Monday, June 29, 2015

The Prolonged Death Spiral Business Model

I recent message from a friend tells me he is putting on his parachute. He can’t take it anymore. He’s tried hard, very hard, to change a challenged company. Actually, I know a little bit more about this company than I should. I once told him that working there was like being aircrew in Catch-22: Only the sane should work there because it was cruel to employ ill people, but it was such a crazy environment wanting to leave was a sign of sanity.

Unfortunately this is not the only company I have heard of, even seen inside, in the last few years that have such a business model. In fact, I’ve now seen so many that I’ve named it: The Prolonged Death Spiral Business Model.

Let me explain… this requires two or three building blocks but I’ll get there…

In Business Patterns for Software Developers I wrote:

“Most [software] companies never make it past the conception stage: ideas stay in people’s heads, business plans fail to be funded or people start but lack the energy to follow through. Even those plans that get past inception regularly flounder – products fail to make it to market, and those which do fail to sell. …

Companies can fail at any time during their existence. However the younger a company is, the more likely it is to fail. Infant mortality is high: most companies under one year old fail. However, once a company is past its first year, survival chances improve remarkably. …

Death comes to a software company when its sales do not cover its costs. Once a software product is developed and sold, companies can reduce costs and continue selling the product. Companies that have an installed user base, particularly when customers are paying regularly for support services, can stagger on for months or even years. This process can be especially prolonged when customers have data locked up in a proprietary data formats or on servers.”

When I wrote this I was thinking of the growth of successful software companies, the kind of companies I wanted to work for. I first saw a prolonged death play out when I was working at Quadratron in the 1990s. What I never realised was that a prolonged death spiral could actually be a viable business model itself.

Quadratron was dying, it eked out its last few years collecting maintenance royalties from legacy customers - one customer in particular. In fact it was dying when I joined, they lured me in with a plan to spend a lot of the remaining cash on a new product. But things were worse than that.

Like so many companies Quadratron found that once you have survived the first few years, once you conquered the risk of developing a product and have an installed user base you can continue milking that base for a long time. Provided you don’t do anything silly like trying to develop a new product that is! Quadratron had been very successful, it had a lot of customers to milk.

When you reduce a software team to care and maintenance only your costs are much lower. Importantly your risks are much lower too, and you have cashflow. Yes, an accounting term I know but it means: money is coming in. And money continues to come in because while some customers may dump your product the longer you are in place the more difficult it is to dump. This is what accountants call “free cashflow”, its how much money the company has to play with, its a better measure than profit because profit can be gamed.

Now, like many others in the software industry I think of venture capitalists as nice people who live in Sand Hill Road, Palo Alto and invest in software companies with the capacity to grow very very fast and make everyone rich. Call this the Californian model of venture capital.

OK, these guys are not so lovable that you want to take them home to meet Mum and Dad but they have financed a lot of good software companies over the years - Lotus, Yahoo, Google. They invest in 100 companies, they expect 90 to lose money - they try to minimise it - 9 to break even and one to make so much money they make up for all the losses.

Then there is another type of financier. Call them the private investor or private equity. I think of this as the European model of venture capital. They buy existing companies and milk them. In buying they look for two things: lots of free cashflow (i.e. day to day profitability) and minimum risk (i.e. they really want to limit their down side.)

As far as possibly they buy the company with debt. With other types of company assets can be used to secure debt but software companies have few assets. So debt is serviced from the cashflow, and the cashflow comes from an installed user base who cannot, and do not want to, change.

Since debt is serviced from cashflow and cashflow comes from existing customers the emphasis is on keeping customers - don’t loose them! So most development work is driven by what individual customers want. Backlogs are stuffed full of customer specific requests.

Growing the company, especially developing new products, would be really risky. The owners and managers are into revenue protection. They want any new product development to be paid for by customers, software alchemy.

Software Alchemy: When a software company believes it can develop a “product” for one customer (preferably paid for by the customer) and then sell the same “product” to multiple other companies.

You can certainly develop technology for one client, you may solve their problems, but developing a product for multiple customers is a different undertaking. Very occasionally, at the start of a technology cycle, companies pull of this trick (usually by accident or by having a very stupid customer.)

Of course keeping customers means you need to persuade customers your product has a future so you need a bit of a roadmap, a bit of a vision but its weak and flexible. If an existing customer doesn’t like it change it! Forwards the end, like when I jumped from Quadratron, even maintaining the pretence of a future for the product is jettisoned to save money. The final few customers are trapped.

Because the company is now loaded down with debt (and needs to pay interest) they find making any sort of profit impossible. Actually, if there was some more free cash then the private equity owners would leverage it by taking on more debt and paying it out as dividend, or they would re-leverage the company - possibly by selling it to another private buyer.

Another trait you sometimes see with these companies is acquisitions: when they can these companies buy related companies who also have products which are past their best but have an installed base. Again they can do this with debt. They hope to get some technology crossover but in reality the people who run these companies don’t have the skills to do that so the mess gets bigger.

By the way: since the companies are loaded with debt they pay no tax because tax can be offset against debt.

These companies chase EBITDA - Earnings Before Interest Tax Depreciation and Amortisation. Because that is the only valuation which makes sense when the company has been leveraged to the hilt.

In short the company is being run as by “financial engineers” - and thats the polite term.

These people know a lot about debt structures and taxation but nothing about software businesses. Today they may be running a software business, tomorrow it could be toothpaste.

Its worth noting these companies want to be Agile because even these guys have heard that Agile will result in lower costs, faster delivering (faster cashflow), and happier customers (even fewer losses and even more reoccurring cashflow.) But they aren’t prepared to make the necessary changes, perhaps a little Agile training or coaching but anything that requires serious investment (e.g. TDD) is off the table.

These companies are a success by some criteria: the people running them and the people who buy them stand to make lots of money. Financially they look good - except the debt. And customer continue to use the products they want to use. They exist, they employ people. By some criteria they are a success, we should not forget this.

They can be miserable places to work in because real engineering is not a consideration. And pity the poor customers who are being led up the garden path about future products.

It would be criminal for any of these companies to take advantage of an ill person by offering them employment. As a sane consultant I’ve even tried to help a few of these companies. However, not wanting to work with these companies - as an employee, contractor or consultant - is a sign of sanity.

If you work for a company which is run by financial engineers in Britain, Europe, America, London, Cambridge, Cheshire or anywhere, you know what you should do for the sake of your sanity.