[00:00:04] Speaker A: Hello and welcome everyone. I'm Peter Lehrman and this is Master's in Small Business M and A. This show is an ongoing exploration into the vast and undercovered world of small business M and 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. MA this podcast is produced by Axial, an online platform that makes it easier for business owners and their M and 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.
[00:00:59] Speaker B: Hey everybody, welcome back.
[00:01:01] Speaker A: This is Peter Lehrman. I'm your host of Masters in Small Business M and A. I am 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.
[00:01:20] Speaker B: Thank you, Peter. So sorry. Gosh, we've been talking about this for coming on two years now, it feels like. So it's great to be on.
[00:01:26] Speaker A: You were worth pursuing. So we're going to cover Sarent 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 areas, 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 some 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 Sarent.
[00:02:00] Speaker B: It wasn't the actual thesis. So David and Kevin Kennedy and Kevin Frick 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 buy 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 that basically lays out their criteria for what's an attractive business. The metrics are something like highly recurring revenue, high gross margins High returns on invested 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 buy. And David went and bought a company called Service Source which was tremendously successful. He grew it from 3 to $100 million of revenue. It was a B2B services company that kind of fit that mold. So the original view for C rent was going to be B2B services. And we were going to go after companies like Service Source that were founder owned bootstrap businesses where either there was a succession that needed to take place or there was a 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 you're augmenting 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're 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 have changed. I think what you saw was one, for software companies, there was a shift from license maintenance to SaaS. There was higher recurrence. So 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 a world where things are in the cloud, it's really asset light. And so these are higher OIC businesses that can grow without a lot of incremental capex. They're kind of inherently high gross margins with margins for our software companies, usually between 60 and 80%. And they're generally growing businesses. There's been a tremendous amount of growth in the broader vertical market SaaS marketplace. As we've seen this adoption curve play through, some of it was today, if you're looking for high gross margin, high roic, high recurring revenue businesses like it's disproportionately software companies. Again, that wasn't the explicit mandate. And then what 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 a period, services and software companies.
A lot of our best investments ended up being software businesses. And so we sort of naturally gravitated 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 realized was there's a real benefit for us in focus and concentrating in a particular 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 owned bootstrap software company from 10 to $100 million in revenue. A lot of why the thesis Vertical market software. It was the attributes of the business that I think we coupled with a little bit our domain expertise and 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 partner with you in the business and work with you at the board level. Having somebody who understands vertical market SaaS is important to all the folks that we're working with. So as a consequence that's where the focus has shifted to David.
[00:05:43] Speaker A: 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 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 in the other, based upon the model of business that the software company decides to employ?
[00:06:30] Speaker B: Yeah, it's a really interesting question.
I tend to believe they're fundamentally better businesses. And you know, it's less to do with a revenue model. You can price revenue model. When you have a license maintenance revenue model, you get a big chunk of license up front, super profitable. As you're thinking about how do you finance a company, it's really attractive to have that license revenue up front and then you have this 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 sort of 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 market SaaS, what we saw was there's a lot of horizontal players, Salesforce as an example, that had 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, you know, CRM for the hospitality markets company we've invested in called Revinated that does that. You have CRM for the auto space. 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 the 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 2008-2015 timeframe was taking a historically license maintenance model on prem and shifting it to a cloud based SaaS model. And generally what we'd see is 2 to 3x 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%. Because once you're cloud based, the ability to turn on incremental features and functionality is just that much easier. And so one of the things that we've seen the license 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 monetized through a payfac. 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%. And so for us, as we think about trying to grow our company's 30 or 40%, if I've got a company that has net revenue retention of 120%, there's just a lot less pressure on my new logo bookings and it's a lot easier way for me to sort of drive incremental revenue growth. Traditional products that are easily embedded.
[00:09:49] Speaker A: 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 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, when 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 it the same way or. Businesses like Shopify 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 how you value payments related business models versus contracted recurring revenue?
[00:10:43] Speaker B: When we went through Covid, I think we were all reminded of the benefit of subscription recurring revenue. We've owned companies in the past that had transactional revenue models that I think we would say were frankly better than subscription. And I looked to a company, we owned a business called Diamond Mine, which was doing payments within the EdTech space. K12 and the cohorts on Diamond Mined were phenomenal. Some of the best cohorts that we'd ever seen in terms of how customers matured over time. Gross 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 were going up. And then you also had the benefit of electronication of payments like card acceptance as a percentage of overall payments across check, cash and card was increasing. It would not be atypical for you to see 130, 140% net revenue retention at Diamond Mined in those cohorts. And so in some respects it's better to have that payment stream that's transactional and not subscription because it's hard to get 30, 40% pricing increases in sort of your SaaS contracts. That creates volatility. So we owned a company, Arbiter Sports, that mostly derived its revenue transactionally through card issuance, again in the K12 space, largely 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, but 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 of those cash flows. And I'll give you a counterexample, which is we invested in a company called Compete, which was software into the restaurant industry. Think about their sort of back of office toast, 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%. Compete's revenue grew in 2020 and 2021 because folks weren't going to rip out their ERP 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 Shopify example as well, where you have those tailwinds behind you. And we've seen a lot of really attractive businesses that 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 it better aligns your revenue model and your success as a software company to the success of your customers.
[00:13:25] Speaker A: 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 do you just have to assume that over the next 50 to 100 years it's just not going to happen again? How do you guys deal with that?
[00:13:50] Speaker B: We're really bad macro guys. We're 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 failures, you sort of discreetly model that in and what we found is that's a really good way to lose deals and not invest in great companies. I think you have to take a longer term view, which is you don't have to sell at 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 hold period and duration and waiting for a recovery and so it might be detrimental to your IRRs. We're sort of more multiple investors anyways. You might see a little bit longer hold period. I mean clearly there's different end markets, there's some that are a lot more volatile and less volatile. The government services stuff, the healthcare 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 could happen. How macroeconomically exposed is it in general? What we've done is said look, rather than trying to sort of predict what the shape and curve of the recession looks like, you can go back and look at historical recessions. And 0708 was very different than 2020, 2021 in terms of the depth and seamless of recovery. And it's really hard to try and figure out what a recession will look like. And instead of doing that, I think the question is build a capital structure. If you've got a macroeconomically exposed business that's going to allow you to survive that. And I think that's where you get in trouble. So if you're over levered and you have an aggressive debt package or you don't have flexible covenants, that's where you get in trouble. For us, we don't discreetly model out the COVID cases. We sort of assume that we're going to hold through those and we try and make sure that we've got the right capital structure to manage through any downturns.
[00:15:39] Speaker A: I'd love to just spend a little bit of time within vertical market software. There's a lot of other factors to think about. There's a lot of these businesses, but it's a really specific niche. It sounds like you're very specific in 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 sarin deal? 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.
[00:16:16] Speaker B: We sort of fundamentally believe it doesn't matter how you pick the subsectors. 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 that stuff. And we sort of said, look, it's better for us to be disciplined and focused on one market, partly 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 within healthcare, for example, that are hard because just endemically pay our 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 those spaces generally that haven't raised capital? And a lot of the really great companies that are in these markets have raised tremendous amounts of capital and I think that they're generally going after bigger tams than we are. One of the attributes that we like is a well defined TAM. If it's a 100, 200, $300 million TAM, the likelihood that Sequoia and SoftBank have invested $500 million to go chase that small TAM is pretty low. And so you tend to find 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 the prototypical CRM deal is, call it a 10 to 30 to 10 to $40 million revenue business.
Generally in a new market. A lot of the companies that we're backing are not guys on Silicon Valley or at 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 an 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 a 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 submarket within that core. And Healthcare, for example, we're not going to compete with Epic and Cerner. We can buy an EHR space that's focused on, for example, with our company Raintree, the therapy market. It's either an adjacent market or it's an adjacent sub vertical there. And the overall market is relatively unvended. It's growing. It's going through its own little adoption curve. I think about this business, Mercury Network, which was actually in 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 as 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 were sort of strong market tailwinds that were driving that adoption. That company at the time was $8 million of revenue, roughly when we invested, and it was growing organically at 30 or 40%. For 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 sort of come in with a lot of your prior year's revenues coming back. We tend to gear a little bit more on the gross dollar retention than 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 those metrics. We look at the gross margin in the 80s, if you can. I think 60 to 80 is kind of that 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 billion fund. How meaningful can an investment into a $200 million TAM 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 in the case of Mercury Network it was sort of an 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 on our operations CMART 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 fund it all for our P and Ls. We do it 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 headhunter. Russell Reynolds ran the Silicon Valley office for them. Is just exceptional at human capital development. One of the core competencies 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 at Mercury was the ability from scratch to help build that team around Jennifer Miller who's a president sort of co founder of that business. But that's really clear value creation lever around that carve out and standing up a whole new team.
[00:22:00] Speaker A: In this case, Jennifer was the co founder.
[00:22:03] Speaker B: She co founded it within a different business.
[00:22:06] Speaker A: She stayed on with you.
[00:22:07] Speaker B: Yep.
[00:22:08] Speaker A: If I heard you right, the business was growing organically 30 to 40% and it had attractive gross margins and gross 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 spent 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.
[00:23:02] Speaker B: We've exited the business. We didn't hold it that long. It was a really unusual company insofar as a great profile. We ended up exiting a little bit early in part because we got an aggressive inbound bid from a strategic. We brought in 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. They didn't have their own finance department.
[00:23:24] Speaker A: So you had to build all that new once it stepped out of its.
[00:23:27] Speaker B: Parent and by the 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 retooled the wholesales and go to market motion. And we invested in the company at $8 million 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 accelerated revenue growth, we increased pricing to your 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 and what I've got the utmost respect for the entrepreneurs that start these companies, is it's incredibly hard to go from 0 to 1. 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 focus tremendous amount on quality of the product, the quality of the experience of the customer and how the customers feel. It's sometimes slightly different skill sets and capabilities to go from 0 to 10, 10 to 30, 30 to 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 doing, which is field sales. You may have five field Sales reps. If you want to continue to grow 30% on $30 million of revenue, you're going to need to book $10 million per year. You're going to have to either grow the sales team, shrink their territories, you're going to have to create more sales enablement resources, you're going to think about different motions, you think about a channel of motion. And generally what we find is the founders and entrepreneurs that we're working with are seeking out help on those questions as they're thinking about doing something that's just to maintain the momentum that they have. If a company's got weak gross retention, and we've invested in a number of companies that have had sort of mid-80s gross retention, that's a little bit 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 product, optimizing sales in the go to market motion, thinking about pricing, and generally in those three areas, which is where we have growth team members dedicated to.
[00:26:00] Speaker A: 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?
[00:26:15] Speaker B: Let's decouple out retention here for a second. There's a couple of different reasons why I think a company can have weak retention, and I'll just name a few. This won't be exhaustive, but one of the reasons why you have weak retention is you're selling into an SMB market, your customers are going out of business. One question is, is there enough wallet to sort of go after in those companies to buy additional products to increase pricing? In some cases we've invested in companies where it was weak retention because it was more of a discretionary product. And like, are you really going to buy more from a company that's sort of quasi discretionary? It's not sort of 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 the more discretionary or ancillary 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 nps, 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, which is why we have three full time people from Simon Kutcher Partners that have joined us here internally. And 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 botch the pricing model. And we see this in the data all the time, which is the scatter plot of pricing is all over the place. It's pretty high. And so at some point 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 the 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 gross 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 I spent 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 investments is in the average time from first contact to close investment is four 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 sort of knowing the reputation in the market, knowing how they're perceived, knowing that team and how they're going to drive and what their thesis is, we're.
[00:29:07] Speaker A: 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 Sarent. 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 sarin 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 with? 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.
[00:29:54] Speaker B: 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 to vertical. And these vertical markets have gone through that adoption curve. I think that adoption curve slowing. You look at the public SaaS data shows decelerating growth. And I think that there's some of that which is, hey, there was a pull forward in 2020 and 2021 of 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 to our perspective, that organic revenue growth is probably the number one driver in valuations that's been, I think buoying 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. Aviante was an investment that we invested in back in 2014. It was $3 million of recurring revenue. But there was a mix of that revenue that was license and maintenance that we switched over. Aviante's grown north of 30x on its recurring revenue as we sort of effectuated that shift and we did M and A. Other examples might be real green, which we invested in, which there was a discrete value creation lever around both license maintenance to SaaS conversion, but also the introduction of payments. I think it's a combination of one, attractive market going through an adoption curve, two discrete value creation levers available within the vertical market. SaaS as you are the system of record, your ability to sell more product and drive sort of outsized growth through better monetization of that install base and then three, the recognition of the quality of these businesses, which again, from a predictability and durability perspective I think is exceptional. And so I think you've seen pretty significant pricing increases in a really attractive exit 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 north of $100 million 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 backed exit. It's a really robust and vibrant set of folks. For us, when we're investing in a company, it's 8 to 10 million dollars of revenue. What we found is there's generally not as much competition. If you're investing out of a 2, 3, $4 billion fund, it's unlikely that you're going to go invest in a 10, $20 million revenue company that's grown at 25, 30, 40%. Just not a big enough check and needle mover. Particularly as we talked about before, if you've got somewhat constrained tam, I think you've seen that and I think that firms like Thoma Bravo have done a phenomenal job and are world class investors and they've driven 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 Tilmo Brother or Vista 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 against them in those cases. But I think you see the acknowledgment of the attractives of the down market segment and we even play well below those guys. I don't think there's a pricing arb opportunity at the upper end of the market and 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 opportunity to drive revenue growth and then the multiple arm on the far side the last 20 years. I don't know if the next 20 years are going to be the same. There's not a lot of vertical markets out there that are untouched. This idea we're skiing through virgin powder and a lot of the hills have been skied. You're seeing markets that are a little bit more vended. As we think about the next 20 years, I think it's really unclear 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 things we talked about was hey, the lowering of the cost of software allowed for this verticalization to happen. Software development allowed for verticalization to happen. That led to a really attractive environment externally for us to be investing in over the last 20 years. I think that the conditions have changed again and will continue to sort of evolve and unclear how that's going to impact these markets going forward. It may create a whole new set of disruptors. It's going to be the next leg of growth for us. That's very much an evolving area. But the last 20 years I think have provided exceptional returns in this category for those three reasons.
[00:35:04] Speaker A: Obviously the AI is over all of software now and either you wield the sword or the sword is wielded against you. Is 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 20 years relative to the last 20 years, do you think the next 20 years could be a year where returns in the vertical market software business are driven more by M and 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 20 years, if the adoption cycles are perhaps slowing down and maturity and adoption is higher and maybe it moves towards more of like a consolidation category, any sort of mega category.
[00:35:58] Speaker B: There's two questions here, 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.
[00:36:07] Speaker A: Have they implemented stuff?
[00:36:08] Speaker B: Yeah.
[00:36:09] Speaker A: 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 part is making that transition?
[00:36:26] Speaker B: None of our companies are sort of building internal LLMs. 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 that out with Copilot within our portfolios to sort of enhance developer productivity. We see this in our support teams within certain companies. Like Tyler, who runs Studio Designer is rolling out AI driven support to lower the cost per ticket. 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 at Saran that runs product and technology, Neil. And so Neil's coordinating and saying great, what are the lessons that are being learned across these different use cases and how do we promulgate those out into the portfolio where 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 are we making sure that we're staying at par with our peers and competitors and some potential new AI driven entrants to 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 market SaaS, it just sort of happens to be. That's the swiveling that we picked and spend time and look to your point like there's been phenomenal tailwinds in that market that have helped sort of drive performance. Some of that candidly over the last 20 years was just a really favorable rate environment that 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. It's 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, Parent Square is a great example of a company we invested in 21 and they had built a better mousetrap. 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 and 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 wave that we're going to go through as you have next gen capabilities? Just a lot of the cloud based vendors displace 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 displace an incumbent than it is to drive a sort of greenfield logo that could be a vector of growth. We do think M and 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 winner take all effects or winner take most effects, we generally have the top two players command serve the majority of the revenue in the space and that's just because you can spend more on R and D relative to your competitor and so you have fundamentally better economics. That's a real benefit to driving M and 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 R and D to build even better products. When we started the firm we really weren't doing M and A. We sort of believed the whole roll up idea was financial alchemy and you couldn't sort of buy a bunch of companies for five times he but done sell it for 15. I think where we are today we're doing 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 of returns for our investments is organic revenue growth. Number two is M and 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 the next generation of technology.
Generally, an attractive way to go clean up sort of the legacy players in a space is to do it through M and A.
[00:40:44] Speaker A: Let's get into deal sourcing. Very long time ago, you guys were axial customers when you believed in the intermediary channel. And 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 intermediated 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 Sarin 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 noteworthy.
[00:41:50] Speaker B: This has been an iterative process where we sort of evolve the team over the past 15 years.
When we started, we originally had the View, which is I started as a Senior Associate/VP, which sort of 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 going 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 TA Summit model with sort of direct outreach. And it was in 2010 or 2011 that we hired Tyler Fair, first person in our BD team who came in and was a dedicated BD person. All he was doing was outbound calling. And 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 also hire someone whose skillset, frankly, was probably better suited towards business development activity. It had a tremendous amount of success. Tyler was an animal. He was incredibly successful here. He went on to build a company called Source Scrub, which took, fortunately, a lot of the IP around 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 or principals on our investing team and they're tackling vertical markets. And any given principal or VP will have two to three active markets. They're going super deep in. It's not just fintech, it's not just lending tech broadly. It's like lending tech within the specialty finance companies or lending tech like the platforms that especially finance companies will use or are you going to the mortgage originators or you're going into the commercial lenders. And so in each of those markets really drilling down to the 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, I think before four years from first contact with a company to close investment. And so it takes a tremendous amount of time. Today probably 20 to 30% of our investments come in through the intermediary channel. I think for us, if a company's 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 is 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 end 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. Super painful because we've Got folks we've been tracking or building a relationship with. This just recently happened to us. Two year relationship, countless dinners in the Bay Area, New York and Austin. Building a relationship with an entrepreneur who wanted to go run a process. And 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.
[00:45:37] Speaker A: 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 and a process that's being run by a 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 2, 3, 4 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 you're 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, make him feel good about. I always wanted to go with Sarent, but I felt like I needed to keep them a little bit honest or something like that.
[00:47:03] Speaker B: 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 Sara 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 150, $200 million TEVs. 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 and say, hey, I want to do a price check, great, we're good with that. We want the markets 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 in 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 it's not to say 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 to 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.
[00:48:21] Speaker A: But your conversion rate, Lance, 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.
[00:48:32] Speaker B: The conversion rates from submitted loi, the conversion rate on submitted loi to closed deal, exceptionally high. When we're one on one with an entrepreneur, we're spending a lot of time prospecting, building the top of the funnel. Like you have top funnel, middle funnel, I sort of call this middle funnel that you have sort of bottom of funnel which is sort of post loi. And we spend a ton of time prospecting. That's time we're spending in these markets anyways. We have dedicated team that's going after that for the execution side of things. A lot of the time gets expended on pre and post loi 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 funnel development, which is engagement. That's part of broader market work that we're doing. It's getting smart in the industry and there's a benefit if you're saying, hey, I'm committed to doing something within edtech 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 2 million of revenue or 50 million 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, marked up 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 that's where a ton of time gets expended. Time and dollars. If you're not set up to do that, which we're generally not the 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, Bain. We're 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 Bain 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 win 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 do something 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 sort of say, 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 who's going 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 to say, 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 hire a banker, run a 10 person post IOI auction, run everyone to ground, it's too hard for us to effectively compete to have it be worth our time. And we've got this adverse selection issue.
[00:51:38] Speaker A: 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 a young private equity firm or 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 do 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?
[00:52:21] Speaker B: 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 08 to 1415, over half of our deal flow came from the intermediated 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 what you're asking someone when they forego that is bet on us and bet 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 as 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?
[00:53:29] Speaker A: 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 Sarent 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 reevaluating? Where are you trying to make the Saran 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, evolved the sourcing model, gotten very clear on software, gotten very clear on sourcing, gotten 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?
[00:54:23] Speaker B: Private equity firms are partnerships driven by people and you raise funds. And that fund is an agreement saying, hey, 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 equity firms, they are more looking like companies and they're selling stakes and they're going public. If you're basically mortgaging the future by selling off the future economics to 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 Sarant, that it was set up as an equal partnership. And they did that based on what David been a portfolio company CEO of Benchmark Capital and saw the success that Benchmark had and the succession planning and transitions that they had. The most important thing to build a great investment firm is do you have exceptionally talented people at the firm? And I think the only way to keep and retain. And by the way, 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. And we've gone through this next chapter of succession with David, one of the co founders, moving into sort of a non active role here. And so he sort of got through the first wave of succession planning. And I think the goal is for all of the partners to sort of 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. Fund 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, I think we were trying to figure out what was the same deal. But more importantly, like it's hard starting from 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 and take the firm to the next level each year this sort of progresses. 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, a bunch of generalists and we got specialized in vertical markets. We ended up getting specialized within the firm around sourcing and our growth team. And then even within the growth team, for example, we now have centers of excellence. So just more specialization. So you can really have subject matter experts that are going to drive outsized 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 constantly trying to figure out what we're going to do better. And that's sometimes incremental changes to what we're doing. Sometimes there's step functions shift to centers of excellence was a step function change. Beyond that for us, we're now about 100 people. I think one of the big shifts for us was as you go from a 10, 20 person organization to 100 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. And so we're going through that evolution right now. We just brought in somebody, a new CEO to help lead a big chunk of the organization that's both going to allow the partners to spend 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 of talent is exceptional.
[00:57:53] Speaker A: 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.
[00:58:09] Speaker B: Good to see you, Peter. Thank you so much for having me. It's been a pleasure. Take care.
[00:58:12] Speaker A: If you enjoyed this episode, check out axial.com there you'll find every episode of this podcast, as well as our recorded Axial member roundtables, some downloadable tools for dealmakers, Axial's quarterly league table, rankings of top small business acquirers and investment banks, and lots of other useful content that we've created over the course of time. If you're interested in joining Axial as either an acquirer, an owner considering an exit, or as a sell side M and a advisor, you can get started for
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[00:59:00] Speaker B: Peter Lerman is the CEO of Axial.
[00:59:03] Speaker A: All opinions expressed by Peter and podcast guests do not reflect the views or opinions of Axial. This podcast is for informational purposes only.
[00:59:11] Speaker B: And should not be relied upon as a basis for investment decisions.
[00:59:15] Speaker A: Podcast guests may have ongoing client relationships with Axial.
