Some people may think that the term lifestyle business is an insult. I couldn’t disagree more. Being the owner-operator of a lifestyle business should be a source of pride; a badge of honor.

As a growth stage investor, I see quite a few lifestyle businesses in our deal log. This type of opportunity finds us because they often meet our high-level screening criteria. They have paying customers, generate meaningful revenue and produce EBITDA and cash every year. They “fit the profile”.

But when I meet with an entrepreneur who is running a lifestyle business, I’m not shy about asking a most important question. It usually goes something like this:

I understand you wish to raise capital to grow your business. But if I’m hearing you correctly, today you own and control nearly 100% of your company. This enables you to lead a balanced life, generate meaningful personal wealth and take great satisfaction from your work. Why would you want to screw all of that up by raising capital?

I mean it too. Raising capital comes with loss of control, changes in lifestyle (read work flexibility) and other issues. More importantly, lifestyle businesses tend to lack one key ingredient that institutional equity investors (particularly growth equity investors) need to generate returns; rapid scalability. Bringing in institutional capital creates an incredible amount of pressure to generate top-line growth. In the context of most lifestyle businesses, that kind of top-line growth is either not achievable or if it is, will so fundamentally alter the character of the business that it will be unrecognizable to the entrepreneur at the end of the process. In short, that pressure will probably do more damage than good from the owner-operators point of view.

So if you are an entrepreneur seeking capital from me and I say something like “You own a great lifestyle business; why on earth would you want to raise capital and screw it up?”, please know I’m coming from an honest place. I’m not insulting you.  I am, however, trying to get you to come to grips with the fact that raising capital may be a surefire way to screw up the good thing you have going.

We investor types juggle a lot of tasks on any given day and given that time is limited, we have limited time for any one task. This can be a real detriment during the diligence process, which requires concerted effort, open-mindedness and an awareness of our own biases. It is all to easy to pick up on a headline we hear and ignore the story behind it.

When we hear a headline delivered as a statement of fact, we are at risk of taking it as gospel truth, particularly if the statement comes from a trusted source. This is particularly true when the headline confirms our own bias or if the statement is delivered with overwhelming intensity. In either case, we may not take time to understand the story behind the headline. If the headline confirms our bias, human nature is move swiftly to the next task. Likewise, human nature overweights headlines delivered with gusto.

I view diligence as a process of gathering facts, filtering them and making sense of them by applying analytical thought models that I trust. I trust those models more than I trust myself, because I’m acutely aware of my own human biases enough to sequester those biases from the decision-making process. And I don’t trust headlines, because they are written by humans who have their own biases.

So ignore the headline; read the story. Give me the facts; I’ll write my own conclusion.

I was well paid though. I received a base wage rate plus a piece-rate, where I was paid an additional amount for each binder bin that I completed. The piece-rate was set based on meticulous analysis of the manufacturing process which determined how many units I should be able to produce per hour. The full-time factory workers, who were lovingly referred to as “factory rats”, were paid under the same scheme. This scheme was intended to motivate higher output on the manufacturing line.

A couple of weeks into my first summer, I figured out that I could improve my output of binder bins, and therefore my compensation, with a couple of tweaks in the process.  During lunch, I shared with some of the factory rats what I had discovered. Their response was not what I expected. Essentially, I was told:

You don’t get it. If you improve the process, management will modify the piece-rate component of our comp scheme. We’ll have to make more units to get the same total compensation. You’ll only be here for the summer, but we’ll have to live with that change forever. Don’t do it. Don’t ruin it for us.

The factory rats didn’t want to help the Company figure out how to produce more, because they didn’t believe they would receive more compensation for identifying ways to produce more. This was my first experience with what compensation experts call “if-then” rewards. I have been skeptical of “if-then” compensation schemes ever since. If this kind of pay for performance scheme doesn’t work for a mundane repetitive task, imagine what happens when you apply “if-then” rewards to knowledge work.

Established management philosophy treats all employees like the factory rats – with carrots and sticks. That philosophy says “I can cause you to do more of what I want you to do if I pay you when you do it” and “If you don’t do what I want, I will withhold rewards or worse punish you”. This is tantamount to giving a mouse a piece of food for pushing the blue button and shocking it if you push the red one.  The only problem is we’re not mice (or rats for that matter). WE’RE HUMAN and that makes us complicated. Carrots and sticks don’t work.

The first book I read on this topic (many years ago now) was Edwards Deming’s The New Economics. Yes, that Deming, the American-borne manufacturing process guru who helped to usher in Japanese domination of manufacturing process. It turns out that Deming was also a management psychologist who was well ahead of his time. Deming believed that we should abolish performance reviews in the workplace and grades in school. He felt that those types of subjective measurements of performance wiped out the employee’s/student’s intrinsic motivation. The employee’s goal becomes to please management, rather than to do good work. The student’s motivation becomes to get a good grade, as opposed to learn. It turns out that we complicated humans like to do good work and we enjoy learning; we are intrinsically motivated beings; external rewards and punishments get in the way.

Many years later, I’m encouraged that there is finally a new management regime beginning to take hold. It is best summarized in my most recent reading on this topic. Written by Daniel Pink, Drive: The Surprising Truth About What Motivates Us gives a good overview of the roots of our antiquated management/compensation philosophy and the science (much of which has been around for many years) that shows how flawed it is. Pink also offers insight into what we can do to change. To sum it up; pay people what they are worth, give them autonomy in their work, provide them the opportunity to master their craft and create a sense of purpose in the workplace. It is not that hard.

My own experiences, my personal reaction to comp. schemes I’ve had imposed on me in the past and years of reading on this topic (Here are my favorites) make me contrary on compensation. I’m done with carrots and sticks. How about you?

Note: For a good summary of Drive, check out this RSA Animate sketch narrated by Pink.

The catalysts that create make or break moments vary. Sometimes the catalyst is external; perhaps the market meeting your product, an acquisition by one of your potential partner’s competitors. Sometimes the catalyst is internal; a great new product release, a partner deliverable. We all know what these moments look like; we’ve all described a moment in time as “make or break”.

The notion of “making” a business in a singular moment is alluring. But entrepreneurs rarely think about the execution risks they will face after they’ve “made the business”; and the fact that there are likely to be future “make or break” moments where they will also have to avoid breaking. For me, ”make or break” is a fallacy. You can absolutely break a business in a singular moment, but rarely can you make a business that way. The only way to truly “make” a business is to exit it, in which case, future execution risk and future “make or break” moments become irrelevant.

Perhaps we should rename ”make or break”. Lets call it a “don’t break” moment. ”Don’t break” moments comes with the recognition that by not breaking, you create opportunity to execute well in the future so that you can see future “make or break” moments where you must also “not break”. If you make it through the gauntlet of multiple “don’t break” moments, you might just have the opportunity to exit the business for a monumental value at some point in the future.

How would you rename the “make or break” moment?

Talk to me when you have “momentum”; or

I need to see some “traction” first.

With more and more VCs looking to make later stage investments, entrepreneurs are receiving this feedback more than ever. You can understand why an entrepreneur might find this feedback frustrating. If they had massive traction, they probably wouldn’t need VC money, or if they did, the deal should be priced at a much higher valuation. That said, the real issue with this feedback is that it triggers a conversation about the definition of momentum. Entrepreneurs complain (rightly so I might add) that the VC definition of momentum comes in the following forms: 1) VC defines momentum by saying; ”I know it when I see it”, 2) VC gives a milestone as a proxy for momentum that if achieved means that the entrepreneur will no longer need capital, or 3) VC gives a milestone but moves the goalposts once the milestone is achieved. Fundamentally, these are all non-answers and don’t serve the entrepreneur particularly well.

I’ve tried to take a different approach. I’m not smart enough to define momentum for every business, so I don’t bother trying. In-stead, I try to work with the entrepreneur to describe the value creation engine of the business; the mechanics through which value is created. With those mechanics defined, investors will get excited about just about any business for which the process of igniting that valuation creation engine is both replicable and scalable.  I lay it out as follows.

Identify the value creation engine for your business

Generically speaking, the value creation engine links the time, energy and capital you invest in the business to the measure of output that you think will be used to value the business at exit. The measure of output you choose depends on the type of business you are building. If your business is about aggregating eyeballs and monetizing them, then you will likely be valued based on unique visitors, users, user engagement, and the “potential” monetization of the audience. For more mundane businesses, your value creation engine may be revenue generation and eventually your ability to generate profits. If you can’t articulate the linkage between time, energy and capital and the value creating output of measure for your business, then you haven’t figured out your value creating engine. For example, wouldn’t it be great to say:

Based on experience thus far, a new account rep. will begin producing between $5k and $10 of incremental monthly recurring revenue within six months of their data of hire.

Make the value creation process replicable

Understanding your value creating engine implies that there is both a process in place to create value and a causal relationship between time, energy and capital and the desired measurable outcome. If there is causation, then the process for creating value is likely replicable; if I do X, then Y. If I do X again, then Y again.

When something is replicable, a measure of control is implied. For my part, I like businesses where the company is in control of X; more sales people, more marketing, more channels, etc. Businesses that rely on “viral” effects where the company has little control over the creation or velocity of the viral process are more difficult for me to get my head wrapped around. If I can’t control X, why should I believe X will continue to turn into Y?

Show that the process is scalable

Some value creation processes have rapidly diminishing productivity curves. The more input you give the process, the less productive the process is in generating output per unit of input. What I’m looking for is a value creation process where I can add a significant amount of additional time, effort and capital as raw material without diminishing the returns on investment; that is scalable. If I add five more sales people, I generate 5 times more leads, which turn into five times more sales, etc. You don’t have to prove this, but you should be able to make a compelling argument for why the process is scalable. A really big market with lots of customer prospects really helps. I’m more likely to believe your valuation creation engine scales in a big market than in a small one.

Entrepreneurs should not be deluded into thinking that there is some magic threshold number that once crossed will enable you to raise huge sums of money. Businesses that have a replicable and scalable value creation process make for attractive investments because additional capital is fuel on a fire that is already lit. In a market where investors are more risk averse than ever, these businesses are the ones most likely to capture the attention and imagination of investors.

While that hierarchical reporting relationship is necessary and constructive, it is far from sufficient for a company to succeed in a dynamic, ever-changing emerging growth environment. My view has always been that venture investors (and Boards more generally) need to get “on the same side of the table” with entrepreneurs and work with entrepreneurs (shoulder to shoulder) to create value. The burden of making this work is clearly on Board members, but there is much a CEO can do as well. As my Partner Jack Tankersley is fond of saying,

The CEO has to give each Board member a job.

It is my experience that Boards are often left unmanaged by CEOs and that an unmanaged Board is a dangerous Board. When smart people (the kind you typically find on venture-backed boards) are left unmanaged, they manufacture activity, because they don’t know what else to do. They create their own “job definition” whether it is aligned with the needs of the company or not. The risk for a CEO is that an unmanaged board can run roughshod over an entrepreneur. What is a CEO to do?

First, a CEO must view his/her Board as a set of tools to utilize. This starts with understanding the skills, capabilities, and relationships your Board has. Identify the strengths and weaknesses of each board member and figure out how to use their strengths to the Company’s advantage.

With an understanding of those resources in mind, a CEO can then give each Board member a job. In other words, define the Board members job and make it a job that they are both likely to enjoy and succeed at on your behalf. Here are a couple of examples:

• A Board member with a deep Rolodex with potential strategic partners can be assigned to work with the Company’s business development team to generate new biz dev activity.
• A Board member with a penchant for strategy and planning can be given the responsibility to help the Company prepare for an annual strategic planning exercise.
• A Board member with a skill in shaping discussion might be assigned to facilitating Board level discussion.

Think about it this way; would you hire an employee without telling them what their job responsibilities are? Of course not! So apply the same management discipline you apply to your employees to your Board. The effects can be really constructive. By assigning tasks, Board members become accountable to the Company. They are forced to work with and for the CEO to help accomplish a task, ensuring alignment. This also sets boundaries for each Board member. By signaling what you want to them to work on, you also signal what you don’t want them to work on.

So if you are a CEO having a difficult time managing your Board, take this simple advice: Give each Board member a job. Your Board will be much more productive as a result, your Board members will be happier because they will know how to contribute, and your Company will be better off.

Back to my conversation with the CEO. We were talking about the use of proceeds for the financing she is trying to raise. In her case, the business is break-even, but has the opportunity to grow into some oncoming market demand. So I asked a classic VC question; “Assuming you close the financing in Q4, 2009, what will your 2010 revenues be?” Simple question right?

Lets say that this company ended 2009 with $3 million in run-rate revenue and that the Company has two sales reps. Each sales rep. has a quota of $10,000 of incremental monthly recurring revenue (“MRR”) bookings per month. Sales reps. historically produce at 75% of quota in this company, so the incremental new bookings per month, per rep is $7,500. At its current level of sales and marketing resource and productivity, this business can expect to generate $1.17 million more in revenue in 2010 than it generated in ’09. To get there, just multiple the $15k per month of incremental revenue the two sales reps. will generate by 78. Why 78? Because 78 is the ”sum of the digits” for revenue producing months in a year. Incremental revenue added in January will produce revenue for 12 months; incremental revenue added in February will produce revenue for 11 months; …; incremental revenue added in December will produce revenue for 1 month. The sum of digits for 12 is: 12 + 11 + 10 + … + 2 + 1 = 78. So the baseline revenue projection for 2010 should be about $4.17 million.

Now lets talk about the enhanced growth opportunity. The Company wants to hire two additional sales reps. who can be expected to produce at the same $7,500 of MRR as the two existing reps. For purposes of the example it will take a quarter to recruit and hire the two new reps and another quarter for them to build a sales pipeline given the sales cycle. Conservatively, these two new reps. won’t begin generating MRR bookings until June. Lets say there is a one-month install cycle so that June bookings convert to revenue in July. So what kind of incremental growth will these reps. generate in 2010? We don’t get to use the rule of 78 this time; no, because these reps. will produce for only six months during 2010, we use the sum of digits of 6, which is 21. That is a lot less than 78; that six month delay between making the decision to hire two new reps and getting them on board and productive really hurts. In 2010, the two new reps. will generate only $315k of incremental revenue. The business can be expected to generate $4.485 million of revenue in 2010; not meaningfully more than the base scenario without additional investment.

While this looks like meager growth, it doesn’t tell the whole story. Remember, this business came into the year with a $3 million run-rate. Without hiring the two new reps, the business should end 2010 with a run-rate of $5.16 million. By hiring the two new reps. that can be increased to $6.24 million, even though the two new reps. are productive for only six months. That incremental run-rate of over $1 million makes a huge difference and sure makes hiring the two new reps. look a whole lot more attractive than the meager incremental revenue they will generate in 2010.

Here are the key takeaways:

1) Get the Base Right: Recurring-revenue businesses are great because they are highly predictable. Applying the rule of 78s and with a little understanding of your sales resources and their productivity, you should be able to estimate your baseline next year revenue with a high degree of confidence.

2) Scaling Takes Time: The most common mistake I see recurring-revenue entrepreneurs make it to underestimate the time it takes for increased sales and marketing resource to impact the top-line. Hiring new sales people today probably won’t move the needle on your next twelve month revenue. More likely, an investment in sales and marketing won’t have meaningful impact until the following fiscal year.

3) Run-Rate Matters: You will see the impact of an investment in sales and marketing in run-rate much faster than in top-line GAAP revenues. If you are asked about what your revenues will be next year, answer the question directly, but also include a description of the difference in the run-rate you expect to end the year with under the no-growth and growth scenarios. The run-rate difference will impress much more than the top-line difference.

By the way, the CEO of the SaaS company I was speaking with got this analysis dead-right. Well done!

This may sound strange coming from a VC. Some entrepreneurs who choose to raise venture capital have great disdain for the necessary evil of reporting to their investors. That disdain is appropriate to the extent investors are asking for mundane information that creates a reporting burden and does not add information necessary for critical board decision-making. But entrepreneurs that cross the line and don’t like to report because, well, they don’t want to report to anyone, are making a great mistake. There is no excuse for not wanting to stand and be counted; no excuse for not wanting to answer difficult questions; no excuse for not wanting your thinking challenged. I once interacted with an entrepreneur who chose another investor over us because, “we understood the business too well”. Apparently this entrepreneur thought my understanding of his business would be a “burden”.

VCs have someone to report to; Limited Partners and Advisory Boards. Yesterday, my Partners and I reported on our progress here at Meritage Funds to our “bosses”, our Limited Partners and Advisory Board, at our Annual Meeting. In a series of sessions, we stood and were counted; we answered difficult questions; our thinking was challenged. In presenting our progress, we strive for transparency and to give a balanced view to our Limited Partners. We talked about the elephant in the room - the difficult macro-economic environment and the difficult fundraising landscape for venture capital funds. We shared our enthusiasm for the opportunity to invest the capital we have raised in our Fund III and the excitement over the opportunities we are currently evaluating. We talked about our failures and the lessons learned. We talked about the challenging spots in our portfolio as well as the upside opportunities. And most importantly, we told our bosses what we were doing to capture the opportunities we’ve created and what we are doing to minimize the risks we see. The picture we drew was not all rosy and bright, nor dark and depressing; it was balanced. In addition to the annual in person meeting, we send written quarterly reports, have quarterly Advisory Board meetings, and a semi-annual conference call that all Limited Partners are free to attend.

We don’t report to our Limited Partners and Advisory Board because we have to, although we do. We do it because it is a good and valuable discipline. If we could convince our investors to gather quarterly, we would be thrilled. The process provides us with the opportunity to record and contend with the facts; to deal with harsh reality; to account for decisions we have made in the past, and to explain and justify what we are going to do next. For us, this is a valuable exercise; one we cherish. The feedback we receive is invaluable and helps to shape and reframe our thinking in constructive and positive ways.

Many entrepreneurs share this view. Such entrepeneurs use their Boards of Directors as sounding boards. They report with transparency and share not only what they have accomplished, but also where they have failed. These entrepreneurs cherish the opportunity to stand and be counted. I like this kind of entrepreneur. They understand that you need someone to report to; and that you can’t report to yourself.

The author, Steve Blank, walks the reader through four distinct exit market cycles and discusses venture capital behaviour and philosophy in the context of those market cycles. The title of the article is a bit misleading as it posits whether or not you can trust VCs under 40. I’ll return to that later; suffice to say for now that it is one of those titles intended to stir controversy, but not fundamentally of value. 

The first cycle Blank covers is the 80s and 90s, where exit markets, particularly the public equity market required five quarters of profitability. As Blank states, the implications for venture investors during that period of time were clear:

What this meant for entrepreneurs and VCs was simple and profound – and is entirely underappreciated today: VCs worked with entrepreneurs to build profitable and scalable businesses. In this time, a successful business was one that had paying customers quarter after quarter, not one that was flipped or hyped to the market despite a lack of earnings or revenue.

Venture Capitalists on the board brought a firm their expertise to build long-term sustainable companies. They taught companies about customers, markets and profits.

Blank then goes into detail on two subsequent phases. The “IPO Bubble” (August 1995-March 2000) and the “Rise of Mergers and Acquisitions” (March 2003 – 2008). In each phase he articulates the warping effect of these markets on VC behaviour. In both phases, he makes the basic point that VCs were building companies to be sold prematurely to a greater fool; either into an overvalued IPO market or to a frothy strategic acquirer. The notion that stable revenues and profits were a key part of the formula for a successful exit was still missing. One might refer to this as “momentum” investing.

Back to the Future

And finally, Blank makes the case that 2009 will be a back to the future period where VCs will have to return to the fundamentals of building real value in their portfolio companies in order to generate meaningful returns for their investors. I think Blank is dead on here.

But I’m here to say that some of us never left the approach of working with entrepreneurs to create fundamentally valuable operating companies. My Partners and I at Meritagebelieve that venture capitalists have to work with entrepreneurs to create fundamental value. This core belief is the very reason for our unusual - and I believe innovative – organizational design. Four of my Partners are in a special category we call Operating Partners. Each is a successful, serial entrepreneur. Each has started companies, raised venture capital, dealt with venture capital boards of directors, and despite those boards, had successful exits. They are full-time, long-term employees of our firm and members of the General Partner. The shortest tenured has been here for five years; they are not like EIRs or Venture Partners. We won’t make an investment unless one of them represents us on the Board of Directors of that company and when they do, they invest their personal capital in the Company along side the fund. They stay with that Company for the life of the investment; cradle to grave. Each is limited to no more than four boards at a time so that have the time and focus to truly assist the entrepreneur. Our whole system is about creating value over a five to eight year investment horizon, not about momentum investing. Momentum comes and goes, trends ebb and flow, markets change. But fundamental value endures.

Does this mean that the traditional VC skill-set is no longer required? Not in my opinion; it takes a myriad of skills, and resources to help a company. The classic VC skillset is alive and well. But not all VCs are created equal. And here is where I’ll diverge from Blank. I don’t think the value of a VC has anything to do with the age of the venture capitalist you select. When I look at an entrepreneur, I don’t evaluate them by age, I evaluate them by experience, wisdom and judgement. I know many 55-year-old entrepreneurs who don’t have these characteristics and a lot of 30 something entrepreneurs that do. I’ll back the wise 30-year-old entrepreneur 7 days a week and twice on Sunday. Likewise, the value of a VC has everything to do with philosophy, wisdom and judgement; and alignment with the nature of your investment opportunity.

Evaluating a VC

What I encourage entrepreneurs to do is to evaluate the VCs philosophy. Are they a momentum investor or are they a fundamental investor trying to build a real operating company? Are they interested more in the theme of your investment than in the fundamental value-creating engine of your company? Do they get caught up momentum buzzwords like web 2.0, eyeballs, mobile, etc., or are they more interested in the needs of your target customers, the vertical market you are attacking and the sustainability of your competitive advantage. Answers to these questions will shed insight on how the VC attempts to create value for their investors.

Momentum investing is inherently neither bad nor good; the same for fundamental investing. But these approaches do work differently in different exit markets. In my personal opinion, we’re in a market cycle that will disproportionately reward fundamental investors and not momentum investors. In fact, fundamental investing works great in any market. Momentum investing often outperforms in strong markets and underperforms in weak ones.

In the long-term, I believe that the fundamental approach is a better fit with entrepreneurs trying to build fundamental operating company value. It is not right for everyone; is it right for you?

Many casually refer to these businesses as “technology companies”, by which most intend Wikipedia’s definition of “information technology”, not the generic definition of “technology“. After all, these businesses create technology to build their service, right? Salesforce.com is a technology company; Yahoo! is a technology company; Akamai is a technology company …; AT&T is a technology company. Whoa! Hold it right there; rightous indignation time; I can hear it already.

AT&T is not a technology company! They don’t know the first thing about technology! AT&T is a communications services business.

So what is the difference? Why do we think of Salesforce.com as a technology company and AT&T as a service provider.

Cognitive Dissonance

Objectively, either all the companies in the list above are technology companies or none of them are. AT&T uses every bit as much technology to run its business as does Salesforce.com. And while some of that technology is different, much more of it is fundamentally the same. More importantly, the technology serves the same singular purpose; it powers the service.

So which is it? Are they all technology companies or are none of them technology companies?

Brace yourself; here comes the controversial statement. If you are a services business, you cannot be technology company. Salesforce.com is not a technology company; Akamai is not a technology company. They are service companies.

To Create of Consume

I’ll return to where I started this post; with the observation that I see many technology entrepreneurs moving into services businesses. Often times, such entrepreneurs bring with them a technology creator mindset, not a technology consumer mindset. And as a result, they are susceptible to a number of mistakes. The most common of these is when the entrepreneur convinces themselves that their proprietary technology is going to make there service provider successful. Here are three examples:

• Wireless service provider that has invented a new technology for mesh wireless networking, enabling quality of service management for voice over wireless applications.
• Tech-enabled service provider for eBay resellers that has invented a new web server technology that will make the technology infrastructure highly scalable.
• SaaS developer who built its own platform for managing its application in the cloud.

What is the problem with these businesses? They are acting like creators of technology, not consumers of technology.

The rationale is that by creating a proprietary technology, the service provider can gain a competitive advantage over its service provider competitors. It is an alluring and dangerous trap. But fundamentally, there is no way the wireless service provider above can keep up with the R&D budgets of Motorolla, Qualcomm, Cisco and the like and create a best of breed mesh QoS technology in the confines of a single wireless service provider. The tech-enabled service provider can’t possibly out-compete the web server technologies on the market in the long-term.

Embedding a proprietary technology business inside a service provider decreases execution focus and greatly increases execution risk. Creating this kind of technology requires a different skill-set, different processes, and a broad market in which to distribute the product. The economics of spreading the costs of creating and maintaining a technology company like this over one, captive service provider don’t work. From an investors perspective, the Company will consume more capital than is required, trying to capture/maintain a lead in a core technology that creates only the illusion of competitive advantage for the service provider. It is hard enough to build a successful service provider. Why would you want to complicate it by having to simultaneously execute the creation and maintenance of a core technology you could purchase from a third-party vendor. And what if the science upon which the new technology is predicated upon doesn’t pan out. Then what?

Rather than invent and maintain truly proprietary core technologies, I encourage all of my service provider investments to be rational and ruthless consumers of technology, not creators of technology. Find best of breed wherever you can, configure it in a way that suits the needs of your particular service and drive your vendors, who have the R&D budgets and skills, to innovate on your behalf. It is much more capital efficient and the execution risk is significantly lower.

What I am not saying

Does this mean services businesses should not be inventive? I’m not saying that at all. In fact, the successful services businesses are highly inventive, but not at a core technology level; rather at a business process level. One of my portfolio companies, Pipeline Trading has developed some amazing algorithms around large block and algorithmic trading of equity securities. This invention is unique to Pipeline and highly proprietary. But it is not a “technology” in the information technology sense of the term, it is a business process. Sure these innovations are expressed through technology; lots of software to be precise. But that doesn’t make the innovation a technology innovation; quite the contrary. Any quality engineer who is given the advantage of understanding the business process expressed by the algorithms could easily write the software. The innovation is not the software itself, it is the algorithm; and that algorithm has fundamentally nothing to do with information technology. It turns out that the competitive advantage is also in the algorithm, not in the software that expresses it.

But, but but…

But what if we really have created an incredible technology (in the information technology sense of the term) in the process of building our service provider? What if I really do have the best cloud-enablement platform in the world. Great, you just hit the jackpot, because you’ve discovered and solved a problem that every other service provider like you will also experience. But don’t keep that innovation captive to your own little service provider; free it. Spin the business off; create a hardware, software or new service provider around the technology; open source it. In fact, this is exactly what the SaaS operator with the cloud-enablement platform did. Kudos; right call!

The highest and best use of a new technology innovation is to sell/license it to anyone and everyone who could benefit from accessing it. That includes the service providers with which you compete. If it is amazing and valuable new technology, you should be able to sell the technology to your competitors and a lot more customers. If you can’t monetize it directly, ask yourself again why you believe the technology innovation will be a source of advantage for your captive service provider?

Final thought

Where does this leave us? Well, if you are a technology entrepreneur coming into a services business, I’d suggest you first change your mindset from one of being a technology creator to a technology consumer. Whenever possible, focus on innovating at the business process level, not the core technology level. Avoid technology “research” projects and focus resources on expressing your innovative business process with software. And finally, if you are absolutely forced to solve a tough core technology problem and create a truly proprietary technology in the process, look for ways to free it from the shackles of your captive service provider. In the end, the technology will have a better chance to flourish and your service provider will be unburdened from the costs, and challenges of having to execute on two fronts simultaneously.

Don’t confuse the services business with a technology business. You can’t; and shouldn’t try to be both.