Entrepreneurs and Venture Capitalists Outsourcing to Product Development Firms

This post was originally written while waiting at the airport in Delhi, India.

Recently a number of memes have circulated the blogosphere discussing the impending challenges to the traditional venture capital model. I have been living this new reality and actively commenting on it.

Let’s start with a few assumptions:

  • Venture capitalists look to minimize risk in their investments, while maximizing portfolio return
  • Entrepreneurs look to spend as little money out of pocket as possible while maximizing the equity they retain in a new venture
  • Due to low barriers-to-entry for entrepreneurs, the traditional VC model (investing larger sums of money for controlling rights) has taken a backseat in early-stage deals

For non-technical founders who require ‘technical reinforcements’ in order to develop an initial prototype, cash flow can be especially tight as the majority of resources go to the third-party builders. One of the common models used by non-technical or limited resourced founders is to assemble a team based on the best price possible. This usually means trying to get people to work for deferred payments or heavy equity supplements.

In an ideal world founders could find five great ruby/php programmers within their own city and willing to work for 3-6 months at heavily discounted rates. Unfortunately this is hugely unlikely. Thus bootstrapping usually entails forming a geographically dispersed team, and having to compromise on specific expertise. For example, you may use engineers without a true information architect. Outsourcing the work in this manner results in extremely high technology risk (in addition to HR and collaboration issues). Nevertheless, most entrepreneurs go with a hybrid of this scenario, using the least expensive option required to get them ‘something’ that can be put in front of a potential investor.

On the flip side, early-stage investors are most comfortable funding companies where the team is located together, since communication channels are more reliable and an investor can drive across town for lunch with the team. It can be almost impossible to pitch someone on the idea that once funded, a bootstrapped team will all turn full-time and relocate to a common city. Far too many variables. Also the investor worries about the underlying architecture of the product: was it built in the right language? Can it be scaled? Do these developers really know their stuff?

What if there was a better way?

Quietly a new crop of company has emerged: software product development specialists. These firms are different from more traditional software development companies. These new firms use global, outsourced talent, while embracing agile development practices and using centrally located teams, vetted and trained in company-owned offices. Because they have access to global talent, these firms can locate programmers, designers, and architects as talented (if not more talented) than an early stage US company could normally find or afford. Employees speak fluent English and reverse brain drain means many were actually schooled in the US. Another interesting aspect to these software product development firms is their ability to rapidly assemble a team custom to the project, and the ability to scale a team much like Amazon’s S3 model. As you need more expertise, or talent, they can simply add specialists based on need. Most firms are large enough and agile enough to recalibrate resources within 48 hours.

Top venture capital firms have recognized the opportunity for a well-positioned and reputable software product development firm to act as a ‘buffer’ between bootstrapping entrepreneurs and risk-minimizing VCs. These firms can theoretically eliminate technology risk. Some software product development firm, such as GlobalLogic and its new 1.0 program, even plan to offer financier channel partners as well as partners for PR, marketing and other early-stage value-added services. In February, GlobalLogic raised a $30M round from Sequoia.

What else does the future hold? Maybe partnerships? A software product development firm like GlobalLogic could offer a ‘discount’ on services to promising startups they vet, in exchange for equity. An incubator model. Once the prototype is developed, the entrepreneurs could be connected with VC channel partners for a Series A Round. End result: a win-win for all involved.

Of course there are serious considerations to outsourcing product engineering even under these types of less-risky circumstances, but I will save that for another post.

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