Why I Don't Invest in "Outsourced" Startups
There is a particular type of startup that I regularly meet but which I will never invest in. I call it an “outsourced” startup. An outsourced startup is one for which the majority of the core work is — you guessed it — outsourced.
Here are a few examples of outsourcing “core work”:
Hiring a software development agency to build the MVP for a software startup
Hiring freelancers to implement core components of an MVP
Hiring a design / prototyping agency to design and build the MVP for a hardware startup
At first glance, it might seem odd to you that I have such a strong reaction to outsourcing development of some (or all) of an MVP. After all, it’s just an MVP. But as Hunter Walk once wrote, a startup’s culture starts with your first hire. That statement is true even if your first hire isn’t a conventional hire.
The Impact of Outsourcing on IP
When people think about the risks of outsourcing, the first thing that comes to mind is usually IP (intellectual property). In actuality, the impact of outsourcing on a company’s IP is generally low. A typical contract with an outsourcing agency or freelancer will make clear which aspects of the work product belong to the company and which (if any) belong to the contractor. So there should be no surprises.
However, there is an indirect impact that outsourcing has on IP that many founders underestimate: the institutional knowledge that a startup loses out on by not having solved the problem itself.
When you outsource development of something, the project is typically defined in terms of input and output. Rarely, if ever, does the project specification define how that should be done. The company will likely make some suggestions based on their experience and expertise, but the “how” is usually left up to the agency or freelancer. As a result, the startup doesn’t get the benefits of all of the lessons learned along the way while building the project.
And those lessons and their associated learnings can be significant.
To understand how much institutional knowledge comes along the way, just ask Rosie Revere, Engineer
The Impact of Outsourcing on Quality
While some development shops and freelancers operate on an hourly basis, the majority do project-based work (“We will charge you $X to complete Y project.”). As a result, they prioritize efficiency — they try to get each project done as fast and as cheaply as possible. While this might be great for the piggy bank in the short term, it can have long-term negative implications.
Most software engineers make decisions about quality (i.e. whether or not to put significant time and effort into a module or component) based on their knowledge of how important that component is likely to be to future plans. If we know that we’re going to continue to build on a particular module, we typically put more thought into how it is designed and implemented. Outsourced agencies rarely have that level of insight.
Patrick Collison, CEO and cofounder of Stripe, recently spoke about the notion of craftsmanship within the context of software engineering. He noted that,
“People very demonstrably care about aesthetics. And if they're a company, they care about the aesthetic characteristics of the products that they produce.”
We don’t often think about software “aesthetics” (unless we’re talking about user interfaces), but any good software engineer knows that there’s a big difference between “good” code and “bad” code. When reading code, you can immediately tell whether the author put thought and care into what they wrote. Over the long term, this matters.
The Impact of Outsourcing on Velocity
Velocity is the metric that matters most to startups. It’s the biggest advantage that up-and-coming startups have over incumbents and can make the difference between winning a new market and being an “also-ran”.
When used strategically, outsourcing can increase the velocity of a startup — specifically, when well-defined, non-core activities are outsourced. At DataHero, we leveraged outsourced development agencies to build many of the connectors we used to integrate with external APIs. This tedious but necessary work was self-contained, easily-defined and did not represent core company IP. Getting it off of the plates of our highly-paid Silicon Valley software engineers was a perfect use of outsourcing.
But when the use of outsourcing encroaches upon core work, it can have the opposite effect on a startup’s velocity.
With outsourcing, you rarely have complete control over the schedule. Your project can get bumped for higher-priority projects (read: clients with more money than you), team members can get swapped in and out without notice and you have little if any visibility into the agency’s culture. Are the people working on your project motivated and taken care of or is it a revolving door behind-the-scenes?
Over the years, I’ve met many startups who lost months of time (and significant amounts of money) due to missteps with outsourcing. In one recent example, a company that outsourced the development of a hardware MVP had to wait 9 months for the output that they were promised in 3. That’s a lifetime for a startup.
If you don’t have control over your timeline, you simply cannot compete.
The Impact of Outsourcing on Culture
In his interview about craftsmanship, Patrick Collision made the following observation,
“As much as the sociology and "cultural" explanations of defensibility are real, the best people consider themselves crafts people in their domain and they really, above almost all else, want to work with the best other people.”
Combining this comment with his earlier statement leads to two important observations:
The best technical people consider themselves crafts people and care deeply about what they’re building
The best technical people want to work with the best other people
Both of these statements contrast with the reality of outsourcing.
There are many good, competent people who work as freelancers and at outsourcing agencies, but not the best-of-the-best. And if you’re trying to win a global market, that’s what you’re competing against.
Moreover, the best technical people want to build “the thing”. While it might seem perfectly reasonable for a company that is lacking certain skills to outsource short-term development, at some point that work needs to be brought in-house (at least, if it represents core work). And the best people in the world don’t want to be handed someone else’s mediocre thing and be told to fix it.
This is the primary reason why so few companies that are founded by venture studios become anything more than quick acquisitions. That entire business model is based on the premise that the founding team of a product company can be replaced wholesale without any negative impact. I simply do not believe that to be true (which is precisely why I generally don’t invest in companies that are founded in venture studios).
Outsourced Companies Can Still Be Successful
Companies that choose to outsource significant portions of their core work can still be successful. They can develop IP that can subsequently be sold or licensed and they can create very profitable cash flow businesses. But they do not generally lead to large, defensible, globally-competitive outcomes.
As a VC, that’s what I’m looking for. A team that, over the long term, develops the knowledge and knowhow to do things that no other company in the world can do. A team that is deeply passionate about what they’re building. A team that can beat my friends.
And that doesn’t manifest when half the money I invest in you goes to the margin of an outsourced development agency.