#246 Mark Leonard's Shareholder Letters

What I learned from reading Constellation Software Inc. President's Letters by Mark Leonard. ---- Get access to the World’s Most Valuable Notebook for Founders at Founders Notes.com ---- [1:10] Business lessons from Mark Leonard by Tren Griffin [2:11] Newsletter: Liberty’s Highlights The Serendipity Engine: Investing & business, science & technology, and the arts. [2:59] I don’t like anyone telling me what to do. I don’t like anyone saying I am an authority figure and you will do it this way. I can’t think of anything that annoys me more. I was stuck by the principal. I challenged teachers. I left home early. I had a bootleg radio license. I built a flamethrower. I did things that weren’t accepted by lots of people. That ability to choose what I think is right is something I prize highly. [4:49] Distant Force: A Memoir of the Teledyne Corporation and the Man Who Created It (Founders #110) and The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success (Founders #94) [4:53] Teledyne grows bigger by dividing businesses into smaller parts wherever possible. Singleton claims that this keeps his managers creative and not wasteful. [5:12] Our preference is to acquire businesses in their entirety and to own them forever. [8:57] The Fish That Ate the Whale: The Life and Times of America's Banana King (Founders #37) [9:18] There are times when certain cards sit unclaimed in the common pile, when certain properties become available that will never be available again. A good businessman feels these moments like a fall in the barometric pressure. A great businessman is dumb enough to act on them even when he cannot afford to. [12:20] Customer relationships that endure for more than two decades are valuable. [13:08] The longer we have owned a small software business, the larger and better it has become. [15:32] Jeff Bezos’s Shareholder Letters. All of them! (Founders #71) [23:22] We didn't get to that point with central edicts or grand plans. We just had a hunch that our internal ventures could be better managed, and started measuring them. The people involved in the Initiatives generated the data, and with measurement came adjustment and adaptation. It took 6 years, but we have fundamentally changed the mental models of a generation of our managers and employees. [23:56] A Man for All Markets: From Las Vegas to Wall Street, How I Beat the Dealer and the Market (Founders #93 and #222) [28:06] Our business units rarely get large. [28:26] This suggests that the size and performance of our business units are almost totally unrelated. I believe that these business units are small for a reason...that the advantages of being agile and tight far outweigh economies of scale. I’m not a proponent of handling our “complexity problem” by creating a bunch of 400 employee business units to replace our 40 employee units. I’m looking for ways of “achieving scale” elsewhere. [29:06] Debt is cheap right now, so it is pretty tempting to use it. Unfortunately, it has a nasty habit of going away when you need it most. [30:42] The Essays of Warren Buffett (Founders #227) [32:51] Book recommendation from Mark: Thinking Fast and Slow [34:53] I love what I'm doing and don't want to stop unless my health deteriorates or the board figures it's time for me to go. [36:42] My personal preference is to instead focus on keeping our business units small, and the majority of the decision making down at the business level. Partly this is a function of my experience with small high performance teams when I was a venture capitalist, and partly it is a function of seeing that most vertical markets have several viable competitors who exhibit little correlation between their profitability and relative scale. (TRUST IN SMALL GROUPS OF SMART PEOPLE) [37:35] There are a number of implications if you share my view: We should a) regularly divide our largest business units into smaller, more focused business units unless there is an overwhelmingly obvious reason to keep them whole, b) operate the majority of the businesses that we acquire as separate units rather than merge them with existing CSI businesses, and c) drive down cost at the head office and Operating Group level. [38:11] I want you to bear with me because I really do think this is a very clear description of what he's building, the advantages the strategy provides, and why he's going to be hard to compete with over the longterm. [40:13] We have 199 business units. We can run a test in 5, 10, 6, 24, whatever it is —we find what works and we can spread it throughout the entire company and spreading best business practices makes those businesses better. The longer it goes, the more businesses we have, the stronger they get over the time. And it's nice you have a checkbook and a phone but I'm way too far ahead— you'll never catch me is essentially what he's saying. [42:00] Copy This!: How I turned Dyslexia, ADHD, and 100 square feet into a company called Kinkos (Founders #181) [43:19] Book recommendation from Mark: The Evolution of Cooperation [44:52] You Don't Know Jack... or Jerry by Robert O. Babcock. Jack Henry and Jerry Hall launched a software company in theh back of a small engine repair shop. Thirty years later, Jack Henry and Associates, Inc., is a thriving operation with over 3,700 employees in close to 50 locations around the United States. [47:22] Book Recommendations from Mark: One Man's Medicine: An Autobiography of Professor Archie Cochrane and Effectiveness and Efficiency, Random Reflections on Health Services by Archie Cochrane The first book is a moving, idiosyncratic and dryly amusing autobiography of a brilliant and erudite outsider that makes you wish you’d known the man firsthand. The second is a stinging critique of a well-meaning but entrenched medical establishment, for their ineffective and dangerous medical practices. [48:23] We spend time on non-randomized observational studies trying to spot business practices that actually add value rather than just adding overhead. [48:34] My favorite part of Mark’s letters [51:09] A huge body of academic research confirms that complexity and coordination effort increases at a much faster rate than head count in a growing organization. [51:50] The business manager needs to be asked why employees and customers wouldn't be better served by splitting that business into smaller units. Our favorite outcome in this sort of situation is that the original business manager runs a large piece of the original business and spins off a new business unit run by one of his or her proteges. [53:39] Something wonderful happens when you spin off a new business unit. [54:16] When you get big you lose entrepreneurship. [54:43] If I were advising my 35 or 40-year-old self on where to go, I would tell him to stay put. Become a master Craftsman in the art of managing your VMS business. It is the most satisfying job in Constellation and will generate more than enough wealth for you to live very comfortably and provide for your family. [55:30] You can't be normal and expect abnormal results. ---- Get access to the World’s Most Valuable Notebook for Founders at Founders Notes.com ---- “I have listened to every episode released and look forward to every episode that comes out. The only criticism I would have is that after each podcast I usually want to buy the book because I am interested, so my poor wallet suffers. ” — Gareth Be like Gareth. Buy a book: All the books featured on Founders Podcast ---- Founders Notes gives you the ability to tap into the collective knowledge of history's greatest entrepreneurs on demand. Use it to supplement the decisions you make in your work. Get access to Founders Notes here. ---- “I have listened to every episode released and look forward to every episode that comes out. The only criticism I would have is that after each podcast I usually want to buy the book because I am interested so my poor wallet suffers. ” — Gareth Be like Gareth. Buy a book: All the books featured on Founders Podcast

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00David Senra?

  Mark Leonard reminds me of Warren Buffett. Anyone who likes reading Berkshire shareholder letters will enjoy Leonard's. The Globe and Mail describes part of what Leonard has accomplished at his company Constellation Software. With an initial $25 million investment in 1995, Mark Leonard has built Constellation into a world-leading consolidator of vertical market software companies. These are companies that create products to help run businesses in specific industries. Over the years, Constellation has acquired over 500 businesses. Typically, Constellation's acquisitions are small, in the $2 to $4 million range. But add them all up, slip in a dose of Constellation's financial and operational discipline, and

• 0:45David Senra?

  you have a company with a market cap of $40 billion. In this age of zero privacy, Mark Leonard has managed to maintain a practically unthinkable level of anonymity for just about any individual, let alone an executive who runs one of Canada's most dynamic and fastest-growing software companies. That was an excerpt from a blog post about the founder of Constellation Software, which is Mark Leonard. I just spent the last several days reading every single one of his shareholder letters, and so that is what I'm going to talk to you about today. And so Mark's interesting for a number of reasons. One, I just touched on in that excerpt, he took a $25 million investment almost 30 years ago and has compounded it over, what, 27 years, to a $40 billion market cap.

• 1:28David Senra?

  I'm obsessed with people that found and run the same company for a long period of time. Based on my math, Mark was 39 when he started the company, and he's still working on the company, and he's 66 years old today. What also makes him interesting is that he's a recluse. There's only one photograph that you can find online of what he looks like. He actually looks strikingly similar to Rick Rubin. And so outside of the occasional underground podcast that you might be able to download on like the dark web, the only way to get information about him is to read his shareholder letters or listen to his investor calls. And I just love the idea of this super smart genius who's just like, I don't need to speak, my numbers speak for themselves. And so the way I actually learned about Mark Leonard is actually through my friend Liberty.

• 2:13David Senra?

  My friend Liberty runs one of the only newsletters I actually read. I read like two newsletters, his is one of them. I'll leave a link down below, but you can go to liberty rpf.com and you can check it out. And it was through reading his newsletter for many years because Liberty's been studying Mark for almost a decade. And so he was the one that helped me organize all the research and all the information that I used as the basis for the podcast. And so before jumping into some highlights from his shareholder letters, I want to pull out this quote that I heard Mark say on this podcast that's not publicly available. And so Mark was asked the question like, why is decentralization, autonomy and control so important to Constellation? And so Mark's answer to this question, you clearly see, okay, this guy's a misfit, he's going to fare right in on founders. So it says, why are decentralization, autonomy and control so important to Constellation? Where did that come from?

• 2:58David Senra?

  And Mark's answer was fascinating. He says, it starts with personal preference. I don't like anyone telling me what to do. I don't like anyone saying, I'm an authority figure and you will do it this way. I can't think of anything that annoys me more. So he's talking about, I'm building a system that I want to work in. Not only that, but I want to attract other people that are like minded. And you'll find that highly talented people are not going to want to work under a highly centralized command and control business. So he's talking about, you know, this was a personal preference. I don't like anyone saying, I'm an authority figure and you will do it this way. I can't think of anything that annoys me more. I was struck by principles, meaning when he grew up, I guess he meant like they literally hit him. I challenged teachers. I left home early. I had a bootleg radio license. I built a flamethrower.

• 3:40David Senra?

  I did things that were not accepted by lots of other people. The ability to choose what I think is right is something I prize highly. Okay, so let me jump into his first shareholder letter, and he says, "The software business has significant economies of scale." He says, "History suggests that we generally grow our acquired businesses frequently, by frequently providing additional products for them to sell into their install base." So, we've made money by selling existing customers more products. And then another way he talks about how they make money is, "Occasionally, however, the reduction of an acquired business," so a business that we bought, "to a profitable core will leave us with a smaller, but usually more profitable business."

• 4:23David Senra?

  So, the way I interpret that, we also make money by making companies more efficient. So, this is really, made me think of what Rick Rubin said. He's like, "It's production by reduction. I enhance things by removing everything that's not its essence." And so, in his shareholder letters, and everything that I've found online about Mark Leonard, talks about, "Hey, let's take something that's big and let's break it down into more manageable pieces." It's very similar. There's a, I read this, this interview with Henry Singleton, one of the very few ones that he did, in Forbes in the 1970s. And it says, "Teledyne," which is Singleton's company, "grows bigger by dividing businesses into smaller parts wherever possible. Singleton claims that this keeps his managers creative and not wasteful."

• 5:06David Senra?

  Back to Mark's letter, this is gonna sound exactly, I mean, he's gonna write this, but this, this comes directly from Buffett shareholder letters. "Our preference is to acquire businesses in their entirety and to own them forever." And if they can't buy a business and keep it forever, they are open to buying small parts of the business. It says, "Occasionally, we have the opportunity to buy a piece of a good business with the prospect of eventually acquiring the rest." And so, this is something he's gonna repeat over and over again. Again, this is just, the blog post I read, and I'll link it down below, at the very beginning, you know, the very first sentence is, "Mark Leonard reminds me of Warren Buffett." I read that blog post after I read his shareholder letters, and I came to that same conclusion. "I'm often asked why Constellation takes minority interest in other public software companies. The answer is simple: value."

• 5:49David Senra?

  Constellation's objective is to be a perpetual owner, there's that word again, of inherently attractive software businesses. Part of a perpetual owner's job, so his job, is to make sure that energetic, intelligent, and ethical managers are running their businesses and that the managers are incentivized to enhance shareholder value over the very long term. He's writing this in 2008, so he says, "So far, we have bought more than 70 private software businesses outright." That number, I said at the very beginning, is over 500 now. "On 10 occasions, however, we have also participated in the purchase of a significant minority positions in public software businesses." Exactly what Warren says. It's like, by preference, I want to own the home business. Sometimes, I realize, hey, pieces of business can be purchased attractively in public markets,

• 6:34David Senra?

  so I will do that as well. So then Mark describes why the strategy is effective and what he's trying to do here. We have the same objective when we buy a piece of a business as when we buy 100%. We want to be a great perpetual owner of an inherently attractive asset. It's very obvious, if you read his shareholder letters, that he's receptive to new information. He's going to change his mind. And so, we're in 2008 shareholder letter. Obviously, there was a gigantic financial crisis that was occurring at this time, and he's going to say something here that's really interesting because he changes strategies in the future as well. So, before, they avoided debt. And now, he's like, "Well, the market has depressed assets. The assets are selling for a lot less than we think the value is. Maybe I should take on debt just so I can buy those assets."

• 7:17David Senra?

  Until recently, we have avoided using significant amounts of debt. Circumstances, however, may dictate a change in our capital structure. The economy is slow. Credit and equity markets are in rough shape. And buyers for vertical market software, which is what we're trying to be, buyers for vertical market software businesses are increasingly scarce. So now, my competition... Later on, he's going to talk about, "This is getting a lot more difficult because people are realizing that the idea that we have, and the idea that some other conglomerates have, that VMS businesses are extremely attractive. Now, as that idea gets spread, I have more and more competition." In 2008, he's like, "The downturn in the market and in the overall economy has kind of eliminated my competition. This is going to be, for a very short amount of time, I should act," is the way I think about what he's saying here.

• 8:02David Senra?

  So it says, "Quite a number of these businesses are for sale at attractive prices. We may not be the successful bidders of these assets, but if we are, we will almost certainly be increasing Constellation's financial leverage." And he knows why this is an opportunity, because it's almost the reverse of the problem he had before. "For most of the last decade, we struggled to find enough attractive acquisitions to consume our operating cash flow. We believe that the situation has now reversed, and we are sorely tempted to buy as many attractive vertical market software businesses as and while we can." And that's why I would say, "Hey, I'm against debt, but maybe I should reverse that, because now I have an opportunity of a lifetime." And to know I left myself here, to my interpretation of as I read this, "We avoided debt, but prices are too good, and we will borrow money so we can buy what we feel are underpriced

• 8:47David Senra?

  assets. Everyone else is scared. The time to act is now." And when I got to this section, one of my favorite, this paragraph that I read probably three years ago. It's from "The Fish That Ate the Whale." It's Founder's Number 37, one of the best books that you could ever read. And there's a paragraph in that book that I've never forgotten. And it describes a point in the career of Sam Zemurray, which is the entrepreneur and the founder that the book is about. And I really feel it's describing what is taking place during this time in history, but also specifically to Constellation's business. So I'm going to read this entire paragraph to you from "The Fish That Ate the Whale." And it says, "There are times when certain cards sit unclaimed in the common pile, when certain properties become available that will never be available again.

• 9:31David Senra?

  A good businessman feels these moments like a fall in the barometric pressure. A great businessman is dumb enough to act on them even when he cannot afford to." So back to his 2008 letter, he says, "We don't like sharing sensitive information with competitors." The maxim I always use, because that same idea comes up over and over again in the history of entrepreneurship, is that bad boys move in silence." So it's going to 2009. Most of the businesses in his ideal world, he's trying to buy Private software businesses that are still, that were usually still run and managed by the original founder. His competition for that is obviously, is going to be private equity companies. So I just want to pull out a paragraph here, because I thought it was interesting, where he's talking about the view of the entrepreneur that's running a software company, and then

• 10:16David Senra?

  the view of a typical private equity firm that wants to buy that, and how they're both biased at opposite ends of the spectrum, and how Constellation takes a different approach. Hopefully that makes sense, once I read this to you. "The toughest challenge in the software business is intelligently trading off profitability and organic growth." So the combination of that, you have to balance that, right? "Many entrepreneurs have a huge bias towards growth at the expense of profits." That's one end of the spectrum. "Most private equity-owned software firms have the opposite bias," which means they're not worried about growth, they're essentially trying to squeeze that asset for every last dollar. At Constellation, and then, so Mark is comparing, he's saying, "This is what entrepreneurs typically do, and this is their bias.

• 10:59David Senra?

  This is the bias that we found for a lot of our private equity competitors. This is how we think about that." "At Constellation, we try to find an optimum position where incremental investment still generates good incremental, long-term returns." "We think both approaches can be improved," meaning the approach of both the founder and the private equity. So really, to note that myself here, in my interpretation of what he's saying here, "Founders think that the future will be better if we are bigger. Private equity wants to squeeze every last dollar out now." And then, once we get to the 2009 shareholder letter, this is where I wrote, "This is the very first time I start to understand what Mark is doing and what he's actually shooting for." And so he's talking about the benefits of having all these software businesses, and

• 11:42David Senra?

  he's saying, "In our businesses, we can nearly always grow revenues organically without incremental capital." And because he's getting out more revenue, more profit, without investing, having to invest more money, he takes those cash flows, buys more businesses, and that's how you're able to compound for a long period of time. But this is why he chose VMS businesses, because they typically have really low attrition rates. So it says, "Our attrition rates also illustrate the long-term nature of our client relationships. Attrition due to the loss of customers in 2009 was 4%. This suggests that our average and, that our average customer will stay with Constellation for 26 years."

• 12:21David Senra?

  Customer relationships that endure for more than two decades are valuable. We have symbiotic relationships with tens of thousands of customers. We handle thousands of their calls each day and issue scores of new versions of mission critical software each year. And so, why would the customer stay on? Because for an annual cost that rarely exceeds 1% of a customer's revenues, our products help them run their businesses effectively, adopt their industry's best practices, and adapt to changing times. And then he explicitly talks about why he has such a long-term bias, why he's talking about, he uses words like permanent, we're going to keep these businesses forever, while we want to buy them and never sell. We have been a serial acquirer of inherently attractive small vertical market software

• 13:05David Senra?

  businesses in a large number of different verticals. This is the punchline right here. The longer we have owned a small software business, the larger and better it has become. If we persist in this strategy, we will continue to add new verticals and make many more software, or excuse me, many more acquisitions each year. So he's saying, okay, we've already bought, what, 60 or 70, wherever they are at this point, we know that they've done over 500 in the next, let's call it 10 to 12 years. Now, here's the problem. How, what, it ties into exactly why he's, he's like this proponent of extreme decentralization and he hates bureaucracy. We've handled our growth to date by largely abdicating management to the managers of each of our vertical businesses. This is why people say he reminds them of Warren Buffett.

• 13:49David Senra?

  We have a very thin overlay of infrastructure at headquarters, just like Buffett. We count on the fact that with each new acquisition comes with general managers who are steeped in their verticals, just like Buffett. Having owned more than 100 vertical market software businesses, we also have some best practices that we can share, just like Buffett. And so, that's an important point. Keep in mind, if you read these shareholder letters and you compare it to what I'm going to talk about on the podcast, you're going to see none of, he talks about return on investment capital, compound percentages, all this stuff. That's not why I, I don't consider myself an investor, right? I read shareholder letters and I think about it from a founder's perspective. The reason I want to read Warren Buffett shareholder letters is exactly what

• 14:34David Senra?

  Mark just talked about. We own 100 businesses. We get to see their performance. We get to see the ideas across a wide section. We can pull out ideas, what he's calling best practices, and we can share it with other people. I want to read Buffett shareholder letters and his biographies and everything else because I haven't found another person that for over, what, let's see now, 70, he started researching businesses when he was like 11, he's like 90. So it's called 80 Years. There's probably no one else on the planet that has spent more time analyzing a wide variety of businesses and he could tell us, hey, this idea clearly works, have seen it happen over and over again. And so I'm going after the exact same thing when I read Mark's letters. Like, how many people have built a business starting with $25 million investment, compounded it to $40 billion? He's been doing it for almost 30 years. He's bought 500 businesses.

• 15:18David Senra?

  So that's the businesses he's bought, right? How many businesses has this guy analyzed? He's clearly going to have a lot of valuable information. And it's the same way when I, the reason I wanted to read, so I read, the very first time I read anybody's shareholder letters, I read Jeff Bezos' shareholder letters. It's episode 71 of Founders, right? I did that episode, I don't know, three years ago. There's not a week that goes by that I don't get a message about somebody just now finding that episode and sending me messages about how much they liked it. And what I really loved is the description to that episode. And it says, "To read Jeff's shareholder letters is to get a crash course in running a high-growth internet business from someone who mastered it before any of the playbooks were written."

• 16:01David Senra?

  Just so you know what I'm shooting for is like, I'm just looking for ideas from people that have spent an enormous amount of time, three decades in this case, studying business. I want to know the business ideas that they found are great, so then we can pull them out and use them for whatever it is that we're doing during the day. So moving on to 2010 letter, this one was really confusing. I was like, what is up with this letter? The company might be sold. By who? What is happening? What is taking place here? There was some kind of shareholder revolt, but it was like light on the details. And he just has a line where he's like, I'm proud of the company that our employees and shareholders have built, and we'd be more than a little sad if it is sold. Interesting enough, that interview I heard, he's like, if you give anybody advice that wants to rent a public company, make sure that you get the shareholders that you deserve.

• 16:44David Senra?

  Again, something that Buffett talks about all over and over again. But what was interesting, Constellation obviously wasn't sold, but I went and looked, I was like, what is the difference in stock price between 2010, when he's writing this, and now? And the stock is up more than 40 times from here. And so he's going to explain what happened in the next shareholder letter. But at the time I was reading that, I had no idea what was taking place, so I'm going to skip to the next year. And then I'm going to run over my own point I just said, like, why? He talks about why he writes the letters. He's like, as a rule, I use these letters to write about our business, not our stock. Something else that he talks about quite a deal, just like Warren and Charlie Munger talk about as well, is the need to only work with people you like, admire, and trust. How a lot of people are out there, rat poison, you have to be very careful.

• 17:28David Senra?

  So Mark talks about, he's like, I want to, if I can, promote from within, and this is why. We nearly always promote from within because mutual trust and loyalty take years to build. And conversely, newly hired, smart, and are manipulative mercenaries can take years to identify and root out. Okay, so now we get to the 2012 shareholder letter. This is when I wrote in gigantic capital letters. This is when I knew I had a podcast to make. Up until this point, I was like, man, I don't know if there's enough information here, like, this is going to be worth anybody's time. And then 2012, I'm like, okay, this is incredible. And this is when I just have a ton of highlights and notes, so I'm just going to jump right into it. Our long-term shareholders, our board, and our analysts all seem concerned about our ability to scale.

• 18:12David Senra?

  I haven't spent a lot of time worrying about the issue, except in response to their inquiries. We've evolved gradually over 18 years, and I don't feel like we are facing an impending paradigm shift. Nevertheless, when a number of smart, engaged constituents consistently harp on the same issue, it is worth investigating both their concerns and the mindset of those asking the questions. So this is what I meant about, he's very open to changing his perspective. If you have better information, you have a better argument. He's not married to any of these ideas and he wants to make sure that he's always improving and getting the most optimal path forward. And so he's going to get into how do his businesses grow? Because the issue is, how can we scale? We can't have, we have, you know, 100 something software companies at this point. Can't get much bigger than this, right?

• 18:57David Senra?

  What are we gonna do? So he says, "There's two components of our growth, organic and acquired. Organic growth is, to my mind, the toughest management challenge in a software company, but it's potentially the most rewarding. The feedback cycle is long, so experience and wisdom accrete at painfully slow rates." And so before I go any further, I'm gonna read the note that I left myself after I read this section, because I think if I put this note at the beginning, it'll make sense what he's about to talk to here. And I said, "This part is incredible. It's about improving the financial performance of his company by understanding human nature and its likely pitfalls. Something as simple as tracking data and then holding one person accountable." He's just writing about it in a nerdy, hard-toparse way.

• 19:38David Senra?

  So that's the note I left myself to try to explain to myself what it is I'm reading. And so, "An engine for growth in normal companies," he's saying, "listen, it's research and development and sales and marketing. So what we did is we separated our research and development and sales and marketing spending into two buckets, what he's gonna call initiatives, and then everything else." And so this is how he defines initiatives. "Initiatives are significant, long-term investments required to create new products or enter new markets. They usually take five to 10 years to reach cash flow breakeven." So these are large investments. It's a lot of money we're putting out, and hopefully if they work out, we're not gonna see that money back in five to 10 years, and a lot of these don't work out. So this is something you have to be very careful of.

• 20:18David Senra?

  "We felt that they should be both measured and treated differently than other expenditures." And a lot of the growth in initiatives comes from just human nature. We wanna overcomplicate things, wanna say, "Okay, we need to add new features, new software, like new parts of our software. We need to go into new markets," without actually knowing if that's gonna work or not. And he says, "The ethos of software companies requires the regular launching of 'visionary' new products by steely-eyed, tenacious developers, product managers, or founders."

• 20:49David Senra?

  Initiatives, so this constant outgrowth of humans constantly wanting to do more, whether that doing more is actually beneficial or not is uncertain, right? Initiatives grew to account for over half of our combined expenditures by 2005, which, not coincidentally, was the peak of our spending. So he's bringing this up because it's like we're not going to be able to scale if we're not efficient with our money. And as we added more and more companies, they all happened to do very similar things, this got out of control. So now he's going to explain how he wound up solving this problem. Remember, it is about improving the financial performance of your company by understanding human nature and its likely pitfalls. Even the best initiatives take more time and more investment than anticipated.

• 21:33David Senra?

  As the data came in, two things happened at the business level. We started doing a better job of managing initiatives and this spending, so research, development, sales and marketing spending, decreased. So the first thing they did is they had to develop a system because we're barking on initiative, we don't know if it's going to happen. So what is the assumption, right? So if you have your assumption, then you can test if you have your hypothesis, you have your assumption, you can test to see if that assumption is wrong. And if you don't clearly define what that is, you might keep going way past and then you forget why you started this to begin with. So I'm going to skip over that part because that's really the summary. You have to find a way to, what is the assumption of this new initiative that you're doing? And how can you tell, like, what is the test you're going to do to know if that assumption's

• 22:18David Senra?

  true or false? And the second, in my opinion, more important part is that they put one person in charge. He repeats this over and over again. You can't have a team, you can't disperse responsibilities, put one person in charge. We created dedicated initiative champion positions. So an initiative was less likely to drag on with a low but perpetual burn rate, meaning we're just burning money, we're being inefficient with our capital, right? Under a part-time leader who didn't feel ultimately responsible. And then he talks about what happened. The most surprising adaptation was that the number of new initiatives proposed plummeted.

• 22:54David Senra?

  So before, not one person was in charge. We weren't very specific on what we were hoping to actually achieve with this new initiative. So it just grew, just what humans do, right? But once you say, okay, what is the assumption you're testing? How do we know if that's true or false? This is an experiment, and we put one person in charge. Guess what? The number of new initiatives dropped, which indicates that we were just being wasteful because initiatives are so expensive. Remember, there were half of all of our spending. Now that number is way down. We're a lot more efficient. And then he talks about how they figured this out. "We did not get to this point with central edicts or grand plans. We just had a hunch that our internal ventures could be managed better, and we started measuring them. The people involved in the initiatives generated the data, and with measurement came adjustment

• 23:39David Senra?

  and adaptation. It took six years, but we have fundamentally changed the mental models of a generation of our managers and employees." So then he continues talking about other ways to grow a company, other ways to scale a company. He talks about, hey, the other way we grow is via acquisitions. And so he talks about who he buys these companies from. This is exactly what Warren Buffett does in shareholder letters, where he says, hey, I buy businesses. There's a ton of other people that buy businesses. This is why all money is not created equal. This is why you'd want to sell me your company as opposed to my competitor. So Mark's going to do something very similar here. "Our favorite and most frequent acquisitions are the businesses that we buy from founders. When a founder invests the better part of a lifetime building a business, a long-term orientation tends to permeate all aspects of the enterprise: employee selection and

• 24:23David Senra?

  development, establishing and building symbiotic customer relationships, and evolving sophisticated products. Founder businesses tend to be a very good cultural fit with constellation. And most of the ones that we buy operate as standalone business units managed by their existing managers under our umbrella." So that's, again, very, very Buffett-like, right? "We track many thousands of these acquisition prospects and try to regularly let their owners know that we'd love the chance to become the permanent owners of their business when the time is right for them." And he's saying he's also about to ride this gigantic demographic wave. This is something that, now, he's just talking about this, we're in still 2012. This is talked about, I'm hearing this a lot more, like, top of mind.

• 25:07David Senra?

  I hear a lot of other people bring this up now, is my point. "There is a demographic element to the supply of these acquisitions. Most of these businesses came into being with the advent of mini and microcomputers, and many of their founders are baby boomers who are now thinking about retirement." So that's one distribution channel for Mark. Now, he's going to talk about this other distribution channel for him. "The most lucrative acquisitions for us have been distressed assets. Sometimes, large corporations convince themselves that software businesses on the periphery of their industry will be good acquisitions. Rarely do the anticipated synergies accrue. And frequently, the cultural clashes are fierce. So the corporate parent may eventually choose to sell the acquired software business."

• 25:50David Senra?

  So founder sold a software business to a larger company. Larger company had its own weird desires and reasons and rationales for doing that. There's no synergy. So now that asset's still valuable, but now it's been distressed. That large company's just like, "All right, I just want to get rid of it." Mark's like, "Okay, cool. I'll take it off your hands and I'll optimize it." And he says, "There's a time that this usually occurs. Most of our, the most attractive acquisitions from corporate, large corporations have happened during recessions." And towards the end of this letter, this is the first time I realized, "Oh, okay. He's completely open to new information and willing to change his mind." The note I left myself on this section is, "This is remarkable. Usually, you only get this type of insight into a founder's perspective on their business in private." He's usually not going to write about this in public.

• 26:35David Senra?

  He says, "From time to time, we flirt with a fundamental change. I was recently in the UK, where a couple of very large, public-sector, vertical-market software conglomerates are for sale. The whisper prices," so it's not, there's not a price on them yet, but people are telling them, you know, "On the low, you could probably get it for this. The whisper prices are ones we could just about stomach if we were financing the acquisitions on a standalone basis, like PE firms that are, like PE firms that compete for these assets. My sense is that we would be better owners of these assets and would generate better long-term performance for them than the PE private equity companies that are trying to buy them." Up until this point, he wanted to do these acquisitions from cash flow. And he's saying, "Well, these things are too big.

• 27:19David Senra?

  Usually, you know, we're sub 3 million, right around there. These are big, but there's still opportunities." And so he's like, "Maybe in the case, I would take on debt or some kind of other financial instrument or more leverage, essentially, to do this. Our current bank facilities do not allow us to make acquisitions which incorporate standalone financing. And hence, this opportunity to make substantial acquisitions on attractive assets that are close to our core competence is moot, but intriguing."

• 27:46David Senra?

  So then, this is where he gets into like this, I would call it like a small, beautiful philosophy. Because at this point, the board, his board is worried about the growing complexity of constellation. And at this point, they own 125 businesses. And so, this is Marx's analysis. Like, is this concern valid or not? And he says, "One early observation is that our business units rarely get large. The biggest is 307 employees, and the average business we own currently only has 44 employees. Two-thirds of our employees are working in businesses with less than 100 employees. When we did a linear regression analysis of performance, the data suggested that the size and performance of our business units are almost totally unrelated.

• 28:31David Senra?

  This suggests that the size and performance of our business units, the size and performance of our business units are almost totally unrelated. I believe that these business units are small for a reason, that the advantages of being agile and tight far outweigh economies of scale. I am not a proponent of handling our quote-unquote 'complexity problem' by creating a bunch of 400-employee businesses to replace our 40-employee businesses. I'm looking for ways of achieving scale elsewhere." Then he goes back to this idea, it's like, "How can I increase the amount of acquisitions we have?" And he says, "Debt is cheap right now, so it's pretty tempting to use it. Unfortunately, it has a nasty habit of going away when you need it most.

• 29:15David Senra?

  Personally, I would use significant amounts of debt to finance our growth if it were long-term, non-callable, and the interest payments could be deferred for short periods. We have demonstrated the ability to generate good returns on incremental capital over the long haul. Unfortunately, investment bankers tell me that this sort of debt doesn't exist." So then, we fast-forward one year. He has found a way to get about $500 million in debt. Really, the way to think about this is, the opportunities were there, so he wants to act right now. So he's like, "Our cash flow is growing fairly fast, but it was still insufficient to finance the acquisitions that we made, so we resorted to using increasing amounts of bank debt." But what's interesting he's talking about is like this isn't a perfect strategy.

• 29:58David Senra?

  We had $485 million outstanding on our debt. We continue to seek longer-term capital to diffuse the fundamental mismatch inherent in buying permanent assets with short-term debt. So he's like, we're doing it now, but this is not something that I want to do forever. And then towards the end of this letter, he has one line that really speaks to the benefit of conglomerates. And this is going to remind me of something that Warren writes about in his shareholder letters. And so he says, "It is clear that acquisitions have added tremendous shareholder value over the years, particularly during times of economic crisis or recession." So Warren says very similar about why, like, what are some of the benefits of being a conglomerate? So I'm going to read this.

• 30:42David Senra?

  This is from The Essays of Warren Buffett, which is episode 227, if you haven't listened to it yet. And he says, "Conglomerates such as Berkshire is perfectly positioned to allocate capital rationally and at a minimal cost. Our structural advantages are formidable. We can, without incurring taxes or much in the way of other costs, move huge sums of money from businesses that have limited opportunities for incremental investment to other sectors with greater promise." So sometimes a business is producing a lot of cash flow, doesn't have anywhere to invest that money. In a conglomerate such as Berkshire, CSI, or Teladega, or any of these other situations, they could find a better home for that money. "Moreover, we are free of historical biases created by lifelong association within a

• 31:24David Senra?

  given industry and are not subject to pressures from colleagues that have a vested interest in maintaining the status quo. Another major advantage that we possess is the ability to buy pieces of wonderful businesses, also known as common stocks. That's not a course of action open to most managements. Over our history, this strategic alternative has proved to be very helpful. A broad range of options sharpens decision-making." That is a fantastic statement by Buffett. "The gains we realized from marketable securities have helped us make certain large acquisitions that would otherwise have been beyond our financial capabilities." So that's interesting. So we have these businesses that are off cash flow. Sometimes the best use of that cash is to buy common stocks.

• 32:08David Senra?

  Those common stocks have been, turned out to be such fantastic investments for us that their gains have in turn made it possible to create large acquisitions that we didn't have the money to do beforehand. So it's like this virtuous cycle, right? In effect, the world is Berkshire's oyster, a world offering us a range of opportunities far beyond those realistically open to most companies. On top of that, we can profitably scale to a far larger size than many businesses that are constrained by the limited potential of a single industry in which they operate. And then what I also loved about reading Mark's letters is he sometimes recommends books, which I thought was very interesting. So this is a first example of that.

• 32:52David Senra?

  He says, "Currently, I'm shamelessly flogging Danny Kahneman's Thinking Fast and Slow." So anytime I mention a book on the podcast, I always leave the link in the show notes. So make sure you look out for that. Same here. I read this book a long time ago, too. "I'm shamelessly flogging Danny Kahneman's Thinking Fast and Slow." His book is about a life, actually two, because Danny wrote it with his partner Amos, well spent. He tells the tale of his intellectual journey via a series of behavioral economic experiments. "He's helped me appreciate the efficiency, speed, and inherent conceit of intuitive judgment and its infrequent but often abject failures." That's just good writing on Mark's part. "Understanding the major findings in behavioral economics provides profound insights into

• 33:34David Senra?

  investing and managing, and this book is the most pleasant way I've found to acquire that knowledge." So now we go to 2014. This was interesting. "Last year, I asked the board to reduce my salary to zero. CSI had a great year, so despite these modifications, my total compensation actually increased. This year, I'll take no salary, no incentive compensation, and I am no longer charging any expenses to the company. I have been president of CSI for its first 20 years. I have waived all compensation because I don't want to work as hard in the future as I did during the last 20 years." I was totally not expecting this when I got to this part, too, but it makes sense when he explains his thinking here. So he says, "Cutting my compensation will allow me to lead a more balanced life with a less oppressive sense of personal obligation.

• 34:19David Senra?

  I'm paying my own expenses for a different reason. I've traditionally traveled on economy tickets and stayed at modest hotels." A large part of his job is travel. "I've traditionally traveled on economy tickets and stayed at modest hotels because I wasn't happy freeloaded on CSI shareholders, and I wanted to set a good example for the thousands of CSI employees who travel every month. I'm getting older and wealthier, and I find that I'm willing to trade more of my own cash for comfort, convenience, and speed."

• 34:50David Senra?

  So I'm afraid you'll mostly see me in the front of the plane from here on out. I love what I'm doing and don't want to stop unless my health deteriorates or the board figures it's time for me to go. I recognize that some of our directors, shareholders, and employees have or are going to have misgivings about this arrangement. I'm still planning to do the work that I've always done: acquisitions, monitoring, best practice development, investor relations, and financing. I'm just not going to do the weekends, all-nighters, and a constant grind of 60-hour-plus weeks that have characterized my earlier career. And part of his ability to cut back is the fact that he's actually built an organization to last, one that can actually outlive and will outlive him.

• 35:33David Senra?

  Keep in mind that CSI has an unconventional organizational structure, and we seem to have prospered to date without a lot of centralized command and control. While I may not be traveling as much as I did before, nor putting in as many hours, CSI has lots of seasoned and accomplished managers at the operating group level who have become far better coaches, culture bearers, and hypothesis generators than I ever was. And then he goes into another benefit of this arrangement, not taking a salary, and he says, "One of the reasons of this compensation change is that I get to sidestep the agent-principal problem. My compensation for being president is now tied solely to my current ownership of CSI shares.

• 36:16David Senra?

  In essence, I'm your partner, not your employee. I like the feel of the partner relationship a whole lot better." And then he goes back into this idea, we're growing bigger and bigger, so we have more pressure to centralize. And just like Henry Singleton, he wants the businesses to be as small as possible. And so he says, "Shareholders sometimes ask, 'Why don't we pursue economies of scale by centralizing functions, like research and development, or sales and marketing? My personal preference is to instead focus on keeping our businesses small and the majority of the decision-making down at the business level. Partly, this is a function of my experience with small, high-performance teams when I was a venture capitalist." So that was his job, he was a venture capitalist before he founded CSI.

• 37:01David Senra?

  Really, what he's saying here is something that you and I have discussed over and over again, that it's just a lot better to trust in small groups of smart people. That's where all the magic happens. So it says, "Partly, this is a function of my experience with small, high-performance teams when I was a venture capitalist, and partly, it is a function of seeing that most vertical markets have several viable competitors who exhibit little correlation between their profitability and scale." So he brings that up again, "Just because you're getting bigger, just because you have more headcount, does not mean you're actually improving your business's performance." So again, trust in small groups of small people. And then he goes into like, what you should do if you also hold this disbelief. "There's a number of implications if you share my view.

• 37:42David Senra?

  We should, number one, divide our largest business units into smaller, more focused business units unless there's an overwhelmingly obvious reason to keep them whole. Number two, operate the majority of the businesses that we acquire as separate units rather than merging them with existing businesses that we own. And number three, drive down costs at the head office and operating group level." And then this next part, it's going to be several sentences. I want you to bear with me because I really do think this is a very clear description of what he's building, the advantages the strategy provides, and why he's going to be hard to compete with over the long term. Keep in mind, we are now, we're in 2014, so this is still quite old, or several years

• 38:27David Senra?

  ago, not quite old, it's not the right way to put it, several years ago. So let me just read this to you. "I find that some of our shareholders confuse our strategy with that of our business units." So constellation software overall with some of our business units, okay? "While there are terrific moats around our individual business units, the barrier to starting a conglomerate of VMS, which is what he's doing, is pretty much a checkbook and a telephone, right? So low barriers to entry, tons of people have phones, tons of people will call businesses saying they want to buy them, and tons of people can raise money to buy businesses, right? Okay." So it says, "There's terrific moats around individual business units, but the actual barrier to jumping in and trying to copy what we're doing is kind of low.

• 39:08David Senra?

  So we've got to find a way to maintain our long-term competitive advantage. Nevertheless, CSI does have a compelling asset that is difficult to both replicate and maintain. We have 199 separately tracked business units and an open, collegial, and analytical culture." This provides us with a large group of businesses on which to test hypotheses, a ready source of ideas to test, and a receptive audience who can benefit from their applications. So those are the business owners running the individual businesses, okay? More quickly and cheaply than any company that I know, we can figure out if a new business process works. This sort of ad hoc experimentation doesn't require enormous systems or the peddling

• 39:53David Senra?

  of a new dogma to the unreceptive. It requires curious managers at a few dozen business units and a couple of clever analysts to plausibly test if a process works. Once a new best practice starts working within CSI, wide access to benchmarking information tends to rapidly breed emulation. So we have 199 business units. We can run a test in 5, 10, 6, 24, whatever it is. We find it works, we can spread it throughout the entire company. And spreading best business practices makes those businesses better. The longer it goes, the more businesses we have, the stronger they get over the time. That's thanks you have a checkbook, that's thanks you have a phone call, but I'm way too far ahead, you'll never catch me is essentially what he's saying.

• 40:34David Senra?

  We have found a few other examples of high-performance conglomerates, which he refers to as HPCs, but I'll always, I hate acronyms and stuff like that, so I'll always say it out. We have found a few other examples of high-performance conglomerates built around the idea of continuously refining their business processes and then driving ever more acquired businesses up their business process learning curve as quickly as possible. So sometimes, listen, I liked reading his letters. Sometimes I thought it'd be more valuable if he kind of dumbed it down. I understand that's not his goal, but if you think about what kind of customer acquisition channel and distribution channel that Buffett's shareholder letters have been, because he can talk to you like you're in like 5th grade. Mark is obviously very brilliant, very smart, but sometimes it's like, whoa, I gotta, I'm

• 41:18David Senra?

  trying to translate exactly what you're saying here. I've had to reread certain sections a bunch of times. I don't think he really necessarily cares about that. Or who, actually, I don't know if he cares about that or not. But there's a couple of separate notes as I'm reading this about, hey, really try to reword this and more people will read them. And again, maybe he doesn't want more people reading them. I don't know. And so even though the wording is a little difficult there, I think the idea is pretty simple to understand. We're going to test, we're going to experiment, all the stuff that we have, all these experiments that we're running across these hundreds of businesses that we owns, the good ones, the good ideas that we find through experimentation, they're most likely counterintuitive. So other people, unless they're running experiments, aren't going to arrive at those same conclusions. And then we're just going to spread them around. It's very similar to why did the founder of Kinko's, Paul Orfala? That's founder's number 181, if you haven't listened to it.

• 42:03David Senra?

  He had this weird decentralized structure for all the different Kinko's stores. He spent no time in the office. All he would do is travel around to different stores and he wouldn't rule by edict. So you had a lot of leeway as a manager of an individual Kinko's. And he was asked, like, why aren't you saying, like, they found the best way to do something? And Paul's like, this is a fantastic idea. I'm going to spread it around the other company. I'm going to share the idea with the other stores, right? But I'm not going to make them do it. And he was asked by one of his employees, like, why aren't you making them do it? He's like, because if I make them do it, that is the best it will ever be. And so he kind of did that. What Mark is talking about here, doing it across a bunch of different businesses in different industries, you could also do that within your own company. Let's say you had stores or divisions or whatever case in Kinko's, you know, you probably had 500 different stores, whatever the number was. And so Paul's traveling around, getting all the ideas.

• 42:48David Senra?

  And said, there's a line in that book that's fantastic because I think it's descriptive of what I'm trying to do with founders, except instead of going around to different Kinko's stores, I'm going around to the greatest entrepreneurs to ever live. And he says, you had to remember, he's been picking up the best ideas from all around the country. So what's Paul doing was doing Kinko's. That is what Mark is doing now across, he's picking up all the best ideas across all the hundreds of businesses he owns. And then I'm trying to do the same thing for you across, you know, whatever, I'll get to 1,000, 2,000, 3,000 different entrepreneurs dot history. And finally, he ends this year with another book recommendation. I'll leave the link down below. He says, "The Evolution of Cooperation by Robert Axelrod has provided me with models for thinking about a number of business problems." Okay, so let's move on to 2015.

• 43:32David Senra?

  This is another smart idea. And so what Mark's going to do is they put, he says, "Each quarter, we study an admirable company and we discuss it with our operating group managers and board members." So this is the entire, I think this year, if I'm not mistaken, this 2015 shareholder letter, is he goes through all the high-performance conglomerates. I think there's about a dozen. I think he said he studied. I can't remember the exact number, but basically he's saying, "Hey, let's look at the cream of the crop. Let's analyze what they're doing and why they're doing it and see if we can use any of our ideas." That's essentially what's happening. "We focus on high-performance conglomerates that have demonstrated at least a decade of superior returns." And why is he doing that? "We study the high-performance conglomerates because they help us understand what CSI

• 44:14David Senra?

  does well, where we might improve, and what alternatives we could pursue." And he says, "We set a high bar on purpose. Keep in mind that we are comparing CSI to a group of wonderful companies. Over the last decade, if you had an equally weighted portfolio of the shares of these high-performance conglomerates, you would have more than doubled the performance of the S&P 500." So I'm not going to go over every single one. I do want to pull out one of these. I'm going to read this book that he recommends, too. "We have reviewed one of our perennial favorite high-performance conglomerates this quarter. It's called Jack Henry and Associates. The company's values are those to which we aspire, and their multi-decade performance is remarkable. I encourage you to familiarize yourself with J-K-H-Y, which is Jack Henry and Associates."

• 44:59David Senra?

  There's also a lovely company history, "You Don't Know Jack or Jerry," is the name of the book, that was written by a retired executive. The book covers the founding of the company through the end of, all the way from the founding of the company all the way up to 2007. It provides many firsthand accounts by employees, customers, competitors, and partners about the business practices, strategy, and culture of the company. Then he goes back to what he's learning from sitting in all these different companies. He's realizing... Okay, not only what do they do smart, like what's some of the intelligence decisions they make, but what are the mistakes they made that we can avoid? And so he's saying like, how do we avoid the pressure for us to centralize? And so he says, "Only one other high-performing conglomerate has followed a strategy of buying hundreds of small businesses and managing them autonomously." That's exactly what he's doing.

• 45:43David Senra?

  "They eventually caved to centralization. My hunch is that it takes an unusually trusting culture and a long-term investment horizon to support a multitude of small businesses and their entrepreneurial leaders. If trust falters across our businesses, they can be choked by bureaucracy. So we have to have a high-trust culture. If short-term results are paramount, as opposed to our long-term focus, the siren song of consolidation synergies are powerful. We continue to believe, however, that autonomy and responsibility attract and motivate the best managers and employees." And then he also talks about that most of these high-performing conglomerates are not in software and that software is a very strange business. And this is an example of that.

• 46:28David Senra?

  "One of the problems with growing asset-light businesses, software businesses, is that historical invested capital required to purchase the business becomes increasingly irrelevant over time." These are good problems to have, by the way, what he's about to describe to us. "We have a number of businesses where current earnings now exceed their original purchase price. If these businesses have achieved that growth organically, they have also likely reduced working capital significantly, perhaps driving the net purchase price below zero, meaning we got all the money back, and hence, the return on investment capital, it's pushed the return on investment capital to infinity." That's such a bizarre sentence.

• 47:11David Senra?

  "These sorts of businesses defy conventional financial statement measurement."

• 47:18David Senra?

  Then he gives us two more book recommendations to end this letter. The first one is One Man's Medicine, an autobiography by Professor Archie Cochrane, and another book that Archie wrote called Effectiveness and Efficiency, which is Random Reflection on Health Services. But he says, "The first book is a moving, idiosyncratic, and amusing autobiography of a brilliant and erudite outsider that makes you wish you had known the man firsthand." Makes me want to read that book, and I might if I read it, obviously turning to an episode for Founders. "The second is a stinging critique of a well-meaning but entrenched medical establishment for their ineffective and dangerous medical practices." But what's fascinating, the reason I'm bringing this to your attention, is because he draws the principles from the book and realizes he sees the same behavior in business. "Archie's observations regarding medical practice and doctors struck me as applying

• 48:03David Senra?

  equally to business practices and managers. The asymmetric effectiveness of most medical treatments, rarely influence positive outcomes while frequently contributing to negative ones, made me think critically about what I and most other managers do." Very smart that he drew this parallel. And so he says, "At CSI, we spend time on non-randomized observational studies, trying to spot business practices that actually add value, rather than just adding overhead." And then we get to my absolute favorite part of all the letters. This is where he just lays out his philosophy about why he's doing what he's doing. "Our strategy is to be a good owner of hundreds, and perhaps someday, thousands of growing,

• 48:45David Senra?

  autonomous, small businesses that generate high returns on capital. Our strategy is unusual. Most CEOs of public companies would rather run a single big business, perhaps two or three big businesses, but rarely 200 businesses. We recognize that economies of scale, centralized management, and world-class talent competing in large and growing markets can be a great business-building formula."

• 49:12David Senra?

  But it isn't what we do. So essentially, he's saying, like, this is the note I left himself here is this is great. We understand that game, but we want to play a different one. We seek out vertical market software businesses where motivated, small teams composed of good people can produce superior results in tiny markets. That is our game, right? What we offer our business managers is autonomy, an environment that supports them in mastering vertical market software management skills, and the chance to build an enduring and competent team in a quote-unquote "human-scale" business. And then he goes into the benefits that human scales, opposed to gigantic centralized companies have, right?

• 49:55David Senra?

  At human-scale companies, all the employees know each other, and if a team member isn't trusted and pulling their weight, they tend to get weeded out. If employees are talented, they can be quirky as long as they are working for the greater good of the business. Priorities are clear. Systems have not had time to metastasize. Rules are few. Trust and communication are high, and focus tends to be on how to increase the size of the pie, not how the pie gets divided. That is how I remember my favorite venture investments when I was a venture capitalist, his job before this, and is how I remember many of the early CSI acquisitions.

• 50:40David Senra?

  Then he continues on this theme, describing why small is beautiful. The larger a business gets, the more difficult it becomes to manage, and the more policies, procedures, systems, rules, and regulations are generated to handle that growing complexity. Talented people get frustrated. Innovation suffers, and the focus shifts from customers and markets to internal communication, cost control, and rule enforcement. The quirky people, the quirky but talented people, rarely survive in this environment. A huge body of academic research confirms that complexity and coordination effort increases at a much faster rate than headcount in a growing organization.

• 51:23David Senra?

  And then he talks about why these gigantic organizations are actually incompatible with human nature. No one wants to admit that they've hit their limit. Some business managers lack the humility, some lack the courage, and most lack the time for reflection to notice that their task is getting too large and the sacrifices are going to be too great. And so his solution is going to echo what Henry Singleton discovered. If a business is, if a large business is not generating the organic growth that we think it should, the business manager needs to be asked why employees and customers wouldn't be better served by splitting that business into smaller units. Our favorite outcome in this sort of situation is that the original business manager runs

• 52:05David Senra?

  a large piece of the original business and spins off a new business unit run by one of his or her proteges. This dividing of larger business units into smaller units is rare, but it is not unknown. One of the high-performing conglomerates that we studied was Illinois Tool Works, which is ITW. I don't think I've heard of this before. It has hundreds of businesses. We began following the company from afar in 2005. The most relevant period in ITW's history for CSI was the tenure of John Nichols. Nichols began consulting for ITW in 1979, and it appears he was the primary author of its decentralization strategy.

• 52:49David Senra?

  He was CEO of the company as it went from 369 million in revenue to 4.2 billion, and he did that in about 14 years. Prior to Nichols' tenure, ITW had acquired only three businesses. During his tenure, ITW aggressively acquired and often split the larger acquisitions into smaller businesses. ITW had 365 separate operating units by 1996, when Nichols retired. And then he talks about the process of studying the company. "I'm sorry, I did not reach out to some of the ITW employees and ex-employees until 2015." So he was on his radar, starting in 2005. Took him 10 years to realize, hey, I need to talk to some of these people. When I did talk with one of the senior managers, he said...

• 53:35David Senra?

  There's some quotes from these discussions that they're having. Number one, "Something wonderful happens when you spin off a new business unit. With a clean sheet of paper, the leader only takes those he needs. They set up an office with good communication and no overhead. They cover for each other. They leave all the bureaucracy and all the crap behind." And then there's two other pieces of advice that, from this conversation, he wrote down and he wanted to remember. Number one, "Don't share sales, R and D, HR, et cetera, because the accountants never get the allocations right and the business units always treat the allocated costs as outside their control."

• 54:15David Senra?

  And number two, and the most important, "When you get big, you lose entrepreneurship." And one of the last things I want to share with you from the letters, this is too good not to include, it is the advice that he would give his 35 or 40-year-old self, so this is a perspective of somebody who's in their mid-60s, multi-billionaire, that's developed an amazing, wonderful business, and he still, what's remarkable is he still thinks that VMS is the business to be in today, right? So he says, "If I were advising my 35 or 40-year-old self on where to go from here, I would tell him to stay put. Become a master craftsman in the art of managing your VMS business.

• 54:58David Senra?

  It is the most satisfying job and will generate more than enough wealth for you to live very comfortably and provide for your family." And I'll close with these four quotes that he leaves at the very end of this letter. "We should no more trust executives who rely solely on their experience than we should trust doctors who ignore clinical trials. Science is organized skepticism. Too much of business is disorganized optimism." And finally, and most importantly, "You can't be normal and expect abnormal results." And that is where I'll leave it. I'll leave a link down below.

• 55:41David Senra?

  You can read all the shareholders, shareholder letters, they're available for free online. And I'll also leave a link in case you want to give a family, friend, or coworker a gift subscription to Founders. As always, I appreciate the support, and I'll talk to you again soon.