Interview on Patrick O’Shaughnessy's "Invest like the Best"

http://investorfieldguide.com/savneet/

"My guest this week is another in a recent series of people that makes me want to work harder, learn more, and do more for others. His name is Savneet Singh, and he has already accomplished a remarkable amount in the worlds of business and investing. He’s preferred to keep a bit of a low profile, but I’m hoping, for everyone’s sake, to change that a little bit." - Patrick

 

Building the Berkshire Hathaway of Software

 

For more than a decade, I like many, loved to talk about, listen to and read everything I could about Warren Buffett (WEB). Constantly looking for patterns to replicate and learn from, I would brainstorm with my now partner, on how we could create the same ethos, longevity, and culture of Berkshire Hathaway. Our aspirations guided not by wealth, but by happiness.

After many years of talk, we’re now on our way. We are building the Berkshire Hathaway of Software.

Software? Why not just copy WEB? After years of study, I have yet to discover a system to copy WEB successfully. In fact, over time, I have realized that some of his favorite patterns are becoming less applicable today. Take for example investing in brands. One of the great lessons from WEB is to pay up for durable brands that can maintain their margin and not be commoditized. He’d often challenge his audience to find a business that has maintained its margins for 25 years, almost always the answer was a brand (or a regulated moat).

But ask yourself, is a brand today worth as much as yesterday?

We as consumers and small businesses are far more comfortable exploring beyond the big brands that we grew up on. Have you bought something that showed up in your Instagram feed recently…trust me if you haven’t, your kids have. Have you subscribed to a product online like pet food that shows up at your door monthly instead of getting in your car to drive to PetSmart and buying the brand you grew up using?

Brands used to signal something about who we were and our aspirations but now our social profiles (Instagram, FB, Twitter etc) brand who we are and want to be. We validate the quality of products not by the logo but by the 1,000s of reviews on Amazon.

I’m not arguing that Berkshire is at risk or that Mr. Buffett is no longer great, but rather suggesting that the next Berkshire will not be built the same way that Buffett and Munger did it.

“When Berkshire came up, we had an easier world than you people are facing this point forward, and I don’t think you’re going to get the kind of results we got by just doing what we did. That’s not to say what we did and the attitudes that we had are obsolete or won’t be useful, it’s just that their prospects are worse. There’s a rule of fishing that’s a very good rule. The first rule of fishing is “fish where the fish are”, and the second rule of fishing is “don’t forget rule number one.” And in life it’s the same thing” — Munger, 2018

So, tell me, why the Berkshire Hathaway of just Software? Because with all the disruption in today’s world, the changing nature of moats (networks vs high fixed costs, social proof vs brands, etc.), we have found software to be the ONLY business model we think a 30-year-old Warren Buffett would invest in. When you dig beneath the surface, these businesses have everything on Buffett’s wish list.

Wait…but WEB hates technology? Buffett doesn’t like technology because it changes fast, making it hard to predict. That’s not the software we’re talking about. The software we focus on, is the type of mission-critical service that acts as the backbone of a business; where there is no benefit to switching and the product delivers far more value than it costs.

It is not the buzzword stuff (Crypto! Artificial Intelligence! Autonomous cars!), but rather a core part of your day to day business life.

Take for example the software used to run a dental practice. It is often integrated into the dentists’ scheduling program, payroll program, billing software and 10 other systems. Once installed the chance of that product being removed is very low (~2% to be exact) because changing products does not offer the dentist any incremental benefit and the switching costs are extremely high. The beauty here is that so long as the software continues to get better, customers won’t leave, allowing the founder to have 98% of last year’s revenue come in on day 1 next year …before he/she has spent a dollar on sales and marketing.

But that’s just the beginning …If you do a great job delivering value to customers, you can even raise prices a little bit each year — WEB often says the definition of a great business is one that can raise price. So in summary, we are talking about a business that can keep its customers for decades, maintain high margins, can potentially raise prices AND find places to reinvest >>> That’s a Berkshire Business.

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.” — Buffett, 2011

Prove to me that software is the best business? Data?

We’ve posted HERE why we think software is the perfect Berkshire business.

If other people have figured this out, what’s left to do?

After studying investors in the software space, we realized that almost everyone is focused on larger companies, within sexier parts of software and they uniformly have very short time horizons. Most investors make decisions that maximize value in the short run, not for the decades that follow. They are not bad people, it is just how the incentives are structured. Private equity is scouring the earth to find the next business to buy, add debt to, cut cost and flip. We call this renting, and it’s not in our DNA. That strategy looks to extract value from the business…we want to add value.

So what is the action plan?

We’re going to find smaller niche software businesses, that have developed a product that customers depend on and work with the founders to help them grow and eventually transition. We spend a lot of time understanding the history of every company’s journey so that we can show great respect to the legacy and people who helped get the business to where it is today. In our book, success in business is survival and we never lose sight of that fact.

Our edge is finding these types of businesses and founders, where the product and team are just a part of DNA of the founder. We then commit capital, never look to sell, and spend countless hours working with the management team to help them tackle their hardest issues (sales growth, hiring, efficiency etc).

We believe that our patience (no time horizons), focus on reinvesting for the future (not maximizing short-term results) and ultra-focus on software (no distractions), provide a world of differentiation from the alternatives.

So why you?

We’ve lived it. I started a financial software business when I was 26 years old. We built an amazing team, scaled to serve some of the largest financial institutions in the world (even governments!) and became the dominant player in our small corner of the world. I know very deeply the challenge of landing your early customers, the loyalty to early employees, the struggle to keep everyone happy and the importance of building & maintaining a great culture.

My company also took private equity money. I saw the advantage of big pockets and experience, but also the challenges around short term focus and constantly chasing an exit. I felt the pain of making changes that my gut knew were wrong and learned what it was like to say goodbye to an entity I gave my blood, sweat and tears to.

That is why we created Tera Holdings; to be stewards for the next generation, not renters of a business to make a return. Our belief is that the keys to this success will lie in the scar tissue created from years of operating — not in the 160th row of an excel spreadsheet.

How will you help?

After having spent a year getting on 60 plane rides and meeting 100+ software founders, I have come to realize that Tera adds value in a few major ways to software founders:

  • A Strong Home — We have immense respect for the heritage and legacy of every business. We understand the personal dynamics, unique cultures and emotions that go into a transition. Our goal is to be the home that creates a smooth transition and sets a path for multi-decade growth.
  • Sales! Every company I have met in my life wants more sales. In fact, what we’ve found to be most valuable in our conversations is our sales playbooks. We have spent so much time operating and investing in software, that we know the levers to scale a sales force, build best in class lead generation, fine-tune commission structures and most importantly: bring a culture of process + data to sales. Sales is NOT easy, and we pride ourselves in helping founders grow their businesses with tried and true playbooks.
  • Simplicity — We are easy to work with. Our goal is to be simple and straightforward. The term sheets come in English, not in legalese. We move quickly. We share our analysis as we learn about the business, this is valuable for founders even if they decide not to work with us.
  • Respect — We have been privileged to learn from some incredible minds/mentors over our careers. This was a function of luck not skill. We believe that respect is earned via experience, not bank accounts.

At our core, we believe our intense focus (software), long-term commitment (permanent home) and operating focus (scar tissue) are true differentiators in a world flooded with people chasing a quick buck.

 

Why Software is the BEST Business in the world… and the data to prove it

1.       Demand for Software is very strong and stable – Spend on software has grown at ~9% about a decade. Looking forward Gartner estimates show that the Software category is expected to grow 8-11% versus the US economy at 2-3% and broader technology spending at 3-4%. Software is a GOOD neighborhood to live in.

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2.       Signals from the Stock Market: “In the short term the market is a popularity contest; in the long term it is a weighing machine.” – Warren Buffett. Over many years, the market reflects the true substance of a business – here you can see that over the last 15 years, a broad basket of software companies has created meaningfully more value than a broad basket of businesses.

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3.       The Compounders: Now what if we pulled out the software companies that constantly buy other great software businesses the results are spectacular – FIVE times better than the S&P 500. 

 

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4.       The best of the best: Who was the best? Constellation software is Canadian holding company that only buys niche small software applications They acquired boring, sticky software businesses and reinvested the cash those businesses generated into the next one. They do NOT get involved in day to day operations. 5 amazing facts about Constellation:

  • Constellation turned 25M into $15Bn – without raising any more money and using ZERO debt.  A $100,000 investment at the beginning would be worth $56 Million today
  • The average customer across all the portfolio of companies uses the software for 20+years
  • The CEO travels in economy – he is incredibly successful + 6’5” and 280 lbs. The tone is set from the top
  • Constellation acquires 30 to 40 companies per year
  • ROIC over 10+ years has been 30%
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5.       Six of the top 10 Private Equity Firms have a heavy focus on Software. Coincidence? probably not.

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6.       Well Run Software Companies are Extremely Profitable…. In fact, software is one of the Most profitable industries in the world. Here are average EBITDA Margins by industry + examples.

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Culture - it's how your team acts when no one is watching

As professional students of business, we have always looked to decipher the habits and characteristics of businesses that have survived decades. We’ve seen those businesses with the “ultimate product”. The ones who have invented a product that is truly unique, defended by IP and impossible to copy. They produce otherworldly cashflow, maintain high margins and offer tremendous perks to employees. While these businesses are exciting to watch (and maybe invest in), they are hard to learn from. The heavy lifting of building the business was upfront, and the monopolistic nature of the business allows it to grow for decades, often with subpar talent and focus. The lessons they provide are not relevant for the vast majority of companies.

Alternatively, there are those businesses that survive decades, not by the sheer genius of their product, but by the culture of their organization. The founders have defined a clear mission, set of principles and guidelines that have perpetuated the organization and created a true barrier to entry. These are the businesses we obsess over. Their ability to not only survive but grow in the face of irrational competition, macroeconomic cycles and leadership changes leaves us in awe.

Take for example, Southwest Airlines. The airline industry is a notorious loser, having literally generated more losses than profits since Orville and Wilbur invented the airplane. Since 1978 the industry has lost over $60 billion. The industry is overly competitive, focusing almost solely on price and deals with many irrational personalities. Yet through it all, Southwest has been profitable for almost 45 years in a row! They used the same planes as everyone else, the same fuel and flew the same skies, yet what Herb Kelleher (founder/original CEO) developed early on was a culture of customer obsession. He geared his employees and management to be so customer-centric that it has led Southwest to become truly a differentiated experience. This focus, plus a sincere desire to treat employees fairly, has led to employees feeling and treating the airline as if they were owners. This culture, while hard to quantify, has become a true differentiator. Herb Kelleher left Southwest 10 years ago and the Company continues to succeed – the true proof of the power of investing in culture.

Not convinced? Have you ever been to a QuickTrip store? QuickTrip is a convenience store chain founded by Chester Cadieux. Cadieux realized early on that creating a culture based on values was going to be critical to his company’s success in a ruthless industry. In the business of convenience retailing, where customers have endless options, it’s hard to build a truly differentiated strategy and most chains resort to endless promotional games, neglect reinvestment and have constant employee turnover. Cadieux was different. He spent 2 months a year meeting his employees, learning, asking and training. He spent much of this time empowering workers. He would give employees the ability to make decisions on what products could go on the store floor - thereby giving them a say and stake in that store’s success. This commitment to employee growth and a constant focus on reinvestment led to QuickTrip outperforming all of its competitors on its journey from $1 million in revenue in 1962 to over $11bn today. This growth has turned hundreds of employees into millionaires and maybe, more importantly, the culture which Chester fought so hard to build, has continued well beyond his involvement. In an industry fraught with headwinds, QuickTrip continues to win.

We believe businesses like Southwest and QuickTrip have an incredible advantage: a cultural moat. They both partake in very competitive industries, yet have each turned out consistent growth and profits for employees and shareholders. Their success is directly tied to the culture and not the genius of a founder, the IP around a technology or a big brand. These cultural moats, if guarded and protected, become the single definable characteristic that propels a company for decades.

You need to build, nurture, and defend culture as rigorously as market share and product experience because, over time, it becomes the most important aspect of ongoing success.

HR: Why it matters and Why it might just be the most important thing.

HR is a polarizing subject. An entrepreneur building a great business has a hard time slowing down to build out an HR function. To them, hiring and adding operating expense for something non-revenue generating is non-sensical. Their belief in growth and their product sometime blinds them into realizing just how important HR can be to that underlying growth. This is ironic given that most established CEOS will tell you that they spend almost 30% of their time on HR related matters.

Contrary to common belief, HR is not just handling employee qualms, payroll and administrative items. HR is actually a building block to growth and today we’ll drill into one element of that – hiring.

Hiring

Most companies have a hiring process, but rarely do they have one that does an excellent job of filtering. It generally works like this: Candidates come in through traditional channels (referrals, ads, etc) and then go through a series of interviews. Once enough people are interviewed a committee meets and ranks the top candidates. The candidates that “feels” the best is then generally hired or presented to senior management for a final interview. Everyone feels included, senior management feels as if a process was followed and it feels like the right move. Yet more often than not, it isn’t the best process. The question isn’t if the employee is good enough, but rather if they are the best to help the organization grow.

We think there is a much better way - first look backwards. Evaluate and single out top performers within the organization and pull out the key characteristics of their performance and personality that make them key contributors. Write those elements out and create a ranking and scoring system that emphasizes those characteristics (1). This process helps you narrow in on what actually creates a top performer.

After you know the key elements of success, filter out your lowest tier performers (both existing and past employees) and figure out why someone may fail in your organization. Find out why prior poor employees struggled or failed (lack of experience? wrong background? wrong education? wrong culture fit?). Make it granular. This is not a search for what you could have done better, but simply a look into the individual traits that are led to failure.   

Once you’ve collected these two data sets, the head of HR should work directly with senior management to codify this data into a recruiting, interviewing and selection process. This is a massive amount of work, but once installed, saves hundreds of hours of time and yield better outcomes. Now you’re no longer hiring based on feel, but you have a science to it. When a candidate comes in the interviewers know what to ask, how to rank, and most importantly has a set of defined metrics to pick candidates. Imagine how you, a founder or CEO, will feel when you can completely trust an objective hiring process to drive the right outcome. Now when a new idea for product development or sales expansion comes up, you can trust a process to get you the right people to execute that idea.

This is not an easy process and it is even harder sticking to the framework. There will be candidates who have the perfect resume, but who don’t score highly on the scoring process. In those instances, you have to say no. Committing to a process will make your team empowered and your organization far more scalable. It comes from the top down, but ends up being the singular activity that allows a founder or CEO scale far beyond themselves.

(1) I’d bet you almost always find that your top performers were overweight hard work/intellect and underweight experience…said another way, you should recruit for the best talent, not resume

 

Should you promote within or poach from the outside?

An organization that scales is an organization that learns. Part of scaling is growing talent and bringing that talent from a functional role to one of management. It’s one of the true joys of being a founder – watching a young person grow into a leader. This feeling, however, creates a large emotional block. When given the choice of promoting within or bringing in outside talent, the founder almost always decides to promote from within. There is a feeling that bringing someone from the outside will disrupt the culture and cause existing employees to feel neglected. “How could someone from the outside know what we’ve built and gone through”.

In building my own business, I often times found myself always falling into this trap. It wasn’t until I took a leap of faith that I realized how important it was to bring in fresh faces. Here’s why:

1.       It’s hard to know if you’ve really got the best or optimal person in the right seat until you know what else the world has to offer. While it’s human nature to think that we’ve built and selected the best talent, it’s truly impossible to really know until we have a comparison.

2.       Cultures need to be stressed and tested. The challenge with only promoting from within is that a system can get stale. New ideas tend to fall away and fewer employees test the cultural norms. Bringing in a new talent, with a different background and unique set of life experiences, opens up the opportunity for new ideas.

3.       Edge. Everyone is human and it’s important for everyone on the team to know that they not only need to be the best in the company, they need to be the best in the industry. If a promotion is assumed, then the motivation to over-achieve wains. In no way are we suggesting that hiring from the outside is a threat, but rather we believe it keeps a strong sense of urgency to continue to push for better personal and company growth.

Like all things in life, there is no singular answer. At Tera we encourage our friends, companies, and partners to always decipher their bias’s and then put into action a plan to test themselves. We think urging managers to evaluate external talent is a way to challenge the bias of status-quo.

Renewal Rates - The Most Important Thing (...and how to calc them)

Why are renewal rates important? I always like to think about things in over simplified apartment building examples that translate across geographies, business types, cultures.  Imagine you have two buildings, in building A – you have 10 tenants.  There are lawyers & doctors that work within the neighborhood, always pay on time, and will never move away.   In building B, you have 10 renters, but they all work at a seasonal resort, the summer batch is different than the winter batch.  These dynamics force you to constantly advertise in the local paper for new renters when the seasons change.  You also never really know how many vacant months you’ll have over the coming years – but with building A, you know every month the rent will come like clockwork for years and years.  Clearly you would prefer to buy building A versus building B.  Higher renewal rate = higher value. We think software works the same way.

How should I calculate the renewal rate? There are a lot of methodologies and each has pros & cons.  A quick overview

-          Client Retention:  This is a logo metric

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-          Net Revenue Retention: 

-          Gross Revenue Retention: 

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Example:  We have 6 customers who spend $60, $50, $40, $30, $20, $10 for a total of $210.  Say 3 and 4 drop out.  The gross retention rate = (60+50+20+10) / 210 = 66.7%.  Say over that time, each of the 4 customers that stayed spent an additional $10 on new products.   The net retention rate = (60+50+20+10) + (10*4) / 210 = 86%.

When should you recognize churn? When the customer “clicks” cancel or at the end of the billing cycle?  It is most representative to recognize churn at the end of that customer’s billing period, given they have paid for usage up until that point.  To get a better understanding of the user behavior, you should probably track when they “click” cancel.

What are good retention rates?  Anything above 90% is great, anything above 85% is good, and 80-85% is okay.  Anecdotally, the best answer is forever.  Did you know that banks still use mainframe software to process credit card transactions? Or that airlines still use mainframes to book flights? (Okay you’ve probably experienced that one.)  There are also some solutions that solve problems so well that customers will stay through their whole careers.  I recently met a dentist that had used the same piece of software for 25 years! 

What can you do to improve your retention rates?  Focus on customer success.  There is a strong correlation behind net promoter scores & retention rates so think about your experience with great companies.  Solve a tough problem & deliver an exceptional customer experience, and the retention rate will follow. 

 

What are the renewal rates of some companies I know? Check it out

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Successful Companies are Bought not Sold

At Tera, we spend a lot of timing trying to understand motivation.  We look to decipher the how’s, why’s and when’s of management, customers, competition, and end markets.  When we’re approached about an opportunity to invest or purchase a company, one of our first questions is Why?  Why sell?  What can Tera contribute that is special?  Why now?  Having spent our lives building software companies, we’ve come to believe that the truly great companies are bought not sold.

When we reflect upon the great investments & deals we’ve made over the last decade,  the companies that were shined, buffed and primed to be sold, were ALWAYS the deals we were happy we skipped.  However, the companies & founders that kept their heads down, focused on operating, and solving a tough problem to keep customers happy, were almost always the best investments.

The difference comes down to motivations.  A company looking to get sold is no longer optimizing to build the best product, team, and customer outcomes.  That company is now optimizing to look good from the outside.  When this change in mindset comes, it’s the inside of the company that suffers.  Employees worry about their future, management stops investing in new products to show higher margins, and the salesforce get pushed to make incremental sales that are forced – not necessarily in the best long term interest of the customer.  The company becomes a worse version of itself and the new owner must go back in, clean up the mess and rebuild the culture.

The company that is bought is the one who never looks to be sold.  It cares deeply about its product, employees, customers.  It never takes the focus off its end goal and mission: customer success.  If an acquirer makes an offer the owner/s aren’t happy with, they can stop negotiating and drop right back into building…and they aren’t bluffing.  In the end this sincerity creates a better outcome NOT only for them, but for the end acquirer.  Great companies get bought and acquirers always do better with a great company.

At Tera, we spend a lot of timing trying to understand motivation.  We look to decipher the how’s, why’s and when’s of management, customers, competition, and end markets.  When we’re approached about an opportunity to invest or purchase a company, one of our first questions is Why?  Why sell?  What can Tera contribute that is special?  Why now?  Having spent our lives building software companies, we’ve come to believe that the truly great companies are bought not sold.

When we reflect upon the great investments & deals we’ve made over the last decade,  the companies that were shined, buffed and primed to be sold, were ALWAYS the deals we were happy we skipped.  However, the companies & founders that kept their heads down, focused on operating, and solving a tough problem to keep customers happy, were almost always the best investments.

The difference comes down to motivations.  A company looking to get sold is no longer optimizing to build the best product, team, and customer outcomes.  That company is now optimizing to look good from the outside.  When this change in mindset comes, it’s the inside of the company that suffers.  Employees worry about their future, management stops investing in new products to show higher margins, and the salesforce get pushed to make incremental sales that are forced – not necessarily in the best long term interest of the customer.  The company becomes a worse version of itself and the new owner must go back in, clean up the mess and rebuild the culture.

The company that is bought is the one who never looks to be sold.  It cares deeply about its product, employees, customers.  It never takes the focus off its end goal and mission: customer success.  If an acquirer makes an offer the owner/s aren’t happy with, they can stop negotiating and drop right back into building…and they aren’t bluffing.  In the end this sincerity creates a better outcome NOT only for them, but for the end acquirer.  Great companies get bought and acquirers always do better with a great company.