In this next iteration of the Capital Allocators series, Matt sits down with Brian Henley, Managing Partner of Recurring Capital Partners to discuss his business and the work that they do with SaaS (Software as a Service) companies. They begin by discussing Recurring Capital Partners and how they work with SaaS companies who are looking for growth capital. They then move into the business of SaaS and the massive changes in the industry that has taken place in the past decade. They also delve into how Recurring Capital Partners evaluates companies that they are considering for growth capital including looking at predictable recurring revenue, a sticky customer base and high growth margins. They finish the discussion on the topic of metrics, sales strategies utilized by software companies and when companies should take equity vs. debt capital.
Episode Transcript
Brian Henley 0:00
I think that in the industry what, what people found when, when push came to shove,
companies were paying their software bill before they were paying their rent.
Matt Waller 0:11
Excellence, professionalism, innovation and collegiality. These are the values the
Sam M. Walton College of Business explores in education, business and the lives of
people we meet every day, I'm Matt Waller, Dean of the Walton College and welcome
to the Be Epic podcast. For next few episodes, I will share my conversations with
capital allocators in the seed, venture and private equity space. They will discuss
how their capital allocation works, and provide tips to entrepreneurs on how to stand
out. I have with me today. Brian Henley, managing partner at Recurring Capital Partners.
Brian has a remarkable experience that- he went to school here as an undergraduate.
And he started his career with IBM in sales. But throughout his experience in his
career, he has been very involved in mergers and acquisitions. And, and at one company,
he was involved in five acquisitions, and exits. And he really became very knowledgeable
of SaaS based company SaaS stands for software as a service and the cashflow capacity
of those kinds of companies. Brian, thank you so much for joining me today. I really
appreciate it.
Brian Henley 1:42
Thank you, Matt. Happy to be here.
Matt Waller 1:44
This is part of a series on capital allocation. And typic- typically, when you're
thinking about SaaS companies that are trying to scale, they're typically talking
about, you know, venture capital and seed funding and those sorts of sources. Your
company focuses on providing debt to those types of companies. Tell me a little bit
about the history of that how you got into it, and why it's important for SaaS companies.
Brian Henley 2:16
Sure, so recurring capital, we're about a six year old firm now, investing out of
our third fund, worked with about 40 companies in the SaaS world, all over the country,
including one in Fayetteville there. And we are in the kind of growth capital part
of the finance world. So you have seed funding, venture capital, growth capital, and
then private equity. So most of the companies we work with are between five and 20
million of revenue, and are looking to grow their customer base, but they have an
established product, and established customer base. You know, throughout my career,
what what I've seen is in, especially in the software space, the business model has
really changed from the beginnings of the software industry, back when I was selling
software at IBM, many, many moons ago that the industry was founded on a license maintenance
model, you would create software, and you would sell a perpetual license to that software,
essentially ownership of that software to a company where you got most of your money
up front. And then you would charge a small annual maintenance fee after that. And,
you know, 10 or so years ago, the industry switched over to more of a subscription
model hence, software as a service, where companies are essentially renting the software.
And you know, you can think about it as you're a consumer, all of the kind of monthly
subscriptions you have from Netflix to Spotify. So what that's done if you're a software
business now you have a lot more predictability of your cash flows and you're driven
by predictability on the revenue. So now what's your revenue gonna be in any quarter?
It really is very predictable based on how many customers you start the quarter with.
Minus you know how many you're gonna lose in that quarter. What you find today in
the software world. If you have a customer base that has some stickiness to it, which
is our term- term for you know, are the customers gonna continue using the software.
If you have a sticky piece of software, there is an underlying asset there that there
are a lot of acquirers of that business, because you can generate a lot of cash flow
out of that business, what that's doing is, it allows you to retain a lot more ownership
of your business to probably someday sell that business or cash flow and dividend
yourself versus a bunch of other investors receiving the benefits of what you build.
So it's an interesting evolution in the capital stack of these businesses, and has
created, you know, an opportunity for a firm like ours to, to be a an active source
of capital for for software companies that really didn't exist 10 years ago. But fundamentally,
what, what supports our business and the software businesses, the thing you have to
understand is, businesses hate to change their software, which has been true for 40
or 50 years in the history of business software. And so that that kind of underlying
friction of companies changing software allows for quite a bit of stability, which
is what creates a lot of value in these businesses. And so we're, we're part of a
source of growth capital for a bunch of really interesting companies, none of which
probably most of the audience would have heard of, we're not we're not financing consumer
related businesses, but more fundamental back office or, you know, kind of vertical
software, businesses, and but, you know, it's part of what makes the world go round.
And part of the productivity that you're seeing in every industry, the digitization
of every business out there, doesn't matter whether it's a railroad business, or a
high tech manufacturer, every business in the world right now is, is being changed
by software. And it's underpinned by a lot of innovation that's coming from entrepreneurs
in the software world that are solving problems that used to be kind of managed with
spreadsheets and you know, homegrown systems. And now people are building kind of
custom SaaS software that's solving some very niche problems in a lot of different
industries.
Matt Waller 7:44
It reminds me of that one of my favorite articles in The Wall Street Journal, by Marc
Andreessen, 10 or 11 years ago, was called "Why Software's Eating the World". I don't
know if you remember that, pretty famous article. But yeah, you see it in all industries.
So let me ask you a couple questions about firms. I understand you, your you look
for firms, with recurring revenue streams, like SaaS companies. And I see the analogy
to commercial real estate, do you have any guidelines around firms that you will provide
capital debt to based on how they've been financed up to that point?
Brian Henley 8:41
Yeah, we're unusual in that we, we don't really look to the existing investors or
shareholders to be there to provide additional capital in the future, we kind of assume
that's not going to happen. So really, what we look for is a management team that
that has a pretty big stake, equity stake in the business, so that they, they would
be willing to make tough decisions like cutting costs, if you know, we have a big
recession and you know, a lot of companies right now are kind of struggling with are
we, you know, should we keep investing in sales and marketing as much as we have been
because are our target customers are they're going to be making purchasing decisions
right now in an environment where everybody's getting conservative? You know, debt
financing becomes the first money out when there's a liquidity event. So the key is
for, for an entrepreneur or ownership team is to make sure they they have more value
than the than the debt on an exit, if if a company has sold, so you know, the things
we're looking for, as I mentioned, predictable, recurring revenue, we, one of the
things that really determines whether you have a software company or not, is do you
have high gross margins, low gross margin businesses are more difficult to finance
with debt, because you have a lot fewer levers to pull on the expense side. Because
you just need a lot of people to service those businesses. So we're looking for, you
know, gross margins, kind of, in the 70% plus range, which most software businesses
have, which gives you a lot of flexibility in that operating expenses are, are somewhat
variable, below that gross profit line. So sticky customer base, high gross margins.
You know, in our due diligence, what we're always trying to understand is why do their-
the software companies customers need this software? And is it a nice to have or a
need to have, we definitely like need to have software. So, you know, you think about
software, to run payroll for, for a business, for example, you know, a soft sell for
a company that uses soft, a certain set of software for payroll, they can't just say,
I'm not going to do payroll, you got to do payroll, our typical structure is a four
year term loan. And so we always have to assume there's going to be a recession, some
time in the next four years. So we're always looking at, okay, what happens to the
customer base in a recession, for this type of business, and that that kind of makes
us more conservative with regard to cyclical industries, cyclical industries are often
tied to consumer spending, it doesn't mean we wouldn't invest in a business like that,
it just means we would be more conservative, because we have to assume they're going
to lose some revenue in a recession. But certainly, you know, in COVID, two years
ago, it was a great proof point, for the stability of software. There was, you know,
I think the, in the industry, what, what people found when, when push came to shove,
companies were paying their software bill before they were paying their rent. Because
they couldn't run their business without their software, they learned that, hey, we
can actually run our business without office space, which, you know, was one of the
big shifts, but we we certainly found a very stable revenue base in our customers
during COVID in a very disruptive time, and the market we're in today is pretty shaky
I would say, a lot of customers are slowing purchasing decisions. But we haven't seen
you know, people not renewing their software. Because they, you know, are continuing
to run their business, but they're just running them a little bit more conservatively.
Matt Waller 13:33
I know, sometimes financiers will with software companies will look at, they'll take
a set of customers from one year. And they'll look over time to see what that set
of customers does, you know, how many are you retaining? What's the change in revenue
and gross profit and various things like that, on that set of customers kind of as
a measure of switching costs. An indication-
Brian Henley 15:09
Exactly
Matt Waller 15:09
Do you look at those kinds of things?
Brian Henley 15:10
Yeah, we call that cohort analysis.
Matt Waller 15:37
Yeah
Brian Henley 14:09
So you will, you will look over time at, you know, you can do it monthly or quarterly,
or, or annually and say, you know, from the customers they acquired in Q1 of 2020,
how many of those are still here? You know, two years later, and you can kind of build
these cohort graphs to see trends. Are- are the customers sticking around the way
they have historically, you know, we see companies all the time that they're trying
to grow so they're experimenting with new markets. So you know, not their core customer
they started with but they're, they're trying some new customer verticals or our sources
of customers. And you have to be careful because you know, you can spend a lot of
money go on acquiring a new set of customers, but they, they might not have the same
need for the software, and the retention will drop compared to what you had before.
So that's definitely part of our analysis, or anybody investing in the software space
today. You know, and it's not rocket science, again, I think it's, you know, it's
easier to predict these businesses now than it used to be when you were just selling
the software, and people could run it, you know, without really communicating with
you. And now, you know, all of our companies, they're getting minute by minute usage
data, because they're hosting the software. So they see how many users are logging
in. And an indication of are you going to lose a customer is hey wow they used to
have 10 users a day logging in, and now they've only got one. Well, you should probably
go check with that customer, something's going on. They're not using the software
as much as they did before. So there's a lot of sophistication, not just from the
investor side, but from the operating side of this businesses that is really keeping
a very close tab on, you know, what, what is the customer activity? And are they getting
value from the software?
Matt Waller 16:17
So a related kind of thing that's of interest many times in these situations is that
there's lots of ways to measure it but the efficiency of sales where you take, like,
gross part profit, say, and mart- and period two minus gross profit in period one
divided by the amount spent on sales and marketing and period one to kind of look
at how efficient is that? Is that very important to you? Those kinds of metrics?
Brian Henley 16:53
Sure, you know, it, it's a, it's kind of a sister analysis to the retention side,
is you have to, you have to take into account, what is the lifetime value of a customer,
like how long on average are those customers going to stick around, you know, there's,
you know, there's reasons you lose customers, you know, for example, we do a lot of
software, and that companies that sell to hospitals, and, you know, hospitals hate
to change their software, but one hospital system acquires another hospital system,
and they have a different set of set of software they use and the bigger acquirer
is going to say hey you're going to use our software now. So it can help and hurt,
you know, you can have customers to go acquire other businesses and bring them to
you. But you can also lose customers. And so, you know, there's, it's important to
what is the customer acquisition costs related to the lifetime value of the customers
and, you know, we have some companies that, that have annual contracts that are hundreds
of 1000s of dollars a year, and we have others that are, you know, 10s of 1000s of
dollars a year. And if you're selling software to a small business, just by nature,
you're going to lose more customers, because small businesses go out of business and
they get acquired more, you know, there's a lot more churn in an SMB market than there
is in an enterprise market. But if you have an efficient customer acquisition model,
and that, you know, you have a viral word of mouth source of new customers, you're
not having to spend a lot of money, you can support a lower renewal rate. But, and
then conversely, you know, if you're selling big enterprise accounts, you have expensive
salespeople, and you're going to conferences, and you know, there's a lot of expense
around getting enterprise customers, but they tend to be more sticky. Because Johnson
and Johnson is not likely to get acquired, you know, next year, they're, they're probably
more likely to be acquiring another, another company. So selling to those enterprise
clients is more stable, but conversely, it's more expensive. So that those those things
go hand in hand, you have to look at both sides of the coin.
Matt Waller 19:29
I've seen some strategies lately. I just came across this and maybe it's been around
for a while and I haven't noticed it as much but one software service that I use to
analyze something here at the university. A few months, maybe a year ago, they said
look, instead of paying this monthly rate, which wasn't very high, I could buy a lifetime
membership. for a certain amount of money, that was an option that they gave, I took
it, I think it's worth it. They've continued to, you know, upgrade their features
and functionality and, and I really like it, you know, so for me, it was probably
a good idea. But I, I wonder about that strategy are you are you seeing very much
of that?
Brian Henley 20:25
Well, it's, it happens from time to time. You know, if you're a software company and
you, you want to generate cash, you can go to your customers and an offer a program
like that. And essentially, you know, we kind of call that pre pre selling the future.
You know, so they, they get that cast today, but they have a liability, which is to
service you forever. So, you know, in our business that we have to look at that as
deferred revenue. So a simpler version, which happens quite often is, hey, if you'll
pay us up front for three years, we'll give you a 25% discount. So we collect three
years worth of revenue today, but we owe you service for three years. So there is
short term deferred revenue, which would be somebody that sells an annual contract
that you pay up front, so you pay up front for 12 months, that the next 11 months
is short term, deferred revenue. But if you if you collected three years, year two
and three, revenue is deferred revenue. On the balance sheet, which if somebody is
acquiring a company, or someone like ourselves is looking at the p&l of a company,
they might recognize that revenue over the next three years, but they've already collected
the cash, so there's not going to be cash coming in. So you have to do an adjusted
P&L to really factor in what are the cash flows coming in the next three years, that's
what investors are really focused on. And by the way, the- the CFO of that company
needs to be careful of, hey, you know, my revenue is going to be stable, because I'm
gonna recognize some some type of value of your contract over some longer period of
time. But I got the cash today, which is good today, but it's not going to be there
tomorrow. So from a, from a purchaser of software, you know, can be a pretty good
deal. But you have to understand it's, it's a short term cash injection for that company,
that, you know, if they can't kind of continue to generate cash, it could- it could
jeopardize the company in the long term.
Matt Waller 23:00
So, Brian, why would someone want to take capital from Recurring Capital Partners
debt versus equity capital?
Brian Henley 23:11
You know, there's a very valid reason to take equity capital, because they have a
team of operators that are going to help you grow your business, we do a little bit
of that, but it's much more around, you know, the, the financing side of the business,
the, you know, helping helping you manage cash and things like that we don't have
big enough margins to go have a staff of operating partners that are gonna go, you
know, kind of help you grow your business. So that's a difference between equity and
debt. That I don't, you know, I don't disagree that, you know, there, there are reasons
to raise equity capital, I'm not saying but it's, you know, there's, depending where
you are in a business of whether you need that kind of help or not, obviously, you're
trying to preserve your ownership of the business versus selling a piece of it. There's
reasons to bring on equity investors, especially if you have the opportunity to bring
some industry expertise, you know, and not just to help you grow your business in
that industry, but also there there is expertise and how do you grow a software business?
You know, when do you hire a VP of HR and when do you bring on a real CFO versus a
controller? You know, there's a there's a science and ex- expertise around growing
software businesses, you know, it's very different running a 10 person software company
versus a 75 person software company versus a 500 person software company, and there's
different equity investors that have a lot of expertise at those different stages.
And so, like we, we work alongside firms like that all the time, and they can be very
valuable, we can be valuable on, you know, kind of the financing strategy of the business
of, you know, what are the sources of cash, and, you know, my m&a background, I often
helping our portfolio companies figure out when to exit how to exit should you hire
an investment banker? You know, how do you think about strategic investment buyers
versus financial buyers? We do a lot of help with companies on the, on the financial
side of the business,
Matt Waller 25:46
I'll tell you one I thought of closing question is about investors in your company,
you know, how do you find investors? What are you looking for?
Brian Henley 25:53
You know, essentially, I'm running a, I created this business as a startup and I had
to go, you know, find investors. You know, it's, it's fascinating, I mean, I've created
a lot of businesses over time, and this one has been very satisfying, because it's,
it's offering something investors really want, which is kind of a great risk return,
and not likely to lose my money.
Matt Waller 26:31
Right.
Brian Henley 26:32
But I get a good yield. And then it's, it's a great service for entrepreneurs, wow,
you can help me grow my business and get new customers but retain ownership. And in
my more ownership in my business, and so it's very satisfying to find a business that,
you know, there's, there's nobody can really say, you know, that business is terrible,
or you're, you're hurting this business, in- in exchange for growing your business,
it's been fun to, to, to work with both the investor side, and the customer side for
us, which is, which are these entrepreneurs all over the country that, you know, I
used to be an entrepreneur, in, in that sense of building, building a company, and
one of the biggest satisfactions I've had, is to have a half a dozen or so of our
portfolio companies have really successful exits. And the first thing that founders
do, who've actually made a lot of money is come back and say, Brian, can I invest
in the next Recurring Capital Fund, because I know what you guys do, and I know how
thorough you are and, and how little risk you took in our company, because I knew
I knew how much value we had in our company. And so we've had a, I call that kind
of full circle of, you know, helping help an entrepreneur and get get to successful
exit to wealth and then helping them preserve their wealth with with our kind of credit
fund investing.
Matt Waller 28:17
Well, Brian, thank you so much for taking time to visit with us today about Recurring
Capital Partners. Very interesting business, and successful business you've created
that helps investors and software as a service company, so congratulations on this
huge success.
Brian Henley 28:38
Oh, thank you. And I have to tell you, you know, when I graduated high school in Crossett,
Arkansas, I told my dad I, I wanted to go into business. And he was he graduated from
the University of Arkansas, chemical engineering degree. And he kind of gave me a
great set of choices. He said, you could go to any college you want that has a Razorback,
as a mascot, and you can major in major in any engineering degree you want. And so
I got an industrial engineering degree from the University of Arkansas, and then later
got a MBA from Harvard. But I always envied my friends who were during undergrad,
were studying some really interesting stuff at the business school and I was stuck,
stuck quote in the science stuff that was not near as much fun.
Matt Waller 29:46
Well, you're getting to live it out now. So congratulations. Good talking to you.
Brian Henley 29:51
Great to talk to you Matt.
Matt Waller 29:54
On behalf of the Sam M Walton College of Business, I want to thank everyone for spending
time with us for another engaging conversation you can subscribe by going to your
favorite podcast service and searching be epic. B E E P I C.
