I recently realized that I have given a lot of entrepreneurs bad advice when it comes to software sales. Unfortunately I have been doing it for many years as an investor.
I used to think that the goal of a Series A software investor was to build a great team, build a great product, and prove that customers were willing to pay for your product. I thought that if I could de-risk the sales cycle and get some proof points, that would be adequate to get other investors to follow on later with capital for scaling.
Almost all my companies are in greenfield market opportunities, where there is no incumbent and the sales cycle is completely unknown, so I put a lot of emphasis on figuring out how to sell early. I have nothing against brownfield markets, but I find it more interesting to build something for the first time.
Since my companies are evangelizing new areas, I used to tell CEOs that they should price high enough to recoup sales and marketing costs. With a field sales team that is inevitably a six figure price point. Customer payments also defer operating costs in the early days, which is helpful because we are a smaller fund.
The mistake I made, which is painfully clear to me now, is that many SAAS markets have a winner-take-all dynamic. This is especially true if your products are sticky, or if they have network effects. There is a new trend called “consumerization of the enterprise” that takes this a step further, with software companies that don’t use sales teams at all. Instead they market like consumer companies and grow virally.
When a company is in a winner-take-all market there will typically be one major outcome, worth billions in enterprise value at exit. Other companies in the sector either survive as a tuck-in acquisition or go bankrupt. This is radically different from “non-winner-take-all” markets where there could be a half dozen reasonable exits. If you are investing in a winner-take-all market the only thing that matters is making sure your money is in the winner.
This “winner take all” strategy thrives in Silicon Valley, where there are a lot of smart programmers who can replicate and improve upon any product. Moreover, these programmers are not motivated by revenues – they only want the world to use their tools.
This trend arrived at the right time, because we are currently in a market with infinite growth capital. If you look at the IPO class of 2013, which is heavily weighted towards west coast software companies, the average paid-in capital prior to IPO was $103MM. That is not a typo. To reinforce the point, almost all of these companies are still losing money, and some are losing more money as they get larger. All that matters today is growth.
My companies, which were focused on revenues, would go to market and build up a base of $5 to $10 million per year in recurring revenue. Once that success became known competitors swarmed in, offering a similar product for free. Some customers would churn and others would renew at 25-50% of the initial contract value. It is impossible to maintain high pricing against free alternatives. The net result is that for a period of 1-2 years my companies would struggle to stay afloat as the existing book of business became an anchor to growth. This is a death spiral for venture-backed companies because nobody funds flat growth.
I have now seen this happen twice, and I have vowed to never let it happen again.
The right strategy in winner-take-all markets is to get as many customers as you can, as fast as you can. Instead of proving early on that customers will pay, prove that the market for your product is vast and that customer acquisition scales quickly.
My new view is that early pricing is irrelevant. If anything, pricing high in the near term is a hindrance. It is better to under-price initially and raise prices over time – increasing dollar renewal rates will amplify future growth. If you are lucky this will coincide with the exact time that you are looking to exit or raise capital. That is a recipe for success.