HotSchedules, Fourth Exit to Investors, But Things Won’t Get Easier

As soon as you take private capital the timer starts. Your friends and family are forgiving and patient, but professional investors are under the gun. The base case analysis for most investors is a 25% internal rate of return (IRR). There are plenty of calculators that show you how much you need to sell for to achieve these levels of returns, but the easy math is that you must triple your value in a 5-year period. As companies get larger, that’s really hard to do. Public equities grow ~8% on average, so you’re achieving nearly a 3x rate of return.

You may recall that TPG was an investor in HotSchedules back in early 2013. Among with many other restaurant assets, TPG executed the proverbial private equity rollup. Rollup strategies are fairly straight forward: buy market share and use your heft to negotiate better terms from suppliers, decrease OPEX through “synergies”, and cross-sell products across the rolled up assets.

These investments usually only meet expected levels of investor returns when levered with substantial debt, which the market or the next private equity owner assumes when the initial private equity (PE) investor exists the business. These difficulties are only compounded when customers are of the unsophisticated variety, precisely like the kinds you find in brick and mortar.

When we heard the news of TPG exiting HotSchedules we had to find out how things transpired, and what would be next for the combined business.

TPG held HotSchedules for 6.5 years. Ideally funds get out in 5 unless they’re making money hand over fist, in which case they’ll typically roll the investment into their next fund. That’s because funds have 10-year lifecycles, with the first five years dedicated to deploying capital and the last five dedicated to harvesting those returns. So did TPG make a killing?

We’ll look at Fourth, first. Fourth took institutional capital from ECI in March of 2011, who exited the business in June of 2015 to Insight Venture Partners for an ROIC of 3.5X and an IRR of 35%. Not too shabby.

Insight Partners teamed up with Marlin, another PE shop, to fold HotSchedules into their portfolio. PE companies often collaborate when deals are sufficiently large, as we’ve talked about previously.

Unlike ECI, TPG has not publicly announced their IRR. Does that mean the numbers weren’t sterling? We’ll need to use what we’ve heard to estimate.

First, the revenues.

HotSchedules is nominally earning enough revenue to go public – which is $100M. However, these are not recurring, SaaS revenues. As we understand it, $40M of these revenues come from one-off, non-recurring sources: implementation services, and Digital Red Book, which is industry jargon for a basic logbook. Our guess is that many of these existing Red Book customers would find another solution if asked to pay a recurring fee for a simple logbook, so HotSchedules has not pressed the issue.

Not only do these “undesirable “revenues conflate the value of the business, they also inflate the number of customers they have. Early in the roll up Red Book touted tens of thousands of customers, but those were not POS-integrated merchants using a SaaS solution.

The revenue CAGR of 13% is decent, but what’s the EBITDA? To satiate the rule of 40, the business would need to have EBITDA margins of 27%. Sources told us HotSchedules was losing $10M per year, which ain’t good for this level of growth.

These numbers would explain the sales figures we heard for HotSchedules, which was pegged at $300M-$350M. Assuming $60M of recurring revenue, that’s a 5-6x multiple, which makes sense if the company is indeed cash flow negative. However, some back envelop math should get TPG to benchmark returns of 25% IRR when accounting for leverage, so it’s not a total loser – but not quite the success ECI had with Fourth, either.

We also heard that NCR offered $470M for the company late last year, but TPG held off. NCR has already proven it has no problem overpaying for assets, and it’s certainly desperate to convince the market it deserves a SaaS multiple on its legacy business. But if NCR had bought HotSchedules it probably would have accelerated the death of HotSchedules, as NCR seems to be the place where businesses go to die. TPG might have realized the same and preferred to wait and see what other offers would make themselves available for the sake of HotSchedule employees.

Now that Fourth and HotSchedules have merged, what should the market expect?

For starters, being an investment banker can be great. By that we mean you get paid when a transaction closes, not on the outcome of the transaction. And most mergers and acquisitions fail. Depending on whose numbers you use, 83% of M&A activity fails to produce shareholder returns. The reasons are many: cultures, people, strategy, products, etc.

When looking at the Fourth and HotSchedules merger, we see many areas for concern.

First let’s talk about product. Fourth and HotSchedules already have overlapping product lines. Each company is a product of a series of acquisitions or mergers in its own right, which means there’s a lot of legacy maintenance across product lines – and folding the two companies together just magnifies this issue. When the new company goes to market, whose product gets prioritized? How do they justify maintaining the lesser of the products in a certain category? There will be infighting about whose product is better – believe us.

Second, there’s bound to be a large cultural gap between organizations, no doubt magnified by the Atlantic Ocean. Neither of the companies is a data company either, which is challenging as the world moves towards data science and AI. Here’s a great litmus test: why haven’t any of these companies produced a tool that automatically builds and manages schedules with AI? It’s not necessarily a hard thing to do once you have the data and the right team. But you’d need the flexibility in cultural thinking to execute this. That’s just not how either of these companies have been built as they were founded by restauranteurs who never prioritized data. At least Fourth has recognized limitations and done work with data science firm GoodData, though GoodData is not a vertical-specific tool.

Third, nobody seems to appreciate market dynamics that are threatening to these two entities. Let’s take a look at how TPG views the market size for HotSchedules.

(The irony is that TPG would put this crap out there when selling one of their portfolio companies but they would never accept the same level of thoughtlessness when buying an asset.)

Most merchants are too small to afford Fourth or HotSchedules; these solutions cost $150, $200, or more per store per month. That’s in contrast to a company like Homebase or Deputy which does scheduling for a fraction of this cost. Remember, we find that merchants bristle when prices creep above $100 per store per month (unless you’re talking about payments processing, in which case merchants are aloof and almost welcoming to the sodomy).

Here’s a data table from NPD and Datassential that proves our point: at least 75% of the market (i.e. merchants who do less than $1M in annual revenue) is too small to buy anything from Fourth or HotSchedules at their current price points (first column is from Datassential, second column is from NPD).

Will HotSchedules and Fourth decrease their price points to go after these smaller merchants? How will that make their larger customers feel – you know, the ones that are paying substantially more for the same products? Further, how will these companies distribute to smaller merchants since these merchants don’t do any self-discovery? At least larger merchants attend conferences where they’re forced to learn new things…

We believe POS companies will dominate much of the solution stack HotSchedules and Fourth are going after, at least downmarket. With the exception of NCR, Square, Toast – all companies who have either publicly announced their desire to build “everything” or whose actions have said as much – and Lightspeed, depending on the day of week, most leading POS companies are establishing partnerships with third parties to substantially augment their capabilities in the solution stack as they’ve realized they cannot do everything. POS companies have the stickiest merchant relationships and they also have the merchant’s transaction data by default, meaning partners employing data science can substantially increase the likelihood that the merchant chooses the POS company’s stack solution.

The other exception, which works in HotSchedules and Fourth’s favor, would be payments companies who don’t understand software and are insufficiently investing in R&D to bring these next-gen capabilities to their POS merchants (note: see how Global Payments still doesn’t have a universal API despite owning restaurant POS companies for nearly four years). It’s highly probable that these payments companies run their POS portfolios into the ground as they view the POS merchants as payments opportunities, not as customers that deserve ongoing, tangible value.

Ah, classic payments.

Here’s what you’d have to believe for the Fourth/HotSchedules deal to make sense.

• Fourth/HotSchedules resolves geographic, cultural, and product challenges
• Fourth/HotSchedules market isn’t yet saturated (but a 13% CAGR tells a different story…)
• SMB merchants self-discover Fourth/HotSchedules solutions and have no objection to paying current price points, or Fourth/HotSchedules produces cheaper alternative
• Competition is of no concern – even though Restaurant365, Compeat, Crunchtime, Harri, and many others are taking significant capital to go after the same, upmarket customers
• POS companies don’t usurp SMB opportunity
• POS companies don’t move upmarket with partner solutions
• Payments companies neuter POS companies/themselves and eliminate themselves from being relevant competitors

The last bullet point is the only one we feel Fourth/HotSchedules has a better than 50/50 shot on going their way.