Below is the result of an independent study during my time at Illinois State University. I was attempting to take the lessons from Thorndike's "Outsiders" and Mayer's "100 Baggers" and apply them to modern software businesses that were on my radar then (I was overly obsessed with free cash flow at the time).

Effective capital allocation is critical to any business's long-term success and growth. This is especially true however in the rapidly evolving software industry. To thrive in this ever-shifting landscape, software companies must allocate their resources strategically and thoughtfully. The purpose of this paper is to explore what effective capital allocation looks like. Then the paper will take these concepts and view some modern small to mid-cap software businesses.

The selection criteria for the companies referenced in this paper were derived from a review of companies that returned massive value to shareholders, past and present, which resulted in identifying three hallmarks of businesses that excel at capital allocation.

1. Acquiring other businesses systematically and cost-effectively.

2. Executives that thought fundamentally like shareholders.

3. Finding creative ways to return value to shareholders.

Having identified what to look for in some of today’s software businesses, one can then examine how these companies are implementing these capital allocation strategies in practice. Ultimately, the goal of this paper is twofold. Firstly, to provide insight and guidance to software businesses on effective capital allocation practices, and secondly, to speculate how certain businesses may generate exceptional returns for shareholders.

With that being said, let’s look at a software business operating today that exemplifies these qualities to the highest degree, Constellation Software. We will use the lessons learned from Constellation and other past high-caliber businesses as a lens to look at and potentially judge recently formed software businesses.

Constellation Software

Background

Constellation Software is a Canadian company that specializes in acquiring and growing software businesses. The company has a unique capital allocation strategy that focuses on acquiring profitable and niche software companies and providing them with the resources they need to grow and expand. Even though this may not be the most common “software” company, which are generally centered around a central product such as Google or DocuSign, Constellation will be a good starting point as we begin thinking about capital allocation.

One of the key features of Constellation's capital allocation strategy is its emphasis on operational efficiency. The company aims to acquire software companies that are already profitable and have strong growth potential. Once acquired, Constellation works to optimize the acquired company's operations, streamline its business processes, and implement best practices to increase profitability and drive growth.

In addition to operational efficiency, Constellation also focuses on long-term value creation. Rather than seeking short-term gains, the company takes a long-term view of its investments and seeks to build sustainable businesses with strong competitive advantages. To this end, Constellation invests heavily in research and development and encourages its acquired companies to focus on innovation and product development.

Another important aspect of Constellation's capital allocation strategy is its focus on cash flow. The company generates significant amounts of free cash flow, which it uses to continually fund acquisitions. Constellation's management team is very disciplined when it comes to capital allocation and only invests in acquisitions that meet its strict internal criteria for profitability and growth potential. (Constellation Software 2023) We’ll focus on this aspect of the company the most throughout this section.

Overall, Constellation Software's capital allocation strategy is centered around acquiring profitable software companies with strong growth potential, optimizing their operations for maximum efficiency, investing in long-term value creation, and maintaining a disciplined approach to capital allocation. This approach has helped the company deliver strong returns to shareholders and build a portfolio of successful software businesses.

Acquisition Discipline

As mentioned above, the company has a disciplined approach to acquiring companies, which is similar to the philosophies of Katherine Graham, Tom Murphy, and Warren Buffett. A key element of this discipline is the use of hurdle rates, which are minimum rates of return that must be met before an acquisition is approved.

Katherine Graham, the former owner of the Washington Post, required a minimum cash return of 11 percent without leverage over a ten-year holding period. (William N Thorndike 2012) This focus on long-term returns is similar to Constellation's approach, as the company typically holds its acquisitions for the long term and aims to generate sustained returns over time. Constellation's long-term approach is evidenced by the fact that it has made more than 500 acquisitions since it was founded in 1995. (Vela Software Group 2021)

Tom Murphy, the former CEO of Capital Cities Broadcasting, sought a double-digit after-tax return over ten years without leverage. (William N Thorndike 2012) This emphasis on after-tax returns aligns with Constellation's focus on generating cash flow and profits from its acquired companies. The company's goal is to acquire companies that have a strong competitive advantage and can generate high returns on invested capital.

Warren Buffett, the CEO of Berkshire Hathaway and perhaps the most famous investor of all time, is also known for his disciplined approach to acquisitions. Like Constellation, Buffett seeks to acquire companies that have a strong competitive advantage and can generate high returns on invested capital. He also requires that the companies he acquires have a significant margin of safety, meaning that they are undervalued relative to their intrinsic value. Buffett's focus on intrinsic value is similar to Constellation's approach of acquiring companies with a long-term sustainable competitive advantage.

While Constellation Software has been secretive about its hurdle rates, it is clear that the company has a disciplined approach to acquisitions that is similar to the philosophies of these three leaders. The company's focus on generating sustainable cash flow and profits, its long-term investment horizon, and its emphasis on acquiring companies with a competitive advantage all suggest a strong alignment with the investment principles of Graham, Murphy, and Buffett.

The use of hurdle rates is an essential part of Constellation's disciplined approach to acquisitions. Hurdle rates are used to ensure that a project or acquisition generates a sufficient return on investment to justify the risk and opportunity cost of the investment. A former Constellation M&A executive, who will remain unnamed, said in an interview:

“Constellation has strict hurdle rates and buy on an internal rate of return basis rather than on multiples. If you are at 24.8%, you need to find a way for it to be 25 or that deal will not happen. In the private equity world, if you're short, you simply throw in more money to get the deal done. That's the reason for their return and share price performance. They're disinterested in making 15% IRR; if it is not 25%, you hold your nerve and look for other businesses.”

While Constellation has not publicly disclosed its actual hurdle rates, the company's focus on generating cash flow and profits suggests that the hurdle rates are likely high. The company's focus on long-term sustainable cash flows also suggests that the hurdle rates are set with a long-term horizon in mind.

Another important aspect of Constellation's disciplined approach to acquisitions is the company's focus on acquiring companies with a sustainable competitive advantage. The company looks for companies with a strong market position, a loyal customer base, and a unique value proposition. By acquiring companies with a sustainable competitive advantage, Constellation can generate high returns on invested capital over the long term.

Thinking Like an Owner

There is a classic story told by Warren Buffett about his experience after acquiring a large stake in the Sanborn Map Company. He was invited to sit on the board which mostly comprised insurance company representatives, Sanborn’s biggest customers at the time. None of the board members owned a meaningful stake in the company and acted as such. The story goes, at the end of one board meeting the members broke out a humidor and started passing around cigars. “That’s my money paying for those cigars,” Warren thought as he sat fuming.

This highlights a prevalent issue in business that may have worsened lately as we emerge from a low interest-rate period marked by excessive hiring and spending. A statement by Murray Stahl and Matthew Houk, managers of Virtus Wealth Masters Fund (VWMCX), summarized the essence of why owner-operators are at an advantage.

“By virtue of the owner-operator’s significant personal capital being at risk, he or she generally enjoys greater freedom of action and an enhanced ability to focus on building long-term business value (e.g., shareholders’ equity). The owner-operator’s main avenue to personal wealth is derived from the long-term appreciation of common equity shares, not from stock option grants, bonuses or salary increases resulting from meeting short-term financial targets that serve as the incentives for agent-operators.” (Mayer 2015)

Constellation Software’s founder and President, Mark Leonard, owns 430,332 shares which translates to a ~2% ownership stake in the business. This may not sound high, until you find that this stake equates to about $748,000,000 as of February 2023.

Much of Mark’s behavior aligns greatly with shareholders, simply because he is one. In a recent filing with the CSA (Canadian Securities Administrators), a passage on Mark’s compensation reads:

“Mr. Leonard’s compensation for acting as President of the Corporation during fiscal 2022 was determined by the CNHR Committee. The President’s performance is reviewed on an annual basis, and changes to his base salary and/or the basis used for calculating incentive compensation in the coming year are made at that time. Mr. Leonard’s and head office employees’ incentive bonus entitlement is calculated in the same manner as the other executive officers as described above. In 2020, 2021 and 2022, Mr. Leonard voluntarily waived his entitlement to receive a salary and a bonus…” (Constellation Software Inc 2023)

For the past three years, Mark has not taken a salary or bonus from the company. This should be a clear indicator that he intends to grow the company's share equity.

Let’s now contrast this with a new CEO’s compensation plan at a once publicly traded; Avaya Inc. (Please note that the shares were trading at ~$0.90 per share when this was published.)

Annual Base Salary: $1,000,000

Incentive Program Bonus: Performance-based cash payout of 0-200% of base salary, with a target of 150%

Sign-On Bonus: $4,000,000, which will be used to immediately purchase shares.

Time-Based RSUs: 875,000 RSUs that will fully vest in 3 years.

Performance-Based Restricted Stock Units: 2,625,000 PRSUs; in which 50% will release if the stock price reaches $5 a share, 100% of which will release if the stock price reaches $10 a share, and 150% of which will release if the stock price reaches $15 a share. (Avaya Inc. 2022)

As you may be able to surmise from the low share price, Avaya was already in trouble when this new CEO stepped in. This should be relevant for two reasons:

1. It details the complexity and absurdity of normal hired executives’ compensation plans, even while the company faces hardships.

2. Demonstrates an intense focus on market share price within a publicly traded company culture.

Not surprisingly about 5 months after this compensation plan was announced the company filed for bankruptcy. With such a short duration between announcement and filing, this compensation plan wasn’t the only reason for the downfall of this once $2 billion company. Avaya got here from years of the culture of not thinking like true owners and worrying about short-term movements in stock. The company underwent a disastrous debt driven share repurchase program under the previous CEO, where they bought shares at very high multiples, most likely to prop up the stock price. We will explore share repurchases in the next section.

This compensation plan should act as a sort of artifact giving insight into the culture of this misaligned company. A side note, while the company was looking in the face of Chapter 11 and common shareholders were to be wiped out, the board changed the rules of the sign-on bonus mentioned above to let the CEO keep his $4,000,000 in cash and not purchase shares. As well as receive an additional $6,000,000 bonus. (Avaya Inc. 2022)

Behavior like this does not encourage the growth of shareholder value and does not align executives with the true interest of shareholders. Below is a graphic provided by Horizon Kinetics summarizing the ideas above quite well.

Returning Value Creatively to Shareholders

The common perception of creating shareholder value is through a typical business process where the company invests capital into its own operations which results in higher revenues, increased net income, and ultimately leads to a rise in share price. Constellation Software and others have employed more creative strategies to enhance shareholder value such as share repurchases, spin-offs, and others. This section will explore some of these strategies in depth. A common theme to look out for is how these methods are more tax efficient than other traditional approaches.

Stock Repurchases

Stock repurchases, or buybacks, are one of the more common ways for companies to return value to shareholders. Put simply, by repurchasing shares a company can reduce the number of outstanding shares, thereby increasing the value of the remaining shares. This can be a more tax-efficient method of returning value to shareholders compared to dividends, as the increase in share value is typically taxed as capital gains rather than dividend income. Also, regular dividends suffer from double taxation; once at the corporate level when the business generates income and second at the individual level when it is deemed income to the shareholder.  Constellation Software has utilized stock repurchases in the past, although not as a primary method of returning value to shareholders.

The biggest share buyback success story is that of Teledyne. Henry Singleton, the founder, and CEO of Teledyne was a pioneer in using share repurchases to deliver high returns to shareholders. During the 1970s and 1980s, Singleton recognized that the market often undervalued Teledyne's shares, and he capitalized on this opportunity by aggressively repurchasing the company's stock. This strategy not only increased the value of the remaining shares but also demonstrated Singleton's confidence in the company's prospects.

Singleton's approach to share repurchases was both disciplined and opportunistic. He would buy back shares when he believed they were undervalued, and he would do so in large quantities, often using the company's excess cash and even taking on debt to finance the repurchases. This approach allowed Teledyne to effectively deploy its capital and enhance shareholder value, while also maintaining a strong balance sheet. From 1972 to 1984 Teledyne bought an unprecedented 90 percent of outstanding shares while the stock was trading at historically low price-to-earnings ratios. (William N Thorndike 2012)

The result of Singleton's share repurchase strategy was impressive. During the period referenced above Teledyne returned a whopping 42 percent compound annual return. This growth was due, in part, to the reduced number of outstanding shares, which magnified the impact of the company's earnings on a per-share basis. One also needs to be aware of how unique share buybacks were at this time. Singleton’s revolutionary thinking was met with plenty of pushback. This perhaps speaks to a capital allocator needing unconventional thinking to produce unconventional returns to a shareholder.

Spin-offs

Spin-offs are another way for companies to return value to shareholders. A spin-off is a process of separating a business unit from its parent company and creating a new, independent company. This can be done for a variety of reasons, such as unlocking value, focusing on core operations, or reducing complexity. It’s common that the company in which the new organization is spinning out from issues shares to its existing shareholder base, thus granting them an ownership stake in this new company.

Constellation is quite new to the spin-off, and it will be exciting to see where these newly independent businesses will go. The company's two recent ventures into spin-offs are Topicus.com Inc, announced in 2021, and Lumine Group Inc, announced in early 2023. Both these companies are miniature versions of Constellation in their business models, acquirers of vertical market software businesses. However, Topicus.com is focused on the European region (Topicus.com Inc 2023) and Lumine Group sticks to the Communications and Media industry (Lumine Group Inc 2023). Constellation has been quiet in its reasoning for the Topicus.com spin-off, however, given their track record of keeping shareholders interest first and foremost, we can suspect that there is good reason for it. The Lumine Group spin-off is slightly more complicated, as it was done in part so newly minted Lumine Group shares could be used in a large acquisition of another company, WideOrbit. (Constellation Software Inc 2023)

Bill Stiritz took the helm of Ralston Purina in January of 1981 and, as you can imagine, did an extraordinary job allocating capital within the company. He performed many of the things described in this paper, bought back shares, acquired businesses systematically, and divested businesses that were not meeting an acceptable return rate. He also grew very fond of the spin-off during his tenure, viewing standard asset sales of companies as tax inefficient. Since spin-offs generate entrepreneurial energy in the new organization, it also defers capital gains, if the company intends to unlock value from a business segment by selling it. (William N Thorndike 2012)

Constellation Software Special Dividends

In addition to spin-offs, Constellation Software has also returned value to shareholders through the use of special dividends. A special dividend is a one-time payment made to shareholders, typically in response to a specific event or circumstance. In 2019, Constellation Software paid a special dividend of $20 per share, funded by the company's strong cash flow generation. This allowed the company to return value to shareholders in a tax-efficient manner, as the special dividend was treated as a return of capital for tax purposes. (Constellation Software Inc 2019)

Another noteworthy detail about this event is that the reasoning behind the one-time dividend payout was exceptionally intriguing. In response to questions from a select group of Constellation Software executives, Mark Leonard wrote:

“The dividend is clearly a signal about capital deployment.  If we thought that we could deploy this capital at high rates of return, we would have kept it.” (Constellation Software Inc 2019)

Mark Leonard and his team demonstrated their unwavering commitment to hurdle rates during this event.

Constellation Software Summary

Constellation Software's capital allocation strategy is centered around acquiring profitable software companies with strong growth potential, optimizing their operations for maximum efficiency, investing in long-term value creation, and maintaining a disciplined approach to capital allocation. The company's management team, led by founder and President  Mark Leonard, exemplifies the owner-operator mindset, which has contributed to the company's success in generating exceptional returns for shareholders.

By employing creative strategies for returning value to shareholders, such as spin-offs and special dividends, Constellation Software has managed to enhance shareholder value in a tax-efficient manner. This focus on tax efficiency, combined with the company's disciplined approach to acquisitions and commitment to long-term value creation, has allowed Constellation Software to stand out as a leader in the software industry and a prime example of effective capital allocation.

Current Examples

Let's take what we learned from Constellation Software earlier and apply it to some small or medium-sized public software businesses. By using the insights we gained from studying Constellation, we can grade these firms on their ability to allocate capital effectively.

Box, Inc. (BOX)

Background

Box Inc is a cloud-based enterprise content management platform that enables businesses to securely store, manage, and share files. Founded in 2005, the company has grown to become a leader in the enterprise content management space, with over 100,000 customers worldwide. Box Inc has raised over $1.2 billion in venture capital funding and is currently valued at over $3.8 billion. (Box Inc 2023)

Acquisition Discipline

Box Inc has a disciplined approach to acquisitions, which is evidenced by its focus on acquiring companies that are complementary to its core business. The company has made 14 acquisitions to date, most of which happened before the company went public and there is no data on sales price, or the acquisitions were very small compared to Box. However, we can explore one post-IPO transaction made in February 2021 with the acquisition of SignRequest for $55 million.

The company appears to make most acquisitions based on potential synergies between the target company and Box Inc’s product offering. Just after the SignRequest deal was signed, the technology rebranded to “Box Sign”, and about 4-months later they had it built into the Box platform. An interesting note on this is that Box took the technology and offered it into the platform with no additional charge to the user, it simply added functionality to the platform they thought was missing. (TechCrunch 2021)

Due to this and the lack of financial statements from SignRequest, it is difficult to define what return the company received on its $55 million. However, we may be able to speak on Box’s frugality briefly. Their main competitor, Dropbox, acquired a similar company two years before Box. Dropbox ran a similar playbook to Box when it acquired HelloSign, rebranding the company to Dropbox Sign and integrating it into its platform. Something might be said competitively about Dropbox having a first-mover advantage on this functionality; however, Dropbox paid a hefty $230 million for HelloSign. (TechCrunch 2019)

This may or may not be an appropriate comparison since the acquired businesses financial data is not publicly available, so we cannot be certain of the return on investment. However, at the most fundamental level, Box did pay significantly less than their competitor in bringing signing capabilities into the business.

Thinking Like an Owner

Box Inc's founder and CEO, Aaron Levie, has a significant ownership stake in the company. As of March 2023, Levie owned approximately 3.1 million shares of Box Inc, which equates to a ~2.2% ownership stake in the company. (Box Inc 2023) This ownership stake gives Levie a strong incentive to focus on long-term value creation and to ensure that the company is making decisions that are in the best interests of shareholders.

Aaron Levie’s pay shows positive signs as well. In 2022 it was reported that Aaron, by his own preference, had a modest $180,000 base salary with a potential for $102,000 in incentive performance compensation. These figures are small relative to his equity in the business, but they may indicate an alignment with shareholders. (Box Inc 2022)

Return Value to Shareholders

Box has driven significant revenue growth since its IPO in 2015, all while driving to a positive operating margin, which it just reached. Revenues in 2015 were $216 million, and in their latest SEC filing, the company now boasts around $990 million. However, the income statement may not be telling the entire story. The company reported a healthy $293 million in free cash flow in the last filing, that flow of capital has been present since 2020. (Box Inc 2023)

Using this internal cash flow, Box and its board have begun driving large share repurchase programs, which may be an indicator of good things to come. (Box Inc 2023)

Final Grade

Overall, Box has shown inclinations toward having acquisition discipline, but it may still be too early, and getting the proper information to determine this fully isn’t available. The company’s CEO and Founder Aaron Levie does appear to have an alignment with shareholders by taking such a modest annual pay. Finally, the company is beginning to buy back shares using its strong internal cash flow, another step in the right direction. Based on these factors, Box Inc receives a B in capital allocation.

Zscaler, Inc. (ZS)

Background

Zscaler is a cloud security company that provides cloud-based security solutions to organizations of all sizes. Founded in 2007, the company has grown rapidly and is now a leader in the cloud security space. Zscaler's solutions are designed to protect organizations from cyber threats, while also providing visibility and control over their networks. The company has a global presence, with offices all over the United States, Europe, and the Asia Pacific (Zscaler Inc n.d.). The company’s market capitalization is currently around $15.6 billion. Between 2012 and 2017 the company raised $148 million in venture capital and went on to IPO in March of 2018 (Crunchbase n.d.).

Acquisition Discipline

Zscaler has a disciplined approach to acquisitions, focusing on companies that can improve the existing product offering. The company has made 8 acquisitions over the past few years, including Smokescreen Technologies, a cloud threat intelligence company.

It is rumored that in the year prior to the Smokescreen Technologies acquisition, fiscal year 2020, the company generated $7.3 million in revenue (Mitra 2021). Zscaler purchased the company in 2021 for a reported $40-45 million (Singh 2022). However, these figures we’re not able to be independently verified so must be taken with a grain of salt.  Nevertheless, if we use these figures, we can estimate that Zscaler purchased the company at a roughly 6x revenue multiple. This is a reasonable price for a company of that size. Being that the acquisition was so small in comparison to the size of Zscaler, this company was most likely not purchased with the idea that it would be a good long-term investment that would increase shareholder value significantly. In all reality, the company was probably purchased for unique threat intelligence products.

The aforementioned 7 other acquisitions appear to be of similar size and shape. It is safe to assume that Zscaler believes the cash generated from operations is best used within the core business to improve their products, rather than purchasing sizeable existing businesses. This focus around the core business is proving to be a fruitful one, with the average analyst forward estimated return on equity to be ~38% (Tikr 2023).

Thinking Like an Owner

Zscaler's CEO, Jay Chaudhry, is a true owner-operator. He and his family own a roughly 42% ownership stake in the company (Forbes 2023). This is a significant stake and shows that Jay is aligned with shareholders. Jay and other executives’ compensation may be telling a different story. In fiscal year 2022, Jay was awarded ~$41 million in stock, and the entire C-suite was awarded ~$147 million (Zscaler Inc 2022).

The flowing of company funds and shares into the CEO’s compensation does not appear to be the best use of capital within the business. Taking what we learned in the last section, ~$41 million in compensation could have been reinvested internally at a ~38% annual return. The return would equate to a ~$15 million increase in net income for the business. It is perplexing why Jay Chaudry would be doing this when having such a great return in the core business.

Return Value to Shareholders

For the short period of time Zscaler has been public, it has displayed incredible revenue growth. With revenue climbing from $80 million to $1.09 billion over the course of 2018 to 2022. Free cash flow over the same period went from $3 million to an incredible $321 million (Zscaler Inc 2022). This is some truly amazing growth over the past 5 years, if the organization can keep up this pace shareholder value will significantly increase.

Zscaler does not currently do any significant share repurchases. They have never recorded a dividend, regular or special, and have never spun off a segment of the business.

Final Grade

Overall, Zscaler is a great business from a financial perspective. The company has made strategic acquisitions and developed a high return on equity. The company's CEO is a true owner-operator, with a significant stake in the company, and the company is generating lots of cash. However, the CEO’s compensation appears to not be fully aligned with shareholder interest. With great high-margin businesses, such as software, there is a propensity to only look for top-line growth rather than look for potential “leaks in the bucket.” The CEO’s excess compensation should be deemed a leak. Based on the following information, Zscaler receives a capital allocation grade of C.

Conclusion

In conclusion, effective capital allocation is essential for any business to achieve long-term success and growth, even in the rapidly evolving software industry. This paper has explored what effective capital allocation looks like and examined how modern software businesses are implementing these strategies in practice. Constellation Software is a great example of a software business that excels at capital allocation, with a disciplined approach to acquisitions, a focus on long-term value creation, and an emphasis on cash flow. We highlighted the importance of thinking like an owner and how to return value to shareholders in creative ways.

Ultimately, the key to effective capital allocation is one word: frugality. Frugality encompasses more than simply being "cheap"; it's an approach to financial management that emphasizes making the most of available resources, prioritizing investments to generate the most value for stakeholders, and avoiding unnecessary expenses. By adopting a frugal mindset, businesses are better equipped to allocate capital effectively, optimize their operations, and ultimately generate meaningful return to shareholders.

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