One of the key concepts at the core of traditional marketing is the 80-20 rule — that some 80 percent of the effects (or in this case, profits) are the result of 20 percent of the causes (here, customers). Indeed, if you’re able to target just a small group of people in order to successfully yield most of your profits, there are all sorts of benefits — it’s easier to reach a small group, it’s easier to build them the right product, and so on. Most large technology sales and marketing organizations have taken the 80-20 rule to heart and focus on some small fraction of the tens of millions of businesses on the globe, often targeting just the Global 2000.
While the 80-20 rule can be very powerful, the reality is that many of the costs associated with building, supporting, distributing and selling technology products have dropped dramatically in the past decade. Yet many enterprise technology executives are operating as though the cost of distribution hasn’t changed since the early 1990s. In the coming years, I expect startups to increasingly target the massively underserved small- and medium-sized business (SMB) segment by taking advantage of the arbitrage between actual and assumed costs of sales. Self-service sales models will be a key element of these startups that will forever change the face of the enterprise technology business.
U.S. Business Statistics | The Economics of Sales
A quick look at Census Bureau statistics on business size reveals some startling information:
- Of the 25 million U.S. businesses, only 5.9 million employ one or more people.
- Of the 5.9 million employer firms, only 17,047 have 500 or more employees, yet those firms account for 49 percent of U.S. employment and 61 percent of revenue. That translates into well under 1 percent of U.S. firms accounting for 61 percent of revenue
- Of the 17,047 firms with more than 500 employees, the 890 with 10,000 or more employees account for 26 percent of U.S. employment and 37 percent of revenue.
Let’s say you’re an enterprise software company and that your economic model requires each sales professional to earn $2 million-$3 million in revenue a year to cover the costs of your operation, including the cost of the sales themselves (salaries, commissions, travel and entertainment, sales support and operations, etc.). Each one of these representatives can only do so many deals every quarter, so the revenue per deal must be fairly high — let’s say that the average deal size per customer, per year, must be around $100,000. And that’s just your part of the solution. There are likely other software, hardware and consulting costs associated with the complete solution.
If we assume that the average pre-tax margin of a small business is 10 percent and we take revenue for the 98 percent of U.S. firms with 99 or fewer employees, divide their aggregate revenue by the number of firms to get average revenue per firm and then take 10 percent of that number to derive pre-tax profit per firm, we get $103,962. In other words, the direct sales model would require taking roughly 100 percent of pre-tax profit from firms with fewer than 99 people for just your component of the solution. These are back-of-the-envelope assumptions and are for illustrative purposes only — the point is that direct sales organizations cannot serve the vast majority of businesses on the planet.
Currently the most effective way to reach the SMB segment is via bundling, for example to have your software or hardware bundled (that is, OEM agreements) with some big-ticket item like a server; that vendor then distributes the combined product through a single or two-tier distribution channel. A very small number of products have the import to be sold through the channel on a standalone basis (such as backup hardware and software). If you compare what the large enterprise has in terms of technology vs. the small business, there is a massive gap. Most small businesses hack together solutions for many of their problems with Microsoft Excel, pen and paper, or nothing at all.
Enter the Web
In Figure 1, I’ve depicted the universe of potential customers in the U.S., from the roughly 300 million consumers at the base of the pyramid to the 17,000 largest enterprises at the top. Large enterprise IT companies have been created by primarily selling to the largest customers. And large consumer web companies have been created by targeting a large percentage of the total population. Far fewer businesses have been created, at least in high technology, by serving the small- and medium-size business segment as they were hard to reach. But that’s all changing rapidly.
Figure 1: The Customer Segment Pyramid
In a web-based software firm, there isn’t a significant marginal cost of research and development (R&D). Cost of goods sold are often very small (especially in software), and CAPEX on a unit amortized basis is trivial. The biggest marginal expenditure is cost of sales. If a company can figure out how to simplify sales delivery and service by leveraging a self-service model, it can reach a large market segment hungry for better products and services.
Using techniques perfected by consumer web companies, a generation of enterprise IT companies will emerge that deliver a vastly superior user experience to IT professionals and employees alike. Improvements in ease of use will liberate employs from terrible software, server-side software development will increase the pace of product improvements and lower support costs, and the self-service model will change the economics of enterprise IT sales forever. Google’s (s goog) success is as much about AdWords offering advertising services to the SMB segment as it is about serving consumers search services.
The dominant player in the SMB segment of the IT market today is Microsoft (s msft), as it’s been able to drive significant sales by riding Windows OEM agreements. If I were Microsoft, I would be more concerned about software-as-a-service solutions eroding my market share in the SMB segment than the threat of consumer web search, but I digress…
While the marginal cost of direct sales is very significant, the marginal cost of self-service looks more like the marginal cost of R&D — that is, very small. With a low marginal cost of sales, the 99 percent of firms that are poorly served today will be served much better in the coming years. And over time, these solutions will likely work their way up the pyramid to penetrate the small group of very large firms that are currently being served by direct sales professionals. If you’re looking for opportunities to disrupt enterprise technology businesses, you would be well-served to start with the sales model.