Building Free Cash Flow
Building Long-Term Mindset
Since reading William Thorndike's The Outsiders and REQ Capital's white paper, I have become an active investor in serial acquirers / holding companies in public markets with my capital. I always wondered if other companies are like Berkshire Hathaway. To my surprise, many great compounders are not just innovating and building their internal operations but also very methodically applying the investing and acquisition strategy to allocate capital. This has made me conclude that every great CEO must be a good capital allocator/investor. Just running operations and investing in your R&D is not the best way to create long-lasting impact and financial returns.
I wondered the other day why so many startups continuously raise capital. Why not build a cash flow engine within the company or acquire it and use it as a source of capital to fund their long-term value creation - R&D and operations for their core business? This is something I believe VC funds can also adopt - rather than continuously raise capital, why not make a few business acquisitions purely for free cash flow, not for growth, and use the free cash flow from the business to act as an LP to the fund? Something similar a startup can adopt, for example, at the Series A stage, the CEO puts 20-25% of the pot into 1-2 acquisitions that generate free cash flow and keep it decentralized and uses the rest 75-80% to fund the R&D and operations of the startups. That 20-25% investment for acquisition can generate a yield that can fund the future operations of the startup, potentially allow the startup to reduce dependence on financial investors in the future, and possibly eliminate the need to raise Series B. The current issue in private markets is that VC funds have funded abnormally large rounds, and the CEOs of these startups have barely thought of building well-rounded companies with strong business and investor fundamentals. The more I think, the more I realize it is up to the CEO to be a master capital allocator. There is no right or wrong answer, don’t follow the fad of YCombinator or silicon valley bullshitters like Elon Musk, who are now digging their own grave by converting their companies into meme stocks, and many of these VC-banked companies that apply blitz scaling principles are not fundamentally strong businesses - they break the culture, society, and nature.
Instead, look at masterful capital allocator CEOs like Mark Leonard and Henry Singleton. Henry Singleton grew sales from $4.5 million (1961) to $1.2 billion (1970) in 10 years—270 times purely through acquisitions. By the end of 1965, he had acquired 34 companies in total. By the late 1960s, he had acquired around 124 companies in its first decade.
Essentially, all great compounders - whether tech or non-tech companies - need to master capital allocation and, as low reliance on debt (liabilities are bad), avoid new equity issuance (avoid dilution) and should focus on optimizing free cash flow. Whether it is SoftBank, Google, or Berkshire. If Google's executive team learns from Constellation Software, they can become a better company in creating value. It has beaten almost every damn technology stock - operates through strategic acquisitions of vertical-specific software firms, leading to consistent 20%+ annual returns.
In a way, SoftBank was also doing the same thing—it acquired, built, and invested. Masa Son built a free cash flow machine by continuously producing free cash flow through an acquisition and building engine.
All these companies build, acquire, and invest—either do it from day 1 or evolve to do it in the later stages of their maturity cycle. Hence, I believe every company CEO should learn capital allocation principles. They should not fool themselves by following a visionary tech CEO but see themselves as value investors at the same time - marry the both tech and the capital allocation of value investors like Warren Buffett. At the same time, their free cash flow is their fundraising strategy.
Sign-off for humanity,
ST
Mail me at » sagar@firstfollowers.co
Note: These are my personal opinion.