This is part of my operating manual series opening up the playbook of private equity and company building luminaries. Check out past ones with Mark Leonard, Andrew Wilkinson, Robert F. Smith, Joe Liemandt, John Malone, Felix Dennis and Mike Speiser.
If you are interested in buying, growing, and selling small companies, check out my course & community on it at IndiePE.com.
Who is Mark Leonard? What is Constellation Software?
Mark Leonard is the billionaire founder of Constellation Software (CSI). CSI is a Canadian software conglomerate that acquires and holds vertical market software (VMS) companies.
They are a perpetual owner (they never sell) and own 600+ VMS companies at this point. They have only sold one business because they were offered a really high price in the early days. Mark regrets selling to this day.
These companies span over 75 verticals from library software to marina management.
Where does the capital come from? How have they performed?
Mark Leonard, started Constellation with $25 million Canadian dollars in 1995 (equivalent to $32.85 million in 2021 US dollars) raised from investors.
The company went public on the Toronto Stock Exchange in 2006 to give some of it’s VC investors liquidity. The bulk of their investors were from a pension fund that didn’t need an exit. The VC investors sold their shares at a roughly $70 million valuation at the time, but no additional money was raised. Constellation’s market cap today is around $31 billion as of June 2021. CSI has reliably compounded at 30+% a year.
What is known about Mark Leonard?
Not much. He writes an excellent annual shareholder letter where I found most of these details. Otherwise, he almost never does interviews or speaks with the press.
His colleagues have described him as "probably the most intensely private individual in IT."
He's allegedly 6'5" 280lbs and has a Gandalf beard. He took 7 years to get through college while working part-time and played basketball, football, and rugby (his best sport) while in school.
Mark Leonard received a Bachelor of Science from the University of Guelph and an MBA from University of Western Ontario. Before founding Constellation, Leonard spent time working as a bounder, mason, gravedigger, dog handler, sapper, and wind energy researcher and then finally some years in traditional venture capital post-MBA.
I’ve included all the photos that seem to exist of Mark Leonard.
Why did Mark Leonard start Constellation?
Mark got his start at Ventures West, a Canadian venture capital firm. It didn’t go very well (mid-single digit returns). This was mostly because venture wasn’t great in Canada at the time. He thought highly of his coworkers, but realized they were playing the wrong game. Game selection matters.
He was particularly irritated by VC's unflinching focus on companies operating in large addressable markets.
He was seeing plenty of companies operating in niche spaces that were great businesses. They just didn't have the upside potential to be huge venture outcomes.
VMS businesses were high gross margin and sticky, and selling mission-critical software that was instrumental in a buyer's operations.
He eventually left and raised $25 million Canadian from his old venture colleagues and mostly from Ontario Municipal Employees Retirement System (OMERS), a pension fund where a friend from business school worked, with the goal of becoming the best buyer of VMS businesses in the world.
What's Vertical Market Software (VMS)?
Horizontal market software are things like word processors and spreadsheet programs that can be used in a wide array of industries.
Vertical market software is developed for and customized to industry-specific needs. These are businesses focused on a niche markets like spa & fitness or dealerships that have specific needs, but aren't attractive to the larger players.
Their favorite businesses are bought directly from Founders. They naturally have the best cultures.
What Constellation Software looks for in businesses to buy?
From their website:
- A mid-to-large-sized vertical market software company (a minimum of $1-million earnings before interest and tax)
- Consistent earnings and growth — generally EBITDA/revenue + revenue growth of 20 percent or more per year
- Experienced and committed management
- An offering price that has been determined
How does Constellation evaluate investments?
Constellation uses the First Chicago Method, a weighted four independent scenario approach (winner, modest winner, walking wounded, wipeout) to assess investment prospects.
Another term for this is mutually exclusive collectively exhaustive scenario modeling or "MECE". The cash flows of each of the four scenarios are probability-weighted, allowing them to use a single hurdle rate across all investment prospects, even if the investments have very different risk profiles. They have dependable base rates to use after hundreds of previous acquisitions.
Employees are encouraged to use the MECE method and similar hurdle rates for all of their investment prospects (VMS acquisitions, internally generated Initiatives, or investments outside of the VMS sector).
How are the businesses organized?
Constellation is composed of a head office that overseas six "Operating Groups" (OGs): Volaris, Harris, Jonas, Vela, Perseus, and Topicus.
Each OG essentially serves as a holding company for dozens of underlying software companies. They are basically a miniature Constellation, "the equivalent of what CSI was ten years ago (plus or minus three years)."
While there appears to be some degree of specialization among these different groups, each OG is ultimately a mix of vertical offerings.
Topicus is the most focused given its concentration on European companies. It's also the only OG that operates independently, having spun out from CSI in 2021.
Each OG is composed of Business Units (BU). Generally, each BU is organized to serve a single vertical. BU managers are autonomous, often competing intensely with each other, and are held accountable only for their own results. Most of the operating decisions are made at the BU level.
What’s the typical size of these businesses purchased?
The company acquires small VMS players, with an average price of $2-4 million.
Constellation bought 134 software companies in 2022:
- Capital deployed: $1.743 billion
- Median deal size: $3.3 million
- Largest deal: $700 million
- Almost 3 deals per week
Constellation has started doing larger deals recently buying Acceo Solutions for $250 million in January 2018 and Total Specific Solutions B.V. for $270 million in 2014. They have stated that they plan to do more larger deals going forward.
How many VMS businesses are there?
Constellation allegedly did 90+ tiny acquisitions in 2020.
There are estimated to be 40,000+ vertical market software which are potential targets for Constellation. Raymond James wrote about the opportunity which Constellation is harvesting in August 2016:
“Our analysis of software vendors indicate substantial fragmentation with approximately 38,000 VMS vendors spanning more than 12 vertical markets, with the highest concentrations in Retail and Media & Services verticals – see Exhibit 8. Constellation has also expanded their database of potential targets with now well over 30,000 targets (adding 4k+ targets per year for the last 3-4 years). Each target has a contact name next to it, with the expectation of staying in contact 3-4 times a year.”
What multiples are they paying?
Constellation doesn't publicly disclose acquisition multiples, but Howard Leung, an analyst at Veritas Investment Research, estimates it pays an average of 0.8 times a target's annual sales (after accounting for any cash acquired).
Most of their competitors would say this is well below market. Constellation is known to turn down deals based on price more so than competitors that can pay higher prices based on squeezing out synergies.
What makes VMS businesses attractive?
- Recurring revenue
- Sticky - mission-critical businesses are sticky. They have high switching costs and make up a small share of the customer wallet (typically 1%) so switching isn't worth the hassle.
- "Enterprising vendors with deep customer relationships and continuously improving products have also built a level of trust with their customers that is hard to replicate. So even if a new entrant has a similar quality product on Day 1, why would a customer switch if they were happy with - and trust - the current vendor? These are products that might represent 1% of customer revenue, so any potential savings are minimal. It is difficult to justify the risk of switching for mission-critical processes.
- “This is especially true for small customers where an owner-operator is responsible for making the decision. These owner-operators have time constraints, and have to weight the return on their time from switching software vendors versus the return on their time from doing anything else. Anything else usually wins.”
- Asset light (resilience) - With no major capital investment requirements, companies have the capability to downsize in case business slows down.
- High margin
Types of businesses Constellation Software has bought/started?
Government - roughly half of CSU’s revenue comes from customers in the public sector: municipalities, school boards, police departments, etc. Incentives in the public sector are notoriously absent and/or misaligned, so the impetus for a salaried government employee to lobby for a change in software vendor rarely exists.
Why do founders sell to Constellation Software?
CSI buys VMS businesses to hold rather than sell. Without the necessity of scoring a quick mark-up like many of their private equity competitors, Constellation can manage patiently, letting the existing team helm the ship rather than intervening to aggressively cutting costs.
The focus on the long-term creates a meaningfully different ownership environment.
CSI acts as a great landing place for employees of companies and managers because they have way more upward career mobility now.
What is Constellation's culture like?
- Long-term thinking
Decentralized Human Scale. Mark has a great description of this:
“We seek out vertical market software businesses where motivated small teams composed of good people, can produce superior results in tiny markets. What we offer our BU Managers is autonomy, an environment that supports them in mastering vertical market software management skills, and the chance to build an enduring and competent team in a ‘human-scale’ business. While we have developed some techniques and best practices for fostering organic growth, I think our most powerful tool is using humanscale BU’s. 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. If the business leader is smart, energetic and has integrity, these tend to be halcyon days. All the employees know each other, and if a team member isn't trusted and pulling his weight, he tends to get weeded-out. If employees are talented, they can be quirky, as long as they are working for the greater good of the business. 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. That's how I remember my favourite venture investments when I was a venture capitalist, and it's how I remember many of the early CSI acquisitions.
That structure usually suffices until there are perhaps 30 to 40 people in the business. At that stage, some of the teams - perhaps R&D if the product is rapidly evolving or has high needs for interfaces or compliance changes - must grow beyond the five to nine optimal team size. 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. The 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.
The larger a business gets, the more difficult it becomes to manage and the more policies, procedures, systems, rules and regulations are generated to handle the growing complexity. Talented people get frustrated, innovation suffers, and the focus shifts from customers and markets to internal communication, cost control, and rule enforcement. The quirky but talented rarely survive in this environment. A huge body of academic research confirms that complexity and co-ordination effort increase at a much faster rate than headcount in a growing organisation. If the BU is small enough, and has a competent BU manager who has several years experience in the vertical, and good functional managers, then he/she will be able to cope with complexity for a while, making the right calls to optimise organic growth as the business grows. The challenge of running a BU of this size is human-scaled.
As a BU becomes larger (by our standards, that’s greater than 100 employees), I worry that even an extraordinarily brilliant and energetic manager, who has been in the vertical and the BU for a very long time, and is surrounded by a strong team that he/she has selected and trained over many years, is going to struggle to steer the business to above industry average organic growth. No one wants to admit that they’ve hit their limit. Some BU Managers lack the humility, some lack the courage, and most lack the time for reflection, to notice that their task is getting too large, and the sacrifices are getting too great. This is the point at which our Operating Group Managers or Portfolio Managers can provide coaching. If a large BU is not generating the organic growth that we think it should, the BU manager needs to be asked why employees and customers wouldn't be better served by splitting the BU into smaller units. Our favourite outcome in this sort of situation is that the original BU Manager runs a large piece of the original BU and spins off a new BU run by one of his/her proteges. Ideally, he/she has been grooming a promising functional manager who’ll be enthusiastic about running and growing a tightly focused, customer-centric BU.
This dividing of larger BU’s into smaller units is rare, but not unknown, in other large companies. One of the HPC’s that we studied was Illinois Tool Works Inc. (“ITW”). It has hundreds of BU’s. We began following the company from afar in 2005. The most relevant period in ITW’s history for CSI was the tenure of John Nichols. Nichols began consulting to ITW in 1979, and appears to have been the primary author of its decentralisation strategy. He was CEO as the company went from $369 million in revenues in 1981 to $4.2 billion in 1995 ($6.7 billion in today’s dollars). Prior to Nichols's tenure, ITW had acquired only 3 businesses. During his tenure, ITW aggressively acquired and often split the larger acquisitions into smaller BU’s. ITW had 365 separate operating units by 1996 when Nichols retired. I’m sorry I didn’t reach out to some of the ITW employees and ex-employees until 2015. When I did talk with one of the senior managers, he said (I’m paraphrasing) “Something wonderful happens when you spin off a new business unit.” … “With a clean sheet of paper, the leader only takes those he needs. They set up in an open office with good communication and no overheads. They cover for each other. They leave all the bureaucracy and the crap behind”. I did record a couple of verbatim quotes from that conversation: "Don't share sales, R&D, HR, etc. because the accountants never get the allocations right and the business units always treat the allocated costs as outside their control", and "When you get big you lose entrepreneurship".
Volaris and TSS regularly divide their larger BU's into smaller BU's that focus on sub-segments of their markets. Volaris feels strongly that splitting larger BU’s into smaller ones allows more targeted products and services that differentiate their offerings from their more horizontal competitors. Harris has very successfully acquired multiple BU's in the same industry and run them independently rather than combining them into one BU. Both tactics forego obvious and easily obtainable benefits from economies of scale. We think we get something valuable when we constrain BU headcount, but it isn’t a panacea for all of our organic growth challenges”
Where does the desire for keeping teams small and independent come from?
Mark has a history of playing team sports and a problem with authority. His team sports background taught him the power of small groups working together.
He would get in trouble in school and hated being told what to do. He loves being convinced to change his mind though.
While in venture capital, he saw how well small teams could perform and what they could accomplish relative to larger bureaucratic companies where so much effort is wasted on things that don't move the needle.
What does a career path look like at CSI?
Leonard considers CSI "as close to a meritocracy as I have experienced."
Constellation lays out an explicit career path for its employees, starting as an employee, before ascending through the ranks to reach "Compounder" status. Leonard outlines this trajectory in his 2018 letter:
“A career path for an ambitious employee joining Constellation might be something like this: Immerse yourself in learning about the peculiarities of VMS economics. At some point, transition from analyst or knowledge worker into a leader of people...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 [Business Units]. Whatever vertical you end up in, that specialization, that focus, will require a multi-year effort to build a trusted network of employees, customers, other industry participants, and even competitors...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.
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...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.”
Some founders sell to Constellation because the career prospects for themselves and their employees are better within Constellation.
How are employees compensated?
In the 2013 President Letter, Mark Leonard writes:
- “Our employee bonus plan requires that all employees who make more than a threshold level of compensation invest in CSI shares and hold those shares for an average of at least 4 years”
As of 2015, CSI reportedly had over 100 employee millionaires, with Leonard noting his intention to bring that figure to 500 over the next decade. Much of that wealth has likely been accumulated through Constellation's stock. Depending on their seniority, employees are required to deploy a portion to buy Constellation stock, up to 75%. This is an impactful move on many levels:
- It ensures Constellation has a class of knowledgeable shareholders that invest more than just money into the business.
- It formalizes employees as owners, positioning them as long-term holders.
- It aligns the constituents of discrete business units with the performance of the parent company. Given the autonomy individual companies have, it would be easy for factions to arise or empire-building to occur. This move ensures each group is incentivized to pull in the same direction.
What happens to businesses after the sale?
The companies typically remain in the hands of legacy management, with CSI intervening only to share best practices and company-wide performance data. Leonard enjoys creating competition between business units.
The integration process often boosts efficiency just by implementing the same processes that Constellation has been using in all their companies. This is generally shared by connecting people doing similar things, not in a super structured checklist way. One of the hallmarks is a disciplined approach to R&D and marketing that avoids spending without getting results.
As the group grows, they realize synergies and increase margins. However, the different Business Units and many of the businesses seem to operate autonomously.
These business units are "human-scale". This is what make employees happy and productive.
- High trust and communication
- Focus on growing the pie
- Become craftsman
- Clear priorities
Net Promoter Score
Net Promoter Score is a key metric for Constellation in managing all their acquired companies.
For those that don’t know, the net promoter score is based on a single survey question asking respondents to rate (on a 10-point scale) the likelihood that they would recommend a service to a friend or colleague.
Constellation sends these surveys all the time and closely track their results. If the results start heading in the wrong direction, they quickly take corrective action.
When they raise prices, NPS do deteriorate, but that doesn’t always show in churn. Customers may not be quite as happy as they were with the lower price, but they stayed and continued to pay it.
A high NPS with low market awareness is the ideal combo for these vertical market software acquisitions. This means there is a sticky product with happy customers that just need sales and marketing. The perfect set up to grow quickly and easily.
Marks says the scientific method is the best method for any business.
Constellation has figured out things that work because it experiments all the time. They think in experiments. Mark has found that at Constellation shorter feedback loops with less and lower quality data is better than longer feedback loops with all the data.
He recommends setting up a system of iterative improvements in your business. Sooner you can learn and iterate, the better.
After each deal, CSU does a post mortem 1 year in. They discuss and share learnings, improve process accordingly.
What does the operating company and Mark do day-to-day?
Not much. The head office has been pushing acquisitions down to the BU level. These divisional leaders are permitted to greenlight M&A deals up to $20 million, 4-5x the average deal size.
This is the only way to keep up the pace of small-cap acquisitions. If they don’t manage to train the BU managers to execute these acquisitions, they would need to look for larger companies. Narrowing down the scope and potentially lowering their margins due to higher valuations.
In the shareholders’ letter of 2015, Mark Leonard writes
“I have been encouraging our Operating Groups to push down more of the acquisition activity to the Business Unit (“BU”) level, even if it means higher capital deployment costs. If we can train a couple of hundred BU managers to be competent part-time capital allocators and provide them with acquisition analysis and structuring support when they need it, then I can foresee the day when we are doing 100 acquisitions per annum, instead of 30”
Leonard outlines the counterintuitive guiding principle that undergirds Constellation's management:
“Head office provides the Operating Groups with capital allocation assistance and decisions, and tries to disseminate some best practices, a few clear rules, a bit of coaching, and coughs up the occasional partly trained employee for the Operating Groups. Compliance, investor relations, and handling the finance function round out the head office duties. Whenever we feel stretched at head office, we download more of our work to the Operating Groups. This delegation to the point of abdication philosophy (first discussed in the 2010 Letter to Shareholders) seems to have worked so far.”
Leonard is a firm believer that autonomy produces better results and motivates employees.
“One of the fundamental beliefs at CSI, is that autonomy motivates people, and bureaucracy does the opposite, so we try to do as many of the important monitoring tasks with as light a touch as possible.”
Study the Eminent Dead
He spends a lot of time studying other high-performance conglomerate (HPCs). Mark thinks they should teach way more business history in schools.
Mark is a huge collector of business history and business biography books (He has read 400+). He recommends everyone learn from behavior and thinking of those that came before them. Reading is the skill that helped him the most.
Roy Thompson is Mark’s business hero. Roy failed publicly 3 times before striking gold in his 40s (Mark really got his start with Constellation in his late-30s). Mark also respects that Roy pivoted from chasing high growth industries to investing in quality businesses. Roy went on to buy 200+ newspapers and turn his family into the wealthiest in Canada.
What would Mark Leonard do differently today?
Incentivize Organic Growth
He wishes he had changed the incentive structure to be focused on organic growth over acquired growth. The current incentive structure caused managers to become acquisitive over everything else. That said, he still says that organic growth has a lower IRR on invested capital.
He also wishes Constellation went global sooner. Especially with large regional platforms outside North America.
Work / Life Balance
Personally he says he wishes he spent more time with his family. He said it was hard to tell this was going to be a regret while in the midst of his career.
Mark has studied a bunch of successful business builders and he says almost none of them had any real work life balance. If you want to build something great, he thinks you need to dedicate a large amount of your time to it.
He thinks this is also just difficult mathematically. He credits the the Dunbar number, which basically states you can only really have ~50 meaningful relationships. If most of those are people you work with, it doesn’t leave much time for people outside of work. This makes work/life balance statistically difficult.
What are some of Mark Leonard & Constellation’s craziest deals?
They acquired one business located in North America.
A day after closing, all the founders and employees left, started a new company and contacted all the customers and got them to switch to their new company.
When they were doing diligence on another company, they discovered that one of the company’s full-time employees was also one of Constellation’s full-time employees.
For more, check out our podcast on Mark Leonard (Constellation Software), Robert F. Smith (Vista Equity), and Joe Liemandt (ESW Capital).
Grab Mark’s unreleased podcast episode here.
If you are interested in buying, growing, and selling small companies, check out my course & community on it at IndiePE.com.
If you know of anything I should add to this please reach out @ColinKeeley or Colin@ColinKeeley.com. I’ll continue updating as I learn more.