How to Create Shareholder Value in Vertical Market Software Companies
December 31, 2016
This post may seem a bit controversial if you're an entrepreneur who built your business organically, from the ground up, but when I think about value creation in VMSCo’s, a well known quote from Jim Collin’s book “Good to Great” comes to mind.
“When you turn over rocks and look down at the squiggly things underneath, you can either put the rock down, or you can say, ‘My job is to look at the squiggly things,’ even if what you see can scare the hell out of you.” - Fred Purdue, Pitney Bowes
Great VMSCo investments are rarely highly efficient, high growth businesses with savvy operators and squeaky clean diligence profiles. If they were, it’d be nearly impossible to invest in VMSCo’s at a good price and there would be significantly less opportunity for value creation.
The very reason that in some VMSCo’s, investors find steady, predictable recurring revenue streams at a low price is because these businesses have imperfections. However, therein lies the challenge; to create the most value in a VMSCo, one usually has to be willing to turn over the ‘rocks’ and face the ‘squiggly things’. After the purchase price, the operator’s willingness to address the brutal facts of the business drives the bulk of the near-term value realized by investors.
The Things You Can Control and the Things You Can’t
Let’s separate a VMSCo’s operations into two categories - (1) the things the operator can control and (2) the things the operator cannot control. Many aspects of the business fall under category (1), the things an operator can control. For example, an operator of a VMSCo should be able to control all aspects of the operating expenses of the business (i.e. headcount, marketing spend, salary increases, etc.) and the projects the business decides to take on. While the operator cannot entirely control the impact of price changes, they are generally able to control the price itself. These are examples of aspects of a VMSCo that are controlled almost unilaterally by the operator/owner of the business. As such, the bulk of the investment thesis and post-investment operational plan should focus here. It’s actually pretty common sense. Why take the risk of building a business case around predictions or forecasts that you do not (or cannot) control when you can build a case around aspects of a business that you do control. Focusing on the things the operator can control greatly reduces the investment risk and in VMSCo’s, it often leads to greater realized value for investors.
The other category, the things you cannot control, includes aspects of the business that an operator usually cannot predict, or can predict with very little accuracy. For example, the operator of a VMSCo cannot control market conditions, regulatory changes, whether or not customers will buy a new product or whether nor not the R&D team will solve a tough technical challenge. Ironically, in my experience, the aspects of a business that operators cannot control tend to be the focus of a VMSCo investment thesis and a big part of the initial post-investment operational plan. I think this is because people often find it more exciting to think about changes to products, markets or business models (versus cost cutting or maintenance price increases) and from an operator’s perspective, they feel such changes enable them to demonstrate their management prowess.
Of course it’s great if an operator or investor believes there is an opportunity to invest in a VMSCo to drive organic growth, because in the long run, this can drive fantastic returns. My only suggestion is to start by focusing resources on the aspects of the business the operator can control before spending too much time on the things they cannot. This also gives operators and investors time to learn about the business before allocating too many resources in a particular area (say, product development).
Why there is an Opportunity to Create Value
One of the main reasons why some investors in VMSCo’s are able to derive great value from their investments is the fact that many VMSCo’s (or at least the best investment opportunities) are owner operated (typically by the founder) or operated by an entity that sees the VMSCo as non-strategic (i.e. a large multi-national that acquired the VMSCo assets as part of a larger deal). Essentially this usually means that (a) the owner has personal relationships with employees and customers, (b) the owner doesn’t have particular financial or operational savvy (i.e. they have focused on entrepreneurship) and/or (c) the owner doesn’t particularly care whether or not the business is running efficiently. Any or all of these situations can create an opportunity for a savvy VMSCo operator to create value for investors. I’ll explain why below.
First, there are two particularly important areas of value creation that VMSCo operator’s usually control: expenses and price. Expenses can broadly be put into five buckets: Research and Development, Sales and Marketing, Professional Services, General and Administrative, Support. ‘People’ are usually the biggest expense in a VMSCo and depending on where the VMSCo is located, people expenses can most often be controlled by the management team. Price, whether it’s a perpetual license, services, annual maintenance, SaaS or something else, can also most often be controlled by the management team. We’re going to focus here on price as it pertains to recurring revenue (i.e. the price of annual maintenance (or SaaS) that is the basis for recurring revenue).
So let’s go back to the situation where there is an opportunity for a savvy VMSCo operator to create value. Many founding owner-operators of VMSCo’s may have ‘bootstrapped’ the business, counting on early customers to be friendly early adopters and counting on early employees to sacrifice upfront compensation for greater long term reward. Founders are likely to have developed personal relationships with employees and customers that make it very difficult for them to make optimal business decisions. They may even have family members in the business or long-time personal friends as customers. Consequently, many VMSCo’s have too many staff and inconsistent prices. This is where the savvy VMSCo operator comes in.
Looking across the five operating expense buckets of a VMSCo, the savvy VMSCo operator can optimize headcount by making the tough decisions that the founding owner-operator could not. In some cases this may be the justification for the entire investment (i.e. that there are way too many people in the business). I’ve seen business rapidly go from around a 5% EBITA margin to a 20% EBITA margin, driven entirely by carefully selected headcount reductions. Hence, looking for VMSCo’s with too many people is an investment strategy unto itself. I’ll discuss how to determine the ‘right size’ of a VMSCo and general tactics for headcount reductions in another post. While staff terminations can be an emotionally taxing process overall, determining where to reduce operating expense is really not that complicated. Essentially it boils down to a few operational best practices and analyzing ratios of revenue to operating expense. For example, if you want to run professional services at a 50% margin, based on services revenue and an average all-up cost per services team member, you can calculate approximately how many people you need on the professional services team.
On the pricing side of things, a similar situation may exist, where founding owner-operators struggle to keep prices consistent across the customer base. Early adopters may have long ago received a preferred annual maintenance price but were never moved to the latest rate card. A friendly local customer may have negotiated a special maintenance price or, a group of customers may have been brought on board before annual maintenance prices even existed. I’ve seen VMSCo’s where the customers all paid a different price for annual maintenance and some paid no annual fees at all. Again, these sub-optimal price situations are a great opportunity for a savvy VMSCo operator to derive value.
Determining how much to increase annual recurring fees can be a bit tricky and is both art and science. The first thing I’d suggest is calling or visiting as many customers as you can to get a feel for the value realized by each customer as well as their attrition risk. Hopefully this was also done as part of the pre-investment diligence process. Look for a proxy to benchmark annual recurring fees by customer such as number of employees, number of vehicles, number of buildings, etc. Using this proxy, ‘normalize’ recurring revenue (i.e. per employee) across the customer base so that you can compare how much each customer is paying. Look for obvious outliers and find the mean recurring revenue relative to the selected proxy. Implement a ‘rate’ card that staff can use to standardize prices. For every customer below the mean, come up with a plan to increase their annual fees, starting with the customers you can afford to lose. As referenced in a previous post, in my experience you can almost always get a 20% annual price increase on recurring fees, if the customer actually uses the product. If necessary, give away product modules with low rates of adoption or give away professional services to get the price increases done. Operators should also look at the support burden of each customer to ensure that every customer on an annual support plan is profitable. If not, consider ‘firing’ unprofitable customers that are unwilling to increase their annual spend. There are lots of tricks to price increases that I’ll discuss in future posts but this should provide a general overview in the context of creating value in a VMSCo.
When looking for ways to create value, it’s important (and sometimes difficult) to not to do too many things to a VMSCo at once. Between turning over all of the ‘rocks’, managing expenses and implementing price increases, there are many ‘controllable’ things that can be done to create value in a VMSCo. In fact, some may argue that in the first 6 months post-investment, it is best to only make changes to the business that are absolutely necessary so that the new investors/operators may validate assumptions made in pre-investment diligence and get a feel for the business itself. To minimize risk, a VMSCo operator should have clear line of sight to the impact their initial changes will have on the business and aim to focus resources on more controllable aspects of the business.
In my experience, investing in a business to grow it organically (as opposed to acquired growth) falls under the category of ‘things you can’t entirely control’. It’s fun, exciting and can build fantastic value but it’s risky relative to some of the other approaches to value creation discussed above. While a well thought out plan to enhance product features or investment in a new sales and marketing campaign will hopefully result in bookings and revenue growth, it’s difficult for anyone to say for sure. It’s especially hard to determine the return on such investment a priori, as the relationship between incremental dollars put into product or sales and marketing and the incremental dollars earned, can be very difficult to determine. This ‘organic growth risk’ is inherent in just about any business and it is exactly what entrepreneurs deal with every day. In fact, growing organically is likely a core skill of entrepreneurs who founded most VMSCo’s. However, if maximizing value for investors is the primary short term goal for a VMSCo, investing resources in organic growth may need to be put on hold until the more sure fire tactics have been exhausted. The great part about shoring up the 'controllable' value creators in a VMSCo is that it creates a stable foundation for investing in future organic growth. I’ll expand on this in future posts, as there is so much more to be discussed on the balance between building short-term VMSCo value and striving for longer term organic growth.
Regardless of the approach to creating value in a VMSCo, it is extremely important to find the right operator for the business. VMSCo value creation is an operational responsibility that requires going deep into the customers, employees and processes of a business. The operator must be willing to face and address the imperfections head on. It’s easy to spend tons of time analyzing scenarios on spreadsheets and for the most part, it’s a great exercise in thinking through the business however, ultimately the fastest path to shareholder returns is driven by the operator’s disciplined execution of a practical plan.
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