Failing prop tech companies. You’re not going to make it. Now what?
by Morgan Carey
on Saturday, September 28th, 2019 at 2:03pm.
Ever since my post iOi article I have received a lot of interest from companies and founders asking me to give feedback on, evaluate or acquire their businesses. Some really awesome people with great vision and a love for prop tech just the kind of people I love spending time with.
There are also some really exciting companies that are growing, have a great customer base, have not over leveraged debt, are at or near profitability and have a unique product set that could really benefit REW and our customers. I’m extra excited about the potential to have some of these companies and their people join REW. We’re being super picky about where we put our resources (time and investment funds) but I think in 2020 you’ll see some great new additions to the REW family.
But those aren’t the companies I want to address today. What about the ones who are clearly not going to make it.
Sadly many of the companies that reach out to me do not appear that they can stay in business.
Here is the typical formula I see:
Founder has lots of enthusiasm for the idea and has not given up on “hitting it big” and wants to get an investor or sell for a multiple of revenue.
Growth % appeared strong in the beginning through the “early years”
Company has sales ($500k-$5M in ARR) but has never made a profit and is in massive debt.
Pricing strategy is all wrong (typically too low) hence the lack of profit with no ability to increase and keep customers.
No more funding available: Investors / lenders realize the company has overspent and does not have a viable model and are going broke (some now want their $ back)
The product already exists and is not innovative or competitive with already established options.
They can’t afford to change the product now and clearly run out of time.
Assessing the situation 2 types of founders: Dreamers and the caring Realists
All the folks I speak to are truly unique, but there tend to be 2 types of founders when it comes to assessing the situation.
Dreamers: The conversation goes like this: If I just had more money, more time or the right partner, I would make this thing work!
These folks are hard to deal with, because often times no matter what you say to them, they are so dead set on winning, that they can’t recognize that they have already lost. This is going to be hard for them to read, but I do hope they do.
#1: If you can’t do it small and right, then you can’t do it big and right. Not one person is ever going to invest in your failed model that clearly isn’t working. Either your product is wrong, your go to market is wrong, or you are not the person to be running this kind of company. It doesn’t really matter though. If you fail small, you will crash and burn at scale. It gets WAY harder.
#2: A different company / founder that is more successful will make this work. So I want them to take over and be a part of it and get rich. If the problem is actually not the product but it is actually the founder or the go to market this is actually possibly true. But here is the thing about this situation, if someone else is going to create the value in the company post acquisition you cannot sell that value back to them. What "they" can achieve after buying your company literally has nothing to do with you. So all you have is a product (and likely one that already exists or is not that expensive to create) so given the amount of risk involved in acquisitions, the time it takes to transition customers etc there is really zero value in the company. No one is going to pay you for it. Their money is better spent on their own, already profitable company that carries no risk and does not need to deviate from their model and deal with the hassle of an acquisition.
#3: My company is worth “x” multiple because much bigger companies are worth “x” multiple. Nope! Small, not profitable companies don’t get multiples of revenue. Sorry. They don’t get multiples of EBITDA either (that wouldn’t even make any sense, since there is negative EBITDA).
#4: But I have all this revenue! Top line revenue attached to a fundamentally flawed business model where you had to spend $3 to make $1 makes absolutely no sense. It’s a failed company. Sure you might have started with lots of funding (perhaps in the millions) but if you spent $3M and only made $1M that is even worse. Revenue alone means nothing to a companies valuation. It is an asset (I’ll talk about it that later) but you cannot sell people revenue as if it were amazon stock. You’ll get pennies on the dollar if you’re lucky. The person buying has to turn this around and clearly that is not going to be easy.
I have a hard time with the dreamers. Admittedly I get frustrated with their inability to assess their situation when the cold hard facts are staring them in the face. I “hope” that a bit of tough love and a dose of truth can help them go from dreamers to realists, but I fear for most, they will choose to crash and burn (and get nothing back for their investors or themselves) because they could not look at their situation objectively.
The Caring Realist:
On the other side are the caring realists. They have gotten here in much the same way, but they realize the dire nature of their situation and they need help. I call them realists because these folks aren’t trying to get rich or expecting someone else to fix their broken company. They get it. They tried. They failed. They are in debt. Now what?
I call them caring realists because they also have another set of characteristics.
What about my customers? These founders have sold all these customers on their dream. The customers are relying on them to continue to deliver a product to them, often times the customer has put a lot of time, effort and money into the product and it’s going to be really hard on them to have to switch. A lot of time, cost and frustration. The caring realist knows this, and they really want to find a way to help their customer in any way they can.
What about my people? These founders have employees. People that believe in them and have often times sacrificed many years at lower pay than they might have gotten elsewhere in order to help realize the founders dream. They love the customers, are proud of the product. The caring realist loves their people and wants to do right by them. This is the best quality of the caring realist. Bless you for this!
What about my investors? Often times with small companies the investors are small too. Maybe even friends and family. The reality is if the company goes under (and it is going to) these people will lose all of their money. It is the risk that investors make (they are betting big on a gamble for a big reward) but the reality is it sucks when you lose all of someone else’s money. The caring realist knows that it was them that convinced them to invest and feels obligated to help return as much value to the investors as possible. Being a realist they also know it will not be anywhere near the amount invested.
I’m one of these companies, what do I do now?
The way I see it, there are really 4 options for you. Taking any one of them means giving up on your dream and accepting that you did not realize the goals you had set out for yourself, but 3 of the 4 allow you to extract some value in most situations.
Wind down / Profit extraction: You have customers and a product they are paying for, so there is revenue there. You also probably have a ton of costs causing you to not be profitable. If you choose the wind down / profit extraction option this basically means shedding all possible costs in order to extract profit where there was none before.
For example, if you are winding down you likely will not be investing any more into the product, and thus you can get rid of your developers, your designers and their management.
You are probably not going to be actively selling the product any more (that would be very wrong) and thus your sales and marketing staff can go.
Since you’re extracting profit, you will also likely reduce even necessary staff to the bare minimum needed to keep the product on life support.
This “can” (and most of the time does) allow you to extract “some” value. But it really is not a fun process.
Here’s a few things to consider when thinking about winding down:
Your customers will ALWAYS leave you much faster than you think. Once the product and service starts to dip they are gone. Don’t count on a large group of them sticking around for a long time.
Your staff are going to leave too. I’m talking the ones you thought you might keep to support the product. They know what’s going on. The moment they see you winding down the company they will start looking for jobs (if they have’t already) and they should. They owe you nothing at this point and have to look out for themselves.
Your personal reputation is going to take a hit. People are going to write nasty reviews about you (both employees and staff) this model is seen as the most selfish of models and can feel very personal. You have to see these people online or on the streets and you have to be able to live with how you chose to handle the shut down of your company. You can mitigate somewhat by being as honest and transparent as possible but it’s still going to be a negative.
Buyout Company: There are lots of these (take constellation for example). These companies are looking for great deals. They want to buy your company, optimize it in many ways in order to turn into a profitable company and extract value for their shareholders.
What it generally means though is that you are going to get extremely low cash offers. You might have $2M in revenue and get an offer of $250,000 for you company (and rightly so your company isn’t worth anything, it’s failing).
As for your people and customers. There is no protection for them. These companies can (and often do) come in and get rid of your entire team (they have far more experienced teams that handle these types of platforms) and can often times increase the price quickly without any new product offering or innovation. It’s a slow death for most acquired companies as customers leave and the buyout firm extracts their profits.
It’s the least amount of cash of the 4 options, but it is an option.
Earn out partner: This is where REW generally plays. Earn out partners are strategic in nature and partner with you to maximize the potential profits for themselves, but also in doing so maximize your potential extraction for yourself and your investors.
Why is called an earn out? Because you are not being paid cash up front for your company. Your earn out partner (let’s say in this case REW) has to invest significantly up front in creating a transition and retention strategy in order to make the acquisition make sense. So the earn out partner is investing $, they are just not giving it to you up front.
The way I look at these deals goes something like this: Spend 6 months post acquisition ensuring the customers are going to be transitioned and taken care of the right way.
Give the staff ample time and notice to find new jobs OR if they are great and their skill set is needed, we may be able to offer them a new, more stable job.
Create a strategy that “adds value” to the customer. Convince them that by being acquired the product is going to be replaced with something better. Give them special pricing and incentives to move and commit to a term.
Treat the customers with extra love and provide extra support taking care of as much of the migration and hassle as possible.
Help them understand that the transition was an alternative to shutting down and that you found the best possible partner for the customers.
Over the next 3 years or less we work together to transition the customers to REW.
Not going to lie, 25-50% of them will be gone in the end. This process is disruptive and we cannot force customers to participate in your earn out (especially if they are not contracted)
But let’s say 70% on average stay. What might that look like on an earn out?
Here is some complete hypothetical math (note every deal is different, please do not ask for this math I’m just using easy numbers to calculate they don’t represent actual numbers)
Let’s say you had the following:
$200 per month per customer $2.4M ARR
Average customer retention after 3 years 70%
50% earn out on profit
$200 profit per customer per month after transition
So the math here is quite easy: The “average” customer number over the 3 years is 70% or 700 customers. 50% of the profit at $200 per month per customer is $70,000 per month
Over a 36 month term would net you $2,520,000 in this scenario.
These are funds you could use to pay back your investors or if you do not have any, these are funds you get to keep.
Fundamentally you end up selling a zero profit company worth nothing in this fictitious scenario for $2.5 million dollars.
And of course the last option:
Fail / Go Bankrupt: This is an obvious outcome if you do not choose a different option. Everyone loses in this scenario.
Obviously I’m partial to the earn out model because that is the space we play and it mitigates the risk on our side while maximizing the potential final sale price on the seller side. But different people have different needs at different times.
Sometimes you’re just done, don’t have that much debt and want to walk away. you might look at a buyout (we do those too, but we like a buyout firm in that scenario)
Sometimes you’re just stubborn and are convinced you’re going to make it.
If you're a dreamer: My advise is read the article again.
If you're a Caring Realist
I’m on a 7 hour flight from Lisbon to Toronto, if you want to reach out and have a conversation about anything in this article feel free to hit my up on FB chat or send me an email. I love talking about this stuff and I’m always happy to help or give advice where I can.
I can’t promise to save your company, but I will give you the best advise I can.