I often write about business and values from the point of view of the CEO of a privately held company. And as a business owner, I take great pride in using a business model that I believe delivers the most value for our clients. That being said, I am the first to warn of the “evils” of Private Equity or Venture Capital backed business models.

My software company, Synthesis Technology, is frequently pursued by a range of PE firms.  Our latest recognition by Inc. Magazine as “one of the fastest-growing private companies in America,” brought dozens of these firms out of the woodwork. Naturally they are all interested in a company with a successful business model, a recurring revenue structure, and actual profits.  They all try to get the door opened by offering “growth equity” and being willing to give the founders the opportunity “to take some of their money off the table.”  I entertain a very select few of these advances to make sure I know what the options are and the mood of the industry.  We’ve actually walked away from real offers.

The reason we don’t take the money is two-fold.

One, we don’t exactly represent the type of enormously scalable business most of these outside investors crave.

Two, as soon as there are professional money managers in the mix, our firm’s priorities would have to shift.

And that’s what this blog post is really about; how money and outside investors change a company, and usually not toward the best interest of its clients, employees, or owners.

A little more about us to help frame up my perspective: Synthesis is a boutique business engaged in providing deep technology solutions for a specialized market niche.  We’re about 50/50 product vs. professional services revenue and pride ourselves on taking on business requirements that really get to the heart of a client’s needs.  Our reward is extreme loyalty among our clients and a blue-chip client list in our industry.

About every 18 months a new competitor turns up in our market, fueled by a multi-million dollar round of capital investment and a lot of market buzz.  Their website looks great and they have high-quality product videos.  Their sales people are aggressive and have great sales support materials and processes behind them.  The brochures and pricing strategy promote the solution as both easy and inexpensive to get up and running.   The product might get dressed up a bit too, but, oddly, this is usually secondary to the marketing push.

With the entrance of this well-healed competitor, suddenly partners are calling and insisting that we have to cut prices.  Clients are telling us about webinars they attended and how “sexy” the product is.  Our market research and finance teams are trying to figure out what “It” is and how they can offer it so cheaply.  Is it really better than sliced bread?

These are the trappings and market impact of outside capital. Every time this happens, we see the same thing:

1) No, they didn’t revolutionize our market’s actual needs, and

2) No, they didn’t use IBM Watson-level artificial intelligence to make difficult problems magically go away.

In other words, they have redefined their business to make their deliverable as cookie-cutter as possible and have pushed all the inconvenient business and cost issues out to the customer or a hapless consulting network.

The investors are seeking to shape the vendor to chase a market opportunity with a “long tail.”  This means that it can’t be an elite technology solution focusing on deep and complicated business problems.  By definition the product has to focus on the generic middle ground of needs defined by the market.

Investors win; Customers lose

The fundamental and overriding goal of the firm once the outside capital arrives is to dress up for its next sale. Thus the vendor’s entire business model has become about growing the company’s valuation and creating a profitable exit strategy for the investor; not about what is best for the employees and customers.  One might say these are one and the same. But alas, they are usually not.

One might say:  “Good for the market.  Competition makes the cream rise to the top!”   In fact as a free market capitalist I might even say something like this.

The problem lies in two fairly immutable facts that come with this brave and visionary new business model:

#1 Free is never actually Free

Free setup is the number one way that an aggressively funded business enters any technology business these days.  “Just write setup off as the cost of client acquisition” says the marketing department.

Again, when these free offers start showing up in my market place and my channel partners start calling and insisting “The market is moving!  You’ve got to drop prices!”   I’m steadfast in my response:  In this tight and expensive technology labor market, NOBODY is giving away real professional services for free. It takes real time, overhead and money to developing a capable and sustainable professional services organization.  Good technical and consulting talent is scarce. In this environment nobody would give away the number of hours it takes to account for a turn-key solution deployment of any magnitude.

So how is it free?  Free setup means either the client is going to be doing all the real work themselves and the technology is limited to what a non-engineer can understand, or you can expect a large corollary spend with an affiliate consulting shop.
#2 Customers (and employees) get left behind when the pivot comes

The business model for “growth stage” equity investment companies is uniform:

1. Find a company with a (hopefully) scalable technology and market.
2. Pour money into sale and marketing and anything that supports top-line revenue or seat growth.
3. Turn the company over in two or three years to the next investment group based on a story of exploding growth.

Depending on the PE or VC firm’s size, they may make between 3 and 13 investments in this model each year.  They only expect 10 to 20% of these bets to pay off.  The others are shuttered or left writhing on the side of the road wondering what hit them.

What that means to you as the customer is that there is an 80% chance that the private equity-backed company you’re getting into bed with will not exist in the same form in three or four years.  The worst case scenario for this 80% is the company is left gutted and with no money to sustain operations for the long term.  The owners who built the business with passion and dedication are probably long gone.

The second worst case scenario is the big pivot.

A pivot is what happens with outside investor decides that the business they thought they were pursuing doesn’t exist or scale how they thought it would.  So, with money left to burn, they switch up the business model.  Last week we were a document automation company; this week we’re a web site developer.  Last week we were a taxi meter company; this week we’re a social media outlet for cupcake delivery.   Last week we were a content management provider; this week we’re a mobile media player.

Again, it’s pretty rare in the business process solution space that money and marketing equate to a long-term positive direction for the company.  Among our clients, their chief ask is that we provide real and long term attention to their needs.  They need consistency, continuity and capability–in that order.  This equates to a people-driven enterprise and a high-touch client service relationship. And, as I’ve mentioned, hiring, training, housing and sustaining a professional services organization, just does not fit the “growth stage equity” model, unless it is an extremely generic and common high demand consulting activity  (e.g. SharePoint integration).   Otherwise, it’s just not worth the investment with all the dependencies it creates on talent pools and accurate utilization forecasting.

So, the pivot is almost never going to be toward deeper technology or services; it’s going to be in the direction of something, anything that will hopefully sell by the thousands and set the company up for the successful investor exit.

In a world where profits don’t matter…

I was getting to know a potential partner company last week and had an interesting discussion with them over a beer.  I was probing to learn where they are in terms of earnings.   They are an ambitious technology play looking to amass a growth rate, as measured by user seat licenses. Naively, I assumed that their business strategy would be based on growing the bottom line, EBITDA as we all call it these days.  In fact, it turns out that net profits don’t matter an ounce to their business strategy. They are happy to run a notable operating loss as long as they’ve increased top line revenue and have good gross margins.  They and their investors are looking to have the company rolled up by a larger player to whom virtually all of the operating and sales expenses can be absorbed by existing infrastructure.  This company is actually pretty awesome and will likely be successful, but do their clients know that they are on a revolving 12-month leash with their capital backers?  Do their employees actually even know this?

In many cases, this strategy is a mistake for all parties.  I recently met with a senior executive from a Boston-area tech company that sells a highly-regarded distributed learning platform.  This gentleman had done real time in the private equity business and knows the model well.  He made a case to me that I wholeheartedly agree with:  “If your technology becomes generic and easy to sell and implement, it also becomes easily replaceable by the next technology to come down the street with a free setup offer.”  Without the professional services engagement, the product company doesn’t really know their client and can’t provide a technology experience that is really tuned to their needs.  They’ve made themselves replaceable vs. indispensable.

So, what happens to us when a competitor shows up with more marketing dollars than God and starts playing for our clients?   Basically we wait them out.  When the market proves that it needs deep technology and real and committed services organization, the capital backed venture usually either fades away or we see the big “pivot”. Our largest competitor in 2014 barely mentions our market on their web site in 2015.  Maybe their new market angle will pay off for them or maybe they’ll pivot again by 2017.  Either way, the market has spoken and generic or “E-Z” solutions don’t satisfy our customer’s true needs so they’ll go look for their scalable market and model elsewhere.

Key Takeaways for SaaS Technology Buyers

Before signing up with a business solution provider it may pay to do some research on the vendor you’re looking to engage with. If they are being fueled by private equity or venture capital you’ll want to think about your spend as if you too are an equity investor in the firm.

• Is the company going to be successful in their play and what will limit your costs if they aren’t?
• Is their technology a commodity you can easily replace and more importantly, is a commodity technology what your firm actually needs?
• If the firm switches hands every two years and likewise, vital leadership transitions in this timeline, what will it mean to you and the service level you expect?

And by all means find out their deficit level.  A company engaged in buying market share through deficit spending is much more likely to have a big pivot than one that is running profitably and building a real EBITDA.