Investing in Bootstrapped Vertical Market Software: A Conversation with Lance Fenton

Hello and welcome everyone, I'm Peter Lerman and this is Masters in Small Business M&A. This show is an ongoing exploration into the vast and undercovered world of small business M&A, where we interview both the proven and the emerging owners, operators, investors and advisors, whose strategies and methods for transaction success have been put to the test. The show aims to surface the nuanced intricacies, the key ingredients, and the important factors that can improve your decision making in your own journey in the world of small business M&A. This podcast is produced by Axial, an online platform that makes it easier for business owners and their M&A advisors to find, research, and privately connect with a diverse mix of professional buyers of small businesses. In addition to learning more about Axial, you can find this podcast show notes, edited transcripts, and many other related resources all for free at Axial.com. Hey everybody, welcome back, this is Peter Lerman, I'm your host of Masters in Small Business M&A. I'm very excited to have an old friend and a great investment professional on the podcast today. Lance Fenton, thank you for giving me some time. I know I've been chasing you for a while here, so thank you for finally carving out some time. It's great to have you. Of course, thank you, Peter. Sorry guys, we've been talking about this for coming onto what it feels like, so it's great to be up. You were worth pursuing. So, we're going to cover Sarant and cover you and the work that you and your partners have done there. The best place I think to start is just to go straight at the thesis that you guys have really organized a lot of the business and the investment business around after spending some time in a couple of other ways. It's now effectively 100% focused on bootstrapped vertical market software businesses. I think largely in America, if I'm not mistaken, but you may be doing stuff abroad as well. Tell us the origin story of that thesis, how you got to that thesis, how it came into focus for you guys at Sarant. It wasn't the actual thesis. So, David and Kevin, Kennedy and Kevin Fripp co-founded the firm in 2008, David had done a search fund where he went and raised capital from some high net worth individuals to go by a company, and the Center for Entrepreneurial Studies at Stanford, where you and I met, and they come out with a white paper for search funders. And basically lays out their criteria for what's an attractive business. The metrics are something like highly recurring revenue, high gross margins, hybrid terms, uninvested capital or light balance sheet. There's attributes like no customer concentration, that I think are super helpful if you're a search funder trying to figure out what type of company you want to go by. And David went and bought a company called Service Source, which was tremendously successful. He grew it from three to $100 million of revenue. It was a B2B Services company to kind of fit that mold. So the original view for Sarant was going to be B2B Services, and we were going to go after companies like Service Source that were found around bootstrap businesses, where either there was a succession that needed to take place, or there was an entrepreneur that had taken the company either as far as he or she could or wanted to and wanted to hand it off to the next person to go run it. And generally, as a part of that thesis, there was going to be some sort of either your augment to the existing management team you're bringing in new folks. But the original thesis was B2B Services. And what we found was in 2008, we were still sort of going through this shift, but certainly going back to 2002, like a 20-year period that's elapsed since then, a lot of the conditions had changed. I think what you saw was, one, for software companies, there was a shift from licensed maintenance to SaaS. There was higher recurrence. You think about a lot of the recurring revenue businesses that are in market today tend to be more SaaS software companies. Software is inherently asset light, and particularly in the world where things are in the cloud. It's really asset light. And so these are higher OIC businesses that can grow without any amount of incremental catbacks. They're kind of inherently high-gross margins, with margins for our software companies, usually between 16-80 percent. And they're generally growing businesses. There's been a tremendous amount of growth in a broader vertical market SaaS market place as we've seen this sort of adoption curve play through. Some of it was today, if you're looking for high-gross margin, high ROIC, high recurrent revenue businesses, like it's disproportionately software companies, again, that wasn't the explicit mandate. And then when it ended up happening for us, we started looking at on a retroactive basis where we're having the most success, and we were investing in both for appeared services in software companies. A lot of our best investments ended up being software businesses, and so we sort of naturally grabbed you towards doing more and more of those. Today, it's probably 90 plus percent of what we're doing, and that's not to say that you can't find really attractive businesses that are services companies that you can generate great returns from. But a little bit for us, what we realize was there's a real benefit for us in focus and concentrating in the procedural market. And part of that is, having invested in something like 80 companies today, we just have better pattern recognition where the disproportionate share of those have been SaaS companies. We've developed a toolkit around, how do you take a founder of Bootstraps software company from $10 to $100 million in revenue, a lot of why the thesis vertical markets off were. It was the attributes of the business that I think we coupled with a little bit our domain expertise in sort of the circle of competency. And I think where you're going to bring on a partner who's going to be an active partner with you in the business, and sort of work with you at the board level, having somebody who understands vertical market SaaS is important to a lot of the folks that we're working with. So as a consequence, that's where the focus is shifted to. David, when he did his search fund that was in 2002, I think Salesforce.com got incorporated in maybe 1999, and was the first kind of at scale cloud software business, not really vertical market, although really more horizontal, but a lot of small niche software businesses back then were on a license and maintenance model, and a lot of those businesses probably have made a transition in their markets similar to the Adobe transition that Adobe made to like a pure SaaS. Are you of the belief that like the businesses are fundamentally better businesses, they're better shareholder value creating businesses when they switch from one model to the next or is it just six in one hand, half dozen and the other based upon the model of business that the software company decides to employ. Yeah, it's a really interesting question. I tend to believe they're fundamentally better businesses, and it's less to do with a revenue model. You can price a revenue model, and you have a license maintenance revenue model, you get a big chunk of license upfront, super profitable, as you're thinking about, how do you finance a company? It's really attractive to have that license revenue upfront, and you have to sort of very sticky 18 to 22% recurring yield that you get out those customers, and because they're paying so much upfront, and they pay for some implementation stuff, the retention on that 18% tends to be high, and so I would separate out revenue model from a license maintenance to serve a SaaS revenue model from delivery model, where I fundamentally think that there's more that you can do with a cloud-based delivery model. For us, there's been a bunch of eras that we've seen in the software space, and so going back to 2008, particularly in vertical markets as what we saw was, there's a lot of horizontal players, Salesforce as an example, that would have built sort of a general-purpose horizontal CRM. As the cost of software development dropped, you started to see the verticalization of those companies. All of a sudden, you have CRM for the hospitality market, it's a company that we've invested in called Revenue, that does that, you have CRM for the autospace. In each of these little verticals, you've got a dedicated full-time CRM, it was sort of cost-effective to go build that, and then there's vertical specific functionality. So an adoption curve, as you've seen in sort of shift from horizontal to vertical, a lot of what we were able to do, and a lot of our best investments in the 2008 to 2015 time frame, was taking a historically licensed maintenance model on-prem and shifting it to a cloud-based SaaS model. And generally, what we'd see is two to three acts uplift on that maintenance revenue when you went in and sort of sold those customers. And what was unlocked when you did that that I think was hard to do in an on-prem world is the ability to drive net revenue retention to 110, 120 percent, because once your cloud-based, the ability to turn on incremental features and functionality, it's just that much easier. And so one of the things that we've seen, the licensed maintenance to SaaS conversion is more or less played out over the last five to 10 years. There's not a ton of historical on-prem businesses that you can convert to SaaS. And then there's a whole wave in the last five to 10 years has been, okay, how do we sort of deploy payments in an integrated fashion? And when you have a cloud-based delivery mechanism, it's a lot easier to have an integrated payments vendor that you're able to go then sort of monetize through a pay-fac. Now we're expanding beyond just payments into broader embedded finance. There's more stability associated with the SaaS revenue model, but that's sort of a math equation on how you value those revenue streams. I think what's fundamentally more attractive about the cloud delivery is the ability to drive net revenue retention through easy integration of incremental products that you can turn on to get net revenue retention to 120 percent. And so for us, it's only about trying to grow our company's 30 or 40 percent. If I have a company that has net revenue retention of 120 percent, it's just a lot less pressure on my new logo bookings, and it's a lot easier way for me to drive incremental revenue growth through traditional products that are easily embedded. You mentioned that one of the opportunities around vertical software, particularly when you're delivering through the cloud, independent of business model, is payments, obviously vertical software businesses. have the capacity to capture transaction activity in ways that maybe horizontal players are less able to and so the like payments business model comes on stream inside some of these vertical markets as well and maybe that's more deliverable and more executable through the cloud. When you have pulled that off or the entrepreneurs and their teams have pulled that off and you have backed them. How do you guys think about that business model evolution relative to contracted recurring revenue do you value at the same way or. Businesses like shop if I seem to have gotten really really big with payment streams being where a lot of the growth is but what's the state of the state in your mind on like how you value payments related business models versus contracted recurring revenue. We went through covid I think we were all reminded of the benefit of subscription recurring revenue we own companies in the past that had transactional revenue models that I think we would say we're frankly better than subscription and I look to a company we under business called diamond mine which is doing. Within the tech space k 12 in the cohorts on diamond mind were phenomenal some of the best cohorts that we've ever seen in terms of how customers matured over time grocery revenue retention was in the high 90s but net revenue retention was going up in part as you got more departments within the school. Overall you were sort of growing with inflation sort of the dollar spent in the school we're going up and you also have the benefit of electrification of payments like card acceptance as a percentage of overall payments across check cash and card was increasing it would not be a typical for you to see. 100 and 3040% net revenue retention at diamond mind in those cohorts until the summer tax it's better to have that payment stream that's transactional and not subscription because it's hard to get 30 40% pricing increases and certainly yours has contracts that creates volatility so we under company you know arbiters sports that mostly derived as revenue transactionally through card issuance again the k 12 space larger the sports officials and when sports stopped in 2020 in March and April. The revenue dropped in that company by about 50% there's pros and cons on both sides of this I think in general what we're seeing is folks are probably more willing to pay a higher revenue multiple both on entry when we're competing on this as well as exit for those companies that have contractual subscription revenue just because of the durability those cash flows. Now I'll give you a counter example which is we invest in a company called compete which was software into the restaurant industry think about their sort of back of office toast is front of office the receipts at restaurants dropped by 70 or 80% and we were the GL so we saw the data. And so you saw revenues dropping 70 or 80% competes revenue grill in 2020 2021 because folks weren't going to rip out their European system and so that speaks to the durability of those models there's probably more upside. Where you have phenomenal cohorts and this is sort of reflected in the shop for example as well where you have those talents behind you and we've seen a lot of really attractive businesses have had that type of model that deserve a premium because the net revenue retention the cohorts demonstrate long term and sustained growth. And I think the nice thing about that transactional model is a better aligns your revenue modeling your success as a software company to the success of your customers. Are you guys worrying about like another version of covid when you're underwriting and stuff like that I know that happened and I know it wasn't that long ago but can you really think about that and worry about that when you're underwriting and be competitive still or just in terms of having to worry about like a downside case of 50% of the revenue going away or you just have to assume that over the next 50 to 100 years this is not going to happen again how do you guys deal with that we're really bad macro guys were really good micro guys so our ability to predict recessions has been awful and so we in 2014 and 2015 started underwriting recession cases. For example when we invested in compete and okay you have a bunch of restaurant failure to sort of screw the model that in and what we found is that's a really good way to lose deals and not investing great companies I think you have to take a longer term view which is you don't have to sell the bottom of the recession. I think you can sort of work your way through that I think more practically what ends up happening is you ended up increasing your whole period duration in waiting for a recovery and so it might be decremental to your IRRs we're sort of more multiple investors anyways you might see a little bit longer hope here and clearly there's different end markets there's some that are a lot more volatile less volatile the government services stuff the health care stuff the education stuff that we're doing tends to be a little bit more recession resistant and so we're sort of thoughtful of hey is there a risk here which is a recession to happen how macro economically expose is it in general what we've done is said look rather than trying to sort of predict what the shade is. This sort of predict what the shape and curve of the recession looks like you can go back and look at this local recessions and 0708 was very different than 2020 2021 in terms of the depth and see this recovery and it's really hard to try and figure out what a recession will look like and instead of doing that thing the question is build a capital structure if you've got a macro economically exposed business that's going to allow you to survive that and I think that's where you get in trouble. So you're over levered and you have an aggressive package or you don't flexible covenants that's where you get trouble for us we don't really model at the covid cases. We sort of assume that we're going to hold through those and we try to make sure we've got the right capital structure to manage through any downturns. I'd love to just spend a little bit of time within vertical markets off where there's a lot of other factors to think about there's a lot of these businesses but it's a really specific needs it sounds like you're very specific and Edtech and Fin Services you've got a couple other partners that are focused in other areas so you guys are specialists within the specialty category. How do you guys draw a classic serendial what are the characteristics other than it being a vertical market software business let's just assume that that's true. What else gets you really excited about a business in this category what are the factors and how do you define those things for yourselves and talk about them with LPs talk about them with entrepreneurs. We sort of fundamentally believe it doesn't matter how you pick the sub sectors. You can make a ton of money and find good investments in oil and gas and you can do it in manufacturing. And there's a lot of firms that do the whole gamut of software consumer and all stuff and we search and look it's better for us to do discipline focus on one market. Probably because we can build patent recognition around what's a good company look like. I also don't think it matters whether you pick healthcare education retail supply chain management. There are certain markets that have been hard because of volatility or there are certain markets where the healthcare for example at our heart because. There's just endemically payer concentration that's going to create customer concentration that's going to be hard to sort of work through. We sort of say look it's less about picking the right vertical and more about drilling really deep holes and just knowing all the companies. There's some sort of arc of vertical market software adoption in all these markets. And the question for us is can you find and build a relationship with the very best companies in the spaces. Generally that haven't raised capital and a lot of the really great companies that are in these market have raised tremendous amounts of capital. And I think that they're generally going after bigger terms than we are one of the attributes that we like. Is a well-defined tam. If it's a hundred two hundred three hundred million dollar tam the likelihood that Sequoia and South Bank have invested five hundred million dollars to go chase that small tam is pretty low. And so you can define these little bootstrapped businesses. Then we sort of look at okay then what are the fundamentals of those businesses and companies. And for us like to put a typical Sierra deal is called a ten to thirty to ten to forty million dollar revenue business. Generally in a new market a lot of the companies that we're backing are not guys on Silicon Valley or Stanford going to Sand Hill road with a top down thesis on mobility is broken. We're going to go build a ride sharing company and it's more somebody who's in Oklahoma City who is coming out of the industry and saying gosh this is really broken about the space I'm going to go fix it. And it's sort of a new category those are always the best for us usually in these markets there's a system of record sort of core solution. And those are the guys that have raised tremendous amount of capital and so it's either we're going to be adjacent to that core or we're going to be in a sub market within that core and healthcare for example we're not going to be with that the concern or we can buy any HR space that's focused on for example their company range tree. The therapy market it's either adjacent market or adjacent sub vertical there. And the overall market is relatively unvented it's growing it's going through its own little adoption curve I think about this business mercury network which is actually Oklahoma City. That was built by an appraiser to solve some of the issues that came out of Dodd Frank in terms of vendor management around appraisal selection. It was going through a really interesting adoption curve is banks and appraisal companies were trying to get compliant with new regulation. And we were the number one number two player in that market and so there was sort of strong market tailwinds that were driving that adoption that company the time was eight million dollars of revenue roughly invested. And it was growing organically 30 or 40% phenomenal retention there's always this question what do you care more about you know gross dollar retention or net dollar retention. And I would say for us we focus a lot more on that gross dollar retention mercury was in the high 90s like 98 99%. It just provides a level of durability and stability in the business that gives you a ton of flexibility beyond the fact that you don't have to go out and acquire those customers again each year you should come in with a lot of your prior years revenue. coming back, we tend to get a little bit more on the gross dollar retention and the net dollar retention. Generally, if you have really high gross dollar retention, you're going to have good net dollar retention. Mercury is probably around 105 to 110. And so we look at both as metrics, we look at the gross margin in the 80s, if you can, in the 60s, 80s kind of net zip code without any sort of apparent customer concentration. That's the company. A lot of the business that we look at, including Mercury, aren't going to be done by bigger players, whether it's VC firms putting capital in or it's bigger private equity firms, because they're kind of viewed to be niche markets. If you're investing out of a $3, $4, $5, $10, $9 fund, how meaningful can an investment into a $200, $9, $10, $10 business be for that fund, because there's a little bit of a cap or a governor on how big that business can be. And so we're sort of getting these companies early in a new market that's going through an adoption curve. And the case of Mercury Network, it was sort of interesting one because it was a carve out of another business and allowed us to sort of rebuild the full management team. But generally, so there's the characteristics of the company that we're going to invest in. We've got a relatively large growth team here, 30 folks in our operations seem our growth team that are here to help drive value. We were early to market with that. We sort of think pound for pound, we would put our growth up against anybody else's and we funded all of our PNLs we do without fees. One of the areas that we were really early in on, the first growth team hire that we had was someone who was a former head 100 Russell Reynolds, Randall Silicon Valley office for them. It was just exceptional at giving capital development. One of the core compass we have is, how do you get the right talent into the business? Sometimes that's augmenting the existing founder CEO, which we do a lot. Sometimes it's the CEO wants to move on so it's building a whole new team. The neat thing for us in Mercury was the ability from scratch to build that team around Jennifer Miller who is a president sort of co-founder of that business. But that's the merely clear value creation lever around that car bound standing up a whole new team. In this case, Jennifer was the co-founder? She co-founded it within a different business. She stayed on with you. Yep. If I heard you write, the business was growing organically 30 to 40% and it had attractive growth margins and growth dollar retention and not too small of a tam, but not too big of a tam. It sounds like the business is doing pretty darn well without you guys having a fantastic human capital growth team spend time with that business. It's already doing very well. It sounds like it's a very good business riding a really nice adoption curve. When you look at what you have been able to work on with Jennifer and her team there, what has changed as a result of you guys obviously putting capital in the business, but you spend a lot of time adding to that management team, what changed about the business and made it even better than it sounds like it already was. It sounds like it just already had excellent high quality company DNA when you guys invested in it. How are you guys able to make the slope even steeper than that? That seems hard. We've actually did the business. We didn't hold it that long. It was a really unusual company as far as great profile. We ended up exiting a little bit early in part because we got an aggressive inbound bid from a strategic. We brought on a new CEO, Will Clemens. We had to stand up, not a full new team, but a pretty significant part of the team because it was a subsidiary of another company that didn't have their own finance department. So you had to build all that new once it stepped out of its parent? In my way, like you know, go through the TSA and get our data out of their servers and standing up new servers and our team helped do the PMO work on that type of stuff. We totally rejouled the whole sales and go to market motion. And we invested in the company at 8 million dollars of revenue. We sold it when it was about 30. And that was two and a half years later. We did an acquisition. We integrated it. We saw a rate of revenue growth. We increased pricing. Dear point, for all of it, there was so much great stuff going on in this business. For a lot of the great companies that we're investing in, it doesn't mean that it's devoid of opportunity. One of the things that we see time and time again, which is the hardest part in what I've got the utmost respect for the entrepreneurs that start these companies is it's incredibly hard to go from zero to one. Taking a company from an idea and establishing out product market fit is the hardest part of that journey. It's also hard to go from 10 to 30 or 30 to 100. It's just hard in a different way. And I think that a lot of the companies that we're investing in have gone through a lot of the hard work of proving out product market fit. They built phenomenal products. We focused tremendous amount on quality of product quality. They experienced the customer and how the customers feel. It's sometimes slightly different skillsets and capabilities to go from zero to 10 to 30, 30, 100. And that's where we can help. And I think that one of the things that we see, for example, and this is where we have the growth team set up to drive that, you may have a single sales motion that you're dealing, which is field sales. You may have five field sales reps. If you want to continue to grow at 30 percent on 30 million dollars for revenue, you're going to need to book 10 million dollars per year. You're going to have to either grow the sales team, strengthen territories. You're going to have to create more sales name win resources. You're going to think about different motions, you think about channel motion. And generally, what we find is the founders, entrepreneurs that we're working with are seeking out help on those questions as they're looking about doing something that's just to maintain the momentum that they have. If a company's got weak growth retention, we've invested in a number of companies that have had sort of mid-80s risk retention. That's what the product market fit piece. There's not much we can do to improve retention. We tried multiple times. That's sort of endemic either to the market or to the product. But if you have a company that has great retention, super high MPS, there's a tremendous amount that we can do to help think about how do you maintain or accelerate revenue growth across new products, optimizing sales and the good of market motion. Think about pricing. And generally, in those three areas, which is where we have growth team members dedicated to. Why is that true? Why are you guys so well equipped when the business has great retention? And why do all of a sudden, all of those ideas fall apart if you lose 10 to 15 or 20 percentage points of retention? Why do all of those things not matter? Let's decouple out retention here for a second. There's a couple of different reasons why I think the company can have weak retention known. And I'll just name a few, which won't be exhaustive. But one of the reasons why you've weak retention is you're selling a new SMB market and your customers are going out of business. One question is, is there enough wallet to sort of go after in those companies and buy additional products to increase pricing? In some cases, we invested in companies where it was weak retention because it was more of a discretionary product. I'm like, are you really going to buy more from a company that's sort of quasi discretionary? That's not sort of a true system of record. One of the trends we see is there's been a proliferation of software companies. A lot of these businesses and they'll have 10, 15, 20 software vendors. People are trying to rationalize that and generally it's the ones that are more discretionary or insular products that get phased out. Another reason is you have weak MPS. For us, as we're thinking about the businesses that we're investing in, sometimes retention is a proxy for MPS, but not always. But if you have really high retention and you have high MPS, for us, that means one, your customers like you and your critical system of record software, they're generally trying to consolidate around what you have. So your ability to do things like better align price to value. And I think pricing software is one of the hardest things to do. This is why we have three full-time people from Simon Kutcher partners that have joined us here internally. Simon Kutcher is probably the best software pricing consultancy out there. And all they do is work on pricing. And the likelihood that while you were starting your software company, you probably botched the pricing model. And we see this in the data all the time, which is the scatter plot of pricing all over the place. It's pretty high. And so that's something where you got to go through and do that. And it's really hard to do if you have weak retention. People are willing to cancel or they don't have a budget to pay for it or they're not happy with the product. And so our ability to pull the pricing lever way higher when you have those characteristics, our ability to introduce new products way higher if your customers love you versus if your customers are somewhat dissatisfied with the product. And that's why when we think about the investments we make, it's both growth revenue retention and NPS that are kind of probably the two most important things. The two metrics that we look at the diligence paired with qualitatively, like this is one of the benefits of going super deep in these vertical markets. Like actually in the last 17 years of my life going deep in FinTech, and that's all the different nooks and crannies, including mortgage tech and payments and banking tech and lending tech. And in those understanding who are the best players reputationally, who are the executives that are building this. That's why a lot of our investment is in the average time from first contact to close investments for years. But we've had a lot of businesses that we've tracked for 10 years. And I have companies that I email today that I've been tracking for 10 plus years, just waiting for the opportunity to find the right investment, building that relationship over a long period of time. And it's sort of knowing the reputation of the market, knowing how they're perceived, knowing that team, and how they're going to drive them with their businesses. We're going to get to sourcing because I think it's super interesting. And it's a really, really interesting part of the story for you and CERRENT. Before we do that, I just want to spend a little bit of time on what the businesses look like, what are the fundamentals of a CERRENT business. And I just want to cover what makes them great investments. Vertical market software has been a place where you guys have generated outstanding returns on a repeated basis. So have others. I want to unpack that. Why are there such great returns here still? What do you think is driving the level of returns that you guys have been able to achieve here? Why haven't they gotten repriced as businesses to a higher level that's taken out some of that return? Maybe the answer is some of that return has gotten taken out. But yeah, I just want to talk about the investment case, separate from the business quality case. I think you can make great returns a lot of different ways. And there's a lot of different strategies to do that. And there's folks who make phenomenal returns doing distressed deals and it's not necessarily specific to vertical market software. There have been some market conditions that have led to phenomenal returns in this category over the last 20 years. We talked a little bit about this before. Some of it's just an adoption curve in that market that's driven higher growth. I think we've seen elevated software revenue growth over the past 20 years as we've gone from horizontal vertical to vertical markets. I've gone through that adoption curve. I think that adoption curve is slowing. You look at the public's ASS data shows decelerating growth and I think that there's some of that which is hey there's a pull forward in 2020 and 2021 in the purchase cycles here when rates went to zero. But I think some of that is folks have gone through and adopted a lot of this software. But I think that that's driven organic revenue growth and our perspective that organic revenue growth is probably the number one driver and valuations. That's been I think booing up the market. We think about our best investments. The companies that have done a 10X plus most of those companies have had discrete value creation levers that we've been able to pull and we talked about them. On the out there was an investment that we invested in back in 2014. It was three million dollars of recurring revenue but you know there was a mix of that revenue that was licensing maintenance that we switch over. Avionte's grown north of 30X. It's recurring revenue as we sort of effectuated that shift and we did that May. Other examples might be real ring between invested in which there was a discrete value creation lever around both license maintenance to SAS conversion but also the introduction of payments. I think it's a combination of one attractive market going through an adoption curve to discrete value creation levers available within the vertical markets as you are the system of record your ability to sell more product and drive sort of outsize growth through better monetization of that install base and then three the recognition of the quality of these businesses which you know again from a predictability and durability perspective I think is exceptional and so I think you've seen pretty significant pricing increases and sort of a really attractive exited environment particularly for I think the size and scale of companies that we're getting into one of the interesting things is when we're successful at building a company we're getting worth of a hundred million dollars in revenue and I think there's a lot of buyers for that asset there's a lot of mid cap and larger dedicated software bio firms whether we're selling directly to them whether we're selling to one of their portfolio companies and sort of a strategic impact exit it's a really robust and vibrant set of folks for us when we're investing in a company it's eight to ten million dollars of revenue what we found is there's generally not as much competition if you're investing out of a two three four billion dollar fund it's unlikely that you're going to invest in a ten twenty million dollar revenue company that's grown at twenty five thirty forty percent just not a big enough check and you don't move or particularly as we talked about before if you've got so much constricting to him I think you've seen that and I think that firms like Toma Bravo have done a phenomenal job in our world-class investors and they've driven you know exceptional returns and we got a ton of respect for those guys when we work with them I don't know that there's a mispricing of software assets at the size and scale that they're playing and a lot of these firms whether it's Toma Bravo or Vissa or others have created down market funds to go capture this lower market opportunity and we bump into those guys from time to time with their smaller efforts it's a different team this is sort of what we're purpose built for and dedicated at and so I think we can compete reasonably effectively again some in those cases but I think you see the acknowledgement of the attractors of the down market segment and we even play well below those guys I don't think there's a pricing our opportunity at the upper end of the market anymore but I do think there is at the lower end of the market because it's just a little bit more inefficient you have the benefit of long-term trends in the opportunities or drive revenue growth and then the multiple of on the far side the last twenty years I don't know if the next twenty years are going to be the same there's not a lot of vertical markets out there that are untouched this idea sort of we're skiing through Virgin powder and a lot of the health of Genski you're seeing markets that are a little bit more vended as we think by the next twenty years I think it's really clear to us what impact AI is going to have and we think there's going to be winners and losers and we're aggressively investing in our portfolio to figure out how we can position the companies that we're investing in to be the winners one of the thing we talked about was hey the lowering of the cost of software allowed for this verticalization to happen software development a lot of the verticalization happened that will do a really attractive environment externally for us to be investing over the last twenty years I think that the conditions have changed again and will continue to evolve and unclear how that's going to impact these markets going forward it may create a whole new seven disruptors it's going to be the next leg of growth for us that's very much an evolving area but the last twenty years I think have provided exceptional returns in this category for those three reasons obviously there's the AI is over all of software now and either you wield the sword or the sword is wielded against you it's the narrative that's in the market if you have any businesses that you guys are working with now that you've invested in or businesses that you're watching and following and waiting for the opportunity to invest who have been incorporating AI effectively I think it'd be interesting to talk about that but separate from the AI era and just how that might change the next twenty years relative to the last twenty years do you think the next twenty years could be a year where returns in the vertical market software business were driven more by M&A and consolidation capabilities as opposed to organic growth sourcing or do you not reach that far in terms of where it goes over the next twenty years if the adoption cycles are perhaps slowing down and maturity and adoption is higher and maybe moves towards more of like a consolidation category and you sort of make a category there's two questions there which is one what are we seeing the evolution of AI probably every single one of our companies is doing something with AI right now have they implemented stuff yeah have they assembled teams with AI engineers yet have they made the transition from being a legacy software business to a software business that has AI and machine learning teams and capabilities inside or is that where they are in most parties making that transition none of our companies are sort of building internal l alarms I think where you see most of our companies is how are we leveraging what's available in the market to increase productivity within our organization and so we're probably the only private equity firm that has a partnership with Microsoft and GitHub and sort of rolling it out with Copilot within our portfolio sort of enhanced developer productivity we see this in our support teams within certain companies like Tyler who runs studio designers rolling out AI driven support to lower the cost particet and so you think about each of the different functional areas in the business people are doing different things and one of the nice things about having a portfolio of 42 companies and we have somebody here centrally concerned that runs product and technology and you know and so Neil's coordinating is in great like one of the lessons that are being learned across these different use cases and how do we probably get those out into the portfolio when people are getting traction probably less on the full dedicated machine learning AI teams internally more with folks functionally thinking about how are we going to become AI enabled to really drive performance within the companies and how they can sure that we're staying apart with our peers and competitors and some potential new AI driven entrants make sure that we have competitive offerings. I mean extracting back for a second as we think about our model it doesn't need to be vertical markets as it just happens to be that's the solution that we've picked and spent time and looking to your point like it's been phenomenal tailings in that market that I felt sort of drive performance some of that candidly over the last 20 years which is a really favorable rate environment led to high valuations as well. I don't know that rate compression is going to be a source of multiple expansion going forward over the next 20 years but we sort of feel like the model of deeply engaged private equity firm and sort of active in sort of helping the companies that we're investing in grow should be attractive irrespective of the external environment we sort of don't know and we don't plan for what the next chapter of growth is going to be it's my expectation that as we've seen with certain companies parents Square is a great example of company we invested in back in 21 and they just had built a built a better mouse trap it's a parent communication tool and the company saw explosive growth and a lot of that growth was driven by just an adoption curve which was not greenfield but displacement of existing folks in a legacy solution for all that the software world may be vended today and the adoption curve may have gone through is there a red ocean displacement cycle way that we're going to go through as you have next-gen capability it's just a lot of a cloud-based vendors displaced legacy on-prem businesses that weren't able to make the pivot to the cloud and so that could be there I think it's a harder longer sales cycle to displacement incumbent than it is to drive a sort of greenfield logo that could be a vector of growth we do think M&A is a big driver and I think there's a lot of different reasons why but within these software businesses we tend to see within these submarkets when they're take all effects or when to take most effects we generally have the top two players commands for the majority revenue in the space and that's because you can spend more on our indeed relative to your competitors you have fundamentally better economics that's a real benefit to driving M&A to sort of build scale within these categories and then being able to invest more by virtue of a broader footprint with your revenue in our indeed to build even better products. When we started the firm, we really weren't doing M&A. We sort of believed the whole role of idea was financial alchemy. And you couldn't sort of buy a bunch of companies for five times even, it's eligible for 15. I think where we are today, we're dealing 15 to 20 acquisitions in the portfolio per year. It's a big part of our growth strategy. When we decompose our returns, the number one driver over turns for our investments is organic revenue growth. Number two is M&A. That will be a big component going forward, and particularly if those first two can coexist. So if you have a replacement cycle with a next generation or technology, generally an attractive way to go clean up sort of the legacy players in a space is to do it through M&A. Well, let's get into deal sourcing very long time ago. You guys were axial customers when you believed in the intermediary channel. I think that you guys have overwhelmingly decided to bet super deeply on direct sourcing relationships with business owners. You probably still leave open a crack in the door for intermediate opportunities, but it seems like you guys have really committed very deeply to direct sourcing on the sourcing side of the business with a big team and a very specific end market of businesses that you want to go and pursue. I'd love to just cover the broad brushstrokes and also any meaningful changes over the life of Sarant from 2008 to 2025 in terms of just what you've learned, what you've decided to change. You spent some time in your notes to me, Lance, talking a little bit about the prepared mind versus acknowledging greatness, concept around sourcing. I'd love to just dive into sourcing. We can start with the direct sourcing model and hearing a little bit about how you guys do it as well as the lead times that you need to be prepared for. And then yeah, maybe go into some of the changes from there that you think are not worthy. This has been an iterative process where we've sort of evolved the team over the past 15 years. When we started, we originally had the view, which is I started as a senior associate slash VP, we started for currently our VP title today. And the view was I was going to be a mini search funder. So I'd be responsible for all my deal sourcing and that was building relationships with intermediaries and knowing deep into vertical markets and building relationships with companies. And then as we built our associate class, I think we were looking to replicate what famously called the T.A. Summit model with sort of direct outreach. It was in 2010 or 2011 that we hired Tyler Fair, first person of our BD team, who came in and was a dedicated BD person. All he was dealing was up on calling it. It allowed us to both align Tyler's compensation to his activity in a way that we couldn't do with the associates quite as directly. But those are a higher someone whose skillset, frankly, was probably better suited towards business development activity. It has tremendous amount of success. Tyler was an animal who's incredibly successful here. He went on to build a company called Source Scrub, which took, fortunately, a lot of this year at IP or in how we would go out and tackle conference lists and track companies. And that's been a super successful investment for him. That was 2010, 2011, the first iteration of the business development team. Today, we have around 15 folks on that team. They get paired up with the vice presidents for principles on our investing team. And they're tackling vertical markets. And any given principle or BP will have two to three active markets that are going super deep in. It's not just FinTech. It's not just lending tech broadly. It's like lending tech within the especially finance companies are lending tech like the platforms that especially finance companies will use, or are you going to the mortgage regeneratory going into the commercial lenders. And so in each of those markets, really drilling down into different areas, it's a lot of work. We spend a lot of time and a lot of money on that team. And it's generally, like I said, before four years from first contact with a company to close investment. And so it takes it for minutes and out of time. Today, probably 20 to 30 percent of our investments come in through the intermediary channel. I think for us, if a company is bringing in an investment that we have not had a pre-existing dialogue with, it's hard for us to get up to speed quickly enough. And some of this is just the benefit you get of seeing how companies operate for multiple years and getting comfort with that. And I tend to think folks have a choice. I think it's hard to do both well, particularly when we play in the bank channel, our conversion rate, just a lot lower versus when we are able to build a one-on-one relationship over multiple years with an entrepreneur. And we can articulate the value that we think the growth team can build in their business. And we've got the domain expertise because we've done a lot of deals in their market. We're just much more effective at converting those opportunities. And I think the challenge is, as a firm, you have to make the choice of, are we going to be set up to do bank deals and acknowledge that we're going to have to win at any cost and get in a really competitive environment? Or are we going to be set up to do the direct sourcing stuff? And where I think we've sort of landed is we can't do both well. And we got to pick a lane. And we're going to be set up really well to do the direct stuff. And we're not going to then therefore compete effectively in the intermediate stuff. It's painful because we've got folks that we've been tracking our building relationship with. This just recently happened to us. Two-year relationship, countless dinners in the Bay Area, in New York, in Austin, building relationship with entrepreneur who wanted to go run a process. So we said, look, we totally respect that. And you want to see who else is out there. But if you do that, it's not going to be for us. And we're going to bow out. That's painful to do, but ultimately you have to. Why do you have to do that in that case? I understand how a fantastic vertical market software business that you don't know that well that comes onto your radar out of an M&A process that's being run by banker, where you guys would say, we know of this business, but we don't know it well. We don't know the entrepreneur well. We're not going to get up to speed on it in the way that we like to. And we're not going to have the relationship and the context and the trend lines of two, three, four years of lead time. And so we're just going to bow out on those processes. If you've known an entrepreneur for two years, three years, your direct sourcing model calls for on average. It takes four years from the time that you meet an entrepreneur to the time that you close a transaction. Let's say you're halfway through that four year timeline or three years through that timeline. And for whatever reason, the entrepreneur is like, I love you guys, but I just can't feel good about only working with you to effectuate a transaction. I need to run a process and I want you guys to be part of that. You guys know the business super well. You know the entrepreneur super well. You have all of those dinners on your side. You have all that time on your side. Why would you bow out of those banked processes when it feels like you could win those processes? Maybe not exactly in the way that you would ideally win them, but still win them in ways that are really profitable for you and are really exciting for him. And as the entrepreneur may can feel good about, I always wanted to go with Sarah, but I felt like I needed to keep them a little bit honest or something like that. If someone's saying, "Hey, I'm going to try and keep you honest," we want to pay a fair price. We talked a little bit about the evolution of Sarah. And I think that the most important thing for us is buying the best companies in each market. And at the size that we're playing at, $152 in my daughter to EVs, price is not the most important metric, particularly if you take a long-term view on a category. The issue that we have, and this is just, it's borne out empirically, if someone's going to go to three people to have one, do a price check rate, we're good with that. We want the market to be, and we're price takers. We don't set the price, the market sets the price, and then we want to try and invest in the best companies. The issue we have is one, the conversion rate, if you're going out to 10 folks, there's 10 great firms out there. I'm sure. We've got a ton of respect for the folks that we compete against. We think we're a little bit unique and differentiated in the vertical markets we play in, and we think we've got more invested over a longer period on our growth team, but since there's not other great options out there, if our conversion is 40 to 50%, when we're one-on-one with an entrepreneur, it goes down to like 10-20%, just because there's 10 people there. Even if we win more than average, it's 15%. There's this question on, return on time, the data would tell you I'm just better off spending my time somewhere else. But your conversion rate lands on the entrepreneurs that are not running a process has got to be low too. You're spending so much time with so many companies, only a small subset ultimately result in transactions. The conversion rates from submitted L-O-I, the conversion rate on submitted L-O-I to closed deal, exceptionally high, one-on-one with an entrepreneur. We're spending a lot of time prospecting building the top of the funnel, like you have top of the middle funnel, I'd certainly call this middle funnel, you have the bottom of the funnel, which is sort of post-L-O-I. And we've had a ton of time prospecting. This time we're spending in these markets anyways, we've dedicated teammates going after that. For the execution side of things, a lot of the time gets expended on pre-imposed L-O-I, coming up with building a model, we're not building models for companies that are top of the funnel. A lot of that four years is top of the funnel development, which is engagement. That's part of broader market work that we're doing. It's getting smarter in the industry. And there's a benefit. If you're saying, "Hey, I'm committed to doing something within that attack," and we're going to be here forever, there's benefits that accrue long-term to building a relationship with all the interesting companies, whether they're two million of revenue or 50 million of revenue, hearing what's going on, what are you seeing? Because that knowledge is transferable. The discrete financial modeling work that gets done is not as transferable. The challenge also is, in a competitive bank process, a lot of times what we'll see is, you've got to have done your market study, market of a purchase agreement, exclusivity, particularly when the market's competitive, is rare. And so you're doing a lot of work with two or three other parties. And not to wear a ton of time gets expended, time in dollars. If you're not set up to do that, which we're generally not, best firms we had this example, this company. We're looking at another business in this exact same space. All the folks that were bidding on the first company have sent over their market studies. They went and hired McKinsey Bay and were sending millions of dollars to go to market work on this company in advance of potentially bidding on it and they're sending it to this other business that's in an adjacent market. If we're not spending the millions of dollars with Bay and McKinsey on those reports and we're not doing that with a view that we're like we might lose this deal then it's going to be really hard for us to be able to wait with conviction in those cases and what ends up happening is when we have engaged we say well we need exclusivity we're only going to spend time if you want to spend with us and I think there's been an adverse selection issue. The most attractive companies have everybody chasing them and you have people willing to do unnatural things in a bank process to win those deals. We start saying well we're not going to do that. The ones that are left over are the slightly less attractive companies and so yes there's a return on time in general we're not set up to compete in auctions and in that case we're not going to be competitive with somebody to send over a fully diligence bid with no outs close in five days because we haven't done our work and we're kind of not willing to do our work because we'd rather spend our time with folks who we're kind of one-on-one with. It's a choice that we've made is they look we're happy if you want to run a very limited three person process to go get a read on price most folks know what their business is worth we want to be competitive on price but if you're going to go higher banker run a 10 person post IOI auction run everyone to ground it's too hard for us to effectively compete to be worth our time and we've got this adverse selection issue that we see. That's super interesting so you're comfortable with a four-year lead time on a direct sourcing model and a fully vertically integrated business development operation as where you just essentially concentrate the time concentrate the capital make that a fixed expense and then close from there. How does a search fund or like a young private equity firm or like a new independent sponsor if you're comfortable waiting four years and you've been working at it how would a new firm that's getting started in your market get underway with a direct sourcing model can you get started with that and win or you have to sort of get there over time and bootstrap your way to being able to finance and afford a four-year lead time. I think it's really really hard to do at the outset we grew up in a hybrid world where you're doing both concurrently I would say if you were to look historically away to 1415 over half of our deal flow came from the intermediate channel and a lot of times didn't have a relationship with those companies and so I think it's hard to go exclusively with the direct model early on it was hard for us I don't want to speak for other folks which is why we sort of had both channels going it was hard for us when we didn't have a track record to do that successfully I think today we're approaching our 20th anniversary here in a few years we've got realizations we've got multiple funds we've got a track record and we've got the resources in the team but effectively we were asking someone when they four go that is that on us and that on the team and it's hard to do that without a track record and so I think we lean on that a lot and so it's a consequence you should feel comfortable and you can look at the empirical data we get the question we share that do you have a track record that you can put up against the expectations of the entrepreneur for you as a partner we were talking offline about how to build a great investment business and build a great investment organization as you just mentioned you guys are getting close to 20 years here what is topical for you and your partners now for Saren in terms of making it a better investment organization where are you spending time thinking about how to get better what are you rethinking or re-evaluating where are you trying to make the Saren investment business get to its next level of excellence and what buckets do you drop some of those ideas into you've made a huge amount of changes over 20 years of all of the sourcing model got very clear on software got very clear on sourcing got very clear on how to be great partners to the entrepreneurs that you back you've had more than modest success you've had fantastic success what's next and how do you guys think about what to get better at next private equity firms or partnerships driven by people and you raise funds and that fund is an agreement that's saying hey you know for the next 10 years we're going to work together on trying to do something with consent from the LPs there's been a shift and some of these private firms they are more looking like companies and they're selling steaks and they're going public if you're basically mortgaging the future by selling it off the future economics of somebody else today I think the most talented people aren't going to stick around I mean I don't know that but it was really important for me when David and Kevin set up Saren it that it was set up as an equal partnership and they did that based on what David bit of a portfolio company CEO at Benchmark Capital and saw the success of Benchmark had the succession planning and transitions that they had the most important thing to build sort of a great investment firm is do you have exceptionally talented people at the firm and I think the only way to keep in retained by we we just promoted two new partners Dexter and John who are phenomenally talented and I've got zero doubt that if we weren't set up as an equal partnership both of those guys would have gone somewhere else or would have gone and done their own thing and I think we've been lucky to retain almost everyone we wanted to at the firm by virtue of the fact that there's a path to one day running the firm but we've gone through this next chapter of succession with David or the co-finders moving into sort of a non-active role here and so he sort of got to the first wave of succession planning and I think the goal is for all of the partners to make ourselves obsolete and that creates the headroom or the space for the next generation to grow up the second piece of it would be just a relentless focus on continuous improvement fun one when we got out of the gates was not doing well we were kind of all over the place in sourcing and a little bit of it was yeah we were trying to figure out what was the same or a deal but more importantly like it's hard to scratch you do the deals that you can and they weren't great deals early on but this relentless focus on continuous improvement how do we get better take the firm the next level each year this sort of progress is and I think that's been one of the hallmarks for us as a firm which is this sort of relentless focus on how do we do each of the things that we do better each year I think what you've seen is this arc of specialization so we budget generalize and we got specialized in vertical markets we ended up getting specialized within the firm or sourcing in our growth theme and even within the growth theme for example we now have centers of excellence there's more specialization so you can really have some subject matter experts that are going to drive outsize performance we're going to continue to get better at what we do every single day and that comes back to sort of the ethos or the values of the firm which performance is sort of top of the list for us so concentrate on figure out what we're going to do better and that's sometimes incremental changes to what we're doing sometimes our step functions shift to centers of excellence was a step function change beyond that for us we're now about a hundred people I think one of the big shifts for us was as you go from a 10-20 personal organization to a hundred folks how do we make sure that you've got the right mentorship development that you're developing the next generation of folks that are there and that everyone's able to perform at the highest level so we're going through that evolution right now we just brought in somebody a new COO to help lead a big chunk of your organization that's both going to allow the partners to start more of their time on the investing part of the job but also make sure that we're world-class sort of running an investment organization to make sure the next generation talent is exceptional super interesting Lance thank you so much for being so forthright on so many of these questions don't always get the benefit of someone just answering as honestly as you have and sharing just so many details so it's been great to see you and great to catch up thank you so much good see you Peter thank you so much for having me it's been a pleasure take care if you enjoyed this episode check out Axiel.com there you'll find every episode of this podcast as well as our recorded Axiel member round tables some downloadable tools for deal makers Axiel's quarterly league table rankings of top small business acquires and investment banks and lots of other useful content that we've created over the course of time if you're interested in joining Axiel as either an acquirer an owner considering an exit or as a cell-side M&A advisor you can get started for free at Axiel.com as well lastly if you have ideas for podcast show guests feel free to reach out to me directly at [email protected] I promise I will respond thanks for listening Peter Laramon is the CEO of Axiel all opinions expressed by Peter and podcast guests do not reflect the views or opinions of Axiel this podcast is for informational purposes only and should not be relied upon as a basis for investment decisions podcast guests may have ongoing client relationships with Axiel.