How to spin off the Product from the Agency

Some Agencies are able to build their own product. This is not easy but it is possible. I wrote about it some time ago: Building a successful product in an agency.

Usually agency owners realize that further development of the product is not aligned with the agency business goals. 

Why is it not a good idea to develop Products in an Agency?

Agency

• can generate high EBITDA even with a relatively small business, 30% or even 40% EBITDA margins are nothing uncommon with a good agency business,
• can pay dividends every year, cash-cow strategy,
• growth is linear but not so risky, you can grow 20-30% YoY for many years,
• value you create is around 10xEBITDA,
• it’s quite hard to sell the whole business. Of course if you design an agency the right way, it’s perfectly possible,
• no VCs or BAs interested in funding it, possible exit to Private Equity or a Strategic Investor, but you don’t need exit as this is a cash-cow.
  

Product

• you need a lot of investment for the first couple of years, no positive EBITDA, no dividends, a lot of stress,
• high risk of going bankrupt during this phase, 
• usually you need some effect of scale to build your EBITDA, which could go up to 90% eventually,
• the value you create is around 10-20x REVENUE (so this is basically a lot higher than for a services business),
• it’s relatively easy to sell it (many more options),
• it’s quite easy to find external BAs, VCs interested in financing growth. 
  

As you see these two business models will cannibalize each other. 

Agency is not investable so you will use the whole cash you generate to subsidize growth of the product. Product is growing slower than it could and the agency is less profitable than it could be. It’s a lose-lose situation.

So why is it so hard to spin off products from the Agency?

3 Problems of spinning off the product from the agency

The Team - for every company you create, you need a Management Team. Usually agency owners are not able to leave the agency business. Building two companies at the same time is super hard. You need to decide where to focus. Despite what you choose, you need some new managers that will run the agency or the product business. 

Cap table - this is somehow connected. If you introduce a new management team for the product company you need to be sure these guys are motivated and will feel fully committed to the new company. This is still a startup and the team is much more important than anything else.

Independence - is this product able to be successful without any further support from the agency? You should think about cash-flow, clients, maybe some additional services are needed. You need to make this independent. At some point there will be a gray area in which the new company can compete for talent, clients etc. with the old company. 

How to solve these problems

I will now present these tactics having in mind each of the stages of a new company.

• Pre-product - prototype is built already, but the product is not finished yet. No clients. Here you need some smart money from the people that will also help you figure out your strategy. Business Angels love this stage. Usually rounds start from 250k eur/usd.
• Pre-money - the product is live already and.. despite the name, usually there are some first clients. Maybe you don’t see a clear pattern yet. Someone is already paying but the whole pricing needs to be figured out. Here you can ask for the first VC money.  Usually rounds start at 1,5m eur/usd.
• Close to the Break Even Point/Scale Up - basically you have a lot of clients and you know what you are doing. You can realize your margin achieving the BEP or you can decide for further growth to win more of the market. This is the moment where everyone is interested in giving you money - starting from VCs and ending at PE Funds, debt financing, you can IPO, you can do whatever you like because you could be profitable.

Cap-table

Different financial players will have different needs when you think about the Team. This is why the cap-table is so important.

When you think about the management Team of the product company you should offer:

• Pre-product/Business Angel Stage - 70% of the shares in the hands of the Team.
• Pre-money/VC Stage - 50%+ of the shares in the hands of the Team.
• Break Even Point/Scale Up Stage - ESOP around 10-15% is usually fine.
  

Technically you can think about ESOP (Employee Stock Ownership Plan) or other instruments. These shares could be vested, still, you need to think about these levels as only this makes the company investable. 

One of the biggest mistakes that Agency owners make at the early stage is they don’t give away enough shares to the Team that will actually run the new company. Then they end-up with a company still at a very early stage of growth that is not investable. This is a trap.

Summary

This is why we decided that at Catch The Tornado we will deliberately shorten the incubation process to 9mo and lower the investment to 50k eur to be able to offer up to 70% of the shares to the Founders. This is what will guarantee that our companies are perfectly investable even at the Pre-product stage. Naturally, our goal is to achieve the Pre-money stage after the acceleration. This gives us a lot of buffer for further rounds with external BAs and VCs. 

We made 3 spin-offs in our career. Of course, every spin-off is a different story but we saw specific patterns and I decided to share them here with you. Happy to hear about your experience on that.

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