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On Startups: Patterns and Practices of Contemporary Software Entrepreneurs On Startups: Patterns and Practices Of Contemporary Software Entrepreneurs By Dharmesh Shah B.S. Computer Science, University of Alabama Birmingham Submitted to the Alfred P. Sloan School of Management in Partial Fulfillment of the Requirements for the degree of Master of Science MASSACHUSETS.N OF TECHNOLOGY In Management of Technology AUG 3 12006 at the Massachusetts Institute of Technology LIBRARIES June 2006 C 2006, Dharmesh Shah, All rights reserved. ARARCHIVES The author hereby grants to MIT permission to reproduce and to distribute publicly copies of this thesis document in whole or in part. Signature of Author: Alfred P. Sloan School of Management May 16, 2006 Certified by: Professor Michael A. Cusumano The~i Advisoi Certified by: Professor Edward B. Roberts Thesis Advisor Accepted by: "Stephen J. Sacca Director, MIT Sloan Fellows Program in nnovation and Global Leadership -1- On Startups: Patterns and Practices Of Contemporary Software Entrepreneurs By Dharmesh Shah Submitted to the Alfred P. Sloan School of Management on May 12, 2006 in partial fulfillment of the requirements for the Degree of Master of Science in Management of Technology Abstract "When you write a book, you need to have more than an interestingstory. You need to have a desire to tell the story. You need to be personally invested in some way. You need to care about it. " Malcolm Gladwell Author, "The Tipping Point" "I have never thought of writingfor reputationand honor. What I have in my heart must come out, that is the reason why I compose. " Ludwig van Beethoven The above quotes answer the basic question that many people have asked me (and I have asked myself): Why are you writing a thesis? The answer is simple: I believe there's a story to be told, and I have a personal passion for the subject. This thesis will analyze the patterns and practices of contemporary software startups. Though much has been written about software companies and much has been written on startups, I'm primarily interested in the intersection: software startups. More specifically, I will explore contemporary software startups that were started after the Internet bubble burst. About The Website: onstartups.com As part of the thesis writing experience, I started a blog called "OnStartups" (http://onstartups.com) where I have been posting articles on software startups. More information on the onstartups.com site is included at the end of the thesis. -2- My passion for learning more about software startups, the opportunity to work with two exceptional individuals as co-advisors and the overwhelming response to my onstartups.com website are my primary motivations for this thesis. Onward! Thesis Advisor: Michael A. Cusumano Title: Professor of Management Thesis Advisor: Edward B. Roberts Title: Professor of the Management Of Technology Chair, MIT Entrepreneurship Center -3- Acknowledgements First, and foremost, I want to thank my wife, soul-mate and soon to be world-wide traveling partner, Kirsten Waerstad. Her staunch support while I toiled away in "my cave" made this thesis possible. Without her love and understanding I could not have pulled it off. I'm sure she'll be glad to have her husband back. I would also like to thank my co-advisors, Professor Michael Cusumano and Professor Ed Roberts. I could not have hoped for a better pair of individuals with whom to work with on this project. MIT is a great place to learn about (and start) software companies and they know more about software and new ventures than anyone. Their accomplishments continue to inspire me and I hope someday that I will succeed in such a way that they will be able to say: "We knew him when he was just a stressed-out graduate student of ours..." I'd like to thank the MIT Sloan community and the MIT Sloan Fellows Program. It has been a great two years and I am forever indebted to the faculty, staff and my fellow classmates that made these years at MIT transformative along so many dimensions. The following individuals all agreed to be interviewed as part of my research: Ray Deck, Don Dodge, Jason Fried, Brian Halligan, Doug Levine, Michael McDerment, Barry Moltz, and Bob Walsh. I recognize how busy you all are, thanks for taking the time. Last, but not least, I would also like to thank the thousands of software entrepreneurs around the world that read my OnStartups.com articles. They have provided moral support, encouragement and unique insight regarding the fascinating topic of software startups. Knowing that in some small way I am now connected to all of them has made the thesis work that much more meaningful. -4- Table of Contents CHAPTER 1: INTRODUCTION ........................................................ 7 SOFTWARE INDUSTRY OVERVIEW ........................................................................... 7 PERSONAL EXPERIENCE .......................................................................................... 9 DOCUMENT STRUCTURE ........................................................................................ 9 CHAPTER 2: ON THE ENTREPRENEURIAL LEAP ...................... 11 SOFTWARE VS. OTHER TYPES OF STARTUPS ............................................................... 11 M OTIVATION FOR STARTING................................................................................. 12 THE BIG IDEA OR THE BIG ESCAPE ....................................................................... 14 UNDERSTANDING STARTUP RISKS .......................................................... 14 ENTREPRENEUR'S ADVICE: GET GOING! .............. .............. ............ ...... .... 15 CHAPTER 3: ON FINANCING AND CAPITALIZATION................. 17 VENTURE CAPITAL FINANCING............................................................................. 17 ANGEL FUNDING.................................................................................................. 21 BOOTSTRAPPING ........................................................................ 22 CAPITAL EFFICIENCY IN SOFTWARE STARTUPS ....................................... .......... 27 WRAP-UP ................................................. 30 CHAPTER 4: ON MARKET POSITIONING AND STRATEGY.......31 ENTERPRISE SOFTWARE MARKETS ..................................... .................... 31 CONSUMER AND SMALL BUSINESS SOFTWARE MARKETS ..................................... 33 HORIZONTAL VS. VERTICAL MARKETS ......................................... ............. 34 MARKET BLENDING: INDIVIDUAL VS. BUSINESS CUSTOMERS............................. 35 W RAP-U P.................... ............................................................................................... 36 CHAPTER 5: ON PRODUCT DEVELOPMENT.................37 CAUSES FOR PRODUCT DEVELOPMENT FAILURES ........................................ ....... 37 DEVELOPMENT METHODS ................................................................ 38 H IRING THE BEST D EVELOPERS .............................................................................. .... 41 OUTSOURCING SOFTWARE DEVELOPMENT ......................................... ............. 44 OPEN SOURCE SOFTWARE..................................................................................... 46 W RAP-U P.............. ......................................................................................... 49 CHAPTER 6: ON ACQUIRING CUSTOMERS................. 51 ONLINE SOFTWARE DELIVERY............................................................................. 52 ONLINE MARKETING................................................................. 52 A NEW TYPE OF SHAREWARE: FREEMIUM MARKETING ..................................... 53 SEARCH ENGINE OPTIMIZATION ........................................................... 54 BUSINESS BLOGGING .................................................................... 56 W RAP-U P ............. ......................................................................................... 58 CHAPTER 7: ON SOFTWARE BUSINESS MODELS ..................... 59 -5- TRADITIONAL SOFTWARE LICENSING ........................................ ............ 59 SOFTWARE As A SERVICE ................................................................ 61 PRODUCT PRICING ...................................................................................................... 64 SUBSCRIPTION PRICING.................................................................65 ADVERTISING REVENUE................................................................ 67 W EB 2.0 BUSINESS M ODELS ................................................................ ......................... 69 WEB 3.0 (WEB 2.0 FOR THE ENTERPRISE) ................................................... 71 WRAP-UP COMMENTS ...................................................................... 72 CHAPTER 8: ON STARTUPS AND THEIR STRATEGIES............ 73 37SIGNALS - SIMPLIFYING TO SUCCEED ........................................................................ 73 ELEMENT55: PLANNING FOR CHANGE .......................................................................... 78 2NDSITE: THE MYTH OF THE MARKETING "SILVER BULLET".............................. 80 BRIAN HALLIGAN: ON SOFTWARE SALES ..................................................................... 84 DON DOGE: ON MICROSOFT AND SOFTWARE STARTUPS .......................................... 86 BOB WALSH: WRITING SOFTWARE TO WRITING BOOKS..................................... 89 ONSTARTUPS.COM: A COMMUNITY FOR SOFTWARE ENTREPRENEURS .............. 91 ONSTARTUPS.COM: THE STARTUP SURVEY .......................................
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