Why HR Technology is a Good, but Not Great Category

HR Technology is a noble software category that almost everyone can rally around its mission: To improve the efficiency and effectiveness of organizations.  Whether it is talent acquisition, performance management, learning or compensation & benefits, no one can dispute that technology to enable HR organizations can have real impact on people’s lives.   In general, as an employee of one of the HR Tech vendor you can feel good about the problems your firm is solving for your clients because you can related to the product or service you are selling.

The HR Tech industry is booming which can easily be seen by the number of startup companies being created every month, the growth of the HR Tech industry conferences  and the record amount of funding invested in the HR Tech category.   Because just about everyone has encountered some type of HR problem that needs to be solved during their career combined with the incredibly low costs of starting a SAAS business these days, everyone and their brother have started an HR Tech company in recent years to solve some piece of the HR puzzle. Many folks have dedicated themesleves to the HR Tech industry and there are certainly many opportunities to have a long career as an employee, industry expert/analyst or vendor.

However, after spending almost four years in the space, I have peeled the onion and found that it really isn’t such a great industry when it comes to profits. If you want to get disproportionate returns on your investment of time or money as an investor, founder or employee this probably isn’t the first category you would pick.

While there are clearly various pros and cons of the industry and everyone must decide what is right for their personal situation, at a macro level here are….

The Top Three Reasons Why HR Tech Is Not a Great Category:

  1. Unusually High Sales Friction: Hard to prove ROI in order to get budget approval

By definition, the HR function is not directly tied to revenue like sales, marketing or product; it is an enabling function.  While there are some roles (for example, professional services organizations) there is a clear connection to revenue to filling sales-related roles, in the significant majority of situations it has hard to show how much more money you will make for any direct HR investment. The vast majority of HR tech investments are justified based on compliance or real cost reductions (e.g. applicant tracking systems or payroll). These types of investments are considered either ‘cost-of-doing-business’ budgets or somewhat easily quantifiable via a reduction in an existing budget.   However, tools which improve productivity or quality are much harder to get approval without significant, measurable benefit data to prove the business case for a sizeable budget. This takes time, effort and commitment from a champion within the organization. Since HR budgets don’t tend to grow disproportionately to a company’s growth, most of the time getting a large budget approval for a new system is dependent on a significant change to another part of the HR budget (e.g. no longer investing in another system).   At the end of the day, the sales friction for these types of quality or productivity solutions makes it harder for HR tech companies to grow quickly.  During my years in HR Tech, this is consistently the most common frustration my fellow founders have echoed: not being able to close new customers at a faster rate due to the challenge of getting a piece of the HR IT budget.

  1. Highly competitive unless you have a moat

If you look at the most profitable companies in the Fortune 500 they have incredible scale (e.g. banks, ExxonMobile), low marginal costs (e.g. biotech)  and/or are fortunate to be in a category with ‘winner take most of the profits’ economics (e.g. Apple and Google).  In addition, having network effects helps create a moat which inhibits others from re-creating the scale that the winners have secured.  With the odd exception (e.g. Oracle, LinkedIn) there not many companies in the HR Tech category that have been able to build a moat and achieve disproportionate profits.  While there are certainly some excellent companies who have achieved scale (e.g. ADP, Workday), their margins are good but not great.  Almost all companies in HR Tech have (or will have) competitors that provide buyers multiple options.  So while there may be ‘lock-in’ to a solution for a large enterprise software platform for a few years, the acquisition costs, competitive pricing and cost-to-serve limit margins and growth potential.  Network effects are pretty rare in HR tech (LinkedIn being a notable exception).  The majority of IT budgets for the HR department are spent on enterprise software solutions and they usually involve traditional sales teams with big price tags and complex implementations – not viral adoption.

  1. Profitable but not liquid: Limited exit options

In the past 10 years, I am only aware of a handful of billion dollar exits in the HR Tech space.  LinkedIn, Workday, SuccessFactors, Taleo and Kenexa-BrassRing. The limited true M&A in the space makes it challenging for traditional, big name venture capital firms to be interested in the space.  If you look at most major HR tech funding announcements they do not typically include well known VCs. While there are some exceptions here and there, what I have been told the challenge in picking early winners (since HR has so many problems companies are always willing to pilot something new) combined with the lack of exit opportunity drives venture partners to prefer investing in other categories.

At least a couple of times of month I get an unsolicited email from some boutique firm offering special services to help HR Tech founders either raise non-traditional venture capital or assist with some type of creative exit opportunity for later stage companies (e.g. at least positive EBITDA or >$10M in revenue).  From someone who is pretty knowledgeable with the traditional Silicon Valley startup path where you continually raise more VC funding until you either get acquired or if you are early lucky, IPO. However, what I have learned the last couple of years, it that there are literally hundreds of HR tech companies who have achieved a reasonable level of success and likely profitability, but they are tweeners who are not big enough or growing fast enough to IPO or be an acquisition target but at the same time, they have real businesses that generate positive cash flow.  This creates a conundrum for the investors and any founder/long-standing employee holding a good chunk of equity about how to liquidate their shares. While dividends are certainly one option, that is usually not the preferred choice.  Imagine putting in many years to build a reasonably sized going concern generating millions in revenue, but not having a clear exit path.  This lack of liquidity options is something that many folks who are vested in HR Tech need to consider when committing to the category.

Conclusion

There are many factors I truly love about the HR technology industry.  It starts with smart, passionate, caring folks who are committed to makes things a little better every day for the working folk.  But, depending on your role, you should know exactly what you are signing up for if you are committing to a career in HR Tech.  It may not be as financially rewarding as you might expect.  If you are looking to hit the jackpot in HR Tech as a founder, investor or early employee, you might want to explore other options or categories before this one.

How to interpret VC feedback – standing out from the crowd

In my past I have been turned down by VCs many, many times.  And while some of the VCs may not be so great at being a VC and not ‘get it’, for what I was pitching, it kind of didn’t matter.  Overall if you speak to more than five investors and basically get the same result it ain’t them it’s you.  But how do you know what ‘it’ is and figure out what to do about it?  It is really hard for someone who is raising money to figure out how to interpret the feedback (explicit or implicit) received.

You can break down what it takes to get funding into three big buckets Team, Concept, Traction.  Just about every question or discussion you had with an investor is evaluating at least one of these areas.

To get funded, you mostly need high marks on two of the three and ideally all three.  And sometimes funding is a no-brainer. If you are already a successful entrepreneur you can probably get by with just having a team and are essentially ‘instantly fundable’.  But most folks raising money don’t have a previous success.

The other ‘instantly fundable’ attribute is having big and growing traction. Mark Zuckerberg was able to raise his Series A from Accel Partners not because of the team, but because he had a pretty good concept and most important traction. Having great traction solves almost everything (except for maybe a small market) in order to get funded. And not just good traction, accelerating traction.

So assuming you are not a previously successful, repeat entrepreneur and don’t have accelerating traction, then it is basically a mix of the team, concept and traction that the VC is looking at.

With your product still in development (and likely without deep proprietary technology behind it) and traction several months away, it is all about evaluating the concept and the team. Interpreting all the messages that were sent by an investor can tell you how close you are.  Do not be surprised if you are a lot further than you expect to be despite all the nice things the VC says to you (like ‘when you have a lead’ or ‘I’m very interested to track you guys as you see some results’).

So let’s start with the team starting with the founders.  Attributes to look at include the technical background of the team. How much engineering experience is there on the team that knows how to ship a scalable product. Also, how much business acumen on the team to address acquisition and monetization elements of the strategy.  Education and previous companies worked at play a role in experience, but at the end of the day an investor wants to know if they can trust the team to build something and get people using it.

One thing most first-time entrepreneurs don’t appreciate is that most other entrepreneurs are also really smart. Most have really top notch educations, strong technical backgrounds and some previous experience in a related field to what they are working on. The question that a VC is trying to answers is ‘Are you exceptional?’.  The best (clichéd) analogy is American Idol. However, not during open auditions, but when the number of contestants has been narrowed down to a much smaller number like 20 or 30.

At that point everyone is a great singer. But what makes you have star potential even though you have never recorded an album before and not a professional singer? What makes the VC believe you have star potential?What crazy thing(s) have you done that most people would never do that shows you got something special? Did you start a business when you were 12 years old?  Did you build a cool product on your own that solved a cool problem? The ‘exceptional’ usually involves some level of either incredible domain expertise that you were able to do something great with or demonstrating some form of salesmanship that accomplished something most people would never dream of even trying.

There are many things that could show that you are ‘exceptional’, but in reality most don’t.

Given the market the team is going after, how much domain expertise is there to understand the nuances associated with the target customer. Of course, more is better.  Most thoughtful VCs can quickly ask a few questions to the founding team to see if the understand the basics and some subtleties associated with the market they are pursuing.  In a consumer business, developing some consumer insights and understanding behaviors is critical.  I can’t tell you how many times I have spoken to a startup who is developing a new product and has yet to talk to anyone who would be a target user.

At the end of the day, a VC is trying to understand if you know your stuff and do you have the passion and dedication to figure it out quickly.

A related element to evaluating the team is their ability to eloquently address the second big attribute VCs care about…the concept.

By concept I mean everything from ‘What is the problem being solved’ to the product experience, to proprietary technology, distribution to market potential.  All that rolled into one. Like we used to say at Intuit…Is it a big unmet need, that you solve well and can you have a durable competitive advantage?

And then there are the other common questions:  How will you get users/customers? How will you get them to come back? How often will they use it? How will you make money? Basically Acquisition/Distribution, Retention, Engagement and Monetization. Related to this is the network effects and scalability of your offering or model.

Do not underestimate the need to have convincing arguments for each of these elements.  Without data around adoption of your product it is very possible that there are risks on several of these attributes. Each of these risks affects your fundability.   This is where an investor can easily drill down and see how well you understand your business by asking questions about your metrics. Even if you don’t have any tangible numbers, you should know the benchmarks you will be compared to. Whether it is eCPM, DAU/MAU, CPA etc. a good knowledge of the key target metrics will demonstrate that you know your stuff.  A red flag for an investor is if they know more about the metrics than you do.

Finally, one last attribute to consider is sex appeal. How hot a space are you pursuing? If you are working on a standalone web property versus a social, mobile, local (insert hot space name here) then you probably won’t be doing so great on the sizzle scale.

It is hard to get a term sheet from a venture capital firm. All you need to do is to look at the numbers of how many Series A investments any firm makes compared to how many startups are created annually.  A longtime venture capitalist once told me that VCs are not risk takers. In fact they are exactly the opposite, they are risk eradicators. The more you have reduced each of the risk factors related to the team, concept and traction described above, the much higher the probability of closing a venture round. Do you have what it takes to be the next American Idol?