Debt, Equity and a Third (and Fourth) Thing that Might Work Better

This morning Seth Godin published a post titled Debt, equity and a third thing that might work better. The third option he covers is pre-selling future income by offering someone $x of every widget you sell forever (it may be a sliding scale that decreases after x units are sold).

I was surprised by this, as I thought Seth was going to discuss another option I’ve seen used with great success: customer financing. That’s when you find one or more (future) customers that help fund your product development in exchange for input into the process and free or highly discounted use of the software.

This situation is so unbelievably advantageous to a startup it’s like strapping rockets to your running shoes. Not only are you getting financing with little risk, but with customer financing you have someone in the industry with a vested interest in your product succeeding.

This customer is going to give you feedback out the wazoo – which is something that’s really hard to get from most users. You’ll be able to improve your product to the point where a real company is using it before you launch.

Money and feedback from a real customer? These are two of the most valuable assets a startup can have.

The Details
It seems like it would be impossible to find someone to even partially fund development of an application. After all, who’s going to pony up a huge chunk of up-front cash to build an app they don’t own?

Here’s the deal: I work in the bootstrapped startup world and in this arena you don’t need $500k to build a product. Think 1-3 person teams who release v1.0 in 4-6 months (mostly SaaS startups and MicroISVs).

In this scenario, $5k or $10k goes a long way towards bringing a product to fruition. $10k can pay for a senior offshore developer ($15/hour) full-time for 4 months. Or all of your logo design, application and sales site design, HTML and CSS…and you’ll have several thousand left over for an epic launch party the day you go live. Do you know how many shots of tequila you can buy for $1,000?

I’ve personally had multiple offers of $10k to fund applications in this manner. The only reason I didn’t fire up my IDE and start writing code was because I wasn’t able to nail down the specifics of the market and how I would market them. As I’ve said before – market and marketing come before everything else.

At DotNetInvoice we’re in the process of talking with two companies who are willing to fund specialized version of DotNetInvoice for their niches. They will receive the exact functionality they are looking for at a reduced rate, and we will own everything and be able to re-sell it into their niche. It’s a win-win.

The benefits to the customer in this case are many: for a tiny investment they get an app built where they have a huge amount of input, that will (presumably) be a commercial-grade piece of software and will be supported and expanded if the product is successful for years to come.

The majority of an application’s expense is in maintenance, so if a business can drop an initial deposit and never worry about construction costs and all that nasty maintenance stuff it’s an appealing scenario.

Why Don’t More Startups Do This?
Customer financing is not popular with startups because it’s hard. It requires selling, and selling is scary.

Most startups would rather live in a world where they don’t have to talk to actual people, definitely not customers, than to find out early on that their idea isn’t going to fly (or that they will have to make drastic changes to make it fly). That dream-world is called “pre-launch” and it’s fun to visit, but if you become a permanent resident you’re doomed.

The other reason it’s not popular is that many of startups don’t have “real” customers, they have imaginary ones. They don’t fix a pain point, they don’t fulfill an existing need, they just have an idea that may be the next Facebook but very, very likely will not. In that case you can’t really do customer financing.

(In that case you can’t even charge money for your service. But who needs revenue?)

The Drawbacks
Of course, there are drawbacks to customer financing.

For one this single customer may think they have more control over your product’s direction than you’d like to give them. They may want features that support a proprietary process that no one else in the industry performs. It’s up to you to either negotiate with them, or build the feature.

In this way, customer financing is more like consulting, which is not what you’re looking to do if you’re getting into products. But this drawback goes away pretty quickly. Once you have a viable product and some revenue, you’re in control. You won’t have to completely cater to this customer forever, and by doing this you’ll be harnessing the #1 advantage of products over consulting: leverage.

Another drawback is that you need to have all your legal ducks in a row. When selling into an industry you won’t want one of the industry players owning part of your company (companies will not want their competition to be able to look at their data) so you need to retain all rights to the app and the business, and you need to get this in writing.

Lastly, it’s a hard approach up-front. Selling is hard and most people (especially developers) don’t want to do it.

But the benefits are big: this approach will increase your chance of creating a real, usable product by at least 100%.

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1 comment so far ↓

#1 Andy Wright on 11.18.09 at 5:15 pm

Thanks for a great post Rob!

This is a model that would be very effective, reduce the risks and result in better products, I think more startups should give this a try.

If you can’t get cash try getting an LOI to get customer feedback on a minimum viable product – http://www.startuplessonslearned.com/2009/10/case-study-using-loi-to-get-customer.html