How is the SaaS Industry Changing in a COVID-19 World?
Covid-19 has shocked the world. All industries are now facing a challenging environment and SaaS businesses are no different. Companies are revisiting budgets and cutting unnecessary spend to survive what could be a long recession and slow recovery. We have seen a negative shift in investor attitudes and exit opportunities for SaaS businesses. At the same time, we have observed an acceleration in companies pursing digital transformation initiatives and the pandemic is pressure-testing, and hopefully proving true, that the best enterprise software solutions are truly mission critical.
Investors are Proceeding with Increased Caution on New Venture & Growth Equity Investments
This pandemic has caused investors to rethink their investment pace, “strike zone” and long-term strategy. Deal are getting done but most of the announced deals fall into a few categories:
A+ SaaS Companies: these are companies with Tier 1 SaaS metrics (strong revenue growth, high gross retention, great sales efficiency and large ACVs) and are attracting interest from private equity and strategic buyers who have plenty of dry powder
Companies with “COVID-19 Tailwinds”: these companies provide solutions that support working-from-home, e-commerce, telehealth, digital infrastructure, etc.
Companies that Need to Raise Money: these companies either mis-planned their cash runway or had unfortunate timing of circling Q2 2020 as the quarter to launch their fundraise process. Alternative capital solutions are harder to secure as lenders become conservative and some existing investors no longer have the capital or conviction to continue supporting the business. Expect aggressive terms or the need for an insider round if you find yourself in this category
Deal dynamics are also changing. Early stage SaaS investing is relationship driven and partnerships can be five to ten-year long marriages with no option for divorce. Investors and management teams are determining if they are willing to start a new partnership after only interacting though video conferences. In a survey Arrowroot conducted, 66% of respondents said they would NOT invest or acquire a software company without physically meeting the management team.
Many companies will find themselves stuck in no-man’s land. Decent, but not great, SaaS metrics, subscale ARR and a product that is proving to be a “nice-to-have” vs. mission critical solution as churn accelerates. With investor appetite shrinking, the question becomes what happens to these companies? We expect to see many arranged marriages over the next 12 months where investors work with competitors to merge portfolio companies to drive scale and profitability.
Acceleration of Digital Transformation Across Legacy Industries
In 2011, Marc Andreessen famously said “software is eating the world”. This trend has been seen across industries and COVID-19 has put a spotlight on the need for large companies to re-think their digital transformation strategies. Companies were greeted with chaos in March 2020 as businesses rapidly transitioned to work-from-home and their technology infrastructure didn’t support this new reality. These companies were caught flat footed with legacy on-premise solutions and a reliance on old-fashioned pen, paper and excel.
Satya Nadella, CEO of Microsoft, said Microsoft saw “two years of digital transformation in 2 months” in their customer base. Arrowroot has seen this across our portfolio as well. Industries that have been slow to adopt technology are using this time to rethink their technology infrastructure. Companies with legacy technology have watched with jealousy as their peers with cloud-based infrastructure and applications have easily adjusted to the new normal.
Arrowroot believes there are positive tailwinds and plenty of industries for software to infiltrate but there are still too many SaaS companies chasing the same problems. We expect to see a bifurcation between the winners and losers faster than previously anticipated. The pandemic has placed digital transformation into the forefront of customers minds but Arrowroot is hesitant to say this level of change is the “new new”. It is difficult to predict if this level of spend is a potential blip or an extrapolation that will result in elevated software spend going forward.
COVID-19 is a True Test for Mission Critical Software
Robert Smith, CEO and founder of Vista Equity Partners, famously said “Software contracts are better than first-lien debt”. We are seeing that statement get put to the test in real time across the SaaS landscape. Many CEOs have positioned their software to be a mission critical solution. The next 12 months will separate the “nice-to-have” solutions with the truly essential platforms. We expect those nice-to-have solutions to see significant churn as customers look to cut costs.
This will even be a trying time for mission critical software solutions. Our advice to our portfolio companies has been to bear hug your customer base. Check-in with your customers, see how they are navigating the new normal and fight to collect AR and lock-in renewals. The more your customer base trends toward SMB, the harder you will have to fight.
Expect Multiple Compression in M&A Market
It is still too early to predict how COVID-19 will impact exit opportunities for SaaS startups. Technology related M&A has fallen significantly in March and April, but it is unclear how long this slowdown will last. There is plenty of dry powder at private equity firms and strategic buyers (Alphabet alone has $117B of cash on its balance sheet). We expect to see increased interest for the best SaaS companies, those that fall into the A+ category mentioned above. Public SaaS company valuations have rebounded, and the best companies are trading at revenue multiples of 10x and beyond. These businesses are valued above pre-COVID levels while the broader market struggles to rebound. Investors are pulling capital out of other industries and increasing allocations into enterprise software. For many of these public SaaS companies, it still makes sense to be acquisitive and to continue building out their product offerings via M&A.
The threshold for a sale to private equity is going to increase. We expect to see multiple compression for companies that are sub-scale with middle to bottom tier SaaS metrics. There will be a greater focus on gross margins and more hesitancy to purchase businesses burning significant money.
In conclusion, we think this shutdown is going to accelerate the separation between the winners and losers in the SaaS market. Companies providing mission critical software should be able to navigate the recession and come out stronger than when they entered. A renewed focus on efficient customer acquisition, profitability and retention will position these companies well for the eventual recovery.