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February 14, 2005
Myths about software startups are hard to bust since so few financial statistics about private companies are available. Take, for example, the prevailing assumption that a typical software company will achieve profit margins of 15% to 20% three to five years after raising its first round of VC. That's a projection many VCs have heard from entrepreneurs seeking funding. But how many companies actually achieve it? One of the few researchers that has collected data to test such assumptions is Sand Hill Group, which just released a study based on a survey of software company CEOs.
I was introduced to Sand Hill Group about five years ago by Rick Sherlund, the software analyst at Goldman Sachs. He had just come back from Enterprise, an annual software conference that Sand Hill organizes, and he was impressed by the number of heavyweight CEOs in attendance. With little fanfare, the event had become one of the industry's must-attend confabs. That's largely because of M.R. Rangaswami, Sand Hill's founder and a former marketing executive at erstwhile software maker Baan. Over 20 years in the business, Rangaswami has built up quite a network, which he taps for conferences and surveys.
Of the software executives questioned in Sand Hill's latest survey, 86% were from private companies, and 65% worked at companies with less than 100 employees. In other words, a lot of the respondents were from mid-stage, VC-backed software startups. When asked, "What is your company's budgeted net profit for the next 12 months?" the largest group of respondents, or 25% of the total, said less than 1%. The second largest group, or 23% of the total, said 5% to 9%. Clearly, that's far below the amount you'd expect by relying on conventional wisdom. Rangaswami says it may be time for conventional wisdom to change. "If no one is meeting the 10% to 15% profit assumption, why are your companies working with those numbers?" he says.
One reason why margins may be under pressure is the growing popularity of delivering software as a service over the Internet. Traditional software licensing is still the primary selling method for 54% of Sand Hill's respondents. But software-as-a-service and subscription licensing are the chief methods for 21% and 14%, respectively. When companies sell services and subscriptions, they recognize revenue from a sale in chunks over several years rather than in one lump sum. Though that approach creates predictable revenue streams for many years, it can also lower revenues in each quarter, which can cause thinner margins.
Maybe it's time for software startups to develop new ways of measuring success?
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