Edward Robson - Capital Allocation in Technology

Speaker A: Foreign. The Cloud Returns podcast covers all types of software investing, whether seed, venture capital, growth, equity, private equity, debt, and even the public markets. Really happy to have Edward Robson on the show. He's partner and chief investment officer at 2717 Partners. I've been trying to get him on the show for three years and I'll let him introduce himself.

Speaker B: Thank you, man, for having me on. I know it's been a journey to get here, but excited to finally do my first podcast and I'm glad, um, that I could be with you.

Speaker A: So kind.

Speaker B: Well, yeah, for me, for context, like 2717 partners, like, you know, I think at its foundational level, like what does it represent? Like 27:17 stands for Proverbs. 27:17 in the Old Testament was iron sharpens iron, so one person sharpens another. And so I thought it was pretty critical that that be kind of the name on the door when you walk in every day to remind you that your goal is to not only create partnerships, but also improve things that make them better. And I think in order to do that, a good sense of self awareness is pretty critical and just a very direct focus on the truth instead of calling balls and sprites. And so we started our firm a couple years ago and we're primarily focused on a couple of different sectors, one of which is technology. Which is the reason I love technology personally is that it's a continually evolving term, right? Like what technology was considered 20 and 30 years ago. So much has changed. It's a constantly evolving landscape. And for someone who is first and foremost a student of investing in business, it is something that is perpetually changing. And so I think we're in an interesting time right now with AI and everything that's come with that and all the downstream, not only short term, but potential long term impacts of this new emerging technology. So technology is kind of like the biggest area where we focus, but we also focus on areas that are technology enabled, whether business services, healthcare or payments. And so that broad focus allows us to perpetually kind of find new and interesting opportunities. Having a lot of breadth in terms of what we can focus on is really exciting because certain pockets and certain end markets can become more interesting and more attractive at different times than others.

Speaker A: That's awesome. And one thing I wanted to cover on the show and you know, having gotten to know you a bit through our own network, is you're very thoughtful about ROIC return on invested capital for most people, but you even have a proprietary version of that and capital allocation in general, which surprisingly is Often underlooked. I remember when Dave Juan from Tide Mark was on the show, he talked about roic and we both kind of took a step back and are like, you know, how often, and this was 2024, 2023, you know, how often do you really see ROIC in equity research in the dialogue about software? And so I think this will be uh, a great opportunity for our guests in the show to have someone who cares about and lay out your framework.

Speaker B: Yeah, well, I think it's a great question. Dave Yuan is an amazing investor and I'm a huge fan of kind of his research that he's put out there. There's a lot that I continually learn from people like him who are just so willing to put themselves out in the public and like, here are my thoughts. Take it. You know, like it or not, like the goal is just to put thoughts out there and get pushback, right? Because that's ultimately how we get better. It's not only investors, but operators and individuals. And the goal is just perpetual. You know, I think one of the benefits for people who have a different background where they have focused on different sectors is at the end of the day a lot of um, the applications can be transferred into other industries. And so, you know, I'll take go back probably 10 years to when I did some industrial manufacturing investing and I did some restaurant investing. And so we'd always be sitting there with these interesting capex opportunities. Hey, we could buy a transformer. We could, you know, do this in house and it cost X, but it'll reduce our, you know, it'll improve our earnings. And so you do the math based on like your entry or exit multiple. And it's like, well, this is a home run deal. We should spend this below the line and then improve ebitda. Same thing at a restaurant. Like there was a company I worked with where we were a fur team franchisee. And when you go look at a new building, a new location, you know, you look at similar metrics that, you know, you look at in software, right? Like what is the payback period? What is the time to break even? And you see particularly when like gross consumer amazing payback terms on those capex investments. And so when you think about like what we call Royka, which is return on intangible capital allocation, we try to come up with like a framework and a way of just thinking through how are software businesses and technology business by and large, like how can they invest through the P and L, which by the way also carries with it tax benefit like if you look through, because it reduces your tax burden. But if you look through Amazon, like my father who was an incredible investor, uh, used to always look at EPS and see well EPS isn't very high and it's because they were investing through their P and L and building out their business. And when you think about software and technology, by and large investing in R and D and sales and marketing to go acquire new customers is a form of growth capex. Uh, it's just on the income statement. And so what we try to look for is what is the return on that capital. Also in the context of a couple different things in terms of like the valuation multiple, that's really important, right? Another thing too is looking at like the customer irr. So if your sales cycle is call it a year, how are you really allocating kind of that overhead expense? And you need to fully burden it for sbc. But what is like the true fundamental economic cost of a customer acquisition and what's the duration of that payback? Because in some of these growth hyper growth businesses if you can get customer payback to be assured as possible, that frees up more capital to be reallocated for more growth capex with P and L. But I think more importantly than what uh, is your return on invested capital, particularly like how we frame it through the ROICA lens is the underlying product. So these investments are even better on a longevity and value creation perspective. It's the durability of uh, the customer and the product is really hot. And so I think a lot of investors look at uh, like gross retention or logo retention. I think there's pros and cons of looking through that lens. But the way that we prefer to focus on is through the contract renewal rate. Because effectively if 95% gross retention is what you achieve every year, but your typical contract ratio is three years, right. That could infer that your contract renewal rate is really closer to 85%. But I think more importantly and just taking a step back, what is recurring revenue? And I think fundamentally the way we approach it is by viewing it as a bond. It's a highly durable, highly free cash flow generative bond. And from there assuming you can get to that level, you could really take a step back and focus on okay, well great, how is the capital being from this bond being not only generated but also reinvested. And then that's when you start to go below the contribution margin line and really get into what is that capital allocation focus.

Speaker A: And when you get into like, you know, like the product and the Grr. And you know the guy we mentioned earlier, Dave Wan, they've done some great stuff on multiproduct in house. We were just doing some benchmarking and kind of works out that like multi product you can see a uh, 400 to 500 basis point grr spread and then even more so on the NRR side. But anything more that you have there on kind of going multi product, evolving the product within a capital allocation lens.

Speaker B: Yeah, I mean I think I could go on for a very long time about this. Uh, I think that's what people are here for.

Speaker A: That's what people want. They want to hear you.

Speaker B: I mean, I think at the end of the day, like, let's just focus on like vertical specific companies for a second. I think because there's so much context and nuance if you break it out between, well, is it horizontal, is it infrastructure, is it vertical, is it enterprise versus SMB? Like there's a lot of puts and takes and so everything is really contextual and situation specific. So it's tough to like lay out a very simple framework. But I think the benefit with hindsight that we have over not only experiencing and observing historical technology cycles, but also m even just events that have played out in the past 10 years that a lot of companies were vertically focused. You know, they're focused on primarily kind of the penetration because if you have a high durability bond, it's a land share graph. A focus on market share is really important. But over time as that market gets penetrated. Right. You kind of work through the early stage of the do your uh, tack goes up, you end up just with different incentive structures having the sales team identify customers that may not be longer term. And so your retention rate actually can go down. And so if your retention rate goes down and your cost of customer acquisition is going up, your unit economics can quickly turn. And so from our point of view, and this is just one man's thoughts, having uh, the ability to forecast out years in advance when you can really, you really need to lean on. Multi product is more important than ever because at a certain point your largest growth factor is going to be maximizing wallet share within your captive customer base. And if you just look at it on like a direct cash flow perspective, a dollar of spend from an existing customer is way more profitable than than a dollar from a new customer. And with the added benefit as you hit on um, improved retention. Right. Like multi product is a great way to expand. But more importantly than just being multi product is moving horizontally within an organization. If you could expand from we're just off as a CFO into an adjacent area of your business that increases stickiness because in order to remove a vendor, you then need more consensus for multiple departments. You no longer want to use this application and so you become more ingrained within the daily user workflows of your end customers. And it just leads to a more durable bond for sure.

Speaker A: And then, you know, one dynamic that's impacting everything and it's going to impact capital allocation product is AI. Um, I know AI changes some of that in terms of what you can do. The surface area a company can cover just as much the amount of competition you're going to see in any given product area. So do you want to help transition the show a bit to like in the age of AI, how you see some of these topics evolving?

Speaker B: Yeah, I mean I think we're still early on AI. I think we try to be grounded in what's been proven today and then take that forward and see how that rate of change is accelerating. I think you have seen over the past six to nine months significant improvements on what the output is and that could continue to improve at ah, an even faster rate. But I think the most important thing is to be grounded on what do we know today. And I think what's really critical is thinking through historical case studies right at the end of the day, technology has consistently proven out to improve workflow efficiencies, replace manual labor and accelerate generally daily workflows for individuals across organizations. Right, right. It's the technology surplus capture. Like this isn't the first time any of this has ever happened. You know, it was interesting. Like at our, in one of our letters we, we sent last year, we talked about how rpa, right. Like that was an automation tool that got a lot of traction. Ultimately it wasn't exactly the home run that everyone thought it was, but it was a very compelling technology that did exactly what we're talking about here with aott to an extent I think secondary to that, you know, low code, no code. You know, that is a thesis and something I've been working on for a very long time. I love to kind of create stuff on my own. And so I was deep in Airtable and deep in all those applications using Zapier, like trying to build stuff on my own. At the end of the day, you know, that kind of product did not end up being end all be all that people thought as we just saw with bending spoons. Acquisition heritage. And so, you know, those two case studies or examples are references of um, technology perpetually builds on a prior generation of innovation. And so what we're seeing today is super powerful. But we uh, also haven't gotten to the point where we truly understand what the return on that investment is. And so we're very cautious about how we think about it in the future and are very kind of open to a myriad of outcomes. And I think it's just being grounded in the truth of today and not allowing the uh, hype exceed expectations.

Speaker A: That's a very good thoughtful feedback. And you know, it kind of might be more in line with the hype is and I, you know, for everyone's benefit. A lot of Edward and his firm's investment coverage is around small cap and midcap public equities, but have a broad mandate. And in that context, as a publicly traded company, let's assume it's one that's more exposed to AI or AI threats. You're going to face some hard decisions of how to pivot, how to double down, how to reinvent yourself. Could you talk about, you know, just theoretically, how you see that dynamic playing out for public companies in an AI age, like making tough decisions, decisions, how management board of directors approach those, those transformations. I know it's a uh, loaded question, but would love to get your thoughts.

Speaker B: Well, I'll approach it from two different schools of thought. First, I think a strong understanding of intrinsic value is really critical in understanding what business are you really in. I think that's first and foremost something that a lot of people need to get their heads wrapped around. And I can assume and easily understand that the world's changed really quickly. Right. If you go back five years, software companies were trading at 20 to 30 times revenue. In that world, every capital allocation decision you made was real. You hire a salesperson and they pay for themselves within six months. Great. They just brought in over seven figures in revenue and you're trading it 20 times. That's an accretive hire. The cost of capital is lower. I think right now how you react in these situations is really critical. And you can't just make short term decisions. You have to have a balanced short and long term approach. But getting your head wrapped from what is the intrinsic value of our business is really critical to then making informed capital allocation decisions. And it's a really tough thing to do. But at the same time it's imperative that people really look deep and reflect and be honest. And the second part is really thinking through where is there the opportunity and viewing that through the lens of uh, what we know to be proven today, in my perspective on what we view to be true today is that coding capabilities are better now than ever for a layman like me. And so when you think about, I always love naval's form of leverage, one of which is coding. And you know, when you have the ability to do more with less, you can choose to do two things, do more with less or do more with more. Typically human beings and individuals have a growth mindset and we want to do more. And so I think what you're saying is huge investment in trying to do more with more until you can't do anymore. But if I think about first and second order benefits, I mean obviously we've seen some infrastructure benefits. Businesses with consumption and usage models have seen a lot of growth. There's a great book called Guerrilla Game and walks you through during technology cycles. Where do the impacts show up first? It's amazing and this is why I always tell people just read books about the past because history does ride and it will repeat occasionally. But if you think about taking it back to the fundamental approach of technology, uh, allows you to do more with less, I think we can all say that AI has proven out to be 100% true. And so there's a lot of independent software vendors that, and this is a theme I've been working on for five or six years that built a vertical application and then they outsourced edge cases and minor point solution functionality to third party developers who um, would build more features, more functionalities for very specific uses. And it was a mutually beneficial relationship because obviously the unit economics didn't make sense to have a bunch of engineers working on building out that functionality. But at the same time adding that incremental feature functionality to the product increased the stickiness of the tension of the business. And so, well now with AI, right, the ability to do more on the coding side with less means that there could be very near term opportunities for you to just go and build that and then capture that incremental revenue for yourself. And I think that's just one of the areas with what I can say, uh, assuredly has been proven that you could see kind of that happen. But I think more importantly taking a step back like that is effectively vertical workflow integration. To the earlier comment, like the consolidation of manual workflows with the benefit of technology is a recurring trend over every cycle. And so this is just like the fundamental lesson, um, from historical technology innovation. And it typically is indicative that we could be entering another wave of solid.

Speaker A: So as you think through these like transformative investments, the capital allocation, the product decisions. Like what are some patterns you've seen in management teams that do this well, that understand these issues well, communicate it well and can get buy in to pursue some of these decisions?

Speaker B: Yeah, I think the strongest people have, uh, a firm understanding that there's not a demonstrative proven benefit yet. I think self awareness is the most important thing. A lot of capital is being allocated. I don't think we've really proven that there's a return on that strategy yet. I think technical founders, technical leaders are really important in this day and age because there's a gap in terms of what we can prove today versus what the expectations are. Again, it comes back to expectation setting and the more closer you are to the progress to the work, the more aware you are of. And so, you know, generally speaking, you know, a lot of people are on podcasts talking about the impacts of AI and they're not as close to the work. And so people who are closest to the work in the most informed typically can make the best decisions.

Speaker A: That is a great call out. It's a very tangible takeaway for people. And I tend to agree, particularly for some of these topics. It's just theoretical is one thing. It's a whole nother to be locked in on your laptop inspecting what you get, you get what you inspect. And that rings true especially so in AI. And then as an investment related podcast, one thing I've been a bit surprised by is just observing the markets is relative to the size of these markets and the valuations, how few IPOs we have in software. Do you have any perspectives on why and if that should be any different?

Speaker B: Well, this is a very long topic that's near and dear. I started my career more than 15 years ago in vertical software investing and then doing what are now called roll ups within like business services, healthcare services. And so it's been fascinating like firsthand to see how private equity specifically has transitioned from like a niche investment strategy into a mature asset class. Like we're in, you look at where we're at in the cycle, we're in the consolidation wave in like the transition to an asset business model. You know, a lot of the institutional asset classes have been tapped out on their private equity exposure. And so you're increasingly seeing a narrative around trying to get access to retail and high net worth because it's an untapped TAM for alts. But imagine also like, I mean I'm in San Francisco and the venture capital ecosystem on a relative scale to private Equity was very small for a very long time and the amount of capital that is flooded into it over the recent years is significant. And I think venture and grow is undergoing the same transformation and is following the exact same roadmap right now. If you look at a lot of the themes that are really getting traction within venture and growth firms, they are more capital intensive problems to be solved, right? Defense technology. I mean the LLMs are consuming a ton of capital which is aligned with the incentive for venture growth. As they make that transition into being asset managers, you're seeing a ton of capital being allocated towards venture firms to go do buy Alice and kind of infuse AI into the business. And so if you're sitting there and you're a uh, GP of one of these firms like the aum, um tam, uh for the buyout roll up technology, uh and views angle combined with funding more capital intensive problems is disproportionately greater than you know, seed series A and series B. And so the incentive structure is stay private longer, right. That allows for maximum capital deployment in the private markets. And I think the incentive structure is all around the line, right? Like if I was a founder of a business and one of my venture investors offered me a ton of money, don't go public. You know, you keep more control, better employee retention. We can fund an annual buyout of employees that want a tender and you don't have to worry about quarterly reporting requirements. It's a good deal and I completely understand it. I think at the same time the gold standard for a good venture and growth investment even five years ago was an ipo. It was an IPO and it not only was an ipo but an IPO and a company that continued to grow and had a great stock. And I think to be fair it be balanced. That's why I always to be balanced. But that was money that those investors left on the table and I think they realized they were giving up a great opportunity by going public. And so I think what you're seeing today is really maximizing price discovery in the private markets before going public. I think there's an ever growing demand of retail investors that are very interested in buying tech IPOs and it's working. And so it's tough for me to make an argument that it should change from the incentive structure. Like personally I believe that the public markets are the only place for the average American, you know, with their 401k, whatever they have to really invest in compound. And I think we need to uh, have more access to these High growth companies in everyone's hands.

Speaker A: I tend to agree with so much of that. And all of those incentives make sense and yeah, how quickly certain things have evolved in terms of these. A lot of these private companies, at least the top 20, top 40 of them, are functionally liquid or liquid enough. And uh, there's all these secondary transactions that, you know, what we thought of an IPO or rationale for the IPO has certainly changed. Personally, I would like to see a bit more of them. Like the, uh, software public company universe, just from, you know, our viewpoint is smaller than it should be. When you think about how important this sector is and how many of these highly valued companies are out there, I think we could use a few more on the markets. And then just one broader question because one thing that's interesting about hosting a show like this is you kind of find out who listens to it. And one thing, you get some private feedback, private Q and A from some relatively prominent folks. And one thing we've learned is people really like the opportunity to hear from investors. Right. For a lot of operators or similar, the investment world is opaque. Not always as transparent as many of their sectors are, and just a natural degree of fear, right. But once they hear something from somebody like, it opens their eyes and makes things a lot more understandable. And so one particularly for you with how thoughtful and how you approach things is how do you assess a CEO?

Speaker B: Self awareness. Self awareness is the most important thing. You know, I think we're talking about, you know, the IPO market, uh, what are the benefits of being public? You know, I talk to probably a handful of, uh, CEOs who are thinking about going public every month or quarter and try to again present like a very balanced perspective. What is the reason to go public? And it all comes back to capital allocation, right? A sense of self awareness. What have you built, what are you building, where are you going? And then what does the opportunity set look like in different scenarios? And I think those are the founders that in the leaders. Not everyone's a founder that's in the CEO, uh, seat, but those are the leaders that want to be in the arena. And I think the public markets is the arena. It's a higher stakes arena with more pressure. But generally the CEOs that have the best outcomes want to take on the challenge. And the understanding of what's the reason to go public can unlock a lot of value creation. One of the reasons that I predominantly make the CEOs is that you get access to a lower cost of capital, a lot of these late stage rounds have a lot of structure and that's a higher cost of capital, in my opinion. And so raising capital that's pure common in an IPO can unlock a lot of opportunities. Because if you think about focusing on short and long term return on invested capital, if you have a lower cost of capital, that opens up the opportunity for things that you can't do. But at the end of the day, it requires the three Cs commitment, confidence and communication. And you need to have a good story for why you want to be public. Otherwise, if you're just looking for liquidity, it's going to be a tough slider.

Speaker A: That's a phenomenal answer. That's so true. The standard is so high and the markets have evolved in that also. The surprising thing is the liquidity environment or liquidity requirements in terms of the scale and market cap. You need just through some market structure changes in terms of trading volumes, equity research and the like, that's getting a little too arcane relative to your phenomenal and very thoughtful framework. So look, this has been a phenomenal episode. Love all of the frameworks, all of the thoughtfulness. Not a surprise. And it's a nice reward for spending three years chasing you down. So really appreciate having you on the show and thank you again.

Speaker B: Well, thank you for having me. This is, uh, fun.