U.S. Enterprise Software - Reflections Post-SaaStr Annual 2022 Conference
“At this point, any founder in SaaS should know the public markets have fallen 50% or so from the peaks of 2021. It’s profoundly frustrating, as SaaS revenue growth hasn’t fallen. The best in SaaS are growing faster than ever, even past $1B or more in ARR. And yet, they are still worth half of what they were just a few months ago.”
– Jason Lemkin – Founder, SaaStr
Executive Summary – Key Insights
- SaaS model still resilient – putting things in perspective: Through Q3’22, U.S. SaaS venture and growth (V&G) deal counts have continued to show healthy growth relative to historical levels (before 2021’s record highs). Annual deal counts averaged ~3500 over the decade prior to last year, and this year’s estimated total will likely near ~4000. Total deal value of a projected $70B+ at year-end is also well above pre-2021 averages of less than $40B. Median deal sizes are incrementally increasing across stages, even in comparison to last year’s levels.
- Valuations – out with the new, in with the old: We expect private market valuations to gravitate toward slightly above pre-pandemic norms over the next 12 months, with 8–11x NTM ARR multiples serving as the stabilized average for top-quartile software companies. As a reference point, top-quartile public SaaS companies were valued on median forward revenue multiples of ~9.0x at the end of Q3’22. Below the top quartile, we expect to see a significant drop-off (Q3’22 multiples for mid-tier performers are ~5.0x). Outliers with BOTH proven scalability and profitability will command market premiums across verticals in the near-term. We expect the multiple compression seen in Series C+ rounds to trickle-down to earlier stages over the next 6 months; in Q2’22, early-stage valuations saw their first decline in the past 10 quarters.
- Late-stage risk mitigation – invest earlier: It appears likely that in the near-term, growth, hybrid, and cross-over investors will continue to diversify strategies with more early-stage bets and heavily scrutinize the profitability potential of late-stage prospects. Median revenues of new V&G investments made by hybrids have decreased 44% YoY through 1H’22, reflecting the higher proportion of early-stage deals executed by this investor class. Similarly, median valuation step-ups have remained relatively stable at early stages (Seed through Series B) but have fallen ~50% since January for Series C+ rounds.
- Efficiency, not just growth – companies go lean: For V&G companies below the top quartile that lack deep-pocketed syndicates, we believe that management teams will opt for paired down operating structures at the expense of some top-line growth to right-size their businesses before going back to market. Between Q1 – Q3 of this year, the number of reported U.S. start-ups announcing layoffs increased a staggering 12.5x. Over the next few quarters, we expect data will also show increases in the number of structured equity, venture debt, and flat- and down-rounds as more SaaS companies struggle to reduce their cash burn while growth slows.
- M&A on the cheap – potential for value opportunities: Despite preliminary data showing U.S. total M&A value down ~40% QoQ in Q3’22, PE buyers and corporates alike have ample dry powder to capitalize on depressed assets and discounted technology and platform acquisitions. As of Q3’22, median valuations of U.S. SaaS M&A deals had risen since last year, most likely due to more late-stage growth companies seeking early exits. However, we expect this trend to gradually reverse, creating opportunities for patient, discount-seeking buyers over the next several quarters. Through 1H’22, overall U.S. V&G-backed M&A deals over $100M were down 43% YoY, signaling M&A values are likely to fall in the near-term.
- Frontier sectors – where capital will flow: We see software investments increasing in emerging domains well-insulated from discretionary spending trends, including clean energy, infrastructure (data/security/developer) tools, applied AI/ML, healthcare technology, and supply chain/logistics. Three of the largest rounds raised in Q3’22 were for clean energy tech companies – TerraPower ($750M), EnergyX ($450M), and Xpansiv ($400M).
Source: PitchBook Data, Inc., PitchBook-NVCA Q3'22 Venture Monitor Report, TechCrunch, Layoffs.fyi, Refinitiv, SVB State of SaaS - H2 2022, CB Insights
Note: Sources marked "PitchBook Data, Inc." includes analysis of data that has not been reviewed by PitchBook analysts unless otherwise tied to a PitchBook article/report.
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1 – An unstable backdrop
With a rapidly tightening macroeconomic environment and continuous volatility in the public markets over the last several quarters, software-focused GPs are increasingly focused on how these trends will impact pricing of new deals, portfolio company financing plans, and LP fundraising dynamics.
U.S. V&G investors – including traditional funds, CVCs, and other alternative managers active in the space – have an estimated $300B+ of dry powder available, and over $160B reserved for net new investments. New fundraising totals in the U.S. have set an annual high of over $150B through the first three quarters of 2022, however, Q3’22 totaled a ~50% decline from the first two quarters of 2022, a directional trend that is likely to be sustained over the next 12 months as LPs re-balance their allocations across strategies.
Meanwhile, software founders and management teams are focused on implementing more durable growth strategies and accelerating time to profitability. Assessing these issues properly will be critical to justifying past valuations and winning over new investors in the current climate.
At the sector’s seminal annual conference – SaaStr Annual 2022 – several key thematic questions emerged:
- How long will the current market correction last?
- Will we return to the flush pre-pandemic markets, or will there be a “new normal” and how will it look?
- How can stakeholders achieve successful outcomes in a volatile funding environment?
In the following sections, we analyze these questions and identify potential opportunities for U.S. V&G enterprise software stakeholders over the next several quarters of uncertainty.
Source: Jon Sakoda (Decibel Partners), PitchBook Data, Inc.
2 – Software sector resilient, but not immune
Rising interest rates and inflationary pressures have especially impacted high-growth, cash-burning software companies. Compared to major public trading indexes, publicly-traded cloud/SaaS companies (EMCLOUD) have fallen 1.5x-2x since January.
M&A of V&G-backed SaaS companies have not fared much better. As noted by Redpoint Ventures’ Tomasz Tunguz, prior to Adobe’s announced $20B acquisition of Figma in September, U.S. V&G-backed software M&A was tracking to its worst year since 2017 at nearly $7B of total value, down from $71B a year ago. Additionally, the markets have gone over 240 days without a tech IPO valued above $50M. This breaks the previous records set during the 2008 financial crisis and 2000s dot-com bubble. Even beyond tech, total V&G-backed IPOs ended Q2’22 at a 13-year quarterly low with 8 completed listings, followed by 5 in Q3’22.
Public valuations for top-performing SaaS companies are now more reflective of pre-pandemic norms, with median NTM ARR multiples of 9.0x. While capital efficiency and unit economics are featuring even more prominently in diligence processes, public SaaS data shows that the top growth companies still command valuation premiums relative to their peers. Mid-level performers are bearing significantly greater scrutiny, with NTM revenue multiples down ~45% from prior pre-pandemic highs, compared to 18% for top-quartile companies, as shown below.
Source: Bessemer Venture Partners Emerging Cloud Index, SVB State of the Markets H2 2022, Cowboy Ventures, Pitchbook Data, Inc.
Similarly, data compiled by Jamin Ball of Altimeter Capital reveals that SaaS companies below the top quartile are being hit particularly hard: the spread between median EV/NTM revenue multiples for mid- (15-30% YoY) and low-growth (<15% YoY) public SaaS companies continues to narrow significantly, revealing the challenging fundraising environment for the majority of V&G companies that lack superior growth metrics.
The moral of the story is that if SaaS companies can’t produce top-quartile bookings or successfully expand LTVs and minimize churn of existing customers to maintain or increase net dollar retention (NDR) rates in this environment, they need to exhibit an ability to consistently generate free cash flow to avoid substantial valuation discounting under current conditions.
3 – Stage risk: a reversal of fortune
Across the V&G asset class, the ratio of capital supply to demand has decreased significantly more rapidly for late-stage deals (-40% YoY) – defined as Series D+ – than earlier deals (-24% YoY) due, at least in part, to the lofty valuations many of these companies are carrying post-pandemic. Simultaneously, there have been notable increases in late-stage investors seeking protective provisions that were often conceded during the market-run over the past several years. The percentage of late-stage growth deals executed with cumulative dividends nearly doubled from Q1’22 to Q3’22, and the proportion of late-stage deals that include senior preferred terms (vs. pari passu structures) has increased ~10% since 2021, nearing its previous high in 2019.
Source: Bessemer Venture Partners Emerging Cloud Index, SVB State of the Markets H2 2022
As detailed in Silicon Valley Bank’s “State of the Markets H2 2022” analysis, the trend of hybrid and cross-over investors embracing early-stage deals as a risk mitigant against late-stage pricing risk has mostly held since these firms began deploying freshly raised, billion-dollar funds in 2021. These investors are slowing late-stage growth deals and making smaller, earlier deals at faster paces as shown below:
Specific to U.S. SaaS V&G deals, it is estimated that deal volumes and dollars invested will end the year 20% and 25-30% lower, respectively, than in 2021. Additionally, valuation step-ups have fallen precipitously at the Series C and later stages (especially the premium levels), while Seed – Series B step-up rounds have seen moderate YoY shifts in line with historical averages.
4 – Sector resiliency – public v. private markets:
In the public markets, there is little evidence that particular SaaS verticals are immune to the current macroeconomic shocks. Even among public companies operating in the perceived most resilient domains (infrastructure, data, and security), market caps are down ~45% YTD, well below the major stock indices.
Conversely, private market SaaS indicators are more variable. Overall, U.S. SaaS funding remains strong as investments YTD through Q3’22 have already exceeded historical annual totals for years prior to the record-setting year in 2021, reflecting the relative strength of recurring revenue, high-margin software companies. Sector data reveals that several verticals are also attracting investor interest at premium valuations in contrast to macro trends. Recent success stories in the private software markets have centered on several key themes: products gaining “escape velocity,” pandemic-related trends generating sustained investor interest, and risk-averse investors seeking safe harbor from emerging sectors with low adoption rates.
Security software continues to prevail as the most resilient sub-sector; while U.S. cybersecurity software V&G funding fell over 50% YoY in Q3’22, total funding YTD of over $10B already exceeded historical average annual totals prior to the sector’s record-setting year in 2021.
To avoid assigning causality from macro themes for every transaction, it is worth analyzing deals that counter current market narratives. Below, we examine Adobe’s acquisition of Figma, and detail the takeaways discussed at SaaStr Annual 2022.
5 – Case study on product-led disruption: Adobe’s $20B acquisition of Figma
In a timely occurrence, on the final day of the SaaStr Annual 2022 conference, it was announced that Figma would be acquired by Adobe for a remarkable $20B price tag. The deal immediately became the focus of dialogue between investors and founders at the conference, with everyone discussing whether this history-making deal signaled the beginning of an industry-wide re-correction, or if it would be a circumstantial case of a market leader removing an existential threat to its business model.
- Adobe signed a definitive agreement to pay an estimated 100x LTM ARR and 50x NTM ARR for Figma, at a purchase price that was double the prior pre-money valuation
- Payouts included a mix of cash, equity, and short-term debt
- The deal also reportedly included one of the largest retention packages ever offered to a management team in a VC-backed exit
Source: PitchBook Data, Inc. - "Adobe's $20B Figma acquisition shows corporations are game. Will startups play ball?", TechCrunch
Insights and takeaways
- Premium prices for premium products: The $20B purchase would be the highest price paid for a privately held, VC-backed company in history, and Adobe is estimated to have paid the highest-ever revenue multiple for a late-stage software company. While still an outlier, the deal provides evidence that macro trends do not universally drive buyer behavior, and industry-leading products with strong economics can lead to outsized outcomes. Figma was a rare breed start-up that was able to reach escape velocity – offering an unmatched product appealing to millions of people with proven exponential growth potential and positioned as a direct threat to the market incumbent.
- An outlier bucking the trend: SaaStr attendees – on both the investing and operating sides – were largely skeptical that the high premium paid was indicative of a broader market turn back in the direction of pandemic-era valuations. The announced acquisition exceeded the cumulative total of all other V&G-backed exits in the U.S. in Q3’22. Investors instead initially assessed that Adobe significantly overpaid as both an offensive and defensive move to remove its primary competitor and to accelerate its product development into the cloud future. Public investors in Adobe were also less than pleased – the stock sold off ~17% in the 24 hours after the announcement, and the price fell more than 20% through late September.
- Corporates positioned for M&A: After several years of taking a back seat to PE buyers, rising interest rates are slowing buyout activity from growth and buyout investors and appear to be giving strategics opportunities to bid competitively on top-tier VC-backed SaaS companies. That said, Adobe’s aggressive pricing is unlikely to reflect where the market is headed and would have likely beat out any financial sponsor bids, even in a healthy buyout market. Instead, looking forward, we believe most corporate M&A activity is likely to be structured around discounts to companies that were overpriced during the market highs in 2019 – 2021.
- Efficiency, not just growth: Beyond building a superior product, Figma scaled revenue efficiently and adopted a product-led growth GTM sales motion. The company maintains industry-leading gross margins in the 90% range – at a scale of $400M+ ARR – and has best-in-class unit economics with NDR rates of ~150%. Adobe’s core business revenue has slowed in recent years, and the premium paid was a lever to quickly resurrect growth without incurring additional debt.
- Durability, it’s a Long Game: In its early years from 2015-2019, Figma’s growth was limited by inferior products that failed to resonate with the market. The platform was changed iteratively prior to finding true product-market fit, and the company failed to monetize a single customer in its first four years of existence. Investors at SaaStr recalled at the time viewing the company's prospects and its vision of displacing Adobe as implausible.
Source: S&P Global Market Intelligence, PitchBook Data, Inc., The Motley Fool
6 – Pandemic trends proving variable
Depending on the software vertical, funding trends fueled by the pandemic’s alterations of consumer behaviors and ways of working, as well as global supply chain disruptions, are now on incongruent trajectories in the U.S. A summary of key sector themes is included below:
- Resilient enterprise tools in focus: Cloud-native security, data, DevOps, and core infrastructure and AI/ML software solutions are among the most prioritized areas of IT spend for Chief Experience Officers over the coming year, according to a Battery Ventures survey released in September. Even in a downturn, companies in these verticals are well-positioned to continue capitalizing on increased cloud infrastructure spend, a market which is forecast to grow 22% YoY to $90B globally in 2022.
- Late-stage digital health slows: Pandemic-related alterations to healthcare delivery, practice management and administration, analytics, and staffing continued to generate robust investor interest through 1H’22; however, U.S. digital health funding deal values fell 48% QoQ in Q3’22. Only 6 Series C+ rounds were financed in this space in Q3’22 and accounted for only 5% of the quarter’s total deal volume. Deal counts fell only 14% QoQ, indicating smaller deal sizes drove the trend.
- E-commerce cools: E-commerce software companies, which saw record 150+% YoY growth in 2021, are now seeing funding diverted to a high-performing minority. Global deal counts were down approximately 60% YoY through 1H’22, though total dollars raised increased, reflecting investors’ willingness to disproportionally back the top performers in a sector dependent on macroeconomic, discretionary trends. High inflation is reducing consumer discretionary spend as seen from the underwhelming performance YTD of both public online shopping and infrastructure/services providers; for example, Amazon, Wayfair, and Target have all announced declining e-commerce sales of ~5 – 10% through 1H’22.
- Supply chain woes create long-term opportunity: Funding for U.S. supply chain and logistics tech startups has also tapered off YTD, though in a more moderate fashion than the broader V&G activity declines. In Q2’22, U.S. V&G investors invested $4.2B in the sector, and through 1H’22, deal values were down only 13% YoY. Strong verticals during Q2’22 included last-mile delivery ($3.8B), enterprise supply chain management ($1.5B), and freight/logistics technologies ($750M).
Source: PitchBook Data, Inc., Rock Health, Crunchbase, Battery Ventures: State of Cloud Software Spending (Sept. ’22), IDC
7 – Potential directions for the V&G landscape over the next 12+ months
We believe V&G investors’ guidance for portfolio companies to implement cash preservation tactics this year will continue, albeit in a more moderate form, over the next 12+ months. Well-capitalized companies that are backed by larger funds should have an enhanced ability to experiment, pulsing growth investments and testing market reaction to maintain aggressive annual top-line growth targets (50+%).
Below the top-quartile, the market will likely be a mixed bag, with some companies patiently waiting for valuation multiples to rise and prioritizing cash flow efficiency to directly compete with the growth leaders in their sectors of focus, and others reluctantly embracing early exit opportunities to provide liquidity for impatient owners. Most companies at early- and growth- stages will likely continue to focus on gross margin expansion and lowering OPEX requirements to attract potential future investors; this practice was referred to as “the healthy reset” at SaaStr.
In terms of V&G investment activity, we anticipate that current holdbacks in LP allocations to the V&G asset class will disproportionately impact the bottom-half of the investor market, but that top-quartile investors will likely continue to meet or exceed their fundraising and deployment targets and may increasingly have the power to set market standards for pricing and deal terms. In Q3'22, roughly 87% of U.S. fundraising dollars were allocated to established managers, with many of the top players in the industry – Bessemer Venture Partners, Battery Ventures, Lightspeed Venture Partners, and Oak HC/FT – closing new $1B+ funds.
The disparity among investor quartiles is likely to grow, as those concentrated at the top are also the ones sitting on the most dry powder to deploy into new investments. Investors at later stages of fund deployment with smaller LP bases will increasingly look to double down on the winners in their existing portfolios. Overall, we expect a reduction in competitive auction-style bidding and more relationship-driven fundraising processes to occur in the background as the markets recover.
We see signs of several emerging areas of focus for V&G investors, including the clean energy transition, applied AI, cloud/edge computing, connectivity/networking, and supply chain/infrastructure technologies. These sectors have the advantage of proven market adoption, clear addressable market opportunity, and more predictable levers to manage growth and profitability metrics. While top-line growth will no longer be the prevailing sole determinant over investment parameters, we believe these sectors are primed for continued V&G interest that will fuel further innovation.
Recent McKinsey research revealed that of the 14 top sector trends identified as commercial priorities in 2022, the clean energy transition and next-generation mobility attracted the most investment dollars, while applied AI – defined as models trained in machine learning with broad use cases – received the highest interest and innovation/adoption scores of the sectors listed below.
Source: PitchBook Data, Inc. - PitchBook-NVCA Q3'22 Venture Monitor Report
It’s notable that many of the “DeepTech” verticals – including Web3, SpaceTech, AR/VR, and quantum/next-gen computing technologies – maintain relatively average interest scores along with their low innovation and adoption scores. We suspect that these nascent verticals will have an even more prolonged innovation path under current market dynamics as investors pull back from speculative, R&D-heavy investments.
The capital-intensive nature of some of these businesses, along with the risk of unproven market traction with customers, are likely to limit the subset of investors entering these domains. Alternative financing strategies will likely bridge these companies’ cash needs; as an example, in early October, Automation Anywhere, a robotics-software company based in San Jose, California, raised a $200M debt round despite having companies such as Salesforce, SoftBank, Goldman Sachs, and NEA on its cap table.
8 – Conclusion: where may we be headed?
V&G stakeholders in the U.S. appear to be cautiously optimistic that private SaaS company valuations will return to near pre-pandemic, historic levels over the next 6 – 12 months, with top performers being underwritten on forward ARR multiples in the range of 8-11x+. Premium SaaS multiples of 20x+ that were commonplace during the pandemic will likely be reserved for the limited subset of companies exhibiting both high-velocity scalability and cash burn efficiency.
Below the top-quartile growers, late-stage private SaaS companies are likely to continue receiving significantly greater scrutiny and valuation discounting unless they can prove unique product differentiation, ability to grow into past valuations, and/or clear paths to profitability. Even with a positive turn in the markets, most V&G stakeholders agree that pandemic-level pricing averages for new investments and exits are unlikely to resurface in the near-term.
However, well-funded GPs will have the option to seek opportunistic bets in a down-market – as we’ve seen in past recessionary periods – and are likely to elevate private market multiples over those of their public peers. As a potential recession looms, companies offering software solutions deemed non-critical and discretionary within the enterprise, and those providing D2C offerings to consumers, are likely to see a sustained pull-back in funding over the next 12 – 24 months.
M&A activity for V&G-backed software companies has slowed as large corporate buyers have pulled back on new growth investments, but evidence exists that there are growth-focused buyers willing to pay significant premiums for superior technology assets and to cement market leadership (i.e. Figma/Adobe, Streamlit/Snowflake, Attivo Networks/SentinelOne). Value-oriented software buyers are likely to increase their acquisitive activity over the next 6+ months as more targets consider sales in a challenging fundraising environment. Financial sponsors in the U.S. can be expected to continue their increasing pursuit of tech buyouts, which now account for 31% of the total market and have become the industry’s predominant area of focus.
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