• Mike Rozenfeld

Capital Allocation: Buy vs. Build

As an investor and operator of software businesses, the question of capital allocation efficiency is routinely revisited at the executive meetings and in the board room. As is true with most complex questions, there is rarely a simple answer or formula that one can apply to get the best answer.

Operators are usually dealing with incomplete information. In fact, they are in the position of executive leadership precisely because of their ability to make difficult decisions, while faced with less than perfect data. The question of how to spend capital most efficiently is no different. On one hand, there are always operational improvements and capital expenditures that seem imperative and mission critical at any point in time. CEOs tend to focus inward on the company and its ongoing issues. I have never met a CEO who didn't have something to improve in their business: hiring a couple of additional engineers or account managers, investing in a new lead generation platform, migrating to a commercial cloud infrastructure, or redesigning the user interface of a flagship product. These and hundreds of other initiatives appear to have the potential to move the needle for your business. Transformative growth seems to be just around the corner...all you need to do is direct capital in the right place and voilà! Alas, too often and hundreds of thousands or even millions of dollars later, we find ourselves not too far from the place we started pursuing these initiatives. These sub-optimal outcomes are not for the lack of trying, but are rather a function of all the many unknowns we had at the beginning of the journey. The VP of Sales with glowing references wasn't able to adapt to your market realities, the new lead gen system slowed down your sales team, and the code your new engineers shipped ended up conflicting with the legacy functionality. Just consider this frightening statistics: based on Inc.'s magazine research, 46-50 percent of hires are considered failures by the time they reach the 18-month mark, irrespective of the hiring process and methodology used.

Investors, who never spent a day in the CEO's shoes, tend to favor M&A and assume all sorts of synergies and economies of scale. These synergies shall all materialize, as if by a wave of a magic wand, while the ink is still drying on the merger agreement. However, the Excel models and beautiful charts cannot account for the all important "soft" components of making any highly integrated merger work. Based on the research from McKinsey and KPMG, anywhere from 70% to 83% of mergers that assumed integration driven benefits failed to achieve them. A great deal of these mergers ended up eroding the value of the merging entities and their shareholders. Companies after all are groups of people with varying cultures, work habits, and relationships. The probability of two groups, without a shared history and each with their own idiosyncrasies and dynamics, coming together in an embrace of efficiency is pretty slim.

I have made many of the mistakes described above during my time as an investor and as a CEO. These missteps served as a great lesson and led to the formation of the idea behind Waverock. At Waverock, we care about teams and cultures. We understand that organic growth in a niche vertical enterprise market is hard. We appreciate the complexity and uncertainty of integrations. We preserve and nurture the agility, entrepreneurial spirit and "can-do" attitude of small teams. We also recognize the undeniable benefits of scale. That is why, our belief is that vertical market software companies need thoughtful long-term capital, patient management, and are best grown alongside each other, reaping the benefits of being bigger without slowing down and acting big.

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