Startups and Outsourcing: Should I Outsource My Development?
By Armando Viteri, Neubloc, CEO
Although rare a few years ago, there is trend to set up "virtual design and engineering departments" (VDED) during the seed stage of a startup company. The economics driving this worldwide trend have become compelling post the "bubble period" of the late 90's. As exit opportunities and valuations have declined from almost a decade ago, the requirement for founders and early stage investors to preserve as much equity as possible in their startup has increased. The ratios are fairly simple: to get the same economic benefit, a founder needs to own five-times more in a company to offset a five-times decline in the valuation. It has become all too common for founders to wind up with very little ownership because they took in too much angel or venture capital money too early. Even if the company's board awards more options to the founders, the founders are stuck with a new and long vesting period plus a requirement to meet the options price to exercise the additional shares.
This simple equation has made founders carefully aware of taking too much money too early -- so as to avoid dilution of their ownership before creating market value. In most cases startups tend to spend their investment dollars getting their initial product or service going. Just a few years ago, these companies perceived product development outsourcing as impractical you needed to keep the "know-how" in-house and the specs just changed too frequently early on. Sophisticated approaches to protect IP and manage offsite development have reversed this perception. As such, much of the investment community has come to view VDEDs as an opportunity -- not a liability. While entrepreneurs can maximize what they get for the equity they give up, investors get more for their invested dollar, which creates greater exit opportunity and flexibility.
Outsourcing product development does not come easily for a startup. Many large American technology companies routinely set up outsource development operations in remote locations because they have the advantage of time, scale, resources and brand recognition to attract and maintain good engineering talent. They hire employees on their own campuses - a substantial advantage over outsourcing. In cases where large companies work with third-party outsource firms, their scale is attractive to the outsource firm. Startups have a very difficult time getting attention from offshore firms with a just handful of engineers. Many offshore firms require hiring teams in the tens if not hundreds of people - not a realistic proposition for a seed stage startup developing its first prototype product.
Even without size or leverage, outsourced product development is the only realistic option for early stage technology companies. With proper partner selection and good management, outsourcing is often the best way a founding team (and their investors) can realize a positive exit for their companies.
Here are the most important areas to evaluate before creating and managing these development teams:
1. What should I outsource?
Outsourcing opportunities have evolved over the past few years. American technology firms tended to assume that all good engineers must be American -- as a result of this logic only non-core products were outsourced. The deciding factor was whether a product was simply an enabler versus a core technology. Another common practice was to outsource products that were fully specified. Underlying this assumption was the idea that creative or independent thinking could not happen far from the "mother ship." Prevailing wisdom discouraged outsourcing products early in their development cycles or if the product was highly innovative. Frequent product changes necessitated close proximity between developers and the management team.
Today startup firms regularly outsource their initial -- and often innovative -- product. Despite the fact that such products lack detailed specifications, or are constantly in flux, many such startup firms are successfully outsourcing their product development.
For example, Neubloc was integral in initially setting up and managing Proximetry's engineering team. Proximetry was a seed stage startup with an ambitious plan to develop millions of line of code for an innovative wireless industry product. Neubloc sourced both the management and the development team in Poland. The team recruited was top notch as well as highly stable. Although the specifications changed regularly the right communications structure was put in place to make sure that the team was responsive and flexible to change. Proximetry was able to deliver its product to the market on time and for a third of the cost. In the first three years of development, Proximetry experienced zero (!!) attrition.
Key to this success was its hybrid development approach - there must be an onshore presence to the outsource supplier. The portion of product development that is developed onshore is the design -- translating market requirements into a set of behaviors/functionality, form factor, and look-and-feel. Neubloc also designates a team lead to spend extensive time (typically 4-8 weeks) onsite to learn the requirements, design and client team stakeholders before returning to his home country. Once back he can lead a larger engineering team through the development process. For larger teams there can be a designated team lead that stays onsite indefinitely - although this option is cost prohibitive for most seed stage startups.
2. How do I select a vendor?
There are two client engagement models employed by outsource development firms: project management and staff augmentation. Staff augmentation typically provides labor at the lowest cost possible to 'augment' an existing engineering team. Project and team management is provided by the product company rather than the outsource firm. This can be quite difficult due to communication as well as cultural and logistical hiccups (unless the US engineering manager really enjoys getting up in the middle of the night). In addition, evolving specifications tend to cause discontinuity in communication. Using a staff augmentation model also makes it very difficult to measure achievements or productivity of the offshore team members.
The other outsource model is project management. A dedicated design and development team onshore and offshore is used with complete responsibility for the product or project. There is a single point of contact (the technical team lead) offshore. Given this person has spent extensive time onshore with the client's management team there is already an established method of communication. Any changes or modifications to the product get funneled through this single point of contact. It is up to the technical team lead to make sure that the engineering team responds to product specification changes. This model enables measurable team productivity and project achievement.
If the product is fully specified, either the staff augmentation or the project management model can work. However, most startups are better off using the project management model as the project output IS the core product.
It is also critical to understand the outsource firm's principal focus. Many offshore organizations are set up to supply a minimum 50 or more engineers - a tough requirement for most startups. Even if these firms accept smaller engagements, they are simply not set up for the needs of an earlier stage company. By contrast, there are software outsourcing firms that specifically incubate startups with the assumption to grow the development team over time. They are organized to handle this type of engagement from seed through growth stages.
3. Where should I base my development?
Although the majority of US companies have outsourced to firms in India, there has been a backlash:
- High attrition in India is a significant drag on productivity - While attrition can be kept to a minimum short-term, it is very difficult to mask the problem of attrition over the long-term. Industry average for attrition in Indian software development firms averages 50% per year (that statistic from Computer Business Review two years ago - the problem has gotten worse since then). Historically the larger US firms establishing an Indian presence were immune to this attrition. Even this has changed for companies like Cisco. Smaller firms are currently experiencing attrition of 100%+ per year according to some sources.
- Exposing your source code - Some Indian firms have had a history of IP theft. When this has happens there is little or no recourse for the American company. Although there is a movement to correct this, the Indian court system has historically favored the Indian company no matter how serious the infraction.
- The quality of the work - According to Zinnov (a well respected analyst firm specializing in offshoring) "more than 75 percent of these global IT initiatives fall short of expectations." Some have focused on attrition as the primary problem while others contend that cultural differences cause communication shortfalls. Regardless of reason the result is the same.
Today Eastern Europe represents a more attractive place to base software development - especially countries within the European Union. A high level of education, an innovative spirit, low attrition, and EU IP law makes it the right combination -especially when factoring that the cost differential has largely disappeared over the past few years.
Summary
Hybrid development combining the best of onshore design with low cost offshore development offers a compelling solution for startup companies today. The lower development cost, high quality result and labor flexibility allows the entrepreneur and early stage investors to retain equity while still delivering a world-class product.
For more information please contact:
Armando Viteri
CEO and President
Neubloc
Email: aviteri@neubloc.com
Phone: (480) 797-2970
