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Chenmark Series 2: Ethos and Incentives

This episode is the second in a three-part series we are running on Chenmark, a highly successful small business holding company founded in 2015.

Episode Description

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This episode is the second in a three-part series we are running on Chenmark, a highly successful small business holding company founded in 2015. Today they have acquired 11 operating companies, completed 30+ acquisitions when including add-ons, and have over 600 employees today.

This second episode focuses on their operating ethos, culture, and incentive structures. We discuss meeting cadence and formats across the company, the use of debt, CEO incentive models, broad incentives beyond CEOs, and lessons learned from building and maintaining good cultures. I hope you enjoy this second part of the series with James Higgins and Palmer Higgins.

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(4:26) – How do your core values extend to your portfolio companies?

(6:13) – What are some ways you learn about the culture and core values of a company you acquire?

(8:32) – Is there a wide range in terms of how quickly teams can adapt to these new core values?

(10:52) – How do you assess the willingness to change the culture in new ownership?

(13:57) – Are there a set of recurring meetings you have in the early days of ownership?

(20:02) – Is there an ideal set of principles and tools you’re looking to reach internally for portfolio companies?

(21:26) – Is there a way you’re storing past decisions in a database?

(27:43) – What’s the next piece of the communication cadence journey for you?

(29:00) – How many acquisitions are you making per year?

(32:34) – Are there any other flywheels you didn’t anticipate coming to fruition?

(35:14) – What’s been the evolution of CEO incentives?

(38:53) – Chenmark’s stock purchase program

(42:54) – What companies do you look to for inspiration on compensation plans?

(44:30) – Does the incentive plan change across roles?

(47:06) – Are there any negative consequences of a Free Cash Flow Compensation plan?

(51:51) – What’s the philosophy behind the FCF compensation plan?

(55:18) – Are there any other common principles around compensation or budgets that don’t fit with what you want to do?

Alex Bridgeman: One thing that would be fun to kind of kick off with was we discussed the core values in a lot of depth in the last episode, but I’d be curious how the core values extend or extend to other portfolio companies. Obviously, those are core values just for Chenmark. But I imagine there’s some kind of similar themes that get shared amongst the other portfolio companies. How does that work? And what kind of sharing or alignment is there?

James Higgins: Yeah, it’s a good question. I think one of the things we’ve been pretty adamant about, essentially since the kind of core values were put in place, is making sure they left room for the individual operating companies to have their own set of core values. And to sort of express some of these sentiments in their own unique way. This is kind of the analogy that we tend to draw is in the US, it means something to be a Mainer or Floridian or Californian, and people can identify along those terms while at the same time identifying as American. And so it’s sort of important to us to preserve the ability for an employee of an individual operating company to identify as a team member of that operating company while at the same time having some association with Chenmark overall. And so, as far as the core values are concerned, we’re not really emphasizing sort of rigid adherence as much as we are emphasizing kind of the sentiment or ethos sort of underlying some of these core concepts and kind of allowing room for individual companies to sort of express those sentiments or that ethos on their own terms.

Alex Bridgeman: And oftentimes, I imagine that when you acquire a company, they already have a set of values, and there’s a culture that’s already there and has been around for a long time. What are some ways that you try to first acclimate and learn more about that culture and core values that that company already has? I imagine there’s only so much you can do during the diligence process with the company before actually working with them directly.

James Higgins: That’s a great question. And to be honest, I think it’s actually sort of rare to have a very strong kind of overt emphasis on core values with a lot of the companies that we’ve acquired or that we look at. I think in a lot of cases, smaller businesses tend to be a manifestation or outcropping of the personality of the owner. And a lot of times, that isn’t necessarily- a lot of times the owner isn’t necessarily trying to bring the rest of the team along with him or her in an explicit way. And so, I would say, and it’s not always the case, but for the most part, kind of the introduction to core values or behavioral standards or any that sort of thing, we’re mainly introducing some of that for the first time. And I would say, in a lot of cases, our approach is more, it’s almost sort of like brand marketing to begin with. So, we’re not saying, hey, here are the core values, you’ll be evaluated on your adoption of these next week. It’s more here are the things we emphasize, and I would say we value consistency more than the speed of execution or adoption. So I think it’s more, hey, these are things we care about. Hopefully, you see us model the behaviors associated with these things. And the way you’re going to tell that is by working with us for the next week, month, year, decade, etc. And so, I think it’s more of a slow build where we’re trying to sort of build buy in and enrollment from the bottom up and less saying, hey, you’re now part of Chenmark, here’s the way you must behave. It’s more hey, here’s the way we do things. Would you like to join us?

Alex Bridgeman: Is there a pretty wide range in terms of how quickly or how smoothly that transition is from kind of the personality of the owner and seller and what they cared about and valued in the company to kind of a new version of those values that have some input from Checkmark and I imagine a lot from the employees at that company as well?

James Higgins: Yeah, I think, and Palmer, you might be better positioned to speak to this given some of your experiences at Mainely Grass or at Seabreeze, but it kind of depends in terms of the speed there. I would say to the extent a company we’re acquiring is being run by someone who’s come through the GVP program, so has had a lot of exposure to Chenmark itself and to other operating companies by the time they’re stepping into a CEO seat, kind of they’re setting the tone in a lot of cases, and so I think that makes the adoption process quicker. I don’t know. Palmer, anything you’d add?

Palmer Higgins: I would say speed ties in as a direct correlation with consistency. So the more a team, and not just the person at the top, but the more the team can buy into the core values and behave consistently in that way I think actually can drive change relatively fast. My experience has been that there’s always a culture in every company, whether it’s overtly stated or not, that’s going to be a big differentiator. And I agree with James that a lot of businesses, a lot of small businesses probably don’t have overt cultural values stated. My experience, if I take Mainely Grass as an example, there was a desire to have very strong alignment around some core values, which drove very quick adoption because it was what everyone wanted to buy into. And I really felt like my role was to give them the freedom to align ourselves around those core values and then evaluate opportunities or decisions through that lens. And in that case, adoption can be quite quick. I imagine if you get into a company where maybe there isn’t that alignment, or at the top, just some people are trying to drive standards and behaviors in alignment with certain core values and others aren’t, or there’s inconsistency in how you uphold them, then I think that’s going to drastically change how quickly they can be actually adopted throughout the organization.

Alex Bridgeman: How do you assess the kind of willingness to change or define a set of values and culture? I imagine at first, there’s going to be perhaps people who are really excited about it or excited to meet you and the new ownership, but that, over time, you’ll learn if they really want to change or not, or if they really do have the culture that they say they do. Like how do you know when a team is ready to change or ready to define what they want to do? It sounds like Mainely Grass was pretty willing to tell you up front that they were excited to identify around some set of values.

Palmer Higgins: Sure, I think the question is you ready, but do you really internalize that deeply, and are you willing to change your behaviors? So I won’t lie, like some people who would have been very strong in alignment around our core values when they were words maybe weren’t – not maybe – were not as much aligned when it came to actions. And so, I think everyone wants to be a part of something, for sure. And I think the important part is to have alignment as opposed to these core values versus those core values. And the important thing is when push comes to shove, and people aren’t a fit for those core values, you have to make tough calls. Because the important thing is you have a team that buys in in principle to the big ticket items that you as an organization say are important.

James Higgins: Yeah, I think just to echo Palmer’s point, I think, I’m not sure we’ve come across a team or a small business where there isn’t some fundamental underlying desire for belonging. I think it’s more rare to find that sort of wrapped up in an explicit framework. And I think for us, what we found is that, again, making sure to provide space for there to be call it kind of enrollment versus conscription. The idea is look, like it’s worthwhile to stand for something and to be fairly upfront about that and to talk about outcomes and behavior kind of along those terms. And I think downstream, then that kind of creates the ability to have- if there’s some kind of dissonance going on, someone’s behaving in a way that’s not necessarily aligned, it creates an opportunity to have a conversation along those terms, as opposed to why didn’t you get this report in on time? Or why didn’t such and such thing happen? It can be more, hey, these are the things that we stand for. It seems like there’s some things going on that don’t necessarily align with those. If the things that we stand for are different than the things that you stand for, we can have a productive conversation about that and determine if this is the right fit or this company or this organization overall is the right fit. I think that tends to create, at least in our experience, a more- sort of a deeper and more meaningful conversation than, hey, why’d you miss this deliverable?

Alex Bridgeman: It sounds like a lot of this istied in with kind of, Palmer, to your point on consistency, having consistent messaging and stream of communication. Are there a set of recurring meetings or ongoing discussions that you’ve set up and have maybe for the first year in the business and then even beyond? Like what does that recurring conversation setup look like in terms of is there weekly team meetings or monthly? And then how do you emphasize or remind folks for values, culture, and areas of focus?

Palmer Higgins: I don’t think there’s a right answer to this. I certainly have a cadence and the organizations that I’ve been a part of have driven a cadence of communication in meetings that are all opportunities to reinforce those elements. I actually rarely talk about core values directly. It’s not like we have meetings that say, hey, this is a core value talking meeting where we’re going to sit around and we’re going to talk about our core values. I think, instead, it’s the interactions between team members or between teams or divisions of the company, we have an opportunity to reinforce your core values through the way that you act or through the way we respond to adversity or to issues. So I can say I’m a big fan of communication within organizations. One thing I’ve learned working now in a couple of different small businesses, being fairly surprised how poor communication is generally, which you think in a small business, communication should be a lot better than in a bigger business. It’s much easier to talk to literally everyone in the company or close to it. You’d be surprised how little that actually happens or how little people are on the same page, and you get even more siloing. And so I’m a big believer in a regular cadence of meetings. I talk to my senior leadership team every single day. We have a daily check in every single morning. We generally have weekly meetings with team, if not daily. It depends. And then monthly meetings on more of a review cadence. And then sort of more infrequent ad hoc stuff around projects. And so, all of those are opportunities to reinforce. One thing I’ve picked up from seeing the value of weekly thoughts, frankly, is getting into a cadence myself of writing to my whole team every single Sunday. And that gives- sort of forces, a forcing function on my end to figure out what I think is most important to discuss, and also lets me address the team in a way that I can’t in person, because generally, I’m working with distributed teams across a very wide geographic footprint that I can’t physically see or shake hands with or whatever on a daily basis. So those are things that I’ve used to communicate, and every one of those is an opportunity to reinforce values and behaviors.

James Higgins: So what I’d add is from a kind of Chenmark overall level, we really try to emphasize at least the opportunity for building kind of lateral connective tissue across the organization. So it doesn’t work- it’s fairly inefficient and not very scalable if information and kind of relationships, relationship capital, flows up, gets digested, and then sort of flows down to kind of the next company over. And so where we can, we try to make sure that we’re creating opportunities for folks at individual operating companies to interact directly with one another. That’s one of the ways that our GVP program helps reinforce that, because in a lot of cases, by the time someone gets to a CEO role at one of our operating companies, they’ve worked at another one of our operating companies or entered the first stage of the program with one or two other people who’ve gone on to even other companies within the organization. And so, you create kind of density of relationships, or our goal is to create density of relationships laterally. And so, ways to do that, we have an all company kind of team lunch on Fridays, where kind of the first half of it is a bit of a social check in, and we kind of get a- we sort of ask a kind of hokey question of the week and get a bit of an update for everyone on how their week’s gone. In the second half of it is we have a speaker present. And often that’s someone internally who’s presenting on some type of project they’ve been working on. Or sometimes we bring in someone external to share their story. And we can ask them questions. And so that’s a sort of feature of our weekly cadence. We also organize increasingly fairly consistent kind of team training schedule. And that can be kind of CEO, sort of upper management level, but also sort of middle or sort of aspiring management level. So again, additional ways to ideally get individuals some relevant and practical training, but also to build kind of relationships and connection laterally across different companies. And we also do two kind of all company leadership events a year. So, we do a retreat. We had our first one last year. We are pretty much locked and loaded for version 2.0 coming up in the spring here. And we do a holiday party at the end of the year, where we bring everyone to Portland and kind of sort of celebrate the year and make sure everyone has time to enjoy each other’s company. And finally, just from like a weekly kind of monthly cadence, I generally am speaking to almost all of our CEOs once a week, sometimes for longer than others, but in general, we’re getting fairly high frequency touch points just to touch base on what’s going on, share information in both directions. And I think the practice there helps build a baseline for kind of what normal is. And so that helps identify, hey, when something’s going really well, that’s an opportunity to celebrate and reinforce and share knowledge, frankly. And if something’s going poorly, it’s an opportunity to recognize, hey, we need to make sure we’re allocating sort of resources and support in this direction to help work on whatever the problem may be.

Alex Bridgeman: When you say like you’re a big fan of communication in small companies, is there an ideal set of principles and tools that you’re looking to reach internally? And then is there a kind of similar Chenmark ideal level of communication that you’re also reaching for? Or maybe you feel like you’realmost there?

Palmer Higgins: I definitely don’t think I’m almost there. I think it’s one of those like it’s a journey, it’s not a destination. What you’re going for is you’re going for situational awareness across the organization, so that people know what they need to know when they need to know it. It’s the proverbial if you can get people sort of contextually aware, you can get people all pulling in the same direction. You know what problems need to be solved, no one’s doing duplicative work, or no one’s working on something that’s already been solved or is no longer a priority or whatever. I don’t think, I certainly never got there. But you’re just trying to drive that awareness to the organization and ideally down the organization as much as possible. So I think part of what everyone talks about, empowering the organization, pushing decisions down the org chart as much as possible, I think what that really entails in my mind is trying to drive sort of contextual understanding down the org chart so that when people are confronted with options, they have a good sort of decision tree to go through to make the right decision or make a good call. So that’s what I’m always chasing. But I definitely wouldn’t say I’ve gotten there.

Alex Bridgeman: Is there a way that you’re storing some of these decisions that have been made in the past in similar situations? I could see some sort of database. Like I don’t know if you’ve used Roam Research before. You could probably even just do it in a giant Google doc of different situations you’ve had with customers or employees, record kind of what the problem was and the decision you made and outcomes, and then allow people to search through it for similar situations that they might be working with in their own companies. Do you have any storage vehicle like that? Or is it kind of all in your heads for now?

Palmer Higgins: I’ve never even heard of Roam Research, so I guess not. Documentation is definitely not my strong suit. I actually just heard of a service called Scribe that was recommended to me that I was checking out and passing along to some of our CEOs. Because process documentation is something that like I’m not great at. So I definitely need to get better that, need to do more of it. I would say what you’re talking about is maybe so detailed, that I might actually shy away from it a bit, to the extent that or in the lens of I’m not wild about focusing on methods. In this specific situation, this is what we did, and so you should try and replicate that. Because the nuance behind that is going to be lost. Exactly what was the situation? Exactly how did that customer come to that situation? What were the expectations set three months ago? What had been communicated with that customer leading up to that issue? And so, I’m much more into the principles behind the methods as opposed to the methods themselves. And if you get that right, the reality is that you could cover reams and reams and reams of situations by ideally transferring a few principles to people. So I can’t tell you exactly every situation that’s going to come across your radar. But if you evaluate things with these three principles in mind, you’re probably going to make the right call. And that’s a lot more scalable than here’s ten thousand different situations that might come across your purview as a leader in terms of either employee situations or customer situations or equipment situations. That would be brutal to try and compile.

James Higgins: One of the things I should have mentioned when talking about kind of team communication is we also do a monthly CEO meeting where all the leaders of all of our companies get together on a call. And a lot of this is modeled after kind of a little bit of like forum structure that you might see in YPO, Rio, or any one of those organizations. But the idea is that you’re identifying impactful issues that have come up, positive or negative, and creating a platform to share relevant experiences that anyone in the group has had around that particular issue. So, it may seem counterintuitive that you have a food manufacturing CEO and a lawncare CEO sharing best practices on a particular issue. And so what we’re not trying to do, to Palmer’s point, is say, alright, well, in this specific situation, this is what you should do, because there’s all sorts of nuance around the particular industry, the particular business, the individuals involved, etc. But oftentimes, that experience sharing can help uncover kind of core principles around a particular issue. And so, kind of soliciting that input from kind of our whole team ends up creating a very interesting mosaic around a lot of these important points.

Alex Bridgeman: I think that makes sense. And I definitely don’t think you should be creating reams and reams of situations that I agree, that would be laborious. Maybe besides like situations, are there some processes or something simple like job description templates that are stored and easily findable somewhere that you can share amongst companies? I feel like you’re in kind of an interesting situation where you have like a YPO just within Chenmark with all your different companies and CEOs, all of which run different businesses with different business models. So you have potentially dozens of case studies of different ways to handle certain problems. Maybe you’re already getting enough of that sharing through kind of the normal communication cadences you’ve talked about. But it just seems like a really unique situation to be in if you’re- I think of like you could have an internal reporter of some kind who their only job is to report to you, but they like create articles and source different processes or content based on what happened in all these different companies and share them with everybody.

James Higgins: So I would say that happens to a degree, but our sort of system and process around that I think you would find disappointing. That happens very often just on a very organic basis. So each- each week. But this is one of the reasons why it’s important to us to build that lateral connection I was mentioning earlier. So if CEOs know each other, and they’re friends with one another and have some shared experience kind of back in their earlier- earlier in their trajectory at Chenmark, what you’ve ultimately doing is reducing the friction associated with picking up the phone or hitting someone up on Slack or sending an email and saying, hey, I need to come up with a job description for an HR manager or whatever it is, has anyone dealt with that? How would you handle that problem? Or I need to reprice a contract, or I need to renew my insurance, or any number of different things. There’s quite a lot of conversation happening on all those topics all the time, it just is happening kind of laterally at the operating company level currently. And so honestly, our focus to date has been more on building the connective tissue to allow that to happen as opposed to building the infrastructure to have that be sort of like a self service portal that lives at the holdco level. But I think it’s worth thinking about that as an additional kind of paradigm or way to kind of reinforce some of these concepts.

Alex Bridgeman: You mentioned communication being a journey, not a destination. What’s that next piece of the journey for this communication cadence you have and this connective tissue you’re working to build?

James Higgins: So honestly, I think a big part of it, and Palmer could definitely jump in here, but I think a big part of it is how it scales. So there’s an intimacy to how we are able to interact currently and a level of sort of personal rapport that we’d love to preserve. And that becomes more challenging as the company count grows and the geographic spread expands. And to be honest, I don’t have a fantastic answer sitting here today on exactly what that looks like at N companies, other than to say our goal is to make sure that when we do the next one, it’s important to us to try to maintain some of the depth of kind of relationship building that we’ve been able to achieve thus far. But I think that’s the big challenge is how do you preserve that as much as possible while also continuing to scale and reinvest capital and ultimately expand the number of businesses that we own?

Alex Bridgeman: What’s the pace of acquisitions today? Like in an average year, how many companies would you acquire or new platforms or add-ons? What’s the number today you think?

James Higgins: It’s interesting, and I mean, the black and white answer is probably around three to five kind of deals a year. I think one of the interesting things that’s happening that, frankly, we really didn’t model for when we were first sort of hatching the idea and laying down the initial infrastructure is that there’s sort of the macro flywheel of Chenmark overall. And you can think of a really simplified kind of holdco compounding model where you say look, every dollar of incremental free cash gets consolidated and sent up to Chenmark itself and then gets reallocated into a new acquisition. And that creates a very simple and fairly elegant excel model. Our lived experience is that, as get familiar with the operations of our individual companies and start becoming part of the fabric of the business and sort of overall community in the various geographies in which we operate, what we’re starting to see is sort of very interesting kind of micro flywheels start to take shape within each of our individual businesses where there’re very compelling opportunities to reinvest either organically or inorganically at the operating company level. And so that creates an additional layer of kind of scaling or sort of capital need that is sort of in addition to kind of the core Chenmark wide flywheel. And so it wouldn’t surprise me if on an absolute number of transactions level, we saw that number tick higher over the next call it one, three, five years as these micro flywheels start to take shape, while we kind of maintain the cadence of one, maybe two larger more kind of platform type acquisitions, if that makes sense.

Alex Bridgeman: I mean, it’s hard to model that sort of stuff on an Excel sheet eight years ahead of time. So I think there’s no reason to blame yourself for that.

James Higgins: Yeah. Well, it’s more, I think one of the things we talk about consistently is it’s very easy to build that simple excel model and say, hey, this holdco idea sounds awesome. I should do that. And that shouldn’t- I don’t say that to dissuade people. I think our lived experience is one where it has been just much more serendipitous and opportunistic than a simple excel model would lead one to believe. And so I think, from a management or sort of infrastructure setup or ecosystem setup perspective, it’s less, all right, well, my excel model says I’m supposed to buy three companies this year, did I or didn’t I? It’s more can we create an environment where we’re open to opportunity wherever it may manifest throughout the organization? So if that looks like a bunch of smaller sort of interesting tuck in opportunities at our various operating businesses, that’s just as much a success as buying a larger kind of, quote unquote, platform company that will sort of be a new subsidiary under the Chenmark umbrella.

Alex Bridgeman: Are there any other flywheels or results of seven, eight years of compounding that were hard to predict but you’ve been pleasantly surprised by? Or unpleasantly?

James Higgins: Yeah, I mean, I’ll take a stab. But I think, Palmer, definitely jump in here. But I would say, in hindsight, definitely predictable but not something that we were hanging our hat on, but I think knowledge and experience and just familiarity with a lot of the core challenges of small business operations is absolutely something that compounds in a very powerful way. Not so much- I mean, obviously, it’d be great if you could avoid issues and pivot toward great opportunities. I think, more often, the way we observe that is the cycle rate improves. So we are able to adapt and overcome challenges a little bit faster now than we were previously. Our ability to onboard a new company or to work through diligence or any kind of element of the acquisition process, a lot of that is quicker and more efficient now. And so that all- all those processes and all those reps do compound and compound in a pretty interesting way that I’m not sure we were as mindful of when we first got going as we are now.

Palmer Higgins: Yeah, I would say, to sort of zoom out more broadly speaking, confidence andconviction in certain decisions is a flywheel. I remember the first time we talked about raising prices on customers and the paranoia that goes on, your whole team tells you you’re going to lose every single one of your clients, every single one of your customers. You’d think if you were to draw a sort of supply demand curve, the demand is completely elastic. And then you do it, and you realize that’s not the case. And then the next company that has to go through it or the same company has to go through it again, you have that confidence and conviction experientially won, confidence and conviction in sort of the ability to diagnose a problem and know what you need to do and have confidence that it’s the right move. I think that definitely compounds and talking about sort of the shared experiences of having been through those experiences in one company, those are going to be highly relatable or translatable to other companies, even if they’re in different industries, the principles are going to be the same.

Alex Bridgeman: Yeah, I think one thing that’s pretty interesting to talk about that I was excited for this episode is CEO incentives and more like management incentives broadly. I remember from when Trish came down for SMBash, she talked about this a little bit. And it sounds like it’s primarily a return on equity focused incentive structure for CEOs. Is that still the case today? And perhaps what’s been the evolution of CEO incentives over time with Chenmark?

James Higgins: Yeah, so I think what Trish described is largely still in place. There haven’t been really any changes over the last several years. But just to sort of recap that, our kind of core financial metric is free cash flow, and each CEO earns a split of each dollar of free cash flow generated. So, it’s a pretty transparent, sort of easy to understand mechanism. The sort of additional wrinkle is that anyone who receives a free cash flow base bonus then has the opportunity to acquire stock in the holding company. So, the idea is that you’re compensated directly and very tangibly in cash for the value or for free cash that you generate for your operating business. But if you buy into the larger kind of capital compounding story of Chenmark overall, there’s a way to participate in that very directly as well. So I think a few different and I think two big pieces that we’ve iterated on since early days, I think it took us a little bit of time to triangulate on free cash flow as the most important measure. So, we had sort of an early version incentive program where we were compensating people mainly just based on the income statement. And that was creating some scenarios where you had some questionable accounting behavior in an effort to juke the stats, so to speak. So, we found free cash to be a more comprehensive measure that was a little bit more all encompassing of all the moving pieces of the business and all the pieces of the financial statements. So that was an early pivot. I think the other piece that we kind of wanted to incent is the power of allocating capital across the organization. So how do you make sure that people have an opportunity to participate in sort of this ecosystem where we can take capital from where it’s being produced, often quite efficiently but with limited reinvestment opportunity, and redeploy it in the areas where perhaps the raw free cash flow yield is somewhat lower, but there is a much larger scaling opportunity. So from sort of a long term return perspective, that’s going to be sort of affected by the returns on capital that we’re able to generate and the scale of our reinvestment opportunity. And so if we are solely compensating people based on their individual performance at the operating company level, there’s less of a mechanism for buying into the larger capital pooling and reallocation opportunity associated with the Chenmark platform. So hence, the idea of creating the employee stock purchase program where folks can participate in that very directly.

Alex Bridgeman: Can you talk more about the stock purchase program? It kind of reminds me of, I think Buffett was talking about why he doesn’t give stock grants to the various Berkshire CEOs. And he said something like, if they want the stock, they’re welcome to buy it on any given day, any given business day, and doesn’t do typical stock grant plans. Can you kind of talk through the stock purchase plan and kind of how you view that program, kind of in a mix of your other incentives as well?

Palmer Higgins: I mean, the reality is like we believe, we would agree with Buffett. So, that’s why CEOs are compensated based on the free cash they generate, they’re compensated in cash. And then they’re left with the decision of do I want to turn around and invest this cash in Chenmark stock. The big difference obviously is like Chenmark stock does not trade on any given day, it trades once a year, one time, once a year. And that is also the liquidity mechanism that we have for stock. So that gives us opportunities for employees to have some liquidity, obviously not stock like public market liquidity in their stock. And that mechanism, to be totally honest, was stolen from the {inaudible 35:38}. I know just James and I both, we actually went to the same high school as the founder. So I knew them and knew that that’s what they did, they sort of make this internal market to sort of give opportunities for equity like compensation without necessarily being public and without dealing with stock options and grants where you’re basically forcing someone else to hopefully value something that’s long term, long duration, and fairly liquid the same way you do. And so I think by having things in cash, having that decision rest with the employee, then giving them the option but not the obligation puts that on the team member and says, hey, if you want to buy in, great, we’d love to have you. You are the only people that have access to Chenmark stock. But if not, that cash is yours.

Alex Bridgeman: Have employees ever asked if that’s available as a grant? Has there been any pushback against it being a stock purchase plan versus more of a traditional option grant? Like if someone came from a company that had option grants as a big part of their compensation driver, is that often a clash with what you have here?

Palmer Higgins: No one’s asked me. So I don’t know if someone’s asked James. But no, it hasn’t come up for me.

James Higgins: It’s come up in various forms, not as explicit as hey, like, what’s your option program? But it has come up in various ways. One of the things that we like about this particular model is that it’s very, very simple. And our goal over time is to responsibly and in very much a crawl, walk, run kind of framework expand the pool of folks internally who are able to participate. And I guess in our experience, it’s important that the plan, if it’s going to be rolled out fairly broadly, it’s important that that is quite simple to understand. And so getting into options and how they’re valued and whether they’re in or out of the money or any of those sorts of things just sort of layers on an extra degree of complexity that’s a little bit tricky. And I think for us, the other piece of it is the kind of affirmative purchase decision, as Palmer mentioned. So, I think there’s tradeoffs with any incentive program. I think we’re always trying to sort of study what others are doing and kind of compare that to our own model. I think, could there be tweaks in the future? Potentially. But for now, I think the sort of benefits of the way we’ve laid things out to us kind of outweigh some of the other options.

Alex Bridgeman: What other companies or organizations do look for for ideas or inspiration on compensation plans? Like who do you admire out in the world?

James Higgins: I think one of the things we’ve been- we’ve stressed pretty consistently kind of since day one, largely due to our own lack of knowledge, is sort of the importance and value of interdisciplinary thinking. So, certainly, as Palmer mentioned, sort of Berkshire and their model is something that we’ve studied a lot. I think it’s quite interesting, there’s a lot of ink spilled on Buffett and Munger as investors and quite a lot less spent on the sort of ecosystem they created. So we tried to spend more of our time kind of parsing tea leaves around the ecosystem. I mean, a lot of the other kind of giants you think of, so more recently, there’s been quite a lot of really interesting content put out on Transdigm. We’ve studied them quite a bit. We’ve looked at Constellation, Walmart, there’s a few others. But honestly, anytime there’s kind of highly transparent information available about programs like this, it’s quite interesting to read about it and try to study up. Whether that means we adjust something accordingly or not, that’s a sort of separate question. But I think when folks are generous enough to share kind of what they’re doing and what’s worked for them, I think that’s really valuable information and something that we try to absorb as much as possible.

Alex Bridgeman: So CEOs are compensated on a dollar of free cash flow method. Is that the incentive structure for anyone who has some sort of equity or business level incentives within a company, or are there different structures for kind of middle management or frontline employee level? Or is it basically all the same, but just different amounts of that incentive?

James Higgins: To be honest, it varies a little by company. So beneath the CEO, it’s sort of up to that individual operator to determine what kind of incentive scheme works best for their particular business. Increasingly, a number of our companies do sort of use a free cash flow type framework to compensate certainly their kind of upper and middle management folks. I would say, and Palmer, you can speak more to this, but generally speaking, a lot of the I would say sort of entry level roles tend to get compensated more on operational metrics than on sort of a kind of all encompassing kind of free cash flow measure. But Palmer, I’ll let you sort of speak more to that.

Palmer Higgins: Outside of the CEO, the best way to pull in free cash flow on an operating company incentive compensation basis is probably to have it determine the size of the pool rather than allocating direct percentages to people. When you’re talking about free cash flow, capital allocation, financing decisions, working capital management, fewer and fewer people are going to have true responsibility over those things outside the CEO, maybe the senior leadership team depending on who’s in charge of what. Then certainly when you get down to the middle management level, and to the field staff or to the sort of direct labor pool, those people are going to be very far removed from a lot of the components that transition from the P&L to the cash flow statement. I’ve definitely experimented with some, have found that a better balance is to have incentives for the SLT, the sort of senior leadership team, and I’ll say like senior middle management be more around sort of longer term goals, focus more on free cash flow generation, and be comfortable with that being a little bit more ambiguous and a little bit less certain. And then as you drive down the organizational chart, have more operational metrics where you’re trying to drive discrete outcomes probably on the revenue through gross profit lines of the income statement.

Alex Bridgeman: Have you found that a free cashflow based compensation plan, does that work against any like big reinvestment projects? Or like you mentioned taking capital from where it’s generated to areas where it might be invested for a decent return over time? If you’re going to invest all that cash in some other investment in a company, if that lowers free cash flow, does that create any incentive for the CEO to not do that plan? Or is it just a matter of you just have to make sure your CEOs are long term thinkers and understand that over time that will work out in their favor anyway, even if it’s not just this year?

Palmer Higgins:  Yeah, I think the solution there is you got to be long term focused. Certainly it could create a perverse incentive if you’re focused on the next 12 months that might take a little bit of a free cash flow hit. I think the benefit offsetting that is that it’s a free cash flow split without a hurdle of free cash flow. Typically, when you talk about bonus pools, a lot of times, say alright, if you hit budget, that’s when you unlock the bonus pool. But what we do is totally different. It’s a split of free cash flow. So as long as there’s literally one dollar of free cash flow, you’re technically earning incentive compensation, which means on the downside, you could have tremendous value destruction and still be getting incentive compensation. But the benefit is that you’re not forcing people to hit arbitrary targets before they’re getting a cut of free cash. So the hope is that you have a balance of short term focus on returns with long term orientation towards free cash flow optimization.

James Higgins: I think it does put a premium on conviction around capital allocation decisions. So I think we emphasize in this sort of setup, set up the structure to reinforce capital, particularly equity efficiency. And oftentimes, the way that can manifest if you’re being very prudent about your deployment of equity is to basically be always focused on how to utilize less of it. I think one of the things that we’re working on or thinking through is how to make sure- how can we work on generating like the requisite conviction around capital reallocation decisions, even if those things are short term negative and making sure that- and sort of making sure people are really thinking through sort of what could go right, essentially, if they redeploy capital into their business. I would say culturally and historically, we’ve been very focused on managing downside and preservation and production of cash. I think as we continue to evolve, there are going to be opportunities where we will need to redeploy capital. And so making sure that we are building process around that that’s sort of as robust as our underwriting process for new deals, for example, is helping to reinforce those decisions and making sure that we chase opportunity when it’s available to us.

Alex Bridgeman: Yeah, I can see like if you’re running some business that was growing really quickly or founded. I don’t know there’s a new market or a product that they came out with that was growing really quickly, and they made a bunch of investments for it. And the company was growing and revenues growing and was becoming a more valuable company. But free cash flow was still low and kind of saying that there could be some conflict back and forth. I guess you just need to find CEOs that are okay with that and understand the long term nature of it.

Palmer Higgins: I think to address that, Alex, I think the reality is like that’s very classic of a startup. Like, the situation you’re describing is the Jeff Bezos, Amazon produces cash flow from operations, but then turns around and reinvests 100% of it, and it’s growing incredibly rapidly. We’re typically not investing in businesses where that type of extreme rapid growth that consumes huge amounts of capital is really a thing. So maybe we’ll get presented with that situation down the road. But typically, when you’re talking about investment opportunities, you’re not talking about payback periods that are stretching out into the decades, you’re talking about investment opportunities that are very real and tangible. And because you understand the business deeply, you have a strong conviction around the payback period. And generally, it’s going to be on a shorter timeframe, not necessarily immediate, but you’re going to have high conviction that you’re going to turn that investment into a return.

Alex Bridgeman: Yeah, that makes sense. You also mentioned that you don’t base compensation around hitting a budget, it’s just free cash flow, whatever the number happens to be. Can you kind of walk through that philosophy a little bit more? Like the most common way that I’ve seen is based on some budget, and that’s where any bonus compensation is triggered from. But yours has been- your model has been less familiar to me from just my conversations on the podcast or with others.

Palmer Higgins: James will probably weigh in here too. My view is that it’s to promote long term orientation. Having experimented with comp round budgets, you miss budget, or especially if that budget is a high watermark, if you miss it, now what you’re- you might not appreciate it, but what you’re really incentivizing is taking bigger and bigger swings to catch back up to where you were and to then reach where you want to go. And so by not having a target that we’re saying, you got to hit this in order to earn anything, I think we’re creating, I believe that we’re creating an environment where we’re allowing our CEOs to be patient and understand that what matters is consistency and chasing better and compounding small gains far more than it is to hit some number that’s 10% higher than what it was next year in order for you to unlock your compensation.

James Higgins: One of the reasons I was late for the podcast today was I was on a budget call, so I can speak to this very tangibly. We often emphasize that the kind of key metric that matters is how you compare to your prior yourself. So when we’re evaluating performance, in most cases, we are paying a lot more attention to year over year comps either monthly or quarterly or trailing 12 months or whatever it is sort of actual to actual, as opposed to sort of budget versus actual, particularly from an evaluative context. That being said, we emphasize budgets as a very, very important tool. But as a tool, not as a mechanism to evaluate whether the CEO is doing a good or a bad job. So we want the budget to incorporate sort of the collective best thinking about how the business is likely to perform and then ideally, internally, that’s work product that can help drive outcomes around whatever that budget happens to be. But we’re not sort of using it as a- kind of our role and our contribution to that process is not saying hey, this should be your number, and more can we participate in the thinking around how we’re getting to whatever our forecast happens to be? Again, the idea there is to make sure that it’s kind of a participatory process to create a very useful functional tool and not sort of a mechanism to evaluate performance. I would say, at the end of the day, what we’re trying to create is an environment where folks are incentivized to produce cash, free cash, and then to also help to generate reinvestment opportunities for that cash. So, your budgeted EBITDA is an input there. So it plays a role, but it’s a little bit tangential to the core emphasis.

Alex Bridgeman: Are there any other common principles around compensation or budgets that you hear about often or methods that are used in other companies you hear about often that you’ve decided just don’t fit with what you want to do?

Palmer Higgins: I have one, but I’ve already talked about it, Alex, on your podcast. I hate commissions. I think they’re terrible incentives. First of all, it’s not a paired metric. So it’s focused on revenue. I don’t care about revenue. I care about gross profit, and I care about free cash. I just think it’s horribly short sighted. I know why people do it. It’s super simple. It’s super easy. But I continue to hate commissions.

Alex Bridgeman: That was even within sales positions or like within sales, like you didn’t-

Palmer Higgins:  Still do, still hate it.

Alex Bridgeman: So where- what’s the 30 second review? Because I’m not sure most folks have seen that conversation of ours yet.

Palmer Higgins: So in general, a single metric not paired against anything is going to be rife with unintended consequences. So I could probably broaden that to just like any compensation structure focused on one single metric that is especially income statement oriented. So, we’ve done it on free cash, but even our definition of free cash is something that’s from a true financial sort of academic sense would be something a lot more burdened. So we’re not- free cash for us is a lot more burdened than just simple cash flow from operations minus growth capex, for example. But my point on commissions was you incentivizing revenue, any company really shouldn’t care about revenue, you should care about unit economics, and you should care about free cash. And unless you’re very, very tight on the pricing leeway you give to sales staff, you’re going to run the risk of selling a dollar for 95 cents. Or even if you do have strict control over pricing, you’re going to run the risk of poorly set expectations in order to get that commission or get that sale. I just don’t think it aligns the organization properly. So I could go on and on for a long time on commissions. I’m sure there’s some very discreet situations where a true pure sales commission, you eat what you kill, can work. I just generally, my view is business is a team sport, and compensating a subset like a sales team on something as super simplistic as revenue generation I think misses a lot of things and creates a lot of unintended consequences.

Alex Bridgeman: James, any that you’ve thought of?

James Higgins: There’s plenty of things. I mean, we talked about the option thing previously. I think there’s plenty of other systems. I don’t know I’d go so far as to say, hey, that just wouldn’t work for our model. I think that’s probably too strong. There’s probably a lot of things that could work, and ultimately, I think, for us, we’ve sort of picked the one that seems to check the most boxes, acknowledging that there may be others out there that have some appeal in one way or another. So, I think there are features that our model doesn’t incorporate. I mean, options being one of them, you could think about like rolling performance over a period of time that would help kind of reinforce sort of long-term orientation. There may be mechanisms to handle the short term negative free cash, long term high return situation we were talking about earlier. I think I would say, my overall views isn’t that we have sort of the perfect be all end all system. I think what we have is working quite well for us right now. But there certainly could be scenarios that come up in the feature that- or an adjustment or a tweak or slight modification. The other sort of big potential unintended consequences to our model, first, is it potentially encourages under- it’s sort of the flip side of what we were talking about earlier. So our model potentially encourages under investment in a company. So, if you’re not even hitting kind of a requisite sort of maintenance capex target, you’re potentially long term destroying kind of long term earnings power, and that’s a problem. Our model also encourages leverage. So we emphasize equity efficiency, and we impose a capital charge for the utilization of equity. So, there is a slight incentive toward utilization of debt. The way we handle those things currently is on the capex side, a lot of kind of pretty involved conversation on what the business requires to sustain earnings power. And honestly, most of our CEOs sort of understand that. So that hasn’t really been an issue for us. And on the capital structure side, that’s something that we have a lot of input on and kind of monitor in a bit of a hierarchical way, which is one of kind of the only things where we have a particularly large sort of outsized influence on the operating companies. So there may be, honestly, ways to tweak or improve that in the future. But for now, I think our models worked quite well.

Palmer Higgins: I’d say it’s important to note that there is no such thing as the perfect compensation system, and even a really good compensation system or incentive structure isn’t going to turn the wrong fit candidate or the wrong fit person into the right fit person. So like, you shouldn’t try. And I think when people are chasing that golden formula with like I just need a few more independent variables to get this formula magic and to couch for all the potential unintended consequences, like it doesn’t exist. And what you’re chasing there is effectively I can turn anyone into the right person with the right really intricate incentive compensation structure. So part of the GVP program, part of having people go through multiple phases before they become a CEO is so we have confidence that we have the right people who are in those seats in very high leverage positions where they’re given a ton of autonomy, and they’re given the keys to an organization with whom many livelihoods are depending, and telling them hey, this is your responsibility, and we trust you. And in the largest degree, we’re here for support. There’s a ton of resources and people who’ve been there before, but ultimately, trust your instincts. And you’ve got to rely on the fact that you have the right person with the right characteristics and the right behavior traits there. And then what I feel like we’re going for on the comp side is just have it be fair, not to have it be right and turn someone who would otherwise want to make bad decisions into someone who magically is forced to make good ones because of the comp structure they have in place.

Alex Bridgeman: Yeah, that’s a good set of principles to anchor around. We’re over time, so I’ll cut it there. But thank you for sharing a little bit more your time. It’s always fun to chat with you guys and hear a little bit more about your philosophy and the work you’ve done so far. So thanks for doing this again and really appreciate it. It’s been fun.

James Higgins: Thanks, Alex. Appreciate it.

Palmer Higgins: Thanks, Alex.

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