Why Tech Startups Should Target Privately-Owned Companies

The dream scenario for many, if not most, tech startup entrepreneurs is to land a major sale with a big, preferably well-known, public company. Credibility, revenue and sales to other major companies will follow, or so the dream promises.

I’m not one to throw cold water on entrepreneurial dreams, but let me suggest a more promising way for a tech startup to gain traction — by focusing on less well known private-equity owned companies. Here are a few reasons why this could be a more effective and successful approach.

A Mismatch of Expectations

To start with, the mindset of tech startup entrepreneurs is much more in sync with that of managers at private-equity owned companies than it is with the views of managers at a public company.

Startups generally focus on the long-term. In fact, they often are incentivized by their VC investors to focus on solving long-term structural problems by offering the marketplace a new technology or solution. And that means their funding sources are committed to accepting short-term pain for the sake of long-term gain.

And even in the most long-term minded public companies, this is simply not the case. First, despite rhetoric to the contrary, Wall Street and investors tend to punish the share price of public companies if earnings don’t steadily increase — and soon. As a result, managers at public companies are leery of making an investment and taking a chance on a new product or process unless the payoff will be almost immediate. As with most worthwhile innovations, the returns from any new tech product/service may take time to build; public companies have little patience.

The Fear Factor

Short-term thinking affects the mindset of managers at public companies in other ways. As employees who themselves are judged on the basis of quarterly numbers, they quickly learn to play it safe and not make risky long-term bets. It’s only logical, therefore, that they are loathe to stick their necks out on an untried product from an unknown company when the upside — perhaps a bonus or small raise — lies many quarters in the future. The downside is earning the reputation as a not-so-trustworthy maverick at best or losing one’s job at worst.

What’s Different About PE-Owned Companies

Private-equity-owned companies are singularly focused on making their businesses better. Their business model aims to create value for shareholders by generating returns that are greater than those available in public markets. And they do. A recent analysis by the American Investment Council found that private-equity firms had a median return (net of fees) of 8.6%, as opposed to 6.1% for companies whose shares trade in public markets.

Now, let’s consider the enterprise buyer on the PE side. Admittedly, just like the public buyer, if the purchasing decision goes awry he or she may get fired. But the decision-making process for the purchase and the operating environment are much different.

First, purchasing decisions of a significant magnitude are discussed at the board level. Usually, the entire management team and board are involved in investment decisions because they know that such expenditures affect the timing and level of cash returned to investors, which is their prime driver. That involvement means that there is more alignment around purchasing decisions and greater commitment once a decision is made.

Second, since the average hold time for a private equity investment is just over six years, a tech startup has more breathing room to deliver results. A two-year window to demonstrate a payoff from an investment in new technology — an eternity at a publicly-owned company — would likely be seen as reasonable at a PE-owned firm.

It is also worth noting that employees of PE owned business often have meaningful equity in the businesses they operate, since fund managers believe employees’ ability to share in the financial success of the company helps to drive outsized performance. If a tech startup can persuade a potential PE-firm buyer of the merits of an investment, it will enjoy a vested interest in the investment’s success.

Coming Back to Mindset

As any sales professional will confirm, numbers and logic go only so far in landing a sale. It’s the emotional buy-in — whether the product or service is consumer, industrial, high-tech or anything else — that clinches the deal.

Many startups don’t take into consideration how the ownership structure of their sales targets affect the feelings and outlook of decision-makers, either because startups don’t think that’s material to their go-to-market strategy or because they don’t fully appreciate its impact on decision-making. But since leaders at startups think so much more like managers at private-equity-owned businesses than they do like managers at public companies, it pays to sow seeds where the ground, and the mindset, is more fertile.