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Should You Do Contract Development Before a Startup? A Common Question and My Answer

Originally published Translated

This article was machine-translated from Japanese by AI (Claude). It may contain errors. Read the original Japanese article.

Over the past year or two, I have received a great many questions from students and young people along these lines: "I want to start a fast-growing startup someday, but I can't decide whether to start with the startup from the beginning or to start with contract software development first."

Recently I get this question about twice a week, and since I have found myself giving similar answers again and again, I am putting them down in a blog post.

My Answer to "Should I Start with a Startup or with Contract Software Development?"

My answer to "Should I start with a startup or with contract software development?" depends on the case, but the answer I personally give most often is this: "If you are aiming for a high-growth startup, wouldn't it be better to build a product on the side from the beginning, or to start a high-growth startup directly, rather than going through a business founded on contract software development?"

That said, this answer comes with various premises and conditions.

If you want to found a company doing contract software development, then you should go ahead and do it, and if you want to earn a certain amount of money, contract software development is one option. I do not mean to oppose that decision itself.

However, once the words "I want to do a high-growth startup someday" enter the ultimate goal, the premises change a little, and I often feel that putting contract work in between does not fit that goal. That is why I am writing this article.

I will explain below why I think it does not fit the goal.

The Purposes of Adding a Contract Software Development Step

When someone who aims to do a startup comes to me saying that they should start with contract software development (hereafter, contract development), I basically ask them why. The following seven reasons come up often.

  1. For exploration
  2. For the company's cash
  3. For personal assets
  4. For product development
  5. For skill development
  6. For a track record
  7. For market entry

At first glance, these reasons sometimes sound plausible. But in each case there is also a slight mismatch between the goal and the means, or they sound like a detour. As a result, my answer often ends up being "then wouldn't it be better to do the startup directly?"

My response to each reason, and the reasoning behind it, is as follows.

(1) Contract Development for Exploration

I sometimes hear, "I am thinking of starting with contract work in order to explore ideas and market needs."

The reason sounds correct, but if that is the goal, I think it is worth considering whether other means could substitute for it.

For example, you can grasp to a certain extent what needs exist through alternatives such as customer interviews. And if you want to acquire industry knowledge, working inside the industry will probably give you better insight than being involved from the outside, as in contract development. As for ideas in general, consulting other entrepreneurs is also an option.

If you have concluded that contract development is the most efficient way to explore ideas and needs and have chosen it for that reason, that is fine, but other means are often more cost-effective. Contract development is an exploration method that takes a great deal of effort, so if exploration is the purpose, I think you should actively consider other means as well. If you do go ahead, I recommend at least deciding which market you will compete in and pinning down to some extent which technology you will use before you explore.

Also, it is worth being careful that the needs you can learn from contract development itself reflect the "needs of an individual company" and "needs of today", and for contract development such as a PoC, they are often "vague needs" as well. These differ somewhat from the needs you need in order to build a product.

When aiming for a high-growth startup, you need to find "needs shared across multiple companies" in "the market several years from now." Among these, "burning needs" become important in the near term. Can contract work find these? Sometimes it certainly can, but the connection is not necessarily a straight line.

Moreover, to people aiming at a product-type high-growth startup, I do not particularly recommend taking on R&D-type PoC projects. In particular, PoC projects from the R&D teams or new-business divisions of large companies often turn out to be "fake traction." Many of the people involved are working earnestly, but the needs of research labs and new-business divisions often diverge from the real needs on the business side that a startup wants to find. Unless you work on real projects that the business unit wants, it will be hard to gain the insight needed to build the final product.

As an exception, if you can meet "cutting-edge customers with cutting-edge problems," it may be a chance to learn the needs that many companies will have several years from now, and to learn the means of solving them ahead of others. It is like how Facebook's internal task management tool became Asana. And if you have a "customer trying to accomplish something big," following along may let you reap the benefits as a third party. But you need to choose such customers deliberately. Also, getting such projects requires a fair amount of luck, and I think you would do better to explore through interviews and the like, which you can manage through your own effort, than to leave it to chance.

(2) Starting with Contract Development for the Company's Cash

Some people do contract development in order to build a reasonably stable cash flow for the company. That is also one option.

However, you should understand in advance that if you create a product development team after the contract development team is up and running, you end up with two organizations with different goals, and organizational management becomes difficult. For example, it is often heard that the contract development team, which generates cash, and the product development team, which burns cash, come to get along poorly. In addition, the mindset and skills needed for contract development differ somewhat from those needed for product development, so you need to be aware that reassigning people is surprisingly hard. It is better to proceed with these organizational management risks in mind.

Some companies do not build a product "after" building a revenue-generating business, but run the revenue-generating business and product development "in parallel." A common pattern is "the company earns money through the president's contract development or consulting, while someone else works on the product in parallel." This is fine if there is something you want to achieve badly enough to take on that kind of president's role, but it looks somewhat unstable from the viewpoint of motivation and the president's own skill development.

Caution is also needed when you expect to bring in outside investors such as VCs in the future. VCs often want to bet on rapid growth of a product, so the existence of a contract business can actually look like a risk. In some cases, you may be advised to spin it off into a separate company so that you can concentrate on product development.

Note that if your strategy is to keep managing funds with your own capital or borrowing and gradually grow the company over time, building a business that earns cash in the near term is a good move. That is also one wonderful way for a business to be, and I think most businesses are better suited to it.

However, if you are considering raising equity funding for the same company over the medium to long term, I think you should concentrate on product development from the beginning. In particular, unlike about ten years ago, the supply of risk money at the seed stage has increased, so I think starting directly as a startup has become an easier option to take.

(3) Starting with Contract Development for Personal Assets

I also hear about people who want to build a contract development company and sell it (exit) in order to build personal assets, and then take on a big challenge with a second venture. I fully understand the logic that having a personal safety net lets you take on big challenges, and the wish to do so, so considering this path is one approach.

However, I feel there are some misconceptions about the personal assets you could expect from selling a contract development company, the amount needed for the next challenge, the time it takes to reach the exit, and the time after it.

Contract software development companies seem to be sold, when they are reasonably profitable, at a valuation roughly equal to their revenue. Even if you sell a contract company that achieved 100 million yen in revenue, the personal assets you obtain are about 100 million yen.

On the other hand, building a high-growth startup usually requires billions of yen in funding (often tens of billions). If you had 100 million yen in personal assets, you might be able to cover about the seed investment with your own money alone, but in any case you will need outside funding from Series A onward.

Moreover, building a contract development company with revenue on the scale of several hundred million yen is not easy in the first place, and M&A does not happen easily either. The timing also depends heavily on the buyer. And acquirers of contract development companies are often seeking to acquire talent rather than assets. Considering that, key people will face a considerable lock-up period after the M&A.

Considering all this, if things go well you may get a moderate amount of funds, but the expected value is not very high, and in terms of time, the time it takes for the company to grow, the uncertainty of the buyer, and the time after the sale are longer than you think. Considering the years you would spend, I often answer that it would be better to raise money from VCs and the like, accepting some dilution, in order to buy that time, gain experience, and grow.

(4) Starting with Contract Development for Product Development

Doing contract development as part of product development also sounds plausible, but in many cases the features requested in contract development differ from the features the product needs. So unless you take on contract projects with considerable deliberateness, it is hard to build features that can be put to use in the product you want to make.

It is also often heard that when you do contract development, how you spend your time inevitably tilts toward the contract side, and you can hardly spend any time on your own product development. Contract development is not that hands-off. I often hear the worry that when you have to keep acting as the PM yourself, you cannot set aside time for product development.

Many people say, "No, we're different. We can do it well," but they seem to end up with the same outcome (like the textbook-writing project introduced in Thinking, Fast and Slow).

That said, there are companies that do it well strategically. They are skilled people who take on contract projects that advance their own product development, or who steer customers so that projects turn out that way. If you can see the final product clearly and create a situation where product development and contract development are aligned, it is a very good option.

(5) Starting with Contract Development for Skill Development and Personal Growth

I also hear about people who start with contract development in order to gain business experience, grow, and take on a big challenge with their next venture.

You can certainly gain business experience, but please be careful: the management ability you acquire through contract software development is, after all, management ability for contract software development.

The muscles built by contract development and those built by product development are somewhat different. To borrow someone else's words, "contract development and product development are the same in the sense that both are sports, but they are as different as baseball and swimming."

More specifically, contract development mainly consists of "listening to a specific customer," translating that into technical language, and developing accordingly. Product development, on the other hand, means "listening to the market, building a product based on your own hypothesis, and putting it to the market and selling it." Both involve developing software, but the business-side activities differ in many ways.

If you start a company and the organization grows reasonably large, you will build the ability to "manage a large organization," but organizational management for a business that has a product is somewhat different from organizational management for contract work.

Rather, in terms of how you use funds and how you take risks, there will probably be occasions when you need to unlearn the way of thinking you cultivated in contract development.

People adapt to their environment, so once you stand on the side that takes contract development work, the more capable you are, the more you optimize for that position. In addition, your network of fellow executives will increasingly consist of people in the same line of business, so skill development suited to where you have placed yourself accelerates. Many people have probably seen a friend who joined a certain large company get steeped in that company's culture and optimized to that company's way of doing things (for better and for worse), and the same happens when you start a company.

So if you add a skill-development step, I think in many cases you should think carefully about whether that experience will truly lead to your next challenge, and if you want to develop skills in order to do a startup, I think it would be better to choose the startup path from the beginning.

(6) Starting with Contract Development for Your Track Record

Some people seem to want to build a track record in which, after going through contract development and selling the company, they become a serial entrepreneur and can raise large funding. But I think there is a misconception here as well.

The senior serial entrepreneurs who raise large funding have experience with product-type high-growth startups, raising billions of yen in those companies and competing globally or in large markets, and that is precisely why they can raise billions of yen from the very start when they begin their second or third startup. They did not raise money simply because they started some company, any company, and earned the label of serial entrepreneur. What is valued is not the label but the substance behind it: the past experience.

For example, if you compare a serial entrepreneur who founded a contract company with someone who has global business experience at a trading company or the like and has a solid network in that industry, I think the latter may even be able to raise larger funding. And if you said, "I had a small exit in contract development, so next I can succeed in global deep tech," not many people would take it at face value (though there are some). Even if you try to leverage your experience, the business domains of the two are quite far apart.

In other words, a track record of founding a company in the contract development field is not necessarily highly valued in product-type high-growth startups. In fact, even if someone with a founding track record in contract software development applies to a high-growth startup support program like ours, it is not a particular plus.

So I think you should choose contract development only after thinking carefully about what kind of track record would be useful for your next challenge.

(7) Starting with Contract Development for Market Entry

There are times when, with some kind of strategy, starting with contract development is effective for entering a market. In this case, you need to think carefully through the steps of your business strategy and be able to explain how that contract project connects to the next one and the one after that. In other words, can you clearly articulate why you are entering through contract work, and what you gain by entering from that angle?

"First get into the commercial flow, and find needs from there" can also be effective at times. If a tectonic shift is likely to occur over the next decade or so, it is one option. It is even more effective if you can commit to that industry over a long span of more than 10 years and, for a while, no competitors seem likely to appear.

However, I cannot recommend entering the contract software development field and then aiming for a high-growth startup as much as I once could, and my impression is that it has been gradually getting harder over the last few years, so please be aware of that. The background includes changes in the domains and strategies suited to startups.

"Experience of a Big Challenge" Rather Than "Small Successes"

So far I have set out the reasons that come up often in these consultations and my responses to them.

To sum up, the experience and track record that are good to have when taking on a big challenge are not general entrepreneurial experience or experience of success, but experience and a track record of having taken on a big challenge or a big business. And even if you build up some personal assets, taking on a big challenge will require using outside funds sooner or later. So I think it ends up better to develop the skill of how to obtain other people's money than to find ways to enlarge your own seed capital.

From the viewpoint of individual skill development too, when you think about how to grow yourself with the time of your life, skill development in a particular domain may not just fail to help in another domain but may even work against you, so you need to be careful about that as well.

Considering these perspectives, I often answer: if what you ultimately want is to do something big, like a high-growth startup, then rather than "succeeding small and then doing something big," wouldn't it be better to take on a big challenge from the start?

That way, even if you take on the challenge and fail, you gain experience, and you can explore product ideas in that domain. You will probably gain the connections you need along the way. And since people who take on big challenges are rare, many people will support you.

If, after thinking about the first step that lets you gain such experience, your conclusion is contract development, then I think you should choose that path with confidence.

(The Big-Picture Perspective)

I suspect these consultations are increasing because good ideas suited to startups have become harder to find at the moment.

However, thinking about Japan's industry going forward, I personally believe that the public good would be maximized if many of the talented people were deployed to exploring opportunities. Contract development, on the other hand, is work based on present needs, and I think it rarely leads to big products in the future. In particular, the fact that many contract projects come from large domestic companies is also a problem from the viewpoint of earning foreign currency in the short term. In many cases the effect would be a transfer of income from large domestic companies to small and medium-sized domestic companies.

Also, contract development is a labor-intensive business. Once a single contract company is created, a large number of talented people are secured there as well. As a result, I think there is another effect: talented people are increasingly not deployed to exploration.

Pursuing personal happiness is each person's freedom, so that is fine, and it is wonderful if economic benefits are created along the way. On the other hand, when I think about Japan's industry going forward, I think we need to build an incentive structure in which talented people take on bigger challenges from the start, and that we should increase support for precisely those people who take on such big challenges.

(I am not saying that support for small challenges should be eliminated; please note that this is only a matter of the strength of support. It is often misunderstood...)

Summary

If you "want to start a business," contract software development is without doubt one option. Contract development is a business with "easy-to-understand needs right in front of you" and an easy-to-understand cost structure. If you make good use of technical knowledge arbitrage, you can earn a reasonable amount. Let me emphasize once more that I am not denying the choice of that path itself.

However, what I write in this article is on the premise of "when you have a high-growth startup in view." In that case, there are many good things that come from using contract development well, but at the same time I think there is a fairly high chance that contract development is a detour.

(Likewise, a high-growth startup is not always the best path either.)

It is important to take steps to accomplish something big, but it is also important to check whether those steps truly lead to the next challenge. I hope this article is helpful when you think about that.

If you are unsure about your choice, proceed while listening to the opinions of a variety of people around you. When you do, I recommend listening not only to the opinions of people close to you but also, as a kind of second opinion, to those of people a bit further away. In a nearby community, there are often only people who share the same opinion. The opinions in this blog are just one opinion too.

That said, if you want to take on something big, I would very much like to support you. If you are thinking about a business in Climate Tech that would reduce the world's GHG emissions by 1%, I can offer advice and support. Please get in touch if there is anything.