Constellation Software Inc. CSU-T has a message for Canadian venture-capital backed software companies that are no longer on a trajectory to reach US$1-billion “unicorn” valuations and struggling to raise funds: Come join our galaxy.
The acquisition machine, one of Canada’s most valuable companies, usually buys businesses from founders or large corporations. But it is now also “looking for venture capital-backed businesses that did not live up to investors’ or founders’ expectations, companies that are running out of options,” said Farley Noble, senior vice-president of Constellation’s large investment group, in an interview. “We would like to help them.”
He said ideal targets generate US$20-million-plus in annual revenue and have raised US$50-million or more in venture capital: “They probably took off like a rocket ship with all that invested capital, burned through all or most of it and now can’t keep fueling that growth. These are going to be challenged businesses that are either breaking even or not profitable.”
It’s a new endeavour for Constellation, which has bought about 1,000 small companies since its founding in 1995. It targets “mission critical” software providers that serve niche subsectors, or verticals, such as golf courses or public transit providers. Its six subsidiaries typically buy companies with US$2-million to US$10-million in annual sales, modest growth, a high degree of recurring revenues, solid cash flows and operating profits, and preferably few rivals. It never sells them.
Constellation’s long track record has earned it a reputation as a top-notch capital allocator, and media-shy president Mark Leonard has drawn comparisons to Warren Buffet. The company’s share price has appreciated by 38 per cent annually on average over the past 15 years and another 14 per cent so far in 2024. (Mr. Leonard, stopped taking any compensation and transferred control of most of his shares to his children in 2015. His remaining stock is worth $1.6-billion.)
Now, it is Canada’s 13th most valuable publicly traded company, worth more than Canadian Imperial Bank of Commerce CM-T and Suncor Energy Inc. SU-T Revenue last year reached US$8.4-billion, up 27 per cent from 2022, as free cash flow jumped by 36 per cent, to US$1.16-billion. Net income rose 10 per cent to US$565-million.
But some investors have wondered how long Constellation can keep up the pace. It spent US$2.6-billion on deals last year, up from US$477-million in 2020. Ernest Wong, head of research at Baskin Wealth Management, has estimated Constellation must increase that to US$8.2-billion by 2029 to maintain 30-per-cent growth.
“This is a company that, despite its size, still puts up strong and respectable cash flow and operating earnings growth,” said Thanos Moschopoulos, a BMO Capital Markets analyst. “The main risk an investor would have to consider is at what point might its growth rate decelerate” as it expands.
Constellation was already struggling to find enough to buy by the late 2010s and paid out surplus free cash as special dividends. Some board members felt Constellation could earn better returns than its investors by deploying that extra cash itself.
So in 2021, it ditched the special dividends and widened its scope, recruiting Mr. Noble, a Constellation veteran who had left in 2018, to lead a new large acquisitions group. Constellation lowered its expected returns on deployed capital for larger deals so it could better compete in auctions.
Constellation has since made several big purchases, paying up to US$700-million to buy sizeable businesses or units carved out of giants such as Nokia Oyj. It has spun out two companies into TSX Venture Exchange-listed entities – Topicus.com Inc. TOI-X and Lumine Group Inc. LMN-X – each worth billions of dollars.
Now, Mr. Noble hopes to also convince venture capitalists to sell to Constellation. As interest rates rose in 2022, many fast-growing software startups hit a wall, slashing costs to preserve cash. That, plus an uncertain economy, stunted revenue growth. Valuations crashed, public markets all but shut for new issues and many venture-backed companies struggled to raise money to fuel expansion.
Venture capitalists now have some zombie companies in their portfolios that likely won’t command the rich exits they once anticipated. That’s where Constellation sees an opening.
Mr. Noble said the company is looking across North America but hopes to make the first deal in Canada, figuring a few business-to-business software vendors here could be a fit. Constellation will start contacting prospects this month. He said Constellation does not expect to pay the kinds of higher multiples that healthier, faster-growing companies command.
“We’ll go out, see what fits, what the appetite is,” he said. “Some founders will say, ‘This is not for me because I’m chasing that IPO, the unicorn status.’ But there will be enough that say, ‘Okay, I’ve tried this and now I see a good home for not only the business, but an owner that can bring a culture and infuse learnings.’
“We want to see Canadian companies succeed, and we think in the Constellation family we can help them do that.” Mr. Noble added: An acquired company “will never be sold again so it will live on indefinitely. That’s a positive story.” Brookfield Asset Management and Sequoia Heritage are also looking to buy stalled tech companies through jointly-owned Pinegrove Capital Partners.
Mr. Noble stressed this was not yet a strategy but “an experiment,” as Constellation continues to primarily buy small companies at a brisk pace. It’s not the only way Constellation has ventured beyond its core focus. Mr. Leonard has expressed interest in looking outside the company’s comfort zone for deals and even explored deploying US$1-billion into the oil industry when prices crashed a few years ago.
Mr. Leonard, a former venture capitalist, has also been keen to increase Constellation’s organic growth rate, or revenue expansion from existing businesses, now in the mid-single digits. He’s stated that the company’s deal prowess has come at the expense of organic growth, as talented employees were drawn to work on pursuing transactions.
So, in 2021, Constellation launched VMS Ventures, a US$200-million venture capital fund to finance entrepreneurial employees keen to launch high-growth startups that it would control. Subsidiary Volaris also backs outside startups through its Venstra Ventures arm. The two units have collectively backed 20 startups.
