Joel cautions: “Don’t write a single line of code before asking this question: “Is my market really big enough?”
Why is it so critical to choose a large market?
Because the financial dynamics of most software companies are driven by these three assumptions:
- You will incur large fixed costs for software development before you can start selling your software.
- Your revenue will arrive in the form of subscriptions fees which will be cheap and low-margin as you compete for early market share.
- You will pay your customer acquisition costs prior to receiving the corresponding revenue, and your revenue will arrive slowly over time.
In the equation below, if your price is low and your costs are high, the only way remaining to increase your profits is to increase your volume. And that means you have to pick a large market.
profit = volume x (subscription price – variable costs [acquisition, support, etc] ) – fixed cost
But wait, you might be thinking, what if I sell to large enterprises, you know, the Global 2000? If I sell to them, I won’t need high volume.
Small software companies play a dangerous game when they pursue large enterprises
At first this seems like a good argument. Once you gain a foothold inside one of these companies, you can expand across the organization. And once established, you can likely remain a supplier for a long time.
But getting a foothold is hard. And expensive. And time-consuming. All of which a small software company cannot afford.
Then once you get inside the enterprise, they are demanding. Your support costs skyrocket and your resources are spread thin.
David Skok tells how one company fell into this trap:
As an example, when I first started working with one of my portfolio companies, they had been approached by one of the top global banks that loved their software and wanted to put it into 2,500 branches. The customer was consuming tons of the company resources, with sales and product people flying everywhere. The problem was the bank needed on-site global support, and there was no way that a tiny startup was in a position to provide that. However because the opportunity was so big, no one was willing to say no to it. It took some outside help to make them realize they couldn’t win the deal, and that they were far better off focusing on the SMB market where their products and ability to service them were ideally suited.
The SMB market is better suited for small software companies
Most business software companies target small to medium-sized businesses (SMB). Within this large category are a number of niches and verticals to pursue.
David Skok continues: “Look for buyers that are feeling extreme pain (where their hair is on fire), and who also have money, a sense of urgency, and a good fit with the features of your current version of your product.”
What else should you look for in SMB markets?
First, explore what you know. Your background in an industry, a functional area of the company, or a profession gives you insight into potential problems that you could fix with your software.
Second, write software for underserved markets. I was at the SalesForce Dreamforce conference last week along with 135,000 other people. Lots of vendors on the floor with similar looking products built on top of the SalesForce platform. I saw lots of white people. Of the ones over forty, lots of men, not too many women.
Can you go in a different direction from other software developers? Are there geographies that are not well-served (South America)? How about markets where women or people who are not white are making the buying decisions?
In summary, the cost structure of SaaS software companies forces you to choose a large market for your software. Most companies look for segments in the SMB market because there are many opportunities and the cost of customer acquisition is lower than with enterprise firms. Look for underserved markets that your fellow software entrepreneurs are ignoring.