Written by Konstantinos Samaras – Beacon Fellowship

Disclaimer: All the views and opinions presented in this article are solely my own and do not reflect the opinion and beliefs of my employer or its affiliates.

W elcome back! Last time I covered the impact of inflation on startup valuations and the ability of VCs to raise capital. As down rounds continue and fundraising pace slows, VCs who have managed to raise capital (or have large amounts of “dry powder” left to deploy) are looking to place their bets.

The pre-2022 cheap money economy favoured high growth investing at the expense of profitability indicators and admittedly, it worked! Until now. As inflation further complicates outlook, what sectors should investors be focusing on? Although this is not financial advice, I believe that Enterprise software as a service (“SaaS”) is primed for further investment.

Sneak peak of Part 2: What sectors have the potential to perform better in the short- and long-term?

Software is top of its class (in VC): Software has continuously amassed the biggest percentage of VC capital since 2012, but not all software is the same. “Software” can mean a lot of different things. I unpack how SaaS’ emergence around 2010/11 has significantly benefitted companies of all sizes and how this sub-sector is likely to continue growing.

· Software is last of its class (in public markets): Despite SaaS’ recent popularity in the VC world, historically, the software industry gets hit the hardest in a market downturn. It happened in the GFC, it happened during Covid-19, and it happened last year. This largely stems from the fact that most SaaS businesses are yet to turn a profit, with profitable ones significantly outperforming their peers and displaying more resilient trends in the public market.

· Why Enterprise SaaS is primed for investment: VCs will seek opportunities in verticals and geographies where demand is less affected by inflation. Following the recent frenzy of deals and ballooning valuations in B2C companies, I see this period as a welcome test in the meaning of revenue recurrence and a return to more traditional value investing. I believe that B2B SaaS companies have higher “antifragility” potential due to their mission critical nature and I expect stronger resilience from sectors with “B2B-like” inelastic demand. I also foresee more emphasis on the difference between front-end and back-end companies (application vs software infrastructure).

As mentioned last time, my professional experience since graduating college has been in the world of credit investing. My credit background largely shapes my perspective when considering any investment: in credit, upside is mostly capped (you’re usually receiving an interest rate for a certain period of time for the money you’ve lent instead of holding the keys to the business) therefore a strong focus is placed on downside protection as an investment baseline. This bias towards downside protection influences the type of startups that, in my opinion, will fare better in the current market cycle, so please keep this in mind as you read through. Let’s dive right in.

SaaS is top of its class (in VC)

Looking at sector-specific trends in venture capital activity in recent years, software has seen remarkable growth in the past 10 years in Europe (as demonstrated by both graphs below; Deals by Number, left and by Value, right). According to Pitchbook, software now accounts for 47% of total European deal value, up from just 17% in 2012. Software deal volume has steadily accounted for 36–40% of the total volume since 2016 while deal value has continued rising. Why is that the case? I view software as the undisputed top focus area for VCs because it allows companies to scale faster while reducing operating costs (“opex”) and/or capital expenditure (“capex”) as a proportion of their revenue — more on this in the next paragraph. But software can mean a lot of different things and can encompass various sub-sectors, so it’s important to distinguish between software and Enterprise SaaS.

Let’s unpack this. Until 2010, software was mostly employed on-premise. Organisations would pay for their IT infrastructure upfront, as capex, purchasing anything from the physical servers to the hardware needed to set up this infrastructure. This led to large upfront costs before systems were up and running, and more costs incurred when these systems required maintenance or replacement. With the evolution of technology, IT shifted to a pay-as-you-go model and the SaaS model gained popularity. Cloud-based (rather than on-premise) solutions offered “as a service” allow for IT operations to now fall into a company’s opex, as opposed to capex (i.e., eliminating the previously cumbersome upfront investments and instead replacing these with predictable, monthly fees where maintenance the data centres and servers no longer falls on the hands of the company, but on the software provider). According to Orlando Bravo, until 2011 growth in software largely mirrored GDP; today growth in software outpaces US GDP by 7.45%. In Europe, Information Communication Technology spend currently outpaces GDP 3:1. I see no reason why these statistics should change anytime soon given SaaS is becoming an ever more important aspect of our lives. The graphs below indicate that even amidst the broader activity decline in 2022, software continues to account for an even larger share of the “deal pie” compared to 2021. The 2022 value of software investments is only down 11% compared to 2021.

Software is last of its class (in public markets)

Despite the continuous ramp-up of VC software spend in recent years, software tends to be over-penalised versus other indexes during public market downturns. In the last three major crises over the past 20+ years (1: Dotcom Bubble; 2: GFC; and 3: Covid-19), software has continually had the largest peak to trough decline in the market. The market reaction has been no different this time around (Cloud Index down 51% compared to a 31% drop in Nasdaq in 2022). It should be noted that the cloud index saw c.50% revenue growth year-on-year while the Nasdaq only rose c.6% over the same period. This “overreaction” of the markets is not a fluke; I attribute it to the fact that the majority of software companies (listed or not) are predominantly unprofitable, which becomes even more apparent during a crisis. Orlando Bravo points to further data (see below right graph) on how profitable software has performed versus the S&P and Nasdaq over time, which demonstrates higher multiples for already-profitable software companies and a lower drop-off from their peak in 2022. This for me is the key to finding successful investments in this environment: identifying companies with the potential for sustainable profitability, regardless of the timing of your investment or the macro conditions. Needless to say, earlier stage companies might not be profitable just yet, but the key is to bet on the startups with the right fundamentals and levers for future profitability. Klarna’s CEO Sebastian Siemiatkowsi captured this sentiment in a recent interview and pointed to the swift return of investors’ focus on fundamentals, which has been largely forgotten in recent years: “Suddenly people don’t want you to lean into the future, but they want you to show profitability.” Growth is great in a bull market, but bull markets don’t last forever, and investors shouldn’t forget that.

Why Enterprise SaaS is primed for investment

According to Financial Times’ US financial commentator, Robert Armstrong,“tech, which was a breed apart in recent years, will now face the same pressures as other companies. Because the Fed [had] distorted asset prices by making cash free, tech companies did not focus on cash earnings. Now we’re in an environment when cash earnings […] matter. Tech was in an environment that incentivised growth. Now all that has changed.” SaaS is primed for a strong re-emergence in VC investing because of its potential for sustained profitability rather than its flashy growth rates (though one does not necessarily preclude the other).

The basic premise of SaaS is the recurrence of revenues attained through the subscription to a service (which renews at set intervals). Such SaaS products can exist across sectors, from discretionary consumer-focused products (B2C) to more complex software servicing the needs of businesses (Enterprise SaaS or B2B). Over the past decade, SaaS companies across sectors raised billions of dollars on the basis of this revenue recurrence. In fact, B2C companies have raised almost double the funding of B2B peers since 2017. Through Enterprise SaaS isn’t considered as sexy as some of its B2C peers, there is a key difference between the two: in B2C, companies serve individual consumers who churn when they find a better product, lose interest, or when they no longer want to pay (in a market that is usually very competitive). B2B companies focus on helping businesses solve or automate problems, which means that fading interest is not a strong a churn factor. Many B2B startups also focus on niche markets where competition could be lower.

The current market developments will prove a test of true revenue recurrence, identifying which companies are going to weather this storm. In this environment, I view Enterprise SaaS as the sector best positioned to be “antifragile”. In the words of Nassim Taleb, “the resilient resists shocks and stays the same; the antifragile gets better”. Although, like all software, Enterprise SaaS might be penalized in the short term (as discussed above), it has the right mix of characteristics for long-term profitability. Why? Think of a company using Workday or SAP for its HR and payroll functions: that’s not something that will stop during a crisis, because it is a mission critical function. GP Bullhound’s latest European SaaS indicates that Enterprise SaaS enjoys the lowest churn within the broader SaaS space. At Beacon they have further observed that Enterprise SaaS companies tend to spend their budgets on tested and proven applications (i.e., spending more on fewer and very specific, often complex solutions and ‘getting all the gunk out’), which creates more streamlined operations down the line. The risk with Enterprise SaaS is therefore not customer churn as such, but customer failure (i.e., if you cater to small businesses and they go out of business, you will automatically lose those contracts). Getting comfortable with the customer cohort of Enterprise SaaS targets should therefore be the #1 priority for investors looking to enter this space, and what I think will differentiate the winners from those who end up with lacklustre returns.

I leave you with one final and slightly different reason to consider investing in Enterprise SaaS: businesses buy such software because it’s in their economic self-interest — it is a productivity enhancing and cost-saving tool. In Orlando Bravo’s own words,

“when you have inflation, the value of your products goes up and [with software] you can pass that through. Of course, you need to discount the cash flow more because of higher interest rates, but that [pass through] improves cashflow so there is a natural hedge.”

I wouldn’t be surprised if there is a decoupling between B2B and B2C in this period as the dust settles and revenue recurrence “shows its true face”. Within Enterprise SaaS, it will also be important to differentiate between front-end and back-end products (i.e., application vs infrastructure).

In sum

We are entering a period where the dispersion in valuations could grow significantly between players with a path to profitability and players who have grown unsustainably. Leading up to 2022, everyone seemed to ride the bull market and over the course of 2022, everyone was largely impacted by the shift to deep bear markets. Going forward, with the cost of cash no longer being zero, I expect startups with strong profitability / cash generation potential to significantly outperform their “high-growth at any cost” peers.

Coming up next

So far, we’ve covered the impacts on the market more broadly and what sectors seem ripe for investment in the current environment. In the final part of the paper, we will cover lessons learned from nimble founders and investors that can serve as important examples going forward for both startups and VCs.