Tuesday, May 30, 2023

Does Your Vendor Have a Sustainable Business Model?

Think for a minute: Who are your three largest vendors? In other words, for your company, who are the three other companies that get the largest monthly payment from you? Now consider, what would you do if they disappeared tomorrow? Or shut you out? Or simply stopped communicating?

Let me skip to the bottom line: You need to ask your vendors to demonstrate that they have a long-term, successful, and sustainable business model. YOU and your business are in grave danger if your key vendors disappear tomorrow, stop fulfilling their promises, or become overwhelmed because they cannot deliver on their promises.

You need to develop a measure of sustainability that makes sense to you and determine where your vendors are on this scale. This discussion is not casual or a mental exercise. This discussion is existential - It could literally affect the chances that your company will survive in a crisis.

Now the wind-up.


All businesses have to do a few things to survive. They need good stuff to sell (products and services); they need clients to buy what they sell; and they need employees to deliver what they sell. There are many other elements of a successful business. Perhaps the most important is a sustainable business model.

Unfortunately, most businesses never think about the sustainability of their company. They don't build a real business plan. They don't write down their mission, vision, and values. They just go to work every day, doing whatever it takes to survive.

If they're lucky, they last a year, or five, or ten. But the statistics on survival are well-known. About 50% of all new businesses will fail within five years (see https://www.entrepreneur.com/starting-a-business/the-true-failure-rate-of-small-businesses/361350). AND there's not much of a learning curve. So 50% of the survivors disappear in the next five years, and the next, and the next.

That's why I always tell people: If you've been in business for ten or fifteen years, you're in the thin air, at the top of the mountain.

Businesses that last have one of two things: Either they have a sustainable business model, OR they have a continuing source of money. Like it or not, many businesses live off of cash flow with no real profit. They are constantly borrowing money and bragging about their "top line" revenue. These companies don't tend to brag about their "bottom line" profit. 

In a perfect world, all companies would have a sustainable, long-term business model. When you think about getting back to basics, you find yourself once again talking about mission, vision, values, and the ultimate secret sauce of repeatable, reproducible success. (I won't go down the rabbit hole of processes, but that repeatable, reproducible success comes from great processes.)

Here's a rule to live by: Businesses that produce their own cash have better business models than businesses that use others' cash. This is true for a very simple reason. You will protect and conserve your own money better than you will protect and conserve someone else's money.

I learned this lesson way back in the 1990s, during the original "dot com" boom and bust. I saw dozens and dozens of companies that took investor money and gave themselves huge salaries, invested in company boats, bought downtown buildings in San Francisco, filled their lobby with video games and big-screen TVs, and gave away sports cars to employees at Christmas.

In other words: They wasted most of the money that was given to them. They did whatever they needed to do to survive every day. And they did not invest in a good, long-term, sustainable business model.

... Skip ahead a bit ...

Private Equity in the SMB IT Ecosystem

A very common model has evolved for some vendors in the IT space. Investors pool their money to create a fund with millions (or billions) of dollars to invest. They find vendors who have a good product, a good market, and generally good employees. In a perfect world, the company will have a strong business model, happy clients, and prospects for great growth and great profit. But none of these last items are actually required. The promise of future business models, happy clients, and profit may be enough.

The PE (private equity) company then buys this vendor, and a number of new rules fall into place. Depending on the size of the fund and the number of investors, most PE companies will want to get their money back in 3-5 years. In that time, they will do whatever it takes to double or triple their investment. On some occasions, they want to quadruple their investment in that time.

As a result, PE companies seek an internal investment rate of about 20%-30%. (For a math-filled primer on IRR, see https://www.investopedia.com/terms/i/irr.asp.) Your key take-away is: They absolutely must make their twenty or thirty percent each year. 

One of the few areas where PE is likely to increase funding is the vendor's Sales Department. They will sell and sell and sell . . . until they can no longer deliver. And, in most cases, they will sell well beyond their ability to deliver. They will spend almost any amount of money to gobble up their competition and grab market share.

As a rule, sales are good. But when sales outstrips the ability to deliver, either you need to slow down your sales or increase your service capacity. The first is unacceptable when you're under the gun to increase sales by twenty or thirty percent. The second is a hard sell when every department is asked to cut expenses to the minimum.

Unfortunately, there are almost no motivations to slow down, take reasonable actions, and build a long-term model for success. Those things don't bring in the quarterly returns that lead to 20%-30% growth.

Very often, the following actions take place after private equity is involved. First, the key personnel are promised lots of money IF the business continues to bring in enough cash. That means these often long-time employees need to do whatever it takes to maintain revenue, retention, and growth.

That "whatever it takes" is often not good for personal relationships. And it it antithetical to a good business model. It certainly does not contribute to long-term sustainability. Here are some common actions you may have noticed. With each of these, ask yourself, "Is this a long-term, sustainable activity?" If not, your vendor's long-term prospects may not be good.

  • Cut employees to create a one-time boost in profitability. Of course this is literally like cutting off a hand to lose weight: It causes more difficulty than it solves. But it always increases short-term profit.
  • Stop (or greatly reduce) spending on new developments, updates, and fixes. Basically, "freeze" the product or service development. Just until the next payment is made, I promise.
  • Consolidate services. If a PE company already has billing, legal, customer service, shipping, and even developers in house, there are pressures to save money by combining these. Of course, the probability that the old standard operating procedures are identical to the new ones is approximately zero. So, billing gets messed up or delayed until the transition period is over. Legal is similarly messed up, as are customer service, shipping, and whatever else is being combined in order to save money.
  • Outsource employees and services. We're all in the outsourcing business. It can be done well or poorly. The important thing is to save money. The disruptive period of transitional (low level) service should only last a few months. 
  • Cut back on training. Maybe don't revert to "sink or swim," but rely on a handful to dedicated long-term employees to do most of the work and train the new people. Certainly, reduce training on customer service, executive coaching, or just about anything else that doesn't make money today.
  • Reduce the average cost per employee so it's in line with the PE objective. Some salaries need to be cut. That's often too distasteful. So, it's often easier to fire people and then replace them with cheaper alternatives. But cost per employee can also mean eliminating performance bonuses and cutting benefits for some or all of the state. The obvious result is to destroy employee morale - and save a lot of money.
  • Raise prices. This is fairly obvious. Even if the primary price is not raised, lots of related prices are increased as well as junk fees. Pretty much anything that is not limited by your contract is fair game. 
  • Sell real estate investments. This might mean combining offices, closing offices, selling off buildings, or moving employees to home offices or co-working spaces. Having employees work from a coffee shop while sitting at picnic tables may not sound like a great work environment, but it saves money.
  • Reduce quality. This is fairly each with hardware. With software, it rarely makes sense. But with services, this can lead to huge savings. A vendor might go from "all inclusive" to nickel-and-diming you. Or they might simply change service hours or options. If you can lay off a hundred people and replace them with a nine-to-five chat bot, you can save a lot of money!
Note: Many of these have dramatic negative effects on customer (that's you in this scenario) satisfaction, loyalty, and the long-term reputation of the vendor. But those things are no longer part of the equation.
  • Delay maintenance. We mentioned postponing development above. But money can also be saved by not updating equipment or facilities. Depending on the nature of the business, these could increase delivery times as well as down-time for the company. But they save money in the short term.
  • Create complicated policies. Hide legal agreements and simply create "rules" that channel reps have to enforce. Make the rules difficult to find, document, understand, or follow. Good examples are requiring excessive paperwork, or hiding requirements and deadlines. All of these are great for increasing partner frustration, but sometimes partners just can't imaging changing to another vendor. So, they might not like the vendor, but they don't feel like they can go anywhere else.

The Irony In Plain Sight: These Companies are Unsustainable by Design

Companies that take these kinds of drastic actions once, in an emergency, may survive. Consider Facebook's recent turn-around. They said this would be their year of austerity and it was. But they started out with $37 Billion on hand. In other words, they were making wise decisions because it was their money at stake. 

When big companies with lots of cash on hand make decisions, they can make those decisions consistent with a longer-term vision. They don't have to make stupid decisions in order to reap short-term rewards. Companies with lots of cash include Apple ($55 B), Alphabet/Google ($115 B), Microsoft ($104 B), and Amazon ($64 B). 

Note: Those cash-rich companies also strive for 20% or more in real growth. But they do so within a strategic, sustainable business model.

According to one source, private equity-backed companies account for more than 27% of all business bankruptcies filed in the U.S. And this is not a new trend. The three-year average is 27.5% of all bankruptcies. The most likely causes for this high rate are excessive debt, aggressive cost-cutting, and poor management. See https://www.thedeal.com/restructuring/pe-backed-bankruptcies-rise/.

Please Note: I've said it before, but these things tend to get lost in the discussion. Private Equity does not have to be greedy or short-sighted by design. It can be reasonable. It can encourage strong values, a focus on people, missions, visions, and values. All of those things would result in stronger long-term investments. All of those things would result in good channel programs with strong relationships. 

But when the one and only goal is to hit a 30% margin payment, all the things that make a good, long-term, sustainable business model just have to wait for "some day" to come.

How do your key vendors score when it comes to a sustainable business model?

Comments welcome.


Earlier articles on this topic:

Is Private Equity Good or Bad?
May 1, 2023 Newsletter commentary

Private Equity Doesn't Have to Ruin Our Industry
Blog post May 02, 2023

Additional reading. For a great little primer on private equity, see https://www.streetofwalls.com/finance-training-courses/private-equity-training/private-equity-industry-overview/.


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