In this episode of The Acquirer’s Podcast Tobias chats with Michael Girdley, Executive Chairman at Dura Software, a firm that specializes in acquiring hyper-niche software businesses. During the interview Michael provided some great insights into:
- Finding Opportunities In Horizontally Focused Hyper-Niche Software Businesses
- The Playbook – System of Systems for Business and Startup Management for Companies with <50 Employees
- Finding A ‘Cusper’ To Run Your Acquisition
- Valuing SaaS Businesses Using The Rule Of 40
- The Inverse Relationship Between Well Prepared Financials And Good Investments
- Successfully Invest By Playing Games Where You Have An Unfair Advantage
References In This Episode
The Playbook – System of Systems for Business and Startup Management for Companies with <50 Employees (Michael Girdley)
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Full Transcript
Tobias: Hi, I’m Tobias Carlisle. This is The Acquirers Podcast. My special guest today is Michael Girdley of Dura Software. It’s a hyper-niche software acquisition business. Absolutely fascinating. I’ll be discussing it with Michael right after this.
Michael: I have a weird background that I went to school on the East Coast, so I hung out with a bunch of people from New Jersey, so I’m very direct. And then I went to the Bay Area where nobody’s direct. Then, I just hung out, worked with a bunch of Berkeley hippies for five years, and then came back to San Antonio where people are neither hippies nor direct. So, it’s like a crazy place.
Tobias: What’s the personality in San Antonio?
Michael: I don’t know if you’ve spent time in Houston, it’s very much kind of a Houston– down to earth, very nice kind people, but very much determined in terms of how they approach life. The other thing that’s weird about San Antonio, we have– almost 70% of the population is Hispanic. It’s a huge Mexican-American influence. So, a lot of the things that are natural in terms of like the Hispanic sense of humor and stuff like that. When I lived in the Bay Area, people don’t joke around like the Mexican Americans do, and I would like talk to a Chinese American person, and they’d be like, “That’s not funny.” I’m like, “Well, the Mexicans thought it was hilarious.” So, we have that, which is an interesting impact on the culture as well. But it’s a great place. I personally love living out in the boondocks, in terms of talking to people from LA and New York and stuff. It’s much more fun to be a big fish in a small pond.
Tobias: What were you doing in the Bay Area?
Michael: I started working for other people. Started as an engineer, and then really realized that I was never gonna be a great engineer and I also liked people too much.
Tobias: What sort of engineering, software engineering?
Michael: Software engineering. I’ve almost always been a software guy except for a few detours. But I ended up working for a couple of different companies. One RSA, you might have heard of it, a big security company. Now, it’s mostly a security conference with a company attached to it. But back when they were in the patent trolling business, I worked for them. And that was my first job.
Tobias: [crosstalk] –fobs for a while, didn’t they? They may still make the fobs.
Michael: So, the Fobs are actually the company– they came from the company that bought RSA. RSA itself was this amazing business that there’s a thing called the RSA algorithm which came out of these three MIT professors and they had a patent on this thing. They went and got everybody to use that for SSL and all the underlying security for the internet. It’s asymmetric encryption. And basically, what they were able to do is just extort out of corporate America hundreds of billions of dollars a year until the patent ran out. And so, the company that bought the patent troll company was a company called SecurID, which did the fobs. And then they took the RSA name. That was my first exposure to unfair games and businesses I wish I owned.
Tobias: You were a software engineer there or you were a product guy there?
Michael: Initially, a software guy, in terms of engineering, I started– we were selling a product specifically towards developers. I started in a role that was engineering working with other companies, developers, so almost a solutions engineering role. And then, I moved into a marketing role there and then I ended up leaving that company to go work at a middleware company called BEA, which is now part of Oracle and I was the product manager for a product called WebLogic.
Tobias: When were you with BEA?
Michael: ‘99 through 2003.
Tobias: BEA, I had some friends who worked at Plumtree who got taken by BEA. And one of them is Jay, who’s the president of the big Australian software engineer. It’s just a big software firm, it’s just slipping my mind. They make Jira, you know who I’m talking about?
Michael: Oh, Jira? Like J-I-R-A? Atlassian is who you’re talking about?
Tobias: Atlassian, yeah. He’s Atlassian. He came through Plumtree and BEA, worked with a few friends of mine Personas [unintelligible [00:04:42] who went to work for Peter Thiel and his macro hedge fund for a while. I don’t know if you crossed over with those guys or not?
Michael: No. I think Plumtree was probably one of the acquisitions after I had left or towards the end of when I was there. My last role, there was like a strategy role, which like most strategy roles, I had a hard time figuring out what to do with a strategy person because the CEO wants to be in charge of strategy. In retrospect, whenever I hear somebody say, like, “I’m gonna take a strategy role,” I’m like, “Don’t do it, bad idea. It’s a great way to get fired.” Unless you’re just gonna repeat what the CEO tells you, you don’t do it.
Tobias: How did you switch over to the investment side?
Michael: That first phase was working for other people in my career. The second phase was working– being a CEO. And I realized that where I want to live is at the intersection of ops and asset allocation. I don’t really wanna do either. I don’t find either one by itself very interesting. And the way I started to get into that was around 2012, I started doing angel investing. And that was really to where– I’ve never had any interest in public equities. I know other people really like public markets. I find them incredibly boring. But private equities are much more interesting. So, I started doing angel investing, specifically giving $10,000 and $25,000 checks to dudes and ladies with laptops and PowerPoints.
Tobias: And anything interesting come out of that?
Michael: Yeah, I ended up investing in a handful of companies, no unicorns out of the bunch, but invested in a company here locally that’s hired like 60 people over the last five years, so that’s pretty exciting. And then, I’ve had some duds. I had one company that gave me back half my money. I was pretty excited about that. I think I was the only investor when they call and they’re like, “I have great news. The company sold for pennies on the dollar. You’re gonna get half your money back.” And I was like, “Yes! Yes! This is a huge win.”
Tobias: Even the [crosstalk] win. Even [crosstalk] is a win.
Michael: Totally the case. They’re like, “Why are you so excited?” I was like, “Well, your other investors will be after they get some more bumps and bruises.” Yeah, a handful, the company– I’m very proud of this one locally that does the– they basically do telemetry systems for vending machines, really very boring business. But it turns out most vending machines were built before the 80s. And they have no ability to take credit cards, that you don’t even know what’s going on in them. So, they’ve built a whole business around that and turned it into micro markets and all this stuff. So, yeah, they’re called Parlevel Systems, they’re here in San Antonio, totally fun little business.
Tobias: So how do you transition from part-time angel investor to– Is it Dura Software?
Michael: Dura is what we’re working on now. I cofounded that with a couple of guys who are former rackers. So, one’s a CFO and one’s a CEO. It puts me in the right role for me, which is board chairman, which is– I wanna live in the asset allocation world a little bit and I wanna live a little bit in the ops world. What I think I do pretty well is finding the right opportunities around that and then convening really the right team. So, my cofounder, Paul, also invested in the business, and he is the CEO. And I think what I saw with Dura is there was this whole asset class of these little software businesses that by themselves were amazing businesses, but nobody was really set up to exploit them. And so, we went with this idea of going and acquiring and building a big business out of all these little tiny software companies.
Tobias: Is it Constellation? Is it an acquisition level? Or is it more expansion capital, or where do you fit into the ecosystem?
Finding Opportunities In Horizontally Focused Hyper-Niche Software Businesses
Michael: A good way to think about us as we do what Constellation does, but where they do a couple things different than us. First of all, Constellation is very upfront about saying they’re in the vertical market software business. We’re not stupid enough to try to compete with Mark Leonard and those guys, their capital is much better than ours will ever be. But we saw that there’s this other category of software that is more horizontally focused. We call it hyper-niche software, and that’s branding. So, we do what we do.
But basically, we go for these very niche use cases that Google, Microsoft, Facebook, they’re never gonna wanna be in that business because it’s maybe a $10 million TAM. For example, our very first acquisition of a hyper-niche product was this piece of software that’s used to manage very large fleets of multipurpose single-user devices, so like kiosk and digital signs. You’re gonna have 50,000 of these things. We went and bought this company, does a few million a year in revenue, and brought them into the fold and deployed our operating model there. We’re more of a horizontal play, whereas Constellation and other folks that are other software accumulators, they focus on vertical.
Tobias: You guys operate in these businesses when you acquire them?
Michael: Yeah. And that’s where I think we’re able to unlock the value. Over the past 20 years, it’s gotten really easy to build a software business from a technology standpoint. AWS, all the toolsets, all the libraries, they make it really easy to do that. But what hasn’t gotten any easier is those technologists who build those businesses, it hasn’t gotten any easier for them to operate them. Sales is even harder than it used to be. It’s not like you can just spam the world or by display ads and hope your customers are going to magically walk in. The insight there is, because we’re operators and my cofounder, Paul, he used to run all of Rackspace’s support, he understands how to run teams. What we do is we bring these businesses in and they all need some work and we deploy our operational excellence into them, and then turn them into nice little businesses that we keep and grow forever.
Tobias: Let’s just talk about– what’s the difference between– you describe it as hyper-niche and you’re prepared to look at the horizontal market. Folks who listen to this show will know that Constellation focuses on the VMS, the vertical. Can you just talk a little bit about the difference between vertical and horizontal?
Michael: Yeah. Vertical software is typically focused on a specific industry. Constellation, which is a great business– they have a whole B to G department or B to G division, or they may have a healthcare division, which is just software that aims at healthcare type of that industry. That could be anything from practice management software to benefits management to any of that kind of stuff. So, they focus there, and that’s fine. Our horizontal play realizes that in the vast world of software, there are a bunch of things that are horizontal across all these industries that aren’t specific to one, but have a common use case that you’ll see across all of those.
Tobias: Like accounting software or something like that?
Michael: Yeah. For a hyper-niche example, let’s say you have compliance software that automatically scans all your financial statements to make sure that you’re compliant with stuff. That would be a very hyper-niche type use case or what I talked about before, everybody needs kiosks or these large-scale digital signage deployments. Our product, Moki, which is device management for those type of deployments, that is a very narrow thing that spans across industries. That’s where the horizontal thing is, it goes across multiple industries.
Tobias: Is that what Brent Beshore describes as “the tastes like chicken” layer of business, is that what you’re trying to?
Michael: For sure, yeah, but we’re interested in the wishbone part that’s unique to a chicken because then you don’t ever have to worry about, is Google going to come in and crush you. Because we’re not going out-engineer them and that’s not really the intention anyway.
Tobias: So, when did you start up? And what was the plan when you got going?
Michael: Yeah. We started about two years ago now. I think the original plan was, let’s create a set of incremental experiments that we’re gonna run in the market, and really try to understand is there something here? And I’m a huge believer– whenever you are going to ask other people to eventually buy into what you’re doing, the best thing you can do is put your own capital to work, or at least at a meaningful level. What Paul and I did, and we had gotten introduced by a great guy here in San Antonio, a man named Graham Weston who’s like the former chairman of Rackspace, kind of the godfather of the tech scene here, as big as it is. And he said, “Hey, Girdley, you need to meet this guy, Paul.” And we went and had lunch and I was like, “Hey, I’m working on a project. I think there’s a business opportunity around these hyper-niche software companies. Do you wanna work on it with me?” He and I just were like, “Okay, you have some money, I have some money. Let’s go out and commit it and buy one and see if it works.” And so, we spent about six months trying to find one, and ended up buying the first one called Moki.
Tobias: What makes it hyper-niche?
Michael: Yeah, so we define that as a whole set of characteristics there. So, first of all, it’s mission critical, meaning that we don’t wanna buy anything that’s gonna go away during a recession. Second of all, we focus only on b2b software. We’re not interested in b2c. It’s not that those aren’t good businesses, I find them very boring. Maybe I’d be a better capital allocator if I wasn’t so emotional about certain things, but I’m not interested in working on boring stuff. Second of all, it’s a very narrow use case, that we see that it spans multiple industries. It’s not something that’s going away. And then lastly, it fits a certain size. We’re not interested in buying into $500 million TAMs, total addressable markets. We are totally happy with being the number one software vendor in an $8 million TAM. And there’s some logic to that because $8 million TAMs aren’t interesting to PE, they’re interesting to VCs and they sure as heck are interesting to the big boys.
Tobias: How are you determining that the TAM is only $8 million? Is it literally like a geographical location? How does it work?
Michael: Sometimes, it’s really easy. You can do things like– we’ve looked at software that specifically only sells to education departments at US states. You can figure that out pretty easily. The second acquisition we did is actually back office email automation software for maritime shippers, and specifically maritime shippers that ship bulk stuff, not container shippers. So, it’s pretty easy to figure out the TAM, when you know there’s only 85 customers in the whole world and the potential spend for each one is whatever. That’s multiplication, even I could do that.
Tobias: How did you undertake that first acquisition? How did you look for it? How did you validate it, assess it when you got it? Can you just walk through that process?
Michael: Yeah. Well, what we did early on was pretty straightforward. We did list building. I hired some dudes on Upwork to build a list of companies. Anybody that’s built a sales machine, that’s pretty standard. I got a list of about 5,000 companies, and we just started going through them one at a time. Doing emails and saying, “Hey, I looked at your company, it looks interesting. Are you interested in selling?” I would do probably 50 to 75 of those a day. And then, based on that, we would just run people through a sales funnel.
An inverse– what any acquirer does. Use some email automation stuff to do those emails, those returning introductory calls. And those early introductory calls are really interesting because at the time, we’re trying to figure out what the market is. And those early calls, I think, are really interesting because after the fifth one where I ended up talking to a seller and I discovered there’s this vein of people who will sell but only for a crazy price, well, I’m not interested in buying anything for a crazy price. So, then we start to move people after those introductory calls through the rest of the process.
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How To Calculate The Value For A Small Software Enterprise
Tobias: Well, let’s talk about a crazy price. How do you know it’s a crazy price and a good price? How do you make that assessment?
Michael: Yeah. Well, I think just like any other investor or capital allocator, you wanna have a margin of safety. But at a very basic level, you can put together a discounted cash flow model on these businesses, they’re pretty easy to model out. We know how to do that just because we’ve spent a lot of time in business and also dealing with these types of software companies now. But based on that, it’s not very exciting for me to go pay 20 times for something that’s not growing quickly. I can– 5%, I can get that get that other places if I really wanna put the S&P.
Tobias: So, what’s a good price?
Michael: I think like most acquirers, we’re looking to see a reasonable IRR somewhere above that 20% to 25% return rate. And that gives us a margin of safety. Part of the reason we keep that number pretty high, like most private equity does, is because I wanna have the opportunity to be 100% wrong and still [unintelligible [00:18:41] out okay. So, if your worst cases that you end up in teens or 10% or 12% IRR, well, that’s okay. You at least aren’t gonna get– your risk of ruin is minimized.
Tobias: In the first acquisition, you build this list, you’re contacting 50 to 75 folks a day. You find there’s a very large number probably who don’t want to sell, that’s the biggest number, and then there’s a very large number who will sell on very generous terms to them. And then you find some folks who are prepared to enter into a transaction. How do you whittle that down and get to the point that you find this is the one we want to really run the test case on?
Michael: Yeah, our very first one, we ended up signing an LOI on it. And to get to that LOI, so basically, the process is you’re gonna have the initial calls with folks. And then, that initial call for us was really about just trying to get them to invest the time to give us the information that they need to tell us so we can value the business and make them an offer. And I know you’ll be shocked by this, but there is an inverse relationship to the size of the business and how decent their financials are. It’s also an inverse relationship to how good of an investment it ends up being, based on how bad the stuff is prepared. So, there’s a number of times–
Tobias: [crosstalk] the preparation, the better the investment?
Michael: Almost always, it’s that way. So, if you see a beautiful [unintelligible [00:20:02] from a broker and who’s running a great process, you’re gonna pay for that one way or another. And we’re happy to get our hands dirty and do the work. So, what we’ve tried to do is we distill everything down to just a core set of information that we need to see and use that to try to come up with an approximation of what the business would look like when we have it. So, the foundations of that are the financials as much as they have them, whether that’s cash or accrual. A customer list, usually anonymized, so we don’t ask people to give us the names of their actual customers, but we’re interested in year-by-year revenue breakdown of these folks.
Tobias: Roughly how much each customer is generating, how concentrated they are, how reliant they are on their biggest customer and so on.
Michael: Absolutely, yeah. You’ll see a lot of these folks that are out there who try to pitch themselves as product companies and they’re really just a consultancy. I’ve seen it before where it’s like 60% of our revenue is these two people customers and we have 45 more customers that comprise the other 40%. That’s not a business, that’s a consultancy. Anyway, we get those three things. We get the P&L, as best they have it, sometimes it’s bank statements. Secondarily is the customer list, ideally anonymized, broken down by year in terms of revenue. And then the last thing that gives you a picture for the business is who are the employees, anonymized, and how much are they making. That gives you a feeling for how the business is run.
And most of these little software businesses, you’re looking for rules of thumb around things like customer concentration, revenue per employee. A lot of times you see these businesses that should be profitable, but the reason they’re not is because they have twice as many people as they should. That’s not a business, that’s a charity. We talked about that as a possibility too. And then you use that, that’s the stuff you can really use to figure out how the model, the business will work out inside of our operating model. That’s what we did with Moki. We figured out an operating model, put together a financial model, and then used that to come back and say, “Okay, here’s what we can pay for the business,” and you present an LOI to them at that point.
***
Tobias: And how many acquisitions have you undertaken over the last two years?
Michael: We have three that have closed, and we have two that are preparing to close.
Tobias: And so, the rough numbers, say you start out with a list of 5,000. Have you worked your way through the entire list to this point?
Michael: Our list has actually gotten really big. It’s one of the things that I’m actually super-optimistic about this space. So, we talked about this idea that very few people have the structure like we do to do these acquisitions. Most people don’t want to be in $3 and $5-million-a-year software businesses. Most people don’t have the execution ability, and we could talk about that. That’s kind of one of the big barriers to entry here. The number of people that talk about doing acquisitions that actually do them is hugely different. And then it turns out, the third thing is the number of these software companies is much bigger than anybody really imagines. One of the databases that we use has over 100,000 companies globally that are under 5 million in revenue. Yeah, so we’ve just barely scratched the surface, but nobody really cares about them, which we do.
Tobias: Let’s talk about the execute. What’s the execution? What differentiated between you and some of the folks who are just talking about it?
Michael: Yeah. Oh, in terms of getting deals done?
Tobias: Or just to follow on from your thought a bit earlier.
Michael: Oh, that there’s a huge gap between the number of people who talk about doing acquisitions and the ones that actually do it?
Tobias: Sure.
Michael: Yeah. It’s one of those things where when I talk to people, they’re like, “Okay, have you done any deals?” They’re like, “Yeah, we’ve done three, we’ve got two more in progress.” They’re actually kind of shocked because so many people just talk. It’s a unique combination of things. You have to be very comfortable with making an uncertain bet on an acquisition. I mean these are big checks we’re writing, $2, $5, $7 million checks. Some of it’s our own money. You have to be very comfortable with that, but at the same time, you have to be grounded enough to be able to operate these things well. And we bring in a whole operational model that we’ve created and standardized across this specific type of stuff. But psychologically, asking why most people talk about stuff and never do it, I don’t really know why because that just seems so—
My camera turned off. I’m back. Okay, cool. Yeah, well, actually, I went through this whole process to get a fancy DSLR hooked up. The problem is it shuts off every 30 minutes, so I don’t look as good as you, but I’m trying.
Psychologically, that just seems so weird to me. I don’t know why people talk about doing stuff and talk it to death. I much more prefer going.
Tobias: So, you have this huge list, you validate it down, you undertake the first acquisition, and then presumably hadn’t built this operating standardized checklist or operating standard that you’re trying to get. This is all learned from the acquisition of this first company?
Michael: Yeah, some of it is from the acquisition. So, I’d say the software specific stuff is there. One of the things I brought is what we talked about with Brent’s idea of everybody has the same kind of 10 problems. I did bring an operating model that is standardized that we use for everything around, hiring, culture measurement, employee measurement, how we run team meetings, how we do strategy.
All of that stuff is an operating model that I learned in my small business days that we’ve brought in and we use. Basically, it allows us to just treat every single little software business, even though it has its own CEO, who is running it very entrepreneurially, we give them the playbook that they have to run. They’re not worried about how they’re going to measure customer satisfaction. They’re worried about how they’re gonna make their customers happy, which are two different things. We give them a playbook and that’s kind of that niche that we fit in. We’re an accumulator of these software assets with a bit of standardization in terms of the centralizing of stuff, but at the same time, we’re very entrepreneurial that each business has its own head, but we give them kind of the playbook that they need to run.
Tobias: Once you acquire them, you said they’re running on– they’re giving you bank statements in the acquisition, but presumably you’re running– you then make them hook up to QuickBooks or something like that so you can monitor that remotely or how does that work? Is it standardized?
Michael: What we do is our finance and accounting is centralized. It’s part of the power of our operating model, which is unlike a fund where a centralized operating company. There’s a lot of advantages to doing it that way. We’re a C-corp. What we can do is we can take some of those general-purpose things like finance, HR, accounting, facilities, and we put that all into a centralized thing that lives in the third cofounder’s office, the CFO. And so, he is the one running all of that finance and accounting for the individual businesses, because we don’t want the CEOs to be spending their time worrying about that. That’s how we transition them oftentimes from having accounting, how much is it my checkbook accounting, to how do we have audited professional P&L statements that are trackable on a quarterly, if not monthly basis.
Tobias: And then the CEO is freed up– presumably they’re primarily strategy and sales? Is that what you’re looking for the CEOs to go?
Finding A ‘Cusper’ To Run Your Acquisition
Michael: Yeah. Our model is actually– we look for a very specific type of person, so we look for a man or woman that we call kind of a cusper. And what it turns out is a lot of those people have been very deep in being a specialist in a specific functional area inside of a corporation. They may have been head of sales, or they may have been head of customer support or ops or any of those type things. But they are interested in getting to a general management and CEO-type role. We give them almost the– my first CEO job, which is we’re gonna take away some of the stuff that’s kind of boring, but we’re going to let you really cut your teeth to expand. And our view is that people who are making that transition, the thing you have to do is you have to go from being very deep in one functional area to being kind of deep in everything. You need to be able to talk about finance, you need to be able to talk about engineering, you need to be able to talk to engineers, even though you come from a sales role.
And my business partner and I, Paul, we really enjoy coaching these people so we wanna develop them into really good CEOs. That’s part of the value prop for them is, okay, you’re going to be entrepreneurial, you’re gonna have your P&L, you’re going to own all these responsibilities, we’re gonna measure the heck out of you, we’re gonna give you training wheels. But this is your chance to grow from that functional area specialist into somebody that is a general-purpose CEO.
Tobias: And do you have some sort of playbook for them? Or is it a case-by-case basis where you guys look at this particular business has this particular opportunity, and we want you to pursue that opportunity?
Michael: Every acquisition will have an investing thesis for us. We’ll ask ourselves, “What changes do we wanna make?” It could be as simple as like, “You know, what you guys should consider doing? Marketing.” Sometimes that is the– One of the business we bought didn’t even actually have an incentive plan for the sales reps. Have you ever heard of a sales rep never having a commission? So, guess what the sales rep did? They just were sitting around on their butt all day. Anyway, so after we bought that one, the sales growth momentum per month, tripled because it’s like, “Hey, we’re gonna align some incentives here.”
Anyway, to come back to your question, we try to give them that input, and then make a clean transition to that CEO of the business and say, “Okay, now you own this. Here’s what we think, but we wanna give you the authority and the responsibility to make those changes to really run the business like you want to.” And the way we’ll make that transition super smooth is, we have three CEOs in the company right now that report to Paul, our CEO, and those folks will be involved almost always in the acquisition of the new business. If we’re gonna give that to one of the CEOs as a second business, then they’ll have an opportunity to be part of the identifying the problem before they’re expected to solve it.
Tobias: So, they’re not necessarily coming from inside the business when you acquire them, you’re acquiring the business and sourcing the CEO to operate that business separately?
Michael: Right. If we’re buying a distressed or a business that we consider not performing as well as it could, our default model is that the CEOs of these companies are the ownership of the companies never come with. They like that, because we’re unique, because the leadership isn’t expected to stay on. And then we’re the only buyer because of our permanent hold model that they can trust is going to take care of their legacy and their people. PE buys you or Strategics buy you, a good chance your products gonna get killed in the next two years. That’s just the way that works. They like us for that reason. We’ll have our own thesis about the way the company should work, and by design, if somebody had their old way of doing it for the past 20 years, it’s not gonna work to bring them in and keep doing the same thing that we wanna do differently.
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Tobias: What have you learned over the last few years of doing these acquisitions? What’s the difference between the reality of it and what you– the thesis of it before you started?
Michael: Yeah, man. Lots of stuff. I think that early on, we were much more trusting of what people’s documents said of them. I talked about this inverse relationship of how much you can trust financial statements, and that sort of thing. That’s a hard-learned lesson. And actually, our very first deal that we were about to do, we ended up pulling the plug on it, because they were misrepresenting to us what reality was, the business wasn’t actually flat, it was actually shrinking 20% a quarter. That kind of changed the entire universe of those things.
Tobias: How do they present it as flat when it was actually shrinking?
Michael: So, here’s the funny thing. These folks are oftentimes selling because they’re running their business poorly. And they don’t know they’re lying to you about their small business. I think for folks that live in the public equity world, you’re accustomed this level of sophistication and audits and all that stuff. It’s important to remember most small businesses are run by so and so with their checkbook. And a lot of these people are doing all kinds of crazy financial shenanigans, like factoring. They’re not lying to you. They truly believe they’re doing much better than they are.
Tobias: And so, they’re not using anything, like even just QuickBooks just to see– you can track pretty easily, it’s all automated in QuickBooks.
Michael: Or if they are using QuickBooks, it’s garbage in/garbage out, stuff just radically mischaracterized. The idea of revenue recognition, no way. Good luck. Good luck with some of that stuff.
Tobias: But they’ve grown these to reasonably sizable businesses because– I saw on your website, you’re talking about $2 to $5 million in revenue. So, that’s very a successful small business.
Michael: Yeah, for sure. There is this idea that, in growing a business, the CEOs have to change. And a lot of these CEOs and owners reach a point where they’re just not comfortable. At the very first level 0 to $1, you’re the doer in the cellar. And then from $1 to $5 million or $1 to $1 million, you become a manager. And then above that, you’re a systems builder, and above that, you’re a business builder, above $10 million, and so on. A lot of these folks are never really comfortable making those transitions and they just get stuck. And you’ll see these businesses that say at a million, we’re supposed to start to deploy systems, and they never do. And the businesses just churn along. And software is a rewarding thing. If you’re selling something at 80% to 85% gross margins, that’s recurring revenue, that’s very sticky with your customers, that covers up like a lot of sins for these folks. So, that’s my explanation of why some of these businesses get bigger, even though they’re not really run super well, is software is a pretty good business to be on.
The Playbook – System of Systems for Business and Startup Management for Companies with <50 Employees
Tobias: That’s kind of interesting. Often you find these things, they’ve got to the peak of some phase, but they just can’t transition beyond that phase to whatever the next level is. And you guys have that, because you’ve been at much, much bigger organizations. You know how to take them from one phase to the next or get the person who can run it at that systems phase and the business builder phase.
Michael: Right. Well, in the playbook we make everybody use, actually forces you to start to create systems. So, we give them a system for hiring. We give them a system for how you’re gonna do your strategic planning, how are you going to do your quarterly goals. We give you a system that forces– you’re gonna use those things. So even if people on our CEO level or the existing company don’t have that, they really don’t have any choice, because we’re just like, “Well, this is the way it’s gonna be.”
Tobias: And that system, that’d be a great book sometime that you could publish, unless you wanna keep that private for the firm?
Michael: No. It’s on my website. You can go, it’s girdley.com is my website, I posted the whole thing. The genesis of what I call the playbook was about five years ago, I made some really bad hires. And I’m a member of a CEO group here called Vistage. And I went to everybody in the group, and I was like, “How do I not hire so terribly?” And everybody else goes, “We don’t know. We hire terribly too.” And I ended up talking to another business partner of mine, and he’s like, “You should check out this thing called Topgrading.” I don’t know if you’re familiar with it, but it’s changed– it’s wonderful. It is a wonderful system for hiring. And so that started me on a quest to go out and say like, “Why am I solving all of these problems that other people have solved? If there’s a system out there for hiring, why don’t I just go find the best of that thing and use it? If there’s a system out there for strategic planning, for SMBs, I can’t be the only person that’s ever had that.” So, I spent two years basically going through and identifying the best of breed of every single one of these systems, and we’ve codified it in this thing we call the playbook. And, yeah, I published it on my website. It’s just like, different people’s books in different people’s systems.
Tobias: Well, that’s brilliant. I’ll make sure I link to that in the show notes. That sounds very interesting. I’d love to have a look at that. Just taking a step back a little bit, what’s your overall investment philosophy?
***
Successfully Invest By Playing Games Where You Have An Unfair Advantage
Michael: I think that I really like to play games that are unfair to me. So, I talked about being bored by public equities. There are so many people out there that I feel like are much smarter than me. And it’s the same attitude I have towards chess. I really like chess. One of the things I like to do is watch chess videos on YouTube. But I’m never gonna be amazing. I don’t think I have the ability and a good enough memory to be a grandmaster or even a master.
Tobias: What are you playing with at the moment?
Michael: I have no idea. I don’t even put–
Tobias: If you play in chess.com, it will give you a rating.
Michael: I think the highest ver is 1600, 1700.
Tobias: Yeah, that’s pretty strong. That’s about it right.
Michael: Yeah, well, kudos to you. So, it’s one of my limitations in life. Actually, I’m a very future-oriented, high-level thinker. So, I have a hard time remembering details, like I’m terrible with people’s names. So, it’s one of those things where I wanna pick the games that I’m gonna invest in, where I can have an unfair thing. I’m also a really bad loser, I don’t like to lose. So, investing, I start to look for things like this opportunity where I can bring something unique, where we can be the only player for acquiring these types of software companies and where I can bring the kind of investment I’ve made in learning how to do a business as well. And the network I have and the reputation I have and bring all those together to play a game that’s really unfair, because that’s much more fun than playing something that is, I would say, much more fair.
Tobias: You don’t wanna compete on a level playing field, which is a little bit like swimming, so you’re a swimmer. I was a swimmer. What did you compete in?
Michael: Oh yeah, I was a middle-distance swimmer. I freestyle and breaststroke.
Tobias: Yeah, I did [unintelligible [00:39:06] and 400 and the freestyle as well, but not as well.
Michael: That was an amazing experience for me. I was a college swimmer. And I looked at the people who were really gifted and the fastest people on the team, and I was that guy who barely walked onto the team. I’m six foot five, blond hair, I look like Matt Biondi, whatever, at the time. Now I look like a fat middle-aged man. But back at the time, I was the one that was really intimidating when we’d go to the college swim meets, but I was not very fast. It was such a good character builder to be a crappy athlete. That’s why I love when I find people who’ve been like that, not very gifted, 11th man on the basketball team who the coach liked, because he just worked his butt off. Those are great people to hire, and I feel like I had that kind of same build up, which is, I was an extremely good mediocre swimmer. But I got so much out of being not very good, if that makes sense.
Tobias: I competed in a few 1500s and had a lot more success in 1500s just because nobody wanted to do it. Unfortunately, [crosstalk] a couple of guys in Australia who had– I know, unfortunately at my university, too, and they competed and won gold medals over like three Olympics, so there was just no chance of even making the university team, even in that event, it’s very, very tough. You still swimming? Destroys your shoulders when you’re young, makes it hard when you’re older.
Michael: No, I actually have– it’s one of my weird genetic oddities. I have hyperflexible shoulders, so I’ve never had shoulder problems. I do have some knee and ankle problems but that’s about it. I find swimming now incredibly boring. I wanna hang out with people. I think I might be somewhere on the spectrum, but I’m like somewhere one the spectrum that I really like people. And so, I actually go to group fitness classes like all the time. That’s what I do, because I love going there and seeing people and I love talking to them. It’s the same reason I like going to an office and like working with people. I like being around people under the right scenarios. So, I don’t swim anymore.
***
Valuing Software Businesses Using The Rule Of 40
Tobias: So, what’s the longer-term plan for Dura? You’ve acquired three, you’ve got two more in the hopper, you’re two years in. It sounds like you speeding up a little bit, is that the plan just to keep on building and compounding over time?
Michael: Yeah. So, we see ourselves as a compounder. That’s the cool thing about what we’re doing. These businesses are profitable when we have them. They’re operating at some version of the Rule of 40. Are you pretty familiar with that?
Tobias: Yeah, it’s the sales and the– [crosstalk]
Michael: Yeah, NOA/EBITDA, which are pretty much the same in software businesses. Plus, the growth rate year over year, in a very high performing software company is over 40. There are some– like a French startup is over 100, It’s pretty cool. When he told me that, I was like, “Oh, it’s pretty awesome.” But, yeah, so that’s one of the measurements we use to measure the overall health of the businesses. “Okay, is your growth rate plus your EBITDA somewhere in the vicinity of 40?” So, yeah, the cool thing is because all these businesses also we mandate that they’re gonna be profitable, like we also do something crazy in tech, which is we just say, we’re not going to lose money. I know that’s insane. If you’re a VC, like well, but we make all these businesses run profitably. And so, the idea being that that free cash, we can then use and reinvest and compound back into doing more acquisitions.
So, the long-term vision is to just keep doing what we’re doing. Growing a little bit organically, but then growing inorganically by redeploying our free cash. And basically, just keep at the same pace we’re doing. Let’s do three to four acquisitions per year. Let’s keep integrating those. Let’s do them really well. Use the free cash to keep doing that. And you can see the end goal. After 10 years, you acquire $10 to $15 million a year in revenue, pretty soon you’re a pretty big company. And you can see what happens with 150-million-dollar-a-year software companies and how the public markets value though.
We’re playing the long-term game here. We plan on staying where we are for a long time, but the end goal is to build a really huge company by accumulating a lot of these little companies.
Tobias: And then to list that at some stage.
Michael: Look, I’ve spent time hanging out with VCs and I’m a part-time partner at a venture capital fund. The one lesson I’ve learned there is predicting what the future is gonna look like 10 years from now, in terms of an exit, is really hard to do. I just know that if we keep doing what we’re doing and executing the way we’ve been executing, we’ll be an extremely valuable thing to somebody, whether that’s a public market or a private equity or tech, like at some point, we just say, “Okay, we’re not gonna reinvest cash anymore and start writing people checks.” All those are options. The key thing really to focus on here is just how do we maximize and create value by building a great business. And that’s where we’re really focused.
Tobias: You’re looking at the landscape for this sort of businesses, software-as-a-service-type businesses have got these extreme valuations on the public markets, and presumably, that’s filtered down into the private markets as well. Is that trajectory gonna persist, do you see it slowing down? How do you think about purchase multiples for these companies?
Michael: Yeah. Well, I think what’s happened in the past six months that’s been really interesting, is we divide the market into four different segments. So, there’s high-growth software businesses of this size, and those are the things that VCs wanna give money to or PE wants to buy. We’re not interested in paying 10 or 12 times, trailing 12 months’ revenue. We don’t do that. Then, there’s the next category that are just pretty darn good businesses. They’re already running pretty well. The owners know what they’re doing. They’re may be generating 20% to 25% EBITDA, growing 10% to 15% a year. Nice businesses, we don’t play there as well. Those tend to sell for three, four, five, six times ARR, and there are buyers that pay up for that stuff. We don’t do that.
Where we play is in the bottom half of the market, and there’s two categories there. One is distressed. And distressed is obviously, they got to sell for some reason. And then, there’s things that are just underperforming. Maybe break even, they’re not doing very well. And so, the market, as we’re seeing with these businesses is actually nuanced depending upon what’s happening at each stage. So, VC has slowed down. Those guys are all flowing their growth rate and so their multiples are coming down a bit. And then for the past six months, up until about a month and a half ago, we didn’t see a distressed company for almost a half a year.
And then, well, COVID happened and we started to see distressed stuff. It was early on, it was like stuff selling it to airlines or restaurants or that kind of stuff. So, it’s hard to predict what’s gonna happen. But I think the point being that you asked the macro level and how it’s trickling down, I think the much bigger impact on each of these businesses is the psychology of what’s happening in the economy as a whole is trickling up much faster than we’re seeing any impact of what Zoom selling for 50 times trailing 12 months or whatever.
Tobias: Sorry, say that last part again. What are you saying in that last little part?
Michael: Yeah, I think that because these small businesses are so much closer to the ground level, we see the impact of the day to day being much more impactful than a trickledown effect from the big markets, if that makes sense.
Tobias: You’re saying that the smaller businesses are much more impacted by the shutdown and by COVID?
Michael: Totally. For that, and then also the psychology. A lot of these folks, it’s hard to value these little businesses. It’s one of the challenges we’ve tried to overcome, is almost every single small software company owner has some friend who read some TechCrunch article that says that businesses are trading for this. And I can just tell you, they’re not. They’re not. Just because one broker does one deal at eight times revenue, doesn’t mean your little software business that’s not growing and is not profitable deserves eight times revenue. I’m sorry, it just doesn’t work that way. So, besides those things on the ground that you’re seeing, there’s also the psychology which is a factor of these things being owner operated, which is very different than the public markets.
Tobias: So, it is an education process presumably with these guys or you can’t get together, bid and ask are just too far apart?
Michael: The number one reason we don’t end up doing a transaction is bid and ask are too far apart, for sure. And that’s okay. If folks don’t have to sell and they wanna get a certain number– I have a friend running a SaaS business that’s in this size that wants five times revenue. I don’t think he deserves it. But he– [crosstalk]
Tobias: And you gotta find one person then.
Michael: Yeah, he’s just gotta make a market of one. So, yeah, we’ve done some white papers and stuff to try to talk to people about what are the things that you should think about, that are impacting negatively the value of your business? Everything from the quality of revenue, to geographic concentration. There’s like 40 different things that can take your business from, say, trading at two times revenue or three times revenue down to trading at one times revenue. Because these people aren’t necessarily in the day to day of valuing businesses all the time, they don’t realize the impact of that on us. But yeah, in the end, it’s tough because we’re trying to educate them from an adversarial place, which is as a buyer. A lot of times, you just gotta move on until you find somebody that’s in the right mindset to do a transaction. So, it’s a messy market for sure.
Tobias: I get the sense that there’s a– it’s an increasingly popular area to be an acquirer, that there are lots of search funds around and there are lots of smaller private equity firms around that are looking to do these small acquisitions. Do you see that competition or is it increasing? What do you see?
Michael: The biggest transition that’s happened is, there’s two. So, one is the number of tire kickers that have come out. So, I’ve just heard horror stories about these search funds. We’ll put in a bid for something and they’ll put in a bid at three times what we put in and I’m just like, “There’s no way that underwrites. No way.” And then six months later, that same seller will come back and be like, “Hey, didn’t work out with those two college kids.”
Tobias: Couldn’t finance. Yeah, we’re back on the market.
Michael: I think the second thing and why I’m very optimistic about this market is unlike VC, when you buy a business and acquire it, you own it.
Tobias: You have to run it.
Michael: You just bought yourself a bunch of problems. So, it makes it very hard for this market to get super saturated quickly. And the other thing you’re seeing is a stratification and a nichefication of the acquirers. So, the stuff we like to buy is totally different than, say what Tiny likes to buy. We don’t compete with them because I think I’ve seen them in a deal once just because we like to do b2b software and he likes to do fire-and-forget-type stuff. And our operating model is different than his operating model, and our financial backing is different than his. Then, there’s probably five or six other players that are figuring out their own little niche, whether that’s developer tools or there’s another one doing e-commerce stuff, we don’t like that stuff, that is also something that’s been happening in the past few years, people nichefying for sure.
Tobias: Are you comfortable talking about how you financed, it was your own money initially? Have you raised outside capital?
Michael: Yeah. We did the first acquisition with our own money. So put our own skin in the game. And then, we use that to raise about $12 million from folks. We had an oversubscribed round last summer that we’ve then used to do that. These businesses are also– you can finance them with bank debt. So, we work with a local bank here that gives us nice terms. So, we’re actually able to lever them up to increase returns and kind of do that from a capital [unintelligible [00:51:37] standpoint.
Tobias: So, you’re looking to conserve as much equity as you can in the acquisitions, put in some debt, the business, so everyone is a small leveraged buy, do they expect it to pay it back or you don’t you don’t mind, they can carry the debt for as long as they want? How do you think about the financing?
Michael: That’s part of the power of our model because we’re a C-corp, we’re borrowing at the C-corp level. So, we get better borrowing because we can accumulate all the debt together, we can actually also add together the profits to enable us to borrow better. And we’re at the level now where you get over that EBITA hurdle where you can start to go to the big national banks and not just necessarily do the small business type loans. All that’s been really good.
In terms of thinking about it, we borrow at the top level but then we think about the leverage on a deal by deal basis. And we’re typically doing an appropriate level of two to three turns of EBITA in terms of borrowing depending upon what makes sense for the business and their history and stuff like that.
Tobias: Do you expect to do more capital raisings on the equity side or do you think it’ll be self-financing at this stage?
Michael: Yeah, so the inflection point is coming up to where the self-financing happens in the next nine months or so. Some of it is just watching and seeing what’s happening. Right now, we have cash in the bank and we’re still working to deploy it. So, yeah, we’ll see what happens, but right now, we’re not fundraising.
Tobias: That’s a nice place to be, particularly given where the market is.
Michael: For sure. It also really helps with recruiting because a lot of times we’re recruiting people who have been laid off from startups or high-risk ventures, and we’re like, “Hey, we’re profitable and here’s our bank account.” And it gives us a set of people that are interested in working with us that have been burned by stuff falling apart and whatever. It’s part of the crazy idea we have in tech to actually make profits. Who knew?
Tobias: Any final thoughts, Michael, anything that we haven’t covered that you’d like to discuss?
Michael: No, I was actually kind of nervous about doing today. You’re the first podcast I’ve been on where I’ve read your book. So, I really enjoyed it. But, yeah, it’s turned out to be well. Thanks for giving me an opportunity to talk about something I’m really proud of.
Tobias: My absolute pleasure. It was absolutely fascinating. If folks want to follow along with what you’re doing or get in contact with you, how do they go about doing that?
Michael: Definitely, check me out on Twitter. It’s in @mgirdley, so M like Michael, and Girdley, my last name. I have really gotten into Twitter, especially more since COVID started. I’d love to connect with folks there and hear what you think about what we’re doing.
Tobias: And your website, Dura Software?
Michael: Yeah, dura.software for the company, you can keep up with us there.
Tobias: Your personal blog for the system?
Michael: Yeah, it’s girdley.com. G-I-R-D-L-E-Y dotcom.
Tobias: That’s fantastic, Michael Girdley, Dura Software. Thank you very much.
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