The Truth About Software Startups

For years, startup software companies have assumed that bringing a product to market first and then investing more than their competitors in sales, marketing and product development was the road map to a winning outcome. However, a new study charting the common characteristics of both successful and unsuccessful software companies claims that, on average, winners are not first to market and do not spend more on sales and marketing or product development. Rather, successful companies become large, profitable businesses for a variety of unexpected reasons.

In “Building a Great Software Business in Booms and Busts Alike: An Empirical Analysis of the Operational Performance of Formative Stage Companies,” Bain Capital Ventures professional Jeffrey Crisan and managing director James Nahirny analyzed financial results from 1990 through 1998 for 304 publicly held software companies. Their baseline criterion for labeling a company as successful is what they call the “Rule of 126” — that is, these software companies achieved $100 million in revenue and earnings before interest and taxes (EBIT) margins of 20% within an average of 6 years after company formation. Companies were considered failures if they had never had a profitable year and had never reached $40 million in revenue.

The authors closely examined the common characteristics of the 61 “successful” and 39 “unsuccessful” companies that met their criteria and interviewed industry executives as well as academics to provide a real-world context for their findings.

A key finding is that sales-force productivity is an excellent predictor of long-term success. “Sales-force productivity is the critical differentiator,” says Crisan. “In successful firms, sales forces are 80% to 120% more productive than in unsuccessful ones.”

Moreover, the authors found that, on average, total sales and marketing expense had no relationship to long-term company success. Successful companies spent about the same on sales and marketing as companies that failed. In fact, operational research conducted with Jim Maikranz, former senior vice president of sales at SAP AG, and Michael Krupka and Jeffrey Schwartz, both managing directors at Bain, has led the authors to conclude that sales success is not about how much a company spends.

“It's about developing a finely honed, repeatable sales message that will resonate with customers,” Crisan points out. “Only after this has been achieved can a software firm effectively grow both its sales and its sales organization.”

Spending more on R&D did not necessarily produce successful products either. In fact, failed companies spent more on R&D than successful firms. For example, in the third year of operations, unsuccessful companies, on average, spent $3.8 million on R&D versus $2.4 million among the Rule of 126 companies. Interviews revealed that successful companies often obtained customer feedback early in beta testing and only invested in features that customers needed. Unsuccessful companies, the authors say, often had large, inefficient product-development teams, relied less on customer input and added features that customers didn't want.

With regard to first-mover advantage, among the 14 companies for which the authors had comprehensive data, about three-quarters of the leading products were not first to market. Examples included Microsoft Corp., which did not market the first operating system (IBM actually had one before contracting with Microsoft), and Siebel Systems Inc., which leads in the CRM market over first movers Vantive and Clarify. Furthermore, many who emerged as market leaders did not produce what was widely considered the best product on the market. Independent experts from the corporate world and academia who closely followed the software market at the time were asked to rate the eventual product winners on a scale of 1 to 5 (with 5 being significantly superior); on average, they gave the winners a 3.5 — that is, a good product, but not the best on the market.

They also refute the common belief that software must be given away initially to ensure market penetration. While all companies discounted in the first year, successful firms generally had higher gross margins in the second and third years. The authors extrapolate that these firms understood that maintaining higher prices tests a product's potential for success, inducing marketers to articulate a compelling customer value proposition.

These findings lead the authors to suggest that new software firms should emulate the tactics of successful ones in several ways. For example, they advise companies to build products to solve a well-defined customer problem; to charge a high, sustained initial price to reflect the value being provided; and to limit product complexity to only essential features. They also suggest that a sales force be developed with a targeted industry expansion in mind, only staffing fully when a company can articulate a clear, repeatable sales message to its customer base. The common traits for success, say the authors, can be used as benchmarks to gauge a company's progress.

For more information, contact the authors at jcrisan@baincapital.com and jnahirny@baincapital.com.