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“Investors and founders have adopted a seize-the-day mentality, believing the pandemic created a once-in-a-lifetime opportunity to shake things up.” – ‘It’s All Just Wild’: Tech Start-Ups Reach a New Peak of Froth

The concept of this article has been sitting on my list for over a year.  Mostly because there is a high likelihood that the article, in writing, turns out to not be as good as the article as it sits in my head.

“When you are a Bear of Very Little Brain, and you Think of Things, you find sometimes that a Thing which seemed very Thingish inside you is quite different when it gets out into the open and has other people looking at it.” — Winnie the Pooh

I am going to try my best to put some thoughts down, and it seems like the tide is shifting in the markets (see the Fifth SaaS Correction).  We might just be in the early days of reversing some “irrational exuberance” that has built up in the marketplace over quite a few years (see Private Equity’s Love Affair with Software Companies and Meet Private Equity’s King of SaaS).

It has been an interesting challenge to help guide a cloud-based, software as a service (SaaS) company, as its finance leader, as the normal bounds of financial rationality got blurry due to the growth-at-all-costs valuation mindset.  Sort of akin to trying to teach someone to play basketball in outer space, where gravity is basically zero, and normal actions, like jumping and dribbling, are unconstrained.  Why would you dribble or pass the ball, when you can float the entire length of the court?  The biggest challenge is not getting tangled up in the lights attached to the roof of gymnasium.

Here are some examples, where traditional decision-making is challenged, when attempting to analyze a growth-at-all-costs situation with a traditional financial framework:

1. How should we think about pricing optimization?  Lost deals carry a huge opportunity cost vs. small price increases.
2. How should we price software and services?  No one seems to care about services, except the auditors since services do not generate ARR, so that is going to drive some decision making and incentive plan design.
3. What are the margins on services?  Why bother with this boring and antiquated view of things.
4. Should we care about the efficiency of internal operations?  That seems like a distraction; we should focus on growing ARR.
5. Which parts of the business should we invest in?  Clearly those that produce new ARR, at the expense of virtually everything else.
6. How should we think about investments in infrastructure, security, compliance, etc.?  Has it cost us any ARR yet?  
7. How should sales commissions be structured?  Theoretically, a sale is worth 10x+ ARR on the deal.  Are you really going to pay more than the first year of the deal is worth to the sales rep, etc.  Seems irrational, but the valuation math indicates maybe you should.
8. What is an acceptable Customer Acquisition Cost?  This is basically the same question – but adding in other broader sales & marketing costs.  And if marketing spend is generating leads and leading to closed deals, the answer approaches an unbounded solution.
9. How much should we invest in launching a new module or product?  Well, as long as the cost is below 10x+ the future ARR, I guess we should go for it.  Let’s ignore the fact that the cash flow from the new product won’t cover development costs for…[insert optimistic assumption]…years.  Hell, why even build a financial model anyway.
10. How should you respond to customer issues?  Well, the math says protect ARR at all costs. 
11. What if more growth makes your valuation on ARR go up?  Oh crap, the model went circular and unbounded.  Better break out Solver.

This is certainly not an exhaustive list, but should serve as some insight into the challenges of managing one of these businesses in this environment.  To be fair, this is not entirely a valuation driven problem.  The economics of software businesses play a role too.  When marginal costs are close to zero and the gross margins of a business are 80%+, there are few “bad” customers or “unprofitable” products.  

I am an engineer by training.  I believe that trade-offs exist in every decision.  And, that is healthy.  Under the current valuation regime, there has been a dearth of trade-offs.  

So, as the valuation pendulum swings from growth only metrics, back toward more dreary metrics (cash flow and return on invested capital), expect some issues to arise.  Just like an astronaut returning from a long stint at the International Space Station, getting used to gravity may take some time.

Over the last number of years, investors and managers of software businesses have been making decisions under this valuation framework revolving around ARR valuations and growth.  That has likely led to some choices that will look less robust in a different valuation paradigm. It will take some time to uncover and unwind those.  It might take even longer to change the mindset of those investors and managers, if that can even be done.  In the dotcom era, there were few pivots.  Many of those businesses could not or would not change their models, and you know how those ended.

Every situation is unique, but here is a real life case study – from Freshworks – a member of the IPO class of 2021.  I think you will look back on this and see they timed this one pretty well.

“We believe that we are early in addressing our large market opportunity and we intend to continue to make investments to support the growth and expansion of our business. We have a track record of bringing new products to market and scaling these new products over time. As of December 31, 2021, we have two primary products with over $100 million in ARR, Freshdesk and Freshservice.” – 10K

Highlighting is mine.  Revenue up year over year ~$121 million; costs up ~$270 million.  Sales & Marketing costs up ~$127 million alone.  So, yes, I would hope that you believe there is a large market opportunity to capture.  The real question is does this business model work, if you care about something other than top line growth?  

The cash flow picture is not good.

Large market opportunity, high growth, but not currently monetizing any of that well.

And, that is the question I wrestle with the most. When is the operating leverage and cash flow going to show up in these businesses, if ever?  How is the switch going to get flipped? 

There’s a large market opportunity.  Ok, good.  The business is growing at a high rate.  That’s great.  But operating leverage is nowhere to be seen, since you are plowing most of the cash flow back into the business – mostly into commercial operations to generate that growth (separate topic: be careful around the assumptions about steady-state cash flow in a growing subscription business – it may not be what you think it is – as it can be distorted by customers paying invoices upfront).  When sales & marketing spend essentially equals gross profit, what is the point?

What is the catalyst that causes the managers of the business to turn off all that sales & marketing spend to increase profitability?  Why would they ever do when slower growth would likely crush the valuation (of their stock options)?   But at these valuations, the cash flow of the business would take decades to cover the acquisition cost of the business.  You Cannot Eat Growth.  This feels like a never ending cycle; until the cycle is ended by exogenous forces. In the dotcom days, the cycle was ended by running out of cash one day.

I found this funny commentary on the situation:

“If you’re curious about where all the billions of dollars of venture and IPO capital are being spent by all these Software as a Service startups, I have figured it out. The answer is in my inbox. Every day five spam emails about signing up for this enterprise software or that – control your employees’ spending, track your employees’ benefits, a million different versions of PEO, etc. They’re basically taking all this money, divvying it up into $85,000 starting salaries and paying saleskids one year out of college to hit small business owners on LinkedIn or try to guess at the email addresses of people like me. It’s cold calling but lazier.” – Reformed Broker

A common way to think about these businesses is the “Rule of 40”.  In the Rule of 40 (https://www.thesaascfo.com/rule-of-40-saas/), managers are supposed to try to keep the sum of year over year ARR growth + EBITDA margin at or above 40.  The result is that faster growing businesses can be less profitable, while businesses that see slowing growing should prioritize profitability. Although even that is getting bastardized (i.e., see Weighted Rule of 40).  A concern I have here is with these recurring revenue business, the income statement benefits / suffers from a huge accounting effects vs. cash flow (see EBITDA Is Not A Good Proxy For Cash Flow ).  Many items, like revenue and contract expenses, are recognized over years, making the income statement less responsive (i.e., misleading) to current events.

The winner takes all?  Yes, I guess this is a fair point to raise.  Cloud-based software is disrupting the landscape. 

“It’s also interesting just how long this can take. If you live in Silicon Valley, it would be natural to think that cloud and SaaS are old and done and boring, but this chart from Goldman Sachs, showing a survey of big company CIOs, suggests that less than a quarter of their workflows are in the cloud so far, and they’re moving slower than they expected.” – Benedict Evans

 And we could be in the early days of cloud disruption – if it really is a disruption.

However, winner takes all means that only a handful of companies will grow into these valuations.  Some companies will be worth it.  But, the average cloud-based software company likely will not be the winner taking all, according to the definition of average.  So, the situation becomes similar to the investment profile for venture capital – one of your portfolio of ten might be a blockbuster; the remaining nine will likely lead to mediocre returns or even losses.  These companies become moonshots.

That might produce acceptable returns if you have a portfolio of these companies.  Which is a much different proposition than if you are managing a single business – a portfolio of one as I call it (this most definitely violates the Kelly Criterion).

I have joked in the past that I like to follow bubbles.  I worked in software and moved to San Francisco in 1999.  After graduating business school in 2005, I bought my first house and joined Wachovia’s investment banking platform eventually ending up on the Leveraged Finance team just in time to get a front row seat to the Great Financial Crisis.  So, I have a few scars.  

And like most humans, I seek to find patterns, whether they exist or not.  So take it with a grain of salt that I see a pattern here, which reminds me a lot of the business models in the dotcom days.  Where valuations were predicated on growth metrics, without much regard to the long term sustainability of the underlying business model.

This appears to be a developing situation and I will continue to watch the developments unfold with a lot of curiosity.  But the pendulum has swung pretty far in one direction over a number of years, and lots of capital has been allocated and is being managed under that paradigm, and it is likely to take some time (not a quarter) for adjustments to roll through.  In fact, my sense is that a lot of folks are still in the denial stage.