Scaling up.
Managers obsess over it. Investors fetishize it. Engineers dream about it.
It’s the ambition of every tech company that seeks to arbitrage demand against the near infinite power of computer processors to reach Xanadu: 90%+ gross margins and growth capped only by market size. Yes! That’s what we’re all marching towards. Right? Plenty of blog posts from your friendly neighborhood venture capitalist about how to get there.
But what if that’s not in the cards? What if demand plateaued; markets didn’t cooperate; your business went from product-market fit to product market unfit? That acquisition, once shiny and new, was trucking along and it hit a speed bump (or a ravine) in its growth trajectory.
The playbook for how to retool a business for growth is one that we spend a lot of time thinking about. In the binary world of tech startups this scenario doesn’t get much attention because oftentimes investors and corporate owners are happy (well, maybe not happy) to write down an underperforming business in favor of focusing on the unicorns in the portfolio.
But in our world - that of software private equity - we often focus on scaling down in order to scale up. Because sometimes you need to take a couple of steps backward in order to travel forward.
What does it mean to scale down to scale up?
The purpose of this blog post is to talk a bit about how we approach right sizing a business in order to facilitate a pivot to growth and increased profitability.
Let’s use Acme App Company as a fictional case study.
Acme App is a 15 year old software company that is part of a larger company called BigCo. 5 years ago the business was doing $30M in revenue and $8M in profits. This year it’ll do $11M in revenue and $1M in profits. As a result, the business has become something of an afterthought among shinier, more lucrative assets in BigCo’s portfolio. The general manager of Acme, who has been with BigCo for many years, has been working to reinvigorate the business but feels constrained by the culture and processes of the corporate parent. The team, which hasn’t shrunk much since the peak, feels ignored and neglected. The product is stable but it has lost some customers to more forward-thinking competitors. There is a decent customer base but it’s not clear who is sticking around out of inertia versus positive selection. Acme has all sorts of robust processes and functions in place - including HR, finance, procurement, multiple layers of technical management, multiple layers of redundancy, a giant office in downtown Minneapolis, and even physical security out front to keep the app burglars at bay.
First of all - congratulations! You’re the new owner and CEO. Your job is to turn this business around or at least optimize it for profitability.
Now what?
Head Shrink
The first, most important, and hardest part of scaling down a business is adopting the appropriate mindset. At a fundamental level the question that informs all decision making goes from What do I need to be successful? -> What do I need to survive? While the existential nature of this may seem dramatic, it’s not. If Acme App continues on its current trajectory it will cease to exist. For this reason, we have found that today’s leadership team may not be tomorrow’s leadership team. There are plenty of exceptions to this so don’t take this as gospel. But in our experience it can be difficult for leaders to adopt a new mindset when they are surrounded by the trappings of their legacy (good and bad). It’s just too painful. Second-in-commands are often great successors because they’ve been watching their boss for a while and have an idea of what they might do differently. What’s more, they tend not to be captive to pride of ownership; as a #2 you are usually executing someone else’s agenda. Again - no hard and fast rules here - just our experience.
Another trap that smart, analytical people tend to fall into is dissecting ad nauseam what happened? As in, why did Acme App go from $30M to $11M? There is a tendency to spend a lot of time trying to unpack history as a way to uncover a path to restoration. In our experience a deep investigation into this is a poor use of time. The focus needs to be on the future: on how Acme App can compete in the current environment given its strengths. What happened doesn’t really matter as what needs to happen in the present reality.
The other shift in mindset is around risk calculus. Mature companies think about risk differently than startups. And rightly so. As a startup your default position is failure. BigCo, on the other hand, has an existing business to protect. So it has developed layers upon layers of processes, administrators, and rules to make sure no one does anything catastrophically stupid such that would endanger the core business. The most palpable manifestation of this is usually seen in three departments: legal, HR and security. Why? Because these departments tend to have the greatest exposure to risk. So defensive resources will flow here as managers invest in protective layers to safeguard the company. Fear, rather than greed, drives risk management. This approach is all good and well when there’s plenty of cash to go around. But as Acme App scales down, it must also recalibrate its approach to risk management. The reason is simple: there’s less to lose.
Small Business > No Business
Glory days, yeah goin back
Glory days, aw he ain't never had
Glory days, glory days
-Bruce Springsteen
Having established that the glory days are over, it’s now time to set about recasting the business in line with its current revenue, earnings and growth potential. For Acme, we need to answer some of these questions:
How will we make sure our investors don’t lose their money?
What’s the appropriate overhead needed for the company to maintain its current position?
Let’s work from the top because this is the order of operations for any scale down.
#1 We at TDV live in a constant state of paranoia about losing investor capital. Our investors are our friends, our family, and ourselves - so we feel highly invested (pun intended) in the outcomes of our acquisitions. For this reason, at all times we - and you - should make sure that there is a path to returning capital. This means managing costs and cash flow carefully. This means paying down any debt quickly. This means being very thoughtful about balancing reinvestment of profits vs capital return. Failure is an expected outcome for 90% of startups; not so in private equity. And so you’ve got a series of painful, unpleasant decisions ahead most of which come down to choosing between bad and worse, without much clarity around which is which. But job #1 is to make sure that everyone gets their money back.
#2 Which brings us to the second point: overhead. In the businesses we buy - software and digital media - staff make up the supermajority of overhead expenses. Let’s acknowledge that there will be a human cost to what follows and that should never be taken lightly. But alas, if we don’t make the necessary changes we’ll all be out of a job. Staff overhead breaks down into roughly two categories: team members needed for steady state operations and team members needed for future growth. There is seldom a clean break between these functions so you’ll need to make some difficult choices. For now, Acme needs to focus on steady state. So the growth team should be quickly reduced or eliminated. While this may seem shortsighted I will remind you that there needs to be short term stability in order for there to be long term success. There should also be reductions in support, sales, marketing, and back office. Cut deeper than you think is necessary and hire back as needed. Any position that does not have a direct sightline to revenue - whether in product, go-to-market, or back office - should be looked at. There will be plenty of gray areas but the filter needs to be: What happens to the business if this role disappears tomorrow? Because the previous regime, under different conditions, found this role to be essential does not mean that the same logic applied going forward. Indeed, the entire organization needs to be right-sized to ensure that company can cash flow so that job #1 happens.
Other than staff cuts, there is sometimes an opportunity in labor arbitrage. Acme has some staff in Minneapolis, but like every tech company, also has team members elsewhere. In this case: Pakistan, Colombia, Ukraine, and Spain. So there may be some savings in consolidating offshore but in the global market for talent this is seldom a straight line. Offshoring can work well for technology teams but less so for customer facing roles such as sales and marketing.
Customer Love
You’ve changed your mindset. Cut a bunch of costs. Ensured that the business is throwing off enough cash so the investment is de-risked.
Now what?
It’s time to go see your customers. There is one big reason for this.
#1 After a transaction, customers will need reassurance that the service they rely on is stable. They will further want to feel confident in their new partner (you). When they first bought the product it was backed by BigCo. Now who is backing Acme Apps? Much can be done over the phone/Zoom but there is no substitute for sitting down in person and meeting your customers. It’s time and money well spent. It’s your opportunity to gain their trust, and in doing so, get in front of potential churn situations. This in turns keeps your cashflow stable and the wheels on the bus while you start to figure out what’s next. After all, you didn’t just buy the business to run it for cash (at least, I hope not).
#1a It’s also your opportunity to learn what your customers need going forward. Where are the gaps in your product? What are your customers' needs? If they are comfortable with you as an operator and the continuity of service, fear will melt away and transform into excitement about the focus and attention that they will be receiving (compared to when Acme was part of BigCo). The energy that comes from this mindshift will open up all sorts of discussion threads about how Acme can evolve to meet their needs. They will basically hand you your product roadmap for the next 3-6-12 months. Your clients will become your partners in this evolution; they will become invested in the company’s pivot to growth. What’s more, they may put dollars against this shift. But this can only happen if you talk to them to find out how you can solve more of their problems. And, as a function thereof, grow the account.
Conclusion
You’ve changed the mindset of the company. You’ve figured out what’s essential to survival. And you’ve locked in your key customers and are leveraging these relationships for future growth. In sum, by scaling down you’re now in a position to iterate Acme back to product market fit. Once the revenue velocity starts to accelerate, you’re now in a position to start slowly making investments back into the business. Hiring more salespeople. Hiring a new head of marketing. Hiring a biz dev lead. But these hires are, in our experience, at least 1-2 years after the company has found its footing in the market. And these hires are invariably different - in almost every way - than the people who occupied these roles at the outset. That’s because Acme will be an entirely different company than the one you acquired.