Could it be possible to apply the idea of a private equity turnaround firm to early-stage startups?

Perhaps instead of figuring out how to fund new startups, perhaps more effort, time and money should go to buying and re-directing startups that are floundering and close to failing.

Obviously the funding and operating model would have to be very different, simply because traditional private equity turnarounds focus on taking on debt, slashing costs and cleaning up free cash flow; but perhaps there is a model for taking on and operating floundering startups. Structuring the acquisition transactions are likely to be sticky, the secondary market for startups is a difficult nut to crack and I’ll admit that much of the value of an early-stage startup are in the core people who may have little interest in sticking around; but it’s an idea worth considering, regardless for the simple reason that opaque, illiquid and inefficient markets (like the secondary market for startups) often provide the best opportunities for creative investors willing to get their hands dirty.

I posed the question What would it take to start a “floundering startup” buyout firm? on Twitter as an afterthought and got some interesting responses; of note:

From Patrick Hadfield,

patrickhadfield @tdavidson Money. And guts! And maybe more money… (link)

And probably more guts…

From Marc Vermut,

mvermut @tdavidson capital; a team of experienced entrepreneurs; engineers; focused strategy; humility; strong biz dev + marketing #whytheyflounder (link)

And Scott Lundgren,

capitalfellow @tdavidson I’m thinking you need a team of turnaround artists, a good negotiator, cash to start a floundering startup buyout firm (link)

Agreed on the need for capital, humility, a focus and strong business development ties; so, what’s the arbitrage?

Marc:

mvermut @tdavidson @capitalfellow: experience, adequate financing and relationships = better execution multiple (link)

I agree; and I think breaking the opportunity down into experience, relationships and financing helps one frame the operating model and investment thesis for a venture buyout firm.

Jay Cuthrell (@qthrul) provided links to relevant examples over on Friendfeed, pointing out the startup collaboration network The Swop, the technology spinout investment firm Garnett & Helfrich Capital and Startup Junkyard, a potential market for startup assets.

My thought:

@qthrul my bet would be that there must be market opp other than death by down rounds or death by sale to big corp (link)

Matthew Ward chimed in later;

hellodelight @tdavidson Go to the oracle… http://bit.ly/2CtBvQ I think the arbitrage from flounder-er comes from patient capital + decent fundamentals (link)

Perhaps, but turning around companies with cash flow is a very different game than jump-starting new companies. The “fundamentals” for emerging companies (pre-revenue or pre-profit) and established companies (revenues and predictable cashflow, shaky profits) are very different. Venture capital and private equity are two very different styles of investing; similarly, a startup buyout firm and a private equity turnaround firm would operate two very different operating and financial models.

Matthew added:

hellodelight @tdavidson Agreed 100%. That’s why I think Buffett is a good example. Fundamentals are key so that your $ + mgmt can actually help (link)

So, the key requirements are a) a management team of experienced entrepreneurs with a broad skill set and deep relationships and b) money.

But how much money? Who are the other buyers in this market? What terms would the prior investors require?

A venture buyout firm would provide an option for entrepreneurs from selling to big companies and could compete by structuring transactions with less cash up front, but the potential for a larger earnout. Obviously this wouldn’t attract all entrepreneurs (especially the “built-to-flip” variety), but as long as the terms are competitive enough to be a viable option, you’d attract (self-select) the types of entrepreneurs you would really want.

How different is this than Series A investing? For one, Series A investors aren’t looking to invest in turnarounds but to provide capital to jump-start promising businesses. The operating model and risks are different and the transaction and investment terms would have to be structured very differently. There would likely be a mix of situations where you a) retained management under a new ownership and compensation structure and b) replaced management and operated the company directly.

Of course, the biggest question: could it work? Or is this just another random idea I should discard quickly?

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Updated: Even as I posted this, I was sure it had been thought of and tried before; thank you to Darren Herman for providing his thought from a couple years ago.