Different Ways to Pay for Product Development
There are a lot more ways to pay for product development than you may realize – including not paying for it at all – see below. Which is right for you will depend on your exact circumstances. You may wish to review the following before starting off on your next product development project:
1. Employees: Most of us are familiar with this method – hire the engineers and technicians that you need to do the work and pay them a salary. This works very well for large companies that can attract top talent and have the scale to afford large specialized teams of experts along with the leadership and management infrastructure necessary to keep everything running effectively. Smaller companies almost never benefit from this model as they struggle to attract talent, have difficulty keeping everyone busy and struggle with low productivity with less specialized/smaller teams. Startups will eventually be big companies, but in the meantime, they do not have the time necessary to build an in house team and may pivot away from the acquired talents specialization.
2. Freelancers: Freelancers can be an effective way to manage the gaps in your technical team. They almost always work on an hourly rate that is often less than the total cost of an employee and many of them are experts in their niche. Mid-size companies use them effectively to augment areas of specialization that do not warrant hiring a full-time person – especially if these companies have effective management structures in place that allows the freelancers to focus on the technical challenges. Small companies often make the mistake of using these specialists as system designers and suffer from the “if you’re a hammer, everything looks like a nail” syndrome. Without management and processes in place, it is hard to utilize this category effectively. Startups, if they come from a strong product development management background, can often use freelancers with good effect. When most of what you are doing is MVPs (Minimally Viable Products) that will never go into production, infrastructure is less important.
3. Outsourced PDC: These companies (including Finish Line PDS) provide complete product development teams – with management, processes, reference designs, etc. They work best with small companies (<$100M in annual revenue) that cannot afford, or do not need, a permanent team – their product cycles are measured in years, not months. Startups are also a good fit as the time to market and cash flow are positively enhanced as compared to trying to start from scratch and build your own team. They do not work well for large companies with existing teams and their own effective processes unless the company suspects the specific project is significantly disruptive of the status quo. Large groups can suffer from NIH (Not Invented Here) syndrome and often have a vested investment in the current technology to the point of dismissing the “next thing” – this is why Walmart, with its very large investment in physical stores, will be put out of business by Amazon who was free from the physical stores to innovate online retailing. There are three different ways to pay a PDC:
a. Fixed Price: Requirements are agreed to and the PDC provides a fixed bid for these requirements. Most PDC will not do fixed priced bidding because of the destructive dynamics set up by this type of contract – once the contract is signed, the PDC must keep within the budget at all costs, and the client wants as much as he can talk the PDC into. The focus becomes less about the potential ROI and more about who will be burdened with what cost and how to justify such action. The result is more energy spent on negotiation and less on product enhancement. In theory, this method works great, in practice, it destroys the relationship. There can be an exception if the project is broken into very small steps and each step is taken one at a time.
b. per Hour: This is the most common method when working with a PDC. A good faith estimate is given for each phase of the project, the PDC keeps good records of each engineer’s time, and each engineer is billed at a rate commensurate with their skill level.
c. Equity: Some PDCs will exchange equity for work done. This can be a very effective method for a startup that is pre-series A and needs an MVP in order to complete a series A round. Typically, this takes the form of a note with interest and unpriced warrants to compensate for the risk.
4. Design & Build: This method is starting to gain popularity – especially with smaller companies. Instead of paying for development, you simply buy the product you need – the design is built into the purchase price. This can be a win-win in many cases as the client simplifies their purchasing decision and the product development team simplifies “management of the customer”. The PDC will own the IP, subject to certain warrants and performance clauses, but this ownership also creates an incentive to create a product that outsells anything else on the market. I personally predict that the world will largely move toward this model exclusively.
5. Combination: Of course, any combination of these methods can be used. In fact, it is rare for us to see any one of these methods used exclusively on any one project. For small companies, they typically have a few engineers in house to focus on the core technologies, use a few freelancers now and then to fill in gaps, and use a PDC to roll everything into a controlled Master Book with the proper controls and documentation necessary for effective manufacturing and sustaining.
Feel free to contact us if you would like to discuss how these different payment options may fit within your own situation.