Constellation Software is a leading provider of software and services to a select group of public and private sector markets. They acquire, manage and build industry specific software businesses which provide specialized, mission-critical software solutions that address the particular needs of our customers.
Mark Leonard founded the company in 1995 - after 11 years in the venture capital space. Over the past 25 years, the company has grown to a $29B market cap and has acquired over 400 companies. Simply put, he has a reputation of being a world-class investor and operator.
I'm proud to say that I'll be joining Constellation Software in the coming days - leading up a corporate development team for one of their business units.
As a part of my exercise for joining Constellation Software, I created a summary of my notes from Mark Leonard's letters to his shareholders from 2008 to 2018. There's a number of interesting lessons that both investors and operators can learn from.
Mark Leonard's Why
My motivation is to help create a company where worthy people succeed. Whether they join us with an acquisition or are hired from the outside, I want to support and encourage employees who work hard, treat others well, continuously learn, and share best practices. I try to make sure that sycophants, spin-doctors, and mercenaries don’t survive in Constellation’s senior ranks. Harder, but not impossible, is helping identify and remove hidebound managers who rely upon habit and folklore to run their businesses rather than rational enquiry and experimentation. Constellation is as close to a meritocracy as I have experienced
A Career At Constellation Software
Stage 1: Immerse yourself in learning about the peculiarities of VMS economics. At some point, transition from analyst or knowledge worker into a leader of people. I find there is no magic to managing and leading. If you are smart, work harder than everyone else around you, treat people fairly, do not ask them to do anything you would not or have not done, share the credit, keep learning and keep teaching, then pretty soon you have followers. If you make sure that the team members are intelligent, energetic, and ethical people with whom you would want to work for the rest of your career, it won’t be long until you are running one of our BU’s
Stage 2: If I were advising my 35 or 40-year-old self on where to go from there, I would tell him to stay put. Work closely with the best customers in your vertical. Help provide them with the software and systems that they need to prosper. Do an occasional tuck-in acquisition to buy a product or customer base more cheaply than you could otherwise build it. Grow revenues per employee so that you can pay your team significantly more every year. Become a master Craftsman in the art of managing your VMS business. It is the most satisfying job in Constellation and will generate more than enough wealth for you to live very comfortably and provide for your family.
Stage 3: For those whose ambition exceeds their good sense, we have a role that we call a Player/Coach. A Player/Coach continues to run their BU, but ambition drives them to acquire a sizable business, usually in another geography or another vertical. We set up most of these acquisitions as stand-alone BU’s because verticals differ, and it is difficult to create a high-performance team if they are geographically dispersed. The BU manager for the newly acquired business is nearly always from the acquisition itself, and hence has deep expertise in the vertical. Should the Player/Coach find a second or third stand-alone business to acquire, they eventually have to give up the day to day responsibilities for running their original BU and become a full-time Portfolio Manager (“PM”). If the PM is good at finding acquisitions, and helping them learn relevant best practices, and continues to deploy at least the FCF produced by their portfolio, then we refer to them as a Compounder.
Craftsman vs. Compunders
- The difference between a Craftsman and a Compounder is often one of personality. Successful Craftsmen can be autocratic or consultative, brilliant or average intelligence, introverted or extraverted, mercurial or imperturbable. Lots of different personalities and styles work.
- Successful Compounders have no choice but to be (or become) more hands-off and trusting. They can be curious and driven, but they can’t be directive. They can nurture, goad and suggest, but they can’t order. No PM can personally know the customers, products, employees, and competitors sufficiently well across multiple BU’s in different geographies and verticals, to make the critical decisions required at the BU level. In the infrequent instances where the manager of a BU isn’t making the grade…if they are failing to build the team, extend their moat and generate an adequate return on their capital, then the PM needs to find a replacement for the BU manager.
How to Value Software Companies
1) Sum of Return on Invested Capital (ROIC) & Organic Net Revenue Growth
- Adjusted net income = cash profits generated after paying cash taxes
- Invested capital = shareholder capital + adjusted net income - distributions
- ROIC = adjusted net income / invested capital
2) Revenue and cash flows per share
- Annual growth in Revenue per share
- Annual growth in cash flow from operating activities per share
- Tangible Net Assets / Net Revenue
Note that these metrics are primarily geared toward businesses with low capital expenditures
Buy From Founders
- Founders invest their life into the business and a long-term orientation permeates all aspects of the business (employees, customers and product)
- Great cultural fit
- Process: Let owners know that they'd love to be a permanent owner when the time is right
- Demographic: Businesses came with the advent of mini and micro-computers and many of their founders are baby boomers thinking about retirement
Buy Distressed Assets
- Look at companies who have bought a business 5-10 years ago, see if the people who supported the acquisition have moved on
- Analyze portfolio companies from a private equity fund that is getting long in the tooth (no real exit plan)
The Evolution of Management Structure
- When a VMS business is small, its manager usually has five or six functional managers to work with: Marketing & Sales, Research & Development ("R&D"), Professional Services, Maintenance & Support and General & Administration. Each of those functional managers starts off heading a single working group.
- Priorities are clear, systems haven't had time to metastasise, rules are few, trust and communication are high, and the focus tends to be on how to increase the size of the pie, not how it gets divided.
Growing Past 30 Employees
- Scenario 1: If the head of R&D in this example is brilliant and is willing to work hours that are unsustainable for most of us, he may be able to parse out tasks for each of the team members despite the increased team size. He may be able to judge the capabilities and cater to the development needs of each of his direct reports. He may be able to recruit excellent new employees, and he may be able to manage the demands and trade-offs required to coordinate with the other functional managers
- Scenario 2: more likely outcome, is that the R&D manager isn't a brilliant workaholic and cannot cope as the team size exceeds double digits. Instead, he'll break his team up into multiple teams. A new level of middle managers will be born, with all the potential for overhead creation, politics, and bureaucracy that comes with another tier of middle managers.
- Talented but quirky people (the builders) don't survive this environment
- Focus shifts from customers and markets to internal communication, cost control and rule enforcement
- Hard for BU managers to maintain strong organic growth when they grow past 100 employees
- Solution: BU grows and breaks off into multiple BU's (allowing for succession). See lesson on working in small teams.
1) Managing Research, Development, Sales and Marketing Expenses
- Temper expectations; they usually need 5-10 years to reach cash flow break-even and expectations always tend to be higher than reality
- Keep early burn-rate of initiatives down until there is a proof of concept and market acceptance (get clients to pay for early development)
- Triage initiatives earlier if key assumptions are wrong
- Create dedicated champion positions so that initiatives don't drag on with a low but perpetual burn rate under a part-time leader who doesn't feel ultimately responsible
2) Growth Profile of A Target Company
- Grows slightly faster than their markets, adding market/customer share, generating good return on capital
- Small market shares are less likely to trigger massive competitive reactions
3) Working in Small Teams
- Constellation's business units are intentionally small (biggest unit is 307 employees and average is 44)
- Regularly divide largest units into smaller, more focused business units unless there's an obvious reason to keep them whole
- Keep multiple small operating units to maximize market share vs. eliminating redundant costs. (conventional M&A logic)
The Future of Constellation Software
One day Constellation may find that VMS businesses are too expensive to rationally acquire. If that happens, I hope we'll have had the foresight and luck to find some other high ROE non-VMS businesses in which to invest at attractive prices. I am already casting about for such opportunities. If we don’t find attractive sectors in which to invest, then we’ll return our FCF to our investors. Even if re-investment opportunities become scarcer, Constellation doesn’t end… it will continue to be a good (hopefully great) perpetual owner of its existing VMS portfolio, and will still deploy some capital opportunistically.