This was featured in our Quarterly Investor Update Letter from Q3 2013.
Small and Medium Sized Business Software Sector Dynamics
It is well understood that one of the biggest shifts in the software ecosystem over the last decade has been the overall transition from traditional enterprise software (sold via one time license and 15-20% maintenance payments), which was historically deployed on premise, to software deployed through the cloud (sold on a fully recurring subscription basis). These companies, known as Software as a Service (SaaS) companies have made for excellent investments over the past ten years, as they’ve been able to displace legacy implementations within the enterprise. To date, the vast majority of successful SaaS companies at scale, have focused on selling horizontally focused solutions to large enterprise companies. Examples include companies such as Salesforce (customer relationship software), Workday (ERP software), SuccessFactors (human resource software), Jive Software (social collaboration software), We believe the enterprise is just the beginning, and that over the next decade, SaaS software will rapidly penetrate and expand beyond the enterprise into small and medium sized businesses (SMBs) with under 25 employees. Traditionally, these businesses might’ve been run with a pen and paper, or potentially some type of boxed software product. Agile, cloud-based software was never really an option for this customer segment for a multitude of reasons. However, changes in the ecosystem and technological advances have paved the way for new vertical application software companies to flourish.
Traditional Sector Challenge #1: Unit Economics made it difficult to sell to SMBs at meaningful price points
Licensed enterprise software has traditionally been sold by higher priced territory based sales reps who sold large implementations to large customers. This sales approach was costly because it required salespeople to consistently show up at a client’s door to sell. This involved flights, hotel rooms, and expensive dinners, as the salespeople courted their clients. Costs were high, but so were the average license prices, so the model worked well if you were selling the right product at a high price point. Accordingly, enterprise software companies rarely sold in this manner to SMBs since it was cost prohibitive. Such customers couldn’t afford the software, and face to face meetings with hundreds of small customers could become very expensive very quickly. In order to mitigate this, software companies would sell meaningfully cheaper and less advanced packaged software, primarily through VARs or the direct retail channel.
In today’s day and age, there are meaningful mitigants to the perils faced in the past, and as a byproduct, software companies can sell to SMBs at higher price points than they did with packaged software, but do so with an enterprise sales twist. If a piece of off-the-shelf packaged software cost $199 to purchase in the past, a package with materially more functionality might cost $99 per month to the same type of user, extracting far more wallet share than before. Software companies can do this because can market and sell to SMBs using internet marketing, via web based demos and live conversations on the phone. In today’s world, software companies selling to yoga studios can use Google keywords to cost effectively market to potential customers without ever having to pick up the phone. Furthermore, within the last 3 years, web based demos have become even more seamless, as products such as join.me have made it easy to share your screen over the internet in a matter of seconds, without any software installation from the counterparty. Software companies are now routinely selling much higher volumes of smaller deals over the phone, something that was traditionally harder to accomplish. These companies have figured out unit economics that make sense, and can scale.
The shift in this regard doesn’t only have to do with the economics, but the ability of the SMB to stomach high end technology. Historically, large enterprises were the ones who could take on more complex software, because they were the ones who could integrate it with existing systems, and have the high end computing hardware to host it. The exact opposite was true of the SMB, which had limited computing power. In today’s age, however, the enterprise is hampered by legacy on premise solutions, making the transition to the cloud doable but difficult. SMBs have a blank slate. Additionally, computing power has converged, and through the cloud, SMBs can handle the same type of complex software the enterprise can.
Traditional Sector Challenge #2: Pricing and Implementation Models Were Prohibitive
If an SMB wanted to buy something more sophisticated than packaged software in the past, the pricing models made it particularly difficult to do so. In particular, most license based software required a large upfront investment on behalf of the buyer. While the customer would benefit from owning the software into perpetuity, it created a significant barrier to entry in the buying process. Customers who couldn’t afford the upfront license fee would have the option to finance it, but this would typically come with onerous interest rates that further prohibited the investment.
In addition to the way in which the pricing was typically structured, the implementation was equally as onerous. Often times this would require on site implementation managers, who would assist in installing and customizing the software, and later in training customers on how to use it. These implementations could take weeks, if not months, requiring a meaningful time investment on behalf of the customer. Changes and customization beyond the initial implementation would require further costly consultation. Often, customers would end up abandoning systems even if they had made the large upfront investment!
In today’s age, the aforementioned issues are materially wiped away. On the pricing side, most SaaS companies price flexibly based upon metrics like the number of users or number of logins. Instead of a large upfront commitment, customers essentially rent the software, enabling them to dip their toes into the water before making a companywide shift. A software package that historically might’ve cost $50,000 for an initial license, might cost $1,500 per month today, with a 30 day notice cancellation period. This is beneficial to the customer as it requires less out of pocket at the beginning, and beneficial to the long term viability of the company, as it allows for a steadier, more predictable revenue stream. Furthermore, since users login and access the software in the cloud, SaaS companies are able to closely track usage metrics and proactively get in front of those customers who are not actively using the software. This is impossible with on premise licensed software.
Implementations and ongoing customization projects are also easier today than they were in the past. While on premise software led to each customer having a different version of the software depending on when they paid for their upgrades, SaaS software is typically multi-tenant and highly configurable. Changes can be made on the fly and an entire company’s deployment is shared on a single version. Additionally, when the software is implemented, it is typically just a mere flip of a switch on behalf of the vendor. When an SMB decides they’d like to purchase, they can literally be using the software later that day in most cases.
Traditional Sector Challenge #3: High Speed Internet Creates Opportunity
Perhaps the simplest prevailing factor leading to the growth of SaaS software within the enterprise is the increasing availability of high speed internet access. As mentioned earlier, the SaaS revolution really started within the enterprise, which was readily equipped to handle software delivered over the internet. A decade ago, high speed internet was just starting to take off and high speed wireless internet was a pipe dream. A decade ago most SMBs did not have access to the internet let alone access it high speed b/c the costs of a business T-1 line were very expensive. In 2004, it would have been rare to go into a spa, salon or pro shop at a golf course and see an internet enabled computer. Due to this constraint, most SMB customers were constrained to purchasing on premise licensed software. Typically, they’d settle for keeping their records on paper, Microsoft excel or rudimentary software installed via CD-ROM.
In today’s age, of high speed wireless internet delivered via LTE and powerful handheld devices, entire businesses are being run off laptops and tablets. Walk into many SMBs today, ranging from a drycleaner to a bagel shop to a yoga studio, and you’ll see some type of lightweight internet enabled device being used to run their business. This simple advancement in technology has formed the bedrock which is paving the way for an entire next generation of SaaS companies serving the SMB market.
So how do we play these changes in the market?
The transition described above has gradually taken place over the past several years and has created opportunities for us as growth investors. There is no greater example of this within our portfolio than Mindbody, the leading provider of business process management software to spas, fitness centers and salons globally. The company, which was founded well ahead of its time, has grown into a formidable and fundamentally solid business with exciting growth and stable unit economics. They currently have nearly 30,000 subscribers, who have replaced legacy systems (or no system at all) with their software. Simply put, selling to 30,000 customers would’ve been next to impossible without the fundamental market changes described above.
Our goal is to continue to seek out high quality businesses that sell into SMBs in a cost effective manner. To that end, we’ve created a defined set of rules that govern how we’re looking at such opportunities:
- Demonstrable historical growth – We’re typically targeting companies on a $5m+ revenue run rate and 60%+ annual growth, which is the point on the curve where we believe companies go from a pure startup to a more viable entity.
- Large market opportunities – Particularly when we’re evaluating vertical SMB software companies, market opportunities can be quite limited. This could make for nice lifestyle businesses for an owner, but difficult dynamics for an investor. Typically, we’re undertaking market sizing exercises where we assess today’s ARPU and multiply by total number of locations.
- Strong customer retention rates – SMB software is typically sold on a subscription basis, often times month to month. This allows us to analyze churn quite thoroughly. We’re looking for 80%+ dollar revenue retention as a benchmark for a successful SMB software company.
- Positive pricing trends and pricing power – Companies that can demonstrate the ability to raise prices or add additional value added services to existing customers are exciting to us. Mindbody, for instance, was able to meaningfully increase revenues by offering payment processing services to existing clients. This led to a meaningful bump in ARPU over the past few years.
- Favorable unit economics – While recurring revenue software companies typically lose money on a P&L basis as they continue to spend on annuity contracts (see Q4 2012 Letter), the unit economics of the business must make sense. We’re typically looking for a <1 year payback period on incremental spend to acquire new customers.
There are a lot of ways in which to invest in this market, but it is our goal to stick to the guidelines above as we continue to evaluate. Most companies we see fall short in one or more of these buckets, typically around retention or unit economics. Companies that can’t easily produce the data to verify the above are the ones we quickly eliminate as investment targets. If mgmt. isn’t monitoring these metrics, we have no interest in backing them.
Over the past several months we’ve spoken to 100+ SMB software businesses and are talking to new ones every day. We’ve built out a market taxonomy (see below) and continue to add to the list in the hopes of finding attractive investment opportunities, for you, our LPs.
 Scale for this purpose is defined as having completed an initial public offering
Horizontal SMB Software Applications (Sample)
Vertical SMB Software Applications (Sample)