The biggest story to come out of the post-March stock market boom has been explosive growth in the value of technology shares. Software companies in particular have seen their fortunes recover; since March lows, public software companies’ valuations have more than doubled, according to one basket of SaaS and cloud stocks compiled by a Silicon Valley venture capital firm.
Such gains are good news for startups of all sizes. For later-stage upstarts, software share appreciation helps provide a welcoming public market for exits. And, strong public valuations can help guide private dollars into related startups, keeping the capital flowing.
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For software-focused startup companies, especially those pursuing recurring revenue models like SaaS, it’s a surprisingly good time to be alive.
Indeed, after COVID-19 hit the United States, layoffs and rising software sales churn were key, worrying indicators coming out of startup-land. Since then, the data has turned around.
As TechCrunch reported in June, startup layoffs have declined and software churn has recovered to the point that business and enterprise-focused SaaS companies are on the bounce.
But instead of merely recovering to near pre-COVID levels, software stocks have continued to rise. Indeed, the Bessemer Cloud Index (EMCLOUD), which tracks SaaS firms, has set an array of all-time highs in recent weeks.
There’s some logic to the rally. After speaking to venture capitalists over the past few weeks, notes from EQT Ventures‘ Alastair Mitchell, Sapphire’s Jai Das, and Shomik Ghosh from Boldstart Ventures paint the picture of a possibly accelerating digital transformation for some software companies, nudged forward by COVID-19 and its related impacts.
The result of the trend may be that the total addressable market (TAM) for software itself is larger than previously anticipated. Larger TAM could mean bigger future sales for and more substantial future cash flows for some software companies. This argument helps explain part of the market’s present-day enthusiasm for public tech equities, and especially the shares of software companies.
We won’t be able explain every point that Nasdaq has gained. But the TAM argument is worth understanding if we want to grok a good portion of the optimism that is helping drive tech valuations, both private and public.
The startup winter that wasn’t
There have been fewer startup deaths since the start of the COVID-19 pandemic in the United States than I anticipated. There are several explanations for why this is the case. One is that most startups simply weren’t hit too hard by the pandemic. In a recent chat with two GGV investors, TechCrunch was told that 10% to 15% of startups are seeing tailwinds from the pandemic, another 70% to 80% of startups are doing just fine, while the rest have hit sector-specific bumps in their journey.
Another possibility detailed to TechCrunch by EQT Ventures’ Mitchell is that some startups are delaying fundraising by extending runway, providing them with more time until their zero-cash day. However, whether they will be able to raise more capital later is not clear. So, some startup closures could be artificially on hold due to a recent discovery of cost control. We’ll see more on that in early 2021.
But as the GGV investors noted, some startups are seeing not merely survivable results in the COVID-19 era, but middling results all the way up to growth acceleration. What could possibly drive flat-to-better growth in a time of stark unemployment and uneven economic results? It appears that the digital transformation’s purported acceleration — something that TechCrunch has covered recently in some detail here and here — is real enough to boost some software companies.
So what? The digital transformation is effectively TAM gains over time for software and cloud services. As more companies move their processes and services online, the demand for digital tooling and cloud infrastructure rises. This means that software companies can sell more product today and possibly more in the future, implying that their future cash flows could be larger than expected, raising their present-day worth.
2020 hasn’t brought the startup winter that many feared. And for some tech companies it’s brought a surprise bounty to boot.
Acceleration?
Speaking with Sapphire’s Das, the VC discussed an acceleration in software results after March. In Das’s view, if a company is selling a hosted digital tool, a public cloud service, or some other type of SaaS product, the market is moving in its direction now more than before.
This secular movement has possibly boosted TAM for software companies. Das cited companies like Snowflake as an example of the point, arguing that some investors have simply not seen how big the data-focused unicorn’s market really is. It includes more than merely the software products it might directly replace, with Das including other, related costs like personnel that currently staff in-house data centers to its possible future sales results.
Considering this piece of Das’s market perspective, it’s easy to be a general software bull. But, we should be careful to not get too excited. Boldstart’s Ghosh told TechCrunch in an email that while “COVID-19 has definitely pulled forward software spend,” that in and of itself “is not the same [thing] as TAM expansion.”
This separation of near-term acceleration and long-term TAM is an interesting nuance, though Ghosh added in his missive that there are “some data points that point to TAM expansion, however.”
Possibly rising TAM, according to Ghosh, could help explain some recent valuation gains, with the investor writing that addressable market “expansion hopefully is actually occurring to justify higher SaaS multiples and paying further ahead of future revenue and free cash flow.”
Partial acceleration
Balancing the perspectives, it seems fair to say that acceleration is happening in some software companies, but that TAM perhaps won’t rise for all.
For the companies that it does lift, however, the results could be extreme. Mitchell told TechCrunch that the best companies are “getting funded with more and faster because they’ve been seen as the ultimate winners in a time when you can create very big winners, because everything else is cheaper. [There’s] more talent in the market, lots of companies to mop up and buy [and there’s the] acceleration of digitization trends, [and] acceleration in some markets post-COVID.”
Startups getting funded with “more and faster” is akin to sharply rising share prices for public companies; each shows an enthusiasm amongst investors to put their money into those companies now, with a greater focus on speed of capital deployment over caution regarding price.
Still, not all software companies are seeing sorts of tailwinds that mean they deserve a dramatically higher valuation than they once command. Mitchell explained this to TechCrunch, saying that investors are placing investments “into two buckets.” The first includes startups with “average SaaS, or consumer-business level or risk. Companies where “it might or might not work” in a good-sized market. But then, in his view, there’s a small percentage of startups that have huge TAM “that has been accelerated by two to five years because of COVID.”
Those companies, Mitchell said, are going to attract “boatloads” of cash. In contrast, the companies that aren’t seeing similar growth are going to endure big valuation compressions and down rounds.
The question becomes what percentage of software companies do catch a tailwind. How many are seeing present-day acceleration and long-term TAM expansion, and not merely the former? And are investors, both public and private, able to separate the two buckets correctly?
We’ll see. But it does seem fair to say that some of rising valuations for public software companies, and a portion of the notable private software rounds we’ve seen in 2020 are less reality-free than we might have thought. That is, of course, if the economy doesn’t turn yet again.
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