Wanted: A Constellation Software for Martech

Published March 16-22, 2024

The Opportunity

I first heard about Constellation Software from a friend a few years ago. He mentioned about a company headquartered in Canada which acquired software companies with a templated process. I had then studied them and was very impressed with their model of efficiency and scalability. Since then, my friend, Ambarish Gupta, went on to start Basis Vectors to replicate this model for SaaS. (I am an early investor in the fund.)

In the past few months, I have got multiple incoming requests from investment bankers and VCs to look at acquisitions of martech companies in their portfolio. I have turned all of them down primarily because Netcore has limited cash of its own to pull off these deals, and in a slow martech market it is also not easy to raise capital at the right valuation – even for a proficorn!

Martech has thousands of companies. Scott Brinker’s 2023 Martech Map lists over 11,000 companies. From the commentary by Scott:

It’s the same dualistic story we’ve seen for the past 12 years in martech. Yes, there is consolidation and churn. Even significant consolidation and churn. But the rate at which new startups have launched has consistently outpaced the exit rate of those who leave the arena, whether victorious or dead.

While competition grows and economic pressure rises — both forces that should lead to greater compression of the landscape — barriers to entry for software products continue to fall and the size of the underpenetrated portion of the market for many of these capabilities remains tantalizingly large.

Of course, this can’t go on forever. We can safely say the upper limit on martech solutions is well below the population of the planet. (“You get a martech company! And you get a martech company!”) The rate of growth has already slowed by an order of magnitude, from 100% year-over-year to just a hair over 10%. Equilibrium seems near.

With the proliferation of companies and the slowing investments, many unprofitable companies face two clear choices: either cut costs to get to profitability, or lower valuation to raise new capital. Both are not easy decisions. The former can make a company a pale shadow of itself consigning it to the “living dead”, while the latter can be hard on founders and their equity/ownership of the business.

In this complex and challenging environment, the untapped potential of the $250 billion of waste in digital marketing spending presents a unique opportunity. By broadening the definition of martech to encompass AdWaste, we can craft a path for a super-aggregator to not only survive but thrive, transforming the competitive zero-sum game into a landscape ripe with mutually beneficial outcomes for all stakeholders.

So, I started thinking about whether the Constellation Software model of strategic aggregation and innovation could be applied to martech. In this series, I will explore a theoretical construct of how this could be done and the potential benefits for founders, investors, and customers.

Constellation Software – 1

Here is how Constellation Software describes itself: “Constellation Software is a leading provider of software and services to a select group of public and private sector markets. We acquire, manage and build industry specific software businesses which provide specialized, mission-critical software solutions that address the particular needs of our customers.”

It defines two types of businesses it acquires: Exceptional and Good.

Exceptional Businesses criteria:

A mid- to large-sized vertical market software company (a minimum of $1-million earnings before interest and tax)
Consistent earnings and growth — generally EBITDA/revenue + revenue growth of 20 percent or more per year
Experienced and committed management
An offering price that has been determined

Good Businesses criteria:

Number 1 or Number 2 market-share holder in a niche vertical market
Revenues of at least $5-million
Hundreds or thousands (not dozens) of customers
Unimposing competitors
An offering price that has been determined

Constellation Software has created six groupings of the companies it has acquired through the years.

As of late January, the company was valued at $77 billion Canadian dollars (about $57 billion US dollars). Its revenue is about US $8 billion.

A few months ago, The Economist wrote about Constellation Software:

Whether by fluke or design, Constellation’s dealmaking success is based on principles that look strikingly similar to those of the world’s heavyweight acquirer, Berkshire Hathaway. Like Warren Buffett, Berkshire’s boss, and his right-hand man, Charlie Munger (who died on November 28th), the founder and president of Constellation, Mark Leonard, seeks out businesses with a lasting competitive edge. In Constellation’s universe, such a “moat” is enjoyed by software firms that specialise in building digital wares for unsexy industries from car dealerships and builders to spas. Tech giants shun these relatively piddling markets and smaller rivals lack the requisite know-how. The result is rich profits for the incumbents.

After a deal is done Constellation, much like Berkshire, runs the business with benevolent neglect. It does not integrate newly acquired companies or parachute in fresh managers. It is content to leave day-to-day operations to the existing leadership. It does not desperately try to squeeze out inefficiencies by centralising common business functions. Constellation believes that splitting a business weakens its bond with customers, notes Paul Treiber of RBC. Cash from the subsidiaries flows to the parent company, which uses it to buy new businesses. These in turn generate more cash, and so on.

… Like Berkshire but in contrast to private-equity or VC funds, Constellation has no exit clock ticking. It can thus be patient with investment decisions. Mr Leonard’s annual letters to investors echo Mr Buffett’s in describing the company as a “good perpetual owner”. This marathon mentality shapes employee pay. Bonuses are tied to returns on invested capital rather than just revenue growth. Executives must invest three-quarters of their bonus in company stock, which they cannot sell for four years. This aligns management’s incentives with those of shareholders.

The chart below shows the scale and size of the acquisitions made by Constellation Software over the years:

Constellation Software – 2

I asked ChatGPT for a summary of Constellation Software’s strategy:

Focused Acquisition Strategy: Constellation Software has a highly focused approach to acquisitions, targeting vertical market software (VMS) companies. These companies often provide specialized software solutions for specific industries, which tend to have stable, recurring revenue streams and high customer retention rates.
Decentralized Management: Post-acquisition, Constellation Software maintains a decentralized management structure, allowing its acquired companies to operate independently. This autonomy encourages the entrepreneurial spirit of the acquired companies, fostering innovation and operational efficiency while benefiting from the resources and stability of a larger parent company.
Disciplined Financial Approach: The company is known for its disciplined approach to acquisitions, emphasizing cash flow, profitability, and sustainable growth. Constellation Software carefully evaluates potential acquisitions to ensure they meet strict financial criteria, which helps in maintaining overall financial health and stability.
Long-Term Growth Focus: Constellation Software focuses on long-term value creation rather than short-term gains. This long-term perspective guides its acquisition strategy, investment in product development, and customer service, contributing to sustained growth and profitability.
Market Niche Specialization: By focusing on niche markets, Constellation Software mitigates competition from larger software companies. This specialization allows for a deeper understanding of customer needs, leading to the development of highly tailored solutions and stronger customer relationships.
Continuous Innovation and Customer Focus: Despite its acquisition-driven growth model, Constellation Software remains committed to innovation and customer satisfaction within its individual business units. This ensures that products stay relevant and continue to meet the evolving needs of their specific markets.
Scalable Business Model: The company’s business model is designed to be scalable, enabling efficient integration of new acquisitions and leveraging synergies across its portfolio of companies. This scalability is key to managing a large and diverse portfolio of software businesses.
Talented Management and Operational Excellence: Constellation Software has a strong leadership team and places a high emphasis on operational excellence. It attracts and retains talented management teams within its acquired companies, ensuring best practices in software development, sales, and customer support.

These two graphics from The Generalist capture the essence of its model.

As The Generalist puts it: “In almost every respect, Constellation Software is an abnormal business. Founded by a disgruntled gravedigger-turned-venture-capitalist, Constellation is a PE firm that never exits, a compounder that buys its growth, a fine-tuned conglomerate with minimal management, and a culturally defensible business skeptical of the very notion. More than a company, it is a teeming ecosystem of entities, each with distinct personalities and ambitions. And yet, each element serves to help the whole thrive.”

Additional resources:

Consolidation

Martech has become a crowded space with many companies facing an existential crisis because funds have dried up and marketing spends from businesses have reduced. Some will die, others will get sold to either PE firms or larger marketing cloud or enterprise software companies. This Darwinian process of natural selection will ensure only the best survive.

This assumes a given current market size for martech software. What if this market could be grown by many times? That may still not guarantee survival of everyone, but it could open new opportunities for growth for many companies. Some costs are common across companies – especially in marketing and sales. Buyers, especially in the mid-market, would prefer a more unified stack than spending money on integrating different point solutions. A simpler tech stack will also ensure data is not siloed enabling AI models to work better. While roll-ups of smaller martech vendors by the bigger ones is an obvious solution (and is already happening), the diversity of B2C/D2C/eCommerce/retail creates opportunities for a larger universe of companies under one roof. Exactly the way Constellation Software has done for vertical market software companies.

The opportunity in martech comes from rethinking the size of the pie. As I have explained in previous essays, about half the spending on digital advertising is being wasted. Businesses spend about 80% of their budgets on acquisition (adtech), 10% on branding, and 10% on CRM (retention and growth of existing companies, the world of martech). As I wrote in Nucore: A Thought Experiment [LINK]: “The global eCommerce industry generates trillions of dollars in revenue. Email is one of the key enablers for customer engagement, conversion, and retention. Yet, its size is in single-digit billion dollars. Add all the other engagement channels and martech solutions, and the figure will go to maybe $50 billion. Compare that with adtech, which powers new customer acquisition. Global spending on digital advertising platforms is expected to be $500 billion. In other words, even as the adtech industry makes 10 cents of every dollar of revenue that ecommerce generates, the CPaaS and martech industry generates just 1 cent.” My estimate is that about half of the money spent on adtech is being wasted on wrong acquisition and reacquisition. Half of $500 billion comes to $250 billion. This is AdWaste.

Until recently, it was very difficult to solve for AdWaste because it was not easy for marketers to build deep relationships with existing customers. Now, several tech and business model innovations like Unistack, Channels 2.0, and Progency can help tilt the scales towards retention and growth rather than continuous acquisition.

The AdWaste thus becomes the fuel for martech companies to tap with innovations to solve the allied problems of siloed data and funnel friction (besides that of marketing waste). Only by shifting the adtech budgets to martech will martech companies multiply their addressable market. A byproduct will be an increase in profitability for digital businesses, especially those which are consumer-facing. This will create the flywheel for value creation in martech.

The question is: how to unlock this opportunity and create a Constellation Software for martech? My answer: MarCo – a Martech Consolidator, which acquires, manages, and builds martech software.

MarCo

MarCo (Martech Consolidator) can start life as a fund which partners with a martech company (like Netcore). This mirrors the beginnings of Constellation Software, as outlined by Speedwell Research:

Over [his] next 11 years in VC [venture capital], Mark Leonard would solidify what he wanted to build. He would fondly recall how fulfilling it was to build something properly as a masonry, which required mastery and would be there 100 years later. (To his surprise, this was in contrast to many of the start-ups he worked with that had a “build to sell” mentality). His masonry experience, coupled with some mentorship that that exposed him to the Buffett & Munger orthodoxy, inspired his plan to construct an enduring company. This nebulous desire, however, only started to calcify after a novel insight about the success of Venture Wests’ portfolio companies. He noticed that their most successful venture investments were vertical market software companies, which to Leonard seemed to have all of the business virtues Buffett would want with a competitive “moat”. The problem though, was that each vertical market software (VMS) company was relatively unimpactful to the overall portfolio results because of their small size. His idea was to create a holding company that would just focus just on acquiring VMS companies, which he imaginatively wanted to call Software Co.

Mark’s reputation as a sharp thinker with an indisputable work ethic made many of his Venture West colleagues enthusiastic to seed his idea, which, alongside an old business school buddy who happened to work at OMERS (Ontario Municipal Employees Retirement System) pension fund, allowed him to raise a full $25mn CAD. There was one piece of feedback though; the name Leonard picked was terrible. And so Software Co. became Constellation Software, a reference to seeing a unifying picture of otherwise unconnected pieces, and officially launched in 1995.

In the early years of Constellation Software, Mark Leonard would lead the acquisition process, focusing on wholly acquiring their first VMS companies. The attraction to VMS was born from the fact that each software offering tends to be mission critical to users and each market is small enough that competition is insulated from the big players who could not rationalize spending in these small TAMs. Additionally, the recurring nature of most revenues and minimal maintenance capex makes software inherently attractive.

Recurring revenue is what SaaS companies get. The challenge for many is that the sales and marketing costs are high (remember: 11,000+ martech companies!) and this hurts their ability to generate consistent and scalable profits. What MarCo therefore needs is one or more anchor martech SaaS companies (like Netcore) which have access to a large portfolio of digital businesses.

Imagine a $100 million fund to begin with — $10 million coming from the anchor martech vendor, $40 million from investors, and $50 million in debt. Assume the debt will come in at 10%, and thus need $5 million in annual interest payments.

Next, let’s assume there is a target martech company with $5 million in revenue and about $1 million in operating losses. So, the split of the $6 million in costs would be something like this:

$1.5 million in cloud costs (assuming 75% gross margin)
$1.5 million in product, engineering and R&D
$1.5 million in marketing and sales (30% of costs)
$1.5 million in general & administration costs

Three costs can be reduced after a takeover by MarCo:

A third of the product, engineering, and R&D costs – by shifting some operations to India
A third of the marketing and sales, by leveraging the strengths of the anchor martech vendor and cross-sell across the growing portfolio
A third of the G&A costs – by consolidating across the group

Together, this can bring in savings of $1.5 million, converting the $1 million loss into a 10% positive EBIDTA of $0.5 million.

Half of this would be used to service the debt on the deal, and the other half becomes the cashflow used for expansion of the business and MarCo.

Growth will also accelerate because of the benefits of cross-sell and integration into the stack, thus leading to higher profitability and more free cash generation.

So far, we have not even factored the benefits of expanding the market size by shifting the AdWaste.

Taken together, this can create a very powerful flywheel for growth – just like what Constellation Software has done.

Making MarCo Happen

MarCo is about bringing three ideas together:

The business model of Constellation Software
The partnership of an anchor martech vendor with a fund
The scale-up of the addressable market by tapping into AdWaste

We have discussed the first and third points. The second one needs an explainer.

Funds typically don’t like to get into running businesses. While some PE funds do take over and operate businesses, they do so on a big scale (hundreds of millions of dollars to a few billion dollars). Its typically a single business where they work with the existing or new management team to build out the business after their entry, in preparation for an exit in a few years, hopefully generating an IRR of 25% or more.

MarCo has a different approach. The anchor martech vendor becomes the operator of the acquired businesses. It has deep understanding of the martech space and also a base of customers and existing tech. As such, it is ideally placed for doing roll-ups. But because of the constraints I mentioned earlier (slowing market growth and limited availability of capital based on its own balance sheet), it cannot make the bigger acquisitions on its own. The fund structure gives it the leverage to do bigger deals.

For investors in the fund, they get a partner who has skin in the game by virtue of the anchor martech vendor’s investment. They get access to a management team which knows how to build and scale businesses. They can consolidate a fragmented industry to create more value. The AdWaste opportunity becomes an added attraction. For entrepreneurs and founders seeking an exit in troubled times, MarCo becomes the perfect partner – an alternative to shutting the business down when capital runs out. For digital businesses, they get better products which are tightly integrated rather than loosely coupled together. They also can look at solving problems with off-the-shelf solutions rather than trying to build them on their own. They don’t need to worry about their seller failing or shutting down. In short, it’s a win-win for everyone on the ecosystem.

Over time, MarCo can create a playbook like Constellation Software has done to simplify the acquisition process. It can also create a business system that ensures management and operational efficiencies. The growth by acquisition model has been used in many industries. What is new here is its application to a single software domain (martech) to build and realign one of the most important industries of our times – selling to billions of customers digitally and making money from them.

MarCo is an idea whose time has come!

Critique

I asked ChatGPT and Claude for a critique of the MarCo idea.

ChatGPT

The MarCo concept, inspired by Constellation Software’s successful model in acquiring vertical market software companies, proposes a novel approach to consolidating the fragmented martech industry. While the idea holds promise, there are several challenges and considerations that merit a critical examination.

Firstly, the martech sector’s inherent complexity and rapid pace of innovation present significant hurdles. The diversity in the needs and technologies across different marketing domains—from email marketing and social media analytics to customer relationship management and ad tech—means that a one-size-fits-all approach may not be feasible. The risk of homogenization could stifle innovation, leading to solutions that are jack-of-all-trades but masters of none, potentially compromising the specialized services that many martech companies offer.

Secondly, the cultural and operational integration of acquired companies poses another challenge. Constellation Software’s model thrives on a hands-off approach, allowing acquired companies to operate independently. However, in the martech space, where integration and interoperability between different solutions are key, this decentralized approach might impede the creation of a cohesive product suite. Ensuring seamless integration while maintaining the autonomy and unique value proposition of each entity would require a delicate balance.

Furthermore, the focus on tapping into ‘AdWaste’ as a primary growth lever might oversimplify the complexities involved in reallocating advertising budgets towards martech solutions. The effectiveness of advertising spend is not solely a function of the tools used but also of the strategies, content, and execution. Merely shifting budgets from adtech to martech without addressing the underlying inefficiencies in marketing strategies may not yield the expected returns.

Another concern is the scalability of the MarCo model in a sector as dynamic as martech. Rapid technological advancements and shifting marketing trends could render acquired solutions obsolete, requiring continuous investment in innovation and development. This need for perpetual modernization could strain the financial model, especially given the high valuations and competitive funding landscape in the tech sector.

Lastly, the success of MarCo would heavily rely on the execution capabilities of the anchor martech vendor. While the vendor’s deep industry knowledge and customer base are advantageous, managing a portfolio of acquired companies, integrating their technologies, and driving synergistic growth would demand a level of operational sophistication and agility that may be challenging to achieve.

In summary, while the MarCo idea is an intriguing proposition for consolidating the martech industry and capitalizing on untapped opportunities, it faces substantial challenges. These include ensuring effective integration and innovation across a diverse portfolio, navigating the complexities of the martech sector, and maintaining a sustainable growth model in the face of rapid technological evolution.

Claude

Strengths:

Leverages proven model of Constellation Software. MarCo seeks to apply the successful acquisition and decentralized management strategy of Constellation Software specifically to the martech industry. This model has a strong track record of creating shareholder value.
Consolidates fragmented industry. Martech is highly fragmented with over 11,000 companies. MarCo can roll up smaller players to achieve economies of scale and provide an integrated stack of solutions to customers.
Taps into large market opportunity. Shifting ad spending waste to martech provides fuel for significant growth in total addressable market. If even a fraction of estimated $250 billion in ad waste can be captured, it massively scales up the market.
Win-win for multiple stakeholders. MarCo offers exit for struggling startups, integrated solutions for customers, and investment leverage for participating funds/investors. Broad value creation.

Weaknesses:

Execution complexity and risk. Acquiring and integrating companies across continents adds managerial complexity. Need systems and leadership to make model work efficiently.
Competitive risks. Larger players may compete more aggressively if market expands substantially. Margins could get compressed despite wider reach.
High debt burden initially. Interest costs are front-loaded before benefits of consolidations kick in. Need patience from funds on financial payoffs.
Culture mix challenges. Blending work cultures across acquired companies can be tricky. Need to preserve autonomy while creating common identity.

In summary, MarCo is a bold strategic idea to consolidate the martech ecosystem. It addresses the needs of various industry stakeholders and has multi-billion dollar potential if executed systematically. However, investors should weigh the managerial and competitive risks inherent in a complex global roll-up strategy built primarily through acquisitions. Overall an idea with merit but not without risks.

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