A search fund playbook for a tech downturn

I’m not currently running a search fund, but if I were I’d use the following playbook.

TL;DR:

• Buy a good SaaS business with unworkable cap structures.
• Re-energize leadership and employees.
• Operate for the long run.

Good companies, bad situations

There are so, so, so many excellent software businesses built in the last 10 years. These companies:

• created products that clearly deliver value to customers.
• generate recurring revenue and have low churn.
• have successful go-to-market strategies, modest growth, and high gross margins.
• are a size-able business by any normally ambitious person’s standards.

However, despite all the positive accomplishments these startups might be spiritually struggling because they raised venture capital at now unachievable valuations. The disconnect between expectations and reality creates dysfunction at every level (at VC firms, within the founder’s psyche, among senior execs, and throughout the organization).

In the worst cases, a good business can be a terrible workplace with constant strategy shifts, unhealthy levels of conflict between teams, poor capital use decisions that reflect desperation, and demotivated employees and founders. Just to be clear, I don’t think this is anyone’s fault…it’s a product of incentives. But, it’s also not a situation worth living with! Life’s short!

A search fund can unlock a lot of value by targeting objectively good, healthy businesses with bad capital structures and making some key changes as an operator.

Reset the capital structure

As a search fund you can facilitate a capital restructuring of a startup during the acquisition process. Specifically, I mean drastically reducing the total liquidation preference so that founders and early employees have a clear path to financial gains from the business.

This means VCs would need to sell their stake to you at a loss. Would they even want to do that? In some cases, I think so!

• Smaller companies that will never meet venture return expectations might not be worth the overhead of board meetings and reporting.
• Venture partners may want to move on to other things in their life and it’s easier for their firm to write off the investment instead of finding a new partner to manage an abandoned portfolio company.
• Giving a partner an exit on a portfolio company that’s never going to reach a venture-style exit means they can focus on more appropriate capital allocation for their risk/return appetite. Trimming their portfolio can allow them to refocus on new themes!
• Taking an investment loss can help with their taxes.

In addition to getting a deal on the price, as an investor you can use a reasonable and modest amount of leverage to help make it attractive for yourself and your LPs. Of course, choose your target businesses accordingly as they should be able to service the debt.

The remainder of your investment gains will stem from acting as an operator in the business and undoing some of the common dysfunctions of startups trying to grow into unrealistic valuations.

Re-energize leadership

After you restructure the debt and equity, you’ve given the founders an opportunity to see some financial gains. They can breathe a sigh of relief! The next question is if that’s enough to re-energize them as operators. If it isn’t you can allow the founders to exit fully from the business and insert a new CEO who is incentivized financially and brings new energy to the company. Even better if they have spent significant time as a software engineer or engineering manager. If you’re taking a traditional search fund model, that can even be you!

Rebuild trust between teams

As I alluded to earlier, good companies with great products can be terrible workplaces. Underperformance against lofty expectations is a recipe for burnout, unhealthy conflict, and bad capital use due to desperation. After resetting the capital structure and re-energizing leadership, you have to rebuild relationships between product/engineering and sales/marketing; the departments that most often mistrust each other in these circumstances.

Rebuild morale with employees

In addition to rebuilding trust between teams, you’ll likely need to rebuild morale with employees. There are a few high impact (though perhaps controversial?) changes you can make.

For the vast majority of employees; move from equity compensation to cash bonuses. Unfortunately, I think stock options have become a cruel punchline for many startup employees. When a company has an unworkable capital structure for the founders, then you can almost guarantee that rank-and-file employees with stock options are frustrated. Today, cash bonuses feel more respectful to most employees.

The other high impact change is to commit to a remote-first work culture. There is a deep desire for remote-first companies in a world where larger orgs are pushing for a returns to office. Take advantage! Or, if you want a headquarters, consider a city outside of SV/NYC.

Operate for the long term

A lot of value is left on the table when everyone’s focused on hitting short term growth metrics. For product and engineering teams, it means you can easily get stuck in a loop of projects that prioritize the results of the next few quarters and not the results of the next few years.

I’ve got a lot of respect for sales and marketing teams, but a common theme in dysfunctional orgs is when substantial product and engineering energy is consumed by marketing and sales projects. In these situations, product and engineering aren’t building for the customer; they are building for internal teams.

Change the culture to operate for the long term from the top down. Critically, make sure your LPs are on board. Start thinking about how you can add new, meaningful value for customers given your company’s strategic positioning. Focus on material shifts in the business, like product-line extensions or solving new customer problems in the value chain.

Improve developer leverage

I’m not talking about layoffs. I’m also not talking about setting unreasonable deadlines and micromanaging your engineers. Instead, you want to enable your engineering teams to effortlessly do more with less. That requires a thoughtful, multi-year approach to increasing developer leverage.

One way to do this is by leveraging industry innovation! The way we build SaaS products has matured significantly over the last 10 years. At this point there are conventional, widely accepted ways to do many typical technical things using well maintained open source software, playbooks, or developer-centric SaaS products. Examine the company’s internally built systems that aren’t directly serving customers and see if and how you can simplify them. And, it’s ok if you create some constraints on internal teams as a result.

To be clear, the point is not to re-platform everything into a modern stack! The point is to be strategic about where you can simplify the tech stack in order to make more space for solving core customer problems. Honestly, a good barometer of whether this is working over time is if your developers are getting progressively happier working on the product.

Having a search fund manager and operator who is a previous engineer or engineering manager is the best way to (1) screen target companies that have potential for improved developer leverage, (2) undertake a strategic review of the opportunities in the tech stack, and (3) maintain conviction and patience on these projects that will improve operating cash flow.

Conclusion

This blog post is mostly a hypothesis that feels pretty reasonable to me. I’m not running a search fund, but if I did I feel like I could have good outcomes for myself and LPs with this strategy. Feel free to steal this for yourself. Or, if you want to connect on this topic reach out to me!