Tech: Leading the race in software investments
The deals market is currently in something of a transition. Buyers and sellers are searching for the right levels of pricing and have a heightened sensitivity to risk, increasing the need for thorough, independent and constructive commercial due diligence (CDD).
In amongst this noise, we’re seeing an uptick in PE appetite for software deals, which (in theory) offer:
- Quality of revenue – actual contracted recurring revenue (no ‘reoccurring’ here)
- Resilience – software is often mission critical and hard to switch
- Scalable – low cost to serve, capex light, with operational leverage
- High growth potential – from replacing inadequate legacy systems to penetrating white space
To use a car analogy; the right software asset has all the safety features that appeal in today’s climate as well as the potential for racy returns.
High performance is a numbers game
Investing in a software business is in many ways a numbers game. The well-known “Rule of 40” is a helpful, if simplistic, heuristic. To continue the analogy, the “Rule of 40” (along with other high level metrics) helps investors get comfortable that the engine works. Is there a baseline to build a racing machine or are we buying a lemon?
It’s only when we really understand the numbers behind a business we can understand the mechanics of the engine, and see how we can tune it for maximum performance.
LTV/CAC is in many ways the golden ratio of software businesses – it allows you to quantify how profitable the business will be at maturity, and how much capital is consumed to get there. Break it down further into component parts and then we can start identifying value creation opportunities.
Software scale-ups live and die by having an efficient and scalable route-to-market – you need to understand lead generation (channels, cost, productivity, capacity) and sales efficiency (conversion, cycles, cost, scalability). You also need to understand your revenue/GM profile (quality, concentration, cost to serve, time to pay back) and customer lifecycle (PS/support requirement, onboarding, retention, up/cross-sell).
Thinking in this way helps you really get under the bonnet of a software business. Multiple arbitrage is no longer a given, you need to be sure of the value creation levers you can pull.
Is there enough road to race on?
So, you’ve got a potential race car, excellent. Do you have enough track to race it on? Can you keep up with the field?
PE investments in software are often constrained by niche markets in some way (leave the moonshots to the venture crowd, though maybe some middling performers in VC portfolios might be ripe for picking…). It’s a question of whether it solves a big enough problem that enough people care about and will pay to solve it. To establish a clear right to win, you’ll need to understand the factors which drive (push/pull) and inhibit (inertia/anxiety) switching. It’s critical at this stage of the race to understand what prospective customers will pay for, how to quantify ROI and demonstrate a quick time to value.
Next, you need to be sure that your car is competitive. What’s your advantage against incumbents, or the VC start up with the bulging cash reserves? Are we demonstrably better than the alternatives (including do nothing), and how do we keep it that way? Is this a ‘winner takes all’ race?
Still kick those tires
Finally, and forgive us for overstretching the analogy, you’ll need a strategy for the race. There is no substitute high quality CDD and value creation support which helps investors understand what the business is, what it could be in the future and how you’re going to get there. In addition to all the above, we can help you:
- have confidence you have the right product strategy;
- maintain differentiation and protect margins;
- avoid getting ‘disrupted’ out of existence;
- explore opportunities like AI/ML; and
- ensure you have a tech architecture that allows you to scale and innovate.
We love software, but it’s complicated. Speak to the team if you have been affected by the issues raised in this thought piece.
Meet some old and new members of the team
Mike started his career as a mainframe software tester for IBM. His ten years in venture capital and growth equity focused on the first wave of SaaS vendors. He’s slightly obsessive about product strategy and GTM efficiency.
Sophie joined Armstrong after four years in Corporate Development at Equiniti and Advanced. She’s spent a lot of time defining strategies for complex software businesses and worked on over 20 M&A processes across the UK and US.
Natasha’s background is strategy consulting, particularly packaging and pricing. She provides CDD and value creation support for tech focused companies.
Mike Callow, PartnerEmail Mike
Sophie Zgraja, ConsultantEmail Sophie
Natasha Fisher, Consultant – Value CreationEmail Natasha