The Right Way To Go From Services To SaaS

The Right Way To Go From Services To SaaS

“How do you build a product company within a service company?” …is a question that a lot of people struggle with.

There are amazing examples of companies who have started off as a consulting or service company who have gone on to launch great products.

Companies like:

Hootsuite: which was built out of Memelabs to help deliver their marketing services

Shopifywhich started off as a snowboard e-commerce site and recently went public

Freshbookswho initially were a marketing analytics/marketing automation company for small businesses who realized that invoicing their customers was a real pain in the butt- so they built this great product

If you’ve tried to do this, you’ll understand… the challenge is:

You have a resource (your team / consultants) that could be making you money but then you’re diverting it to build something that isn’t making you money just yet.

I went through this when I was building Spheric.

I had a team of 30 engineers and developers and thought that we had to build a product because consulting is very transactional…

… also, it’s not repeatable and it doesn’t scale (you’re always trying to get the next client to fill up the hours or get new projects).

I think it’s just a natural human instinct that when something isn’t going well (ie. you’re running out of money, you realize that your cash is running low or you have a demand that you can’t deal with), that it’s very easy to say, “Hey, I know we’re working on this product, but let’s shift it back to working with the customer.”

… and then the product gets put on the back burner.
Click here to subscribe

So I’m going to suggest that for step 1, you take the resources (team) and put it outside of the business and really treat it like a separate entity.

Services to SaaS by Dan Martell

For example, you can hire a new person and fund it from the profits from your service company or you can take somebody from your team and start building out that capacity. You can start out as simple as with one person.

I think 37signals is a great example of this, they hired DHH as a contractor to work 10 hours a week to build Basecamp – even though they were working with customers full time.

They wanted to build the tool for themselves, thought there was a need for other people to use it and then had DHH build it part time while they were working with them.

That to me is a really good way to keep the new product and the new entity “clean.”

Dealing With Partners: How To Split Equity When It Comes to Cash and Time

The other challenge that I’ve seen a lot of times is when you have multiple founders in the service company but only one goes off to work on the product.

If you go off and start putting all of your time and energy 100% into the product and the way you’ve structured it was that the service company owned the product (because the service company financed it through its profits), then it’s this really weird situation where you have partners in the business who aren’t active in the business, who aren’t really responsible for the success of the product and who are MAJOR shareholders.

This is an issue because you won’t have the equity to compensate the rest of the team who deserve it, and if you’re the person running the product you’ll grow resentful towards your previous partners for owning such a disproportionate percentage of the new product.

So that’s why I always suggest to start clean. It’ll help you avoid those issues.

What you want to do is say, “I’m going to dedicate “x” amount of money (let’s call it $200,000), over the next 16 months with one or two developers and it’s going to go in at a valuation of $1,000,0000.”

Treat it like an investment.

Because truly that’s what it is! You’ve got profit, you’ve got cash and you’re putting it into another entity as an investment.

Also, if the service company owns a disproportionate share of the product company, what you’re really doing (beyond not incentivizing the product company founders) is preventing investors from coming on board.

Every road dilutes 20% of the companies equity, so if the service company makes itself the size of a multiple stage VC (or more), then there will never be any more room for new investors.

So give yourself (the service company) an extra boost in equity by doing it at a low valuation (for example, $1,000,000 seems about fair), and then that way the cap table is really clean for new investors.

The service company essentially has an equity stake in this new product company at that valuation.

Now that may not seem like very much because a lot of people might be co-founders in a service company and think, “It wouldn’t even exist if it wasn’t for my idea!”

But trust me, if you’ve been building companies for a while, you KNOW that it’s never the initial idea…

… it’s the initial team that makes it successful.

It’s continuously investing time and overcoming obstacles that is going to be the reason it’s successful – not the initial idea or capital.

What this allows you to do is give the person running the company enough equity in the cap table (the way that you give away shares) so that you can incentivize to build a team.

Click here to subscribe

Again, I’ve seen this happen so many times!

I’ve actually invested in a company recently that was spun out of a service company.

When I first looked at it, I looked at their cap table – and the service company owned 70% of this new product!

Right off the bat you have 70% ownership of the company owned by a small group of people – so you don’t have enough equity in the company to even incentivize the CEO or other key team members long term.

After sharing my thoughts on the matter the founders restructured the team, their approach and commitment to the company and I eventually invested.

If you’re building a venture backed company that’s going to grow to $100M a year revenue in the next 7 years (because that’s what you’re supposed to be aiming for), then there’s no way you’ll have the cap table structure to win.

It’ll be like walking around with lead on your feet.

In Summary: Keep It Clean

So that’s the overall structure.

Spin it out, keep it clean, take the money from the service company, invest it in the product company.

Build a new team if possible (so you’re not pulling that team back in to other client work) and really allow it to thrive and grow.

By all means, if there are opportunities to refer customers to the product, help them out, or give any other resources, etc. you want to do that because you have a vested interested in seeing it be successful.

Setting the product company up this way will give it the best chance, although it doesn’t guarantee anything (because no startup is guaranteed!).

This will also allow you to build a structure to grow and eventually raise venture capital (if you want), and build a really cool, meaningful company.

So that’s my framework for when people ask me how to build a product company within a service company. It’s the structure and approach I suggest because it’s the one that’s going to set you up to succeed.

Even if your goal is to eventually wind the company down or sell it so you can work on the product full time – it’s still the way you want to do it – then it’s just a decision as to where you spend your time long term.

I hope you found this helpful, it was a really great question and one that I know a lot of people struggle with. I know I struggled with it (I did it wrong!) and I’ve since seen really great examples of companies who do it amazingly, which is why I wanted to share it with you!

  • http://www.spindows.com/ Clay Hebert

    Great post, Dan.

    Just this weekend, I recently met Adam Brault, the founder of &Yet (And Yet), a really cool company who derives most of their revenue from services but is simultaneously building really cool products, like Talky (https://talky.io/), RequireSafe (https://requiresafe.com/) and Human Javascript (http://humanjavascript.com/).

    I’ll share this post with Adam. The structure you outlined is helpful for any services business thinking about building products.

    Thanks.

    • http://twitter.com/danmartell Dan Martell

      Super interesting… their site makes it seem like they co-create products with service companies?

      Neat model, although wouldn’t work for venture backed companies … well, maybe for initial MVP.

      Even though I offer a clean framework above, the truth is most startups are messy 🙂

      However it gets done matters most.

      Thanks for the comment.

      DM

      • http://blog.bmannconsulting.com/ Boris Mann

        &Yet are an example of a foundry, which is an emergent class of entities much like the accelerator boom.

        It can work with venture backed companies, if you spin the people into the new entity as well. If VC is the right direction.

  • http://www.candybanners.com Jan Walczak

    Great article Dan. Our service company this year has invested significant capital into product dev so this was a fantastic read. Keep em coming.

    • http://twitter.com/danmartell Dan Martell

      Jan,

      Glad it landed for you.

      It’s tough to cover all angles and variations in the situations this could apply to (ex: individual freelancer doing both at the same time) but I felt this is the one that can really hurt you if you’re planning on raising $ at some point.

      Appreciate the comment.

      DM

  • http://radical.io Briana Sim

    Very relevant to me and my company as we always knew we wanted to grow our services company to be able to fund our future product company, and have both live side-by-side. Great points to think about and plan for – thanks!

    • http://twitter.com/danmartell Dan Martell

      Briana,

      Glad it could help.

      I’m still unsure if having both strive side by side each other … but they can definitely live.

      All depends on the goals… what I’ve seen is a plan to migrate away from services to product revenue over a 2-3 year period.

      Hope that helps.

      DM

      • http://radical.io Briana Sim

        Thanks, it does help. I suppose I meant side-by-side more as in both businesses are active…but they would definitely be run operationally by separate leadership and technical teams. Figuring out equity splits would definitely be needed. Hiring and incentivizing the right people would also be key in my mind. We’re not quite there yet, but it’s always good to have the end-goal in mind.

  • http://grantgrigorian.com Grant

    Awesome video Dan – I forwarded it to all of my friends running services companies who’ve recently launched products of their own.

    Very relevant and top of mind as consulting companies expand their business models to include products, either as stand alone businesses or to complement their existing products.

    Reminds of this article I found relevant back in the day:
    https://hbr.org/2013/10/consulting-on-the-cusp-of-disruption

  • Pedram Daraeizadeh

    Great video Dan. And thanks for sharing the tips. If keeping things separated makes the most sense, do you think these service companies would be interested in outsourcing the whole product building process to another service company? Could this outsourcing process grow to become a partnership between the two companies with a healthy structure?

    • http://twitter.com/danmartell Dan Martell

      Pedram, I haven’t seen this work long term.

      What I have seen work great is outsourcing to build the initial prototype.. then migrate it in house long term.

      I do this all the time, just hire a developer on http://www.odesk.com for 40 hours to build a quick prototype to see if my idea is feasible and worth persuing BUT I always bring it in house afterward.

      Just builds bandwidth for the team if there’s a constraint.

      my2cents.

      DM

      • Pedram Daraeizadeh

        That makes sense Dan. But I think those service companies may need to hire more than just a developer. They’ll need PM, designer, QA, etc. Would it work for them just to hire a smaller agency to handle the entire prototyping? I like the idea of productizing the process of building prototypes for other service businesses or even people who want to test their ideas.

        • http://twitter.com/danmartell Dan Martell

          Oh, if the company isn’t technical, then of course… the challenge around building your company around that use case is they typically don’t have much $$$ to invest vs. another company that has a clear direction of how that solution will increase revenue in their business (if that’s your business).

          my2cents.

          DM

  • Justin Gordon

    Dan, how do you handle the case of wanting to use services folks “on the bench” to work on the product and then rotate back on to consulting when new projects come in?

    • http://twitter.com/danmartell Dan Martell

      Justin, I don’t recommend it – rather you pay for external resources so they can stay focused and work to get the people on the bench billable. My whole Migration Method starts from that premise.

      That being said, if you have to do both at once, then I use a day part split… so M-W client work, T-F on the app.. and NOTHING can pull you from that schedule.

      Honour it, and you’ll make progress.

      DM

Never Give a boring software demo again

Get FREE access to my Rocket Demo Builder™

The Winning Webinar Method

How to get paying customers, not just leads.

Register Today

Book A Growth Session Call with me.

Need a coach to help you scale your SaaS business?
Then let's chat.

Book A Call