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Colin and Brent discuss Colin's operating manual for Constellation Software, owner for 500+ software companies.

Reach out to Colin Keeley and Brent Sanders on Twitter with any feedback.

Colin Keeley: [00:00:00] Hello, and welcome back. This is Colin Keeley. Here

Brent Sanders: [00:00:03] And I'm Brent Sanders.

Colin Keeley: [00:00:05] we are two guys buying and building wonderful internet companies.

Brent Sanders: [00:00:08] Yes, indeed. And we've been talking a fair amount on these episodes about ,  constellation software. So it's this dude named Mark Leonard who started constellation software and they're into what are called. These vertical markets versus horizontal. Like maybe you could explain the difference there, my understanding is what we're going after.

It w we have been looking at and businesses that are like super specific, like invoicing software or  CRMs for bowling, alleys, whatever it is, something that's very specific that in my mind, the big advantage is like, You get a customer and it's really hard for them to turn out or I shouldn't phrase it that way.

There's very little churn because it's so specific and you're one of three or two players in a specific space. So we've, I've been learning a little bit more about constellation, but I think you just shared some of your notes. You've been going super deep on, on intelligent gathering around it. What's the thinking, first off around this company, like what, what has attracted you to it?

Colin Keeley: [00:01:07] So he is one of the best deployers of capital ever. So a little bit of background on Mark Leonard just to begin. So he's the billionaire founder of constellation sauce. Which is a conglomerate of 500 plus of these vertical market software companies. And so this all started. So I have been taking notes on this for like years and it's easy in Rome to tag them all.

And then I just started organizing them and I've been working on this post, which I just finally made it. For, years and it was always in draft form. And I finally cleaned up all my messy words and made it open, but so he is super duper private. So he had a bad experience with the press a long time ago where it sounds like someone took his words, like out of context.

And since then he hasn't talked to the press at all. And so he's the most press shy billionaire ever, but he does have annual. So I've read through all his annual letters and he's done a few interviews with like people he works with. And occasionally it will leak out as like an MP3 file and then I'll immediately get scrubbed from the internet.

So if you want a DME, I have an MP3 file. I'll send it to you on Twitter. I sent it to you already. I don't know if he listened to that, but that was a pretty, yeah. So mark is ,  6, 5, 280 pounds, allegedly with again, aganda beard. And ,  there's only three photos I could find with him in existence.

So it took him seven years to go through college. He played basketball, football, and rugby was his best sport at the time. And then he got into some crazy jobs. He was a ,  Mason, he was a grave Digger. He's a dog handler. He's a wind energy research. And then he eventually ,  went to business school and ended up in venture capital.

And so while in venture capital, it wasn't going like particularly well, he was always irritated by VCs focused on these companies with large adjustable mobile markets.

Brent Sanders: [00:02:57] Yeah.

Colin Keeley: [00:02:57] And so he saw plenty of these great companies operating in these little niches. Like you alluded to a bowling alley CRMs and that kind of thing.

Brent Sanders: [00:03:05] Okay.

Colin Keeley: [00:03:05] But they didn't have like huge potential upside. So he wanted to raise a fund, just focused on these like mission critical VMs software companies. And he ,  I could stop wherever, but the next step was he raised $25 million Canadian from his old venture colleagues and from OMERS, which is a pension fund up in Canada,

Brent Sanders: [00:03:24] Yeah.

Colin Keeley: [00:03:24] With the goal of becoming the best BMS buyer in the world.

Brent Sanders: [00:03:28] It makes a lot of sense. I totally understand that perspective after spending some time in the venture world, we're also like the other part of this is you're not worried about product market fit at the earliest stages. This is like pre series a where it's here's an idea and there's a huge market.

And can you connect these dots from afar? Versus something that just makes sense. And I hate to say it, but. I feel like I could be just projecting, but I feel like having a nice, diverse set of work before getting into this kind of world definitely helps like seeing how real businesses work and getting your hands dirty on it.

I don't know if it has to be a grave Digger, it doesn't hurt. Maybe there's something around resilience around that, but either way. Things that are simple and make sense. It's hard to make that connection in venture. And that's why it's so hard. I think,  it's there's a lot of glitz and glamor around.

I think, this idea of picking winners, which is almost  part of The mystique of venture of seeing the potential in your investing, in the people, not necessarily idea and assuming they're going to get to the right market. And it's just like a lot of things have to go right in versus this world where.

I should say vertical market software where it's yeah, there's a business sort of a niche that, that exists. And ,  the stickiness is really strong. And so it's if you can provide good service to small markets in and do it in multiple ways ,  I don't see what's wrong.

Colin Keeley: [00:04:51] The one thing I didn't mention is like how he's performed. So he raised his $25 million Canadian in 1995, which is equivalent to 35 million us dollars today in a size of a fund. And later he took the company public because he had to give an exit to his VC investors, his pension fund investors, which was the bulk of the fund.

We're happy to continue going on.

And so this has resolved ,  he took it public at a roughly $70 million evaluation. So 33 to 70 million, and now today they never raised any additional funding. And today is valued at $31 billion as reliably compounded at 30 plus percent a year

Brent Sanders: [00:05:30] Oh, my God.

Colin Keeley: [00:05:32] all this time.

And so the way the business works. He acquires these businesses. They cashflow really nicely. They don't necessarily grow that much, but he uses that cashflow to acquire more businesses. And so last year in 2020, allegedly, they acquired ,  90 plus of these small VMs businesses.

Brent Sanders: [00:05:52] and these businesses, like I'm saying. My favorite part of them they're sticky. You don't have a ton of churn. They're very specific. One of the things I feel like you mentioned was like Harbor software, how many Harbor software platforms are there. And so as you look at the space, there aren't a ton of.

Incumbent and there are not a lot of like new entrance in this space, but the other part is it's software. So it's high margin, right? There's not a lot going on to, shirts of these businesses.

probably have sales and support and a handful of people, but they don't really, that's not like the thing that's generating know.

Colin Keeley: [00:06:27] Yeah. So what makes these things so attractive? It's recurring revenue, right? Software as a service they're super sticky. So they have high switching costs. They make up a small share of the customer wallet, typically 1%. And it really just isn't worth the hassle. As we talked about a bunch of other times before, to switch these things, don't make up a big cost, but it provided a bunch of value to you.

And then they are, the software so that. if you don't have any major capital investment requirements, you could downsize the business. You could cut it down to one person, like why an engineer keeping everything up and running if you need to ,  it's super high margin. So that's where all the cashflow is coming from.

And then we've talked about. Like bowling alley or marina software, roughly half of what they do is government software. So a lot of stuff with municipalities school boards, police departments, and what they stumbled upon is like the incentives are so messed up for these public employees where there's no real reason for a salaried employee to lobby to change the software vendor that they're using.

It's just like, why rock the boat? No one gets fired for keeping the same software in place.

Brent Sanders: [00:07:32] that's a wild, I guess that's a interesting place to play, but ,  it reminds me of, some of the players that, that just yeah. Dig into this municipal municipality software, which it's funny. We were working on a separate project around this, what ,  last year around Hey, there's one player that does all of the building code management or all the, whatever it is.

And it really is you do need software for this and you need ,  furthermore, you need like your. Community be able to have access to information. So anyways, that's a really interesting detail that I actually didn't know that they were going after, which is the stickiest of the sticky. So it's really, obviously you want to keep your software, your product working well and you don't want to just deliver crap, but which kind of begs the question like as an acquire, it sounds like, yeah.

They're going to be around. They don't hop in and just do cost cutting. They'd let, so my assumption is that the companies that they're purchasing are generally profitable, they are looking for  big upside outcomes. So there's what is your sense for the payback? Do you have any details?

I'd probably all private, the deals that have been done, but, one would assume that there's, a four year payback and then all of the profits are now going into the constellation.

Colin Keeley: [00:08:47] So I don't have firsthand knowledge of the acquisition prices. I know that they're much more disciplined than other people that are playing in this space or the private equity funds. Cause they are not acquiring things and pushing for like immediate synergies or cross selling or like raising prices dramatically or firing everyone and just like hiring employees abroad that are way cheaper.

So they are, I've heard often pay like  a one to 1.5 revenue, multiple in this space, which is really low. But they're offering a really nice home for these folks as is without the pressure to aggressively grow or anything. And then we haven't talked about how it's structured, but ,  yeah.

Companies employees that are acquired have like way more upward mobility than they would ever have in these like niche software companies. Like they can continue to move up and own more and more in these ,  in the business units or the operating groups.

Brent Sanders: [00:09:43] Do they see ,  are you saying ,  let's say I'm working at the bowling alley sophomore. I'm the lead developer and the product stabilize, I'm getting bored. It's idle. There's a possibility I could go work for a different portfolio company or maybe elevate up a level and maybe manage a couple of different projects.

Colin Keeley: [00:10:01] Yeah. So the way ,  it's structured yeah. Is constellation exists. And then the six operating groups, which all kind of focus on different things. One, I actually spun out and only does European software companies. And then others have different focus like industrials or whatever. And then beneath those is a bunch of business units.

And then the business units are targeting one vertical and they're composed of multiple software companies.

And so there's a pretty clear career path where if you're operating one business, you never. You never get forced to operate less than you were before. So if you're really good at operating one, they'll put two under you.

And then if you're really good at operating two, maybe you get put in control of a business unit and then all the acquisitions, except for maybe the absolute largest ones are pushed down to the business unit level. So it's like these people that own a couple companies are the ones acquiring this third company.

So that's how they're able to do 90 plus acquisitions in a year. These business unit operators are empowered to make acquisitions up to four times the average acquisition price, which is like they can do it up to 20 million. I think the average is a 5 million or below.

Brent Sanders: [00:11:11] So like almost like little fiefdoms that can be created in these business units, which I guess is my concern would be if I was trying to do this, let's say without knowing anything about constellation, but if I was like mark and trailblazing this, like the first concern, let's say things are going well in your first, let's say year or two, and then.

You got a lot of people that start to have a potential to weigh things down. So it seems like he's got this idea to keep teams small, which I couldn't agree more with. And give people autonomy, which is probably hard when it's, Hey, I raised this money. You have an initial founding team, but then you start adding more and more people like do directions and incentives start to conflict.

It seems like it would get hard, but obviously he's managed it like a pro.

Colin Keeley: [00:12:01] So he, yeah, a lot of what he talks about is keeping everything human scale. And so in my article, I just embed a bunch of his excellent quotes on talking about keeping things, human scale and why he does that. But basically his background is team sports. So he loved working with small teams. Accomplishing big things.

And then in the venture capital world, he saw small startups like race ahead of big companies. And he saw like the power of these human scale teams. And then  personally, he just got in trouble. Like he hates authority and he got in trouble, a bunch as a kid. And any time anyone tried to force anything on him, he would rebel against it.

And so he just it's management by abdication is what he calls it.

Brent Sanders: [00:12:44] I love that.

Colin Keeley: [00:12:45] It's so he just believes like this is the best way to operate. So they're giving up like synergies for sure. And cross-selling, and maybe they could do better, but it's the only way to like really incentivize people to do the best work he believes when there's these small teams and people are more focused on like trust and communication and growing the pie, then I'm like ,  political squabbles or something that happened with a larger company.

Brent Sanders: [00:13:07] Yeah. Yeah. I couldn't agree more with that philosophy. I think, especially from a tech perspective is I think three engineers can do. They can do far more than a team of 10 because there's just so much more ,  Marginal value that gets added as you add more people, you just get less and less out of the team is what it means to say.

And, a small team is the way to roll out. And I just haven't seen it done at scale. And I guess this is a good example of it is and it takes very careful organization. I think. So once things start getting big, like keeping it. So it feels small and people can make decisions.

So these business units and operating groups seems to be quite the interesting way to segment things.

Colin Keeley: [00:13:49] It is a bit of a question now at this point that they've grown so large, like how much bigger it can they get. And so it's leaked out that they have basically our CRM of 40,000 plus to these VMs software companies that fit in there ,  like target. They've acquired 500, but there's 40,000 plus to go.

And they think it's expanding faster than ever. It sounds because it's easier and easier to make software. So th they said it's growing 4,000 companies a year. And so th this ,  if we're stumbling into this space, it's is it competitive? Like it's no, it's not that competitive. The biggest one is only acquired 500 of these 40,000.

Brent Sanders: [00:14:25] Yeah.

Colin Keeley: [00:14:26] One of the thing is what they're doing now. They've acquired so many of these, but they have gotten so big that they have started doing bigger acquisitions. So they did one for 250 million in 2018. 1200 and 70 million in 2014. And they said, they're going to be doing more of those going forward as well.

Brent Sanders: [00:14:43] What's the profile of these larger companies? Is it, CRMs or is still vertical, but like at what point you start running into. Big software company. Like it was in a sense, like an Intuit could be considered a vertical software, not so much now that I think about it, it's like, it's a, but if you were to just buy QuickBooks as a single business, as if it was, it's Hey, we just do accounting stuff, but then again, it seems like QuickBooks can be used for a broad range of purposes beyond just, keeping books.

Colin Keeley: [00:15:11] Ah, that's a good question. I actually didn't look at what they do. It looks like one is a conglomerate as well. And one. There's like point of sale terminals, which  I think verticals market software, like it could be billion dollar companies, but you could also, if you stumble into horizontal, you could get things that grow much faster, but then you also have more downside.

There is like Google or Microsoft or whoever would find that market appealing and come after you. So maybe less durable, but higher upside, which has always balanced between vertical and horizontal approaches.

Brent Sanders: [00:15:45] I wonder how their technology works at, like you, you buy up all these companies. And one thing we're already seeing just with one company in, in looking at, seconds and thirds is it's different stacks and it's different philosophies. Yeah, there, there are standards that we want to accept, but everybody's, every business is an indifferent spot and has a different sort of tech landscape.

I wonder how they're able to manage that. And if there are efficiencies that can be created across companies  everyone's doing the same thing, or you've mentioned it, somebody quote of, software, just, it tastes like chicken, which is. Kind of minimizing. These are software companies.

It's Okay.

it tastes like chicken, but it's the economic engine for your entire business and fund. It's you got to give it a little bit more credit than that. And ,  maybe his point is it doesn't matter as long as it works,

Colin Keeley: [00:16:32] Yeah. So this was Robert Smith. I think the wealthiest black man in America, he's the founder of this to equity. And it is a somewhat insulting to a technologist like yourself, but he acquires these software companies and he just says, software companies taste like chicken. So they're all selling the similar thing.

They all operate in a similar way and he's ,  quite removed from the actual technology at this point.

Brent Sanders: [00:16:55] Yeah, he's probably right to it, to an extent where, if you're leading something like this, if you are abstracted way enough, it's Yeah.

People are going to argue about databases. Those neck beards are going to complain about this, that, or the other thing. But at the end of the day, it's, you're just putting data into databases and stuff like that.

Yeah. I think he's such a, bad-ass that, he's a deal maker. He's less concerned about the, what did you write your software in? Is it PHP seven or is it Ruby? It's he probably does not give a shit.

Colin Keeley: [00:17:22] Yeah. It is a bit of a question for us. If we do two smaller ones, like then you only have what, one dedicated developer to it or at the moment, like you're helping out with some stuff. It is more of a pain, but once you buy these ,  I don't know, multimillion dollar companies, you have a team on it.

Who cares? I guess what it's being run on.

Brent Sanders: [00:17:40] Yeah, that makes sense. Yeah. I would tell you like ,  that's the one thing that I'm wondering about is, are there efficiencies to be created across, like once you have a portfolio you don't want, of course we never want to force something from a technical perspective, but are there like, you get one company that is in one spot and other companies in another, the cross pollination, we definitely saw benefits.

In our, in the venture portfolio across like getting tech leaders together and, learning from one another and really just pushing each other to ,  to write better software and build more stable systems. And which resulted in less, obviously less technical debt, less longterm tech costs, which.

Venture companies is unavoidable, right? You have this explosive growth. You're going to rewrite systems. You're going to make mistakes. The businesses are going to be changing, but for our world where it's like, Hey ,  the roadmap is paved on ,  on, and on to the horizon. That's where I feel like there is an opportunity to ,  put standards in place.

It really like boring stuff, but we'll have a much more ,  A bigger payoff because it's like, Hey, you're investing in, keeping these systems, low maintenance and stable, and you're not paying for people to come in and fix things. All right.

Colin Keeley: [00:18:50] Yeah, I may have made it sound like there are like, there's no advantages besides an upward mobility and your career trajectory for these businesses. But as soon as the business is acquired ,  CSI or constellation shares best practices in like company-wide performance data. So they are sharing like ,  Vista equity has a hundred point checklist that they're famous for.

I suspect that constellation has something similar where it's like, Hey, do all these best practices. You don't have to. We're just recommending that you do this is a great way to grow and make sure you're getting the most out of things. And a lot of this looks like. Connecting people that are doing similar things is you alluded to more so than like hard structured  centralized stuff.

Brent Sanders: [00:19:31] Yeah mean, it's interesting. Clearly this is a model that works. I don't know if he's, marks the first of his kind, but this is definitely a model that. I would continue to model ourselves off of this is I think in terms of there's 40,000 targets potentially out there, they've invested in 500, we're dipping into one to two so far.

And ,  it just seems like there's a lot of room for growth ,  but furthermore, like I think the idea of. Doing a couple deals is easy compared to, Hey, doing 10 a year and after year five, you've got, these 50 companies or so how do you scale that? And so I think that's where the real genius is here is like navigating the scale challenges.

Colin Keeley: [00:20:11] He had, I don't have the exact one in front of me, but I think a couple of years ago he decided that the head office got too big and he cut it by 80%. And he's look, we're not doing any of this work anymore. I'm pushing it all down to the operating groups and the business units. And it was like the company rocketed up from there.

Like it did not have a negative impact on the company whatsoever. So I think you have this natural tendency to blow it a little bit, and then you ruthlessly cut down and push it down to the people actually doing the work.

Brent Sanders: [00:20:41] sure. Yeah, I like it. I think I like his style. We'll just believe it. That.

Colin Keeley: [00:20:48] Yeah, he's a fascinating ,  it's a bit of a discussion. Like how much of this do we want to take as we move forward? And how much of it do we want to do a little differently? Is there anything that jumps out at you that you don't like or wouldn't want to do that way? Yeah.

Brent Sanders: [00:21:00] No, frankly, like it's a blue, it's a bit of a blueprint, right? It's Hey, we don't have a ton of information. You have what you're able to glean ,  from interviews and whatever sources you can find in, in. And a lot of this stuff's private, but I think the, I, the idea of staying small as like something, and not from a portfolio size, but from a, like a person. So things get more and more complex with people. That's one of my main concerns in my experiences with growing businesses is like, the people are the difficult part. That's the real challenge. So that's where my head is at. But yeah ,  there's nothing really that jumps out here that I'm like watch out for that pitfall other than, letting your head off.

Big enough where you're able to cut 80% of people.

Colin Keeley: [00:21:45] So it's worth pointing out that as I'm focusing on how they done it, he has been a very diligent student of other high performance conglomerates, whether in the VMs space or in others. And he said two of the top five were also VMs, a high-performance conglomerates. So something here with these like super high profile.

Business models that make it very effective and he has stolen everything he can from like everyone else. And, oh, I'm a, we're just doing the same thing stealing what's worked before and trying to put it into practice.

Brent Sanders: [00:22:14] I can dig it. Yeah. Is there anything that you were looking at that you're like, oh, I don't want to make that mistake.

Colin Keeley: [00:22:19] I'm a little undecided on the whole horizontal versus vertical. So you could go the VMs route. So vertical market software you're kept on the upside, but then you're also kept on the downside. So no one's gonna enter the marina software market when there's a dominant player and people just, aren't going to switch that easily.

Similarly with government. Government software, but then if you do, you can do horizontal businesses. And I think the upside is much greater, but then potentially is a bit of a discussion on how low the downside is. If you have  Microsoft or Google coming into your space. So could do that.

And that's like mix of venture capital and private equity. It's like venture equity or something. When you have that maybe greater upside. And so that is something I think we have to think about if it's immediately cut as we talk with software companies, if they don't have a specific niche, like if they're too broad, too horizontal, do we just immediately cut them as like a first filter and stay with VMs going forward?

Brent Sanders: [00:23:19] I feel like it's, it is an interesting thing to be true to, but as we're seeing from them, it's like some of these larger companies they're at what point is that? Not real. It's vertical ish, right? It's it's going back to Intuit, right? It's like their accounting software. That's vertical, but it's also can be super, you get into payments, you get into all the ancillary pieces, but how else do you grow?

You're just offering.

Colin Keeley: [00:23:43] I mean into it's $132 billion company. So I would, I don't know, is that vertical? It's a bit of a question as the software market gets so big.

Brent Sanders: [00:23:52] I like the, I love the least getting started, I liked the space so much, especially around like the very specific going back to bowling alley CRMs, that kind of stuff is, I think there, it doesn't have to be this massive Tam or this giant like, oh, the addressable markets, huge.

When you can capture a big piece of it, it's actually a sensible.

Colin Keeley: [00:24:11] My other thing I've like undecided on is do you, I think the software market is so big now that you can focus on just one thing. So like Andrew Wilkinson has. We commerce, which is only is basically constellation for only Shopify, apps. So like you could he raise that on 200 something million just to do that.

Brent Sanders: [00:24:32] Yeah. Yeah. That's the fun.

Colin Keeley: [00:24:34] I think, yeah, you could do that. Like you could just be software companies or you could do something super specific like that. And just that like specificity, that nicheness is something you have to decide on.

Brent Sanders: [00:24:45] Yeah, we're going to change the name of the podcast to riches in the niches.

Colin Keeley: [00:24:49] Yeah, I'm open to it.

Brent Sanders: [00:24:53] Good work. Good work might be taken.

Colin Keeley: [00:24:56] Yeah. Anything else you wanted to cover?

Brent Sanders: [00:24:58] No, this has been great. You got to check out Colin's ,  article here. So you got to promote that on your Twitter or whatever else, but check out ColinKeeley.com. I'm sure you haven't linked on your homepage, but it's ,  it's definitely worth checking out it. I love these kinds of ,  I liked the one you did on Wilkinson back when that was probably a year ago, but just all the different notes and all the different sort of ,  investigation that you're able to tie together.

Colin Keeley: [00:25:22] Thanks. Yeah. Check it out. I'll put it on Twitter and everything and that's it. Take care, everyone.

Brent Sanders: [00:25:27] Yeah, thanks for listening.