Martin Ward of Waypoint Partners

Martin Ward

Software businesses attract much higher market valuations than service businesses.

It’s quite a statement, but the logic is sound: software is inherently easier to scale and capable of generating high gross margins, since digital products have low marginal distribution costs. The SaaS business model, with its recurring subscriptions, also lends itself perfectly to long-term customer profitability, provided of course you have a good strategy for securing customer success.

Service businesses, on the other hand, are harder to scale since they rely on people as their main product offering. People are never easy to find, train and retain, plus they have higher marginal costs – good people are expensive! In a service business, most of the value walks out of the door every night, so the risk on future performance is higher, which is also factored into the business valuation.

The flipside is that service businesses are generally easier to bootstrap, since they require less capital to create the product. They generally have positive profitability and cash flow from the outset, unlike a software business where the product needs to be built before it can be sold.

So, is it possible to have the best of both worlds?

The answer, in my experience, is yes.

Service businesses are well positioned to create great software propositions. Why? Because their people often experience the customer’s situation first hand and understand what real customer value looks like; the software functionality emerges directly out of the customer’s need.

But it doesn’t stop there:

  • The software offering enhances the value of the core service; for example through workflow functions to streamline service consumption, or giving the customer actionable insights from service delivery. Services are often commoditised and the software play can serve as the ‘secret sauce’ for attracting new customers, creating unique value that is hard for competitors to replicate.

  • The advantages extend to the software development lifecycle. Software-only ventures are unavoidably tested in the full glare of the customer. Often, the early user experience is less than perfect, creating the risk of frustration and rejection. For a hybrid business, the software platform is used by the vendor’s own staff as part of the service delivery, with the customer avoiding the intricacies of the software, particularly data entry tasks.

  • Finally, there is the development spend needed for software. Typically in a software-only venture this will come from capital fundraising in return for equity. A service business has a significant advantage here; provided it’s profitable, cashflows from service activities can be used to fund, or at least part-fund, the software development. Hence the hybrid business can retain all or most of the new value that’s created.

Other key factors to consider

The skills, capabilities and mindset needed for a software offering are very different to those of a service offering and there are some significant considerations to note:

  • It’s important to approach the software proposition as a distinct offering that’s built and serviced professionally if real value is to be created. New skills and resources will almost certainly be needed to build a robust platform.

  • A related challenge is the temptation to build bespoke features for each customer. This may be necessary in the early days, but if the software platform isn’t built properly for re-use, with a single code set, these multiple versions will soon create a support nightmare. It will also take much longer to build and implement a solution for each customer.
  • Finally, cross-funding needs careful consideration. A software subscription can be funded through services, but in this case the value inherent in the software will be less clear, impacting the valuation uplift. Where such cross-funding is to be done, it’s wise to create separate, transparent software license agreements with a defined commercial value ascribed to each one.

Going to market with purpose

The last piece of the puzzle is the go-to-market strategy. In the hybrid scenario, the software offering might be sold only alongside services as a value-add, or independently as a pure-play SaaS offering.

The scenarios that are going to be supported need careful consideration to avoid market conflict: for example, do you sell your software to organisations that might compete with your services; do you sell your services to customers who don’t want to take your software; and do you sell software to organisations in sectors where there is no service opportunity?

Of course, all of these issues are addressable, and smart vendors will find the business model that works best for them and their markets. Either way, it doesn’t have to be a case of either/or; a solid service business can greatly benefit from the secret sauce of a software play, it just has to be done purposefully and professionally.

Are you a service business wanting to explore a software opportunity?

If you would like to discuss your situation, please contact Martin Ward.