The Two Stage Software Rocket Startup

"Let's call this pattern the two-stage software startup. Unlike a two-staged rocket, the first stage is light and runs on little fuel, it's the second stage that has the big burn, if it ignites.

The first stage of the new model software venture builds a useful product as cheaply as possible. Actual engineering is focused ruthlessly on the unique value and differentiating features. In most cases, open standards are exploited to address as large a market as possible using off-the-shelf APIs and libraries. In many cases, the software is written on top of open source platforms, such as LAMP, to keep down development and initial customer costs.

Code is usually written to published interfaces, rather than integrated into the open source itself, to avoid 'contamination' by GPL and other OS licenses. Often, a portion of the development will be sent offshore, particularly if the founders have prior experience or cultural connections with a reliable venue.

Build as little as possible, as fast and cheaply as possible, while demonstrating some unique value. From the classic VC view, many of these efforts will result in a product, or even a feature, rather than a sustainable company...

The second choice after a successful first stage launch is to light the second stage, which will require venture funding. Second stage activities will consume cash in advance of the sales to fund them, as they must occur before imitators arrive. They may include adding functionality to meet customer requests, rebuilding parts of the product for greater efficiency and defensibility, adding the necessary sales force, scalability, and system integration to be able to sell to a higher end market, such as the CXO enterprise level, or carriers.

At the point of making the second stage decision, the technology risks have been greatly reduced, and a portion of market risk eliminated. The company has already been learning from the market, though it will undoubtedly need to relearn some things as it shifts focus.

Entrepreneurs who choose to enter this stage will receive valuations well above what they would have commanded before achieving a first stage takeoff, though perhaps not as much as they might hope: The VC will understand the business still requires significant investment to become sufficiently defensible for an eventual exit, and that the management team which succeeded in the first stage may need to be supplemented for the second phase."

From Due Diligence: New Model Software Startups: Two Stage Ventures.