. Before this company launched a hosted CRM solution, companies had to pay large sums to integrate and deploy software to manage customers and prospects. In addition to money, it took lots of time to deploy this software. Salesforce.com changed all of that with a simple, hosted, affordable solution.

   Finally, Google is a great example of a company that raised the standards of usability and simplicity for search engines. As a result, they have found a way to capture millions of eyeballs every day, and leverage those eyeballs into advertising revenue.

   It makes intuitive sense that if you want to launch a new product that succeeds in the market, it has to be better than competitive offerings in a measurable, important way. If you want to develop a new product, start by brainstorming ways to be better, faster, and cheaper than what others are offering right now.

2. Find a niche.

   If you can't develop an edge over the competition, then you should consider launching a product that fills an un-served or under-served niche. If you take this route, you have two options.

   First, you can offer an existing product to an under-served market. For instance, there are many industries out there that still lack a basic portal or front-to-back business management software system. Entrepreneurs I know are currently marketing software to address the needs of numerous under-served markets: health spas, furniture manufacturers, local telephone exchange carriers, behavioral health centers, and religious organizations. There are hundreds more industries like these to target.

   Second, you can find a product that makes existing solutions more complete or fills a gap in a large company's product offering. A recent article in Business 2.0 called "The New Road to Riches" (October 1, 2004) describes how to leverage this strategy, and be bought out by larger competitors. According to this article, "golden opportunities" include niches in wireless applications (applications and content for cell phones), network storage (niche products and management software), wireless security for mobile users, grid computing (software to manage grid computing and applications to leverage their huge computing power), and convergence applications (video mail, instant message-based gaming, and applications supporting iTunes and other online music/video products).

   If some of these niches seem too esoteric for your programming capabilities, don't fret. These are not the only categories out there, but they are the ones with huge market potential. You can still make plenty of money finding a niche application that falls under the radar of these larger opportunities.

3. Change the world.

   If you are really ambitious, why not develop a product that changes the world? Few people successfully apply this strategy, and it can cost huge development and marketing dollars to make it. But the rewards are huge for those who do prevail.

   Generally, software developers have a hard time with "change the world applications." That's because their applications are made for inventions and products that have already changed the world (e.g. the PC, the Internet, vast networks, mobile devices).

   Still, there are many current examples. Tivo, a product that lets people watch what they want when they want it, has the potential to change the way the world watches television. Instant music download programs are changing the way people buy and enjoy entertainment. Peer to peer applications have enormous potential to change how people work, collaborate, and share information. Ebay has created a new economy that allows anybody anywhere to become a small merchant. And Meetup.com has allowed people from around the world to get together easily based on common interests.

4. Develop a me-too product.

   Common wisdom and business school theory say that "me-too" products can't succeed. Experience proves them wrong. In large, developed, and especially in growing markets, there is plenty of room for me-too products. If you can't develop a direct edge, find a niche, or change the world with your product, you can still make a good living being good enough.

   Business schools and the popular business press tend to focus on companies that dominate their markets or have especially well-known brands: Starbucks instead of Dunkin Donuts, Fedex instead of DHL, Disney World instead of Six Flags Great Adventure, Hertz instead of Avis. Yet these second- and third-place, less glamorous companies are often quite profitable, sometimes even more profitable than their better-known and larger rivals.

   For those of you who run much smaller organizations than the ones just named, keep in mind that the market for most products and services is huge. You can be very successful by riding the wake of demand created by larger companies. Why not let others blaze the trail, while you take advantage of their hard-earned wisdom?

   I know one developer who makes an excellent living selling survey/questionnaire software over the Internet. He competes with hundreds of companies offering very similar software. How does he succeed? According to him, "I don't need to dominate the survey marketplace. I just need to sell ten units a week and I make a great living. Ten units a week is easy!" And so he keeps his overhead low, and budgets his marketing to make his numbers.

   The secrets to success with this strategy include:

   • Make sure your product is good enough to meet market expectations.
   • Keep your overhead low and your prices competitive.
   • Set a revenue target that is reasonable, yet makes you an excellent living.
   • Build credibility with testimonials and an ironclad quality guarantee.
   • Consider bundling added features to give extra value to customers than what they get from the market leaders.
   • Invest in effective marketing and sales tactics to hit your numbers.

   In some cases, the me-too strategy can prove to be enormously profitable. As a reader pointed out in my blog recently, Microsoft buys me-too companies all the time to get them out of the way. Similarly, many companies are now investing in acquiring "eyeballs" so that they can sell out to Google and other search engines. For instance, iWon.com recently got bought for hundreds of millions of dollars, primarily because of a business offering free smiley face icons via a desktop application with search functionality.

   In conclusion, this fourth strategy is under-rated, and is sometimes the best option available to many developers and designers.

Four Strategies to Launch Products

The previous section defined different ways to position your product in the market. But it's also important to think about how you will launch your products. The following four models have worked for many entrepreneurs. They are not mutually exclusive, so you can pull what you like from each model to develop a process that fits your style and goals.

Model 1: Slow and Steady Organic Growth

The owner of the survey software company quoted above uses this strategy to run his product business. He built the application himself, tested it slowly with prospects, and kept improving the product and his marketing. He funds everything internally, and originally started with savings he accumulated while working as a software developer.

In this model, you grow your product with internally generated revenues, whether from your Web design/development revenues or accumulated savings. People who take this path rarely look for outside investors (although you can), which means that they own 100% of the equity of their company, and don't have to deal with investor relations. They also enjoy the benefits of launching products at their own pace, with limited downside.

The disadvantage of this model is that, if your market is huge, you may sacrifice revenues by shutting out investors who can help you accelerate revenues. As many venture capitalists say, "One hundred percent of something tiny is not nearly as lucrative as 20% of something huge."

Model 2: Cross the Chasm

Geoffrey Moore's classic book Crossing the Chasm describes a compelling model for growing any technology product. While his model is based on a rapidly growing industry (one causing discontinuities, as the Internet did in the 1990s), it applies to almost any growing business.

Moore borrows heavily from studies of adoption of new agricultural products during the Green Revolution in the 1950s. In his model, new products progress through a life cycle. In the first stage, a few brave early adopters and visionaries are willing to experiment with a new product. Early adopters accept the new product because they love technology for technology's sake, and are passionate about tinkering. Visionaries see the potential of a new technology/product and know that they will have an edge by being the first to adopt them.

In the second stage, the general public begins to get involved. Unlike visionaries and early adopters, this "Main Street" audience needs a complete product, one that solves their entire problem. For instance, whereas early adopters would assemble their own PC, Main Street wants to pull a PC out of the box, be able to use it with minimal hassle, and have a source of tech support if something goes wrong.

The third group of buyers comprises conservatives and skeptics: people who are skeptical about what a product can do. They need complete plug-and-play functionality, and typically only come on board when they have to.

Finally, there are laggards, who never buy a new technology. These are the people who still don't have televisions, computers, or telephones -- even if they can afford them.

Moore's insight is that most technology companies get hung up shifting from early adopters to Main Street. That's because the much larger mainstream audience has very different requirements than early adopters, and don't view early adopters as credible references.

To overcome this problem (the "chasm"), Moore suggests a very compelling and clear strategy:

1. Choose a specific target market.


2. Develop a total, complete, comprehensive solution to that target market's needs. If you try to be a horizontal solution, or develop a solution that meets everybody's needs, you will water down your functionality and develop a mediocre product that doesn't please anyone.


3. Develop clear marketing messages, in the target market's language, that compel them to buy.


4. Dominate that target market.


5. Adapt the product to a new, but related target market.


6. Repeat, until your product becomes the industry standard.

This model works time and time again for my clients, especially those who suffer the consequences of a lack of focus. Once they choose a specific niche and serve it, their revenues leap, even though they have a smaller number of prospects than they did before. The act of focusing increases conversion rates, so that a much higher percentage of people take interest in the product. At the same time, marketing costs decrease with focus compared to a shotgun approach.

This model also ties nicely to the niche positioning strategy detailed earlier, although Moore suggests that a niche company can eventually become a "500 pound gorilla" by knocking each niche over, like a set of bowling pins.

Model 3: Be a Cheetah

Another model that many entrepreneurs follow is based on the hunting strategy of the cheetah. When a cheetah spies its prey, it puts everything it has into chasing it -- for a short time. After a hundred yards or so, the cheetah knows if it will catch the prey or not. If it has a solid chance of landing a meal, it pursues. If it doesn't, it stops and rests for the next chase.

For entrepreneurs launching products, the "cheetah" model includes the following tactics (see the October issue of Business 2.0 for a more in depth summary of this strategy, although they don't use the cheetah metaphor):

1. Stay lean and mean. Keep your overhead low. Avoid fancy offices, salaries, and perks. Outsource development. Use freeware wherever possible.


2. Hone in on a niche that you can fill, especially a gap in the market or in a larger company's product line (which also sets you up to be acquired at a nice price).


3. Fund with savings, friends, and family. Avoid angels and VCs as they complicate the process and take away too much equity. Work hard to launch your product (or company) for under $50,000.


4. Get visible the low-cost way. Create buzz about your product via articles, publicity, trade shows, referrals, speaking, and whatever else it takes to get word out about what you are doing. If you are targeting a product gap in another company's offering, find a way for them to learn about you (so that they consider buying you).


5. If you don't get a solid customer base or interest within 12-18 months, do what the cheetah does and move on to different prey.

Model 4: Drill for Oil

This model is similar to the cheetah model except it relies on lots of testing of different products in parallel, then the development of those that seem to have legs.

This option is based on the world's most profitable direct marketing companies (e.g. The Franklin Mint, The Danbury Mint, Time-Life Books, Ronco). These companies have found very low-cost ways to develop and test products. For instance, they often market a product before they have developed it, to gauge interest. They do this by testing ads in a variety of media. If a variety of test ads work, they expand the product in a big way. If a test ad fails, they fulfill a few orders, and move on to other tests.

This model is elegant because you can test a large number of products in a short time, and your downside is limited.

The Internet makes this model even more powerful, thanks to Google AdWords, banner ads, and other online marketing media. You can test all sorts of products quickly and efficiently, and roll out the ones that work.

As in the oil drilling business, the best of the best find that out of 10 products ("wells"), 2 are super-hits, 3 are bombs, and 5 are mediocre but profitable.

Keep your Eye on the Prize

Let's conclude by getting back to basics. The primary purpose of being in business is to make as much money as you can, while hopefully doing something you enjoy. Developing products can be far more profitable than providing services, because of the repeatable nature of a product vs. a service. Therefore, it makes sense to add products to the mix of solutions you offer.

If you master the art and science of developing, testing, and rolling out sound products, you have three excellent opportunities before you:

• First, another company could acquire you. With a proprietary product, your enterprise value increases, especially compared to have a services-only firm.
• Second, you could generate a lucrative income.
• Third, even if the first two opportunities don't materialize, products can still get your name out there, so that people hire you for design and development services.

Unfortunately, no article can tell you what product to launch. But that's your next step, and I sincerely hope that the strategies laid out here help you frame your approach.