5/15 OpenView Capital Markets Roundup

Not all growth is created equal.

In (Zoom) conversation this week, a friend noted that “if you take a million coin flippers, one of them will come back in a century and say, ‘I’ve flipped a coin 1M times and correctly predicted it would land on heads each time. I’ve modeled coin flipping and can’t lose—it is always heads.”

The point being that despite the probability with a fair coin being exactly 50%, empirical data leads us to form conclusions that expose us to significant risk. Much like the conclusion that high growth begets high valuations because enterprise SaaS companies have large markets, sticky revenue and have always generated large, predictable cash flows at scale.

But not all growth is created equal—nor deserving of the same multiples. Since the topic of software companies with iffy accounting remains current (this week Smartsheet updated key risk factors) we want to double-click on the discussion of non-GAAP SaaS metrics.

Everything is valued on cash flow… eventually. For growth SaaS assets, investors are comfortable with annual losses because the invested capital (product & engineering and sales & marketing expense) is creating future value as large cash flows. How? This invested capital drives revenue growth. Once acquired, each dollar of subscription revenue—at scale—will cost about 30 cents to deliver (COGS), 5 cents to process (G&A), and another 35 cents to maintain both the product and customer relationships (product upkeep and renewal sales). At scale, each dollar of revenue equates to 30 cents of cash flow. This piece outlines in more detail how to think about segmenting “maintenance” vs. “growth” expense in SaaS businesses.

The above logic is why ARR growth, retention and CAC payback (or whatever sales efficiency metric you prefer) matter. SaaS metrics aren’t just nice to have—they are core to the thesis around investing in enterprise SaaS. But as they aren’t required disclosure investors are forced to either rely on passing management commentary or to parse through heavily massaged metric definitions (just take a look at how differently each enterprise SaaS company defines “dollar-based net retention” in 10k footnotes).

As reader Paul Barnes pointed out, “When we consider return versus risk, increased transparency greatly reduces the risk…such realities come out eventually” (source). Berkshire Hathaway noted in their 2020 annual letter: “[Audit] committees remain no match for managers who wish to game numbers…”

Increasingly it feels like public SaaS investors are just coin flippers who keep landing on heads—especially after a second week of record high prices in the SaaS markets. Each quarter rosy sell side guidance is followed by a strong beat and raise and opaque commentary about ARR, retention and efficiency. Investors “sort of” get a sense for these things but don’t demand more detail because the markets are so large and tailwinds so strong that the coin keeps coming up heads like it always has before.

But it isn’t a fair coin—management can put heads on both sides and eventually, these trends will slow down and folks will start seeing tails. We firmly believe that a rigorous accounting-like standard for SaaS metrics should be required for public SaaS companies. Short term this would result in both positive and negative repricing across the SaaS landscape, but long term would contribute to healthier SaaS markets overall.

Financial Resources

Business Planning 
On the final episode of OpenView’s Building to Last podcast, Blake Bartlett spoke with co-founders Robert Wahbe and Oliver Sharp from Highspot. They discuss the do’s and don’ts of communication during a crisis as well as some mental health tips for leaders during this difficult time. A few takeaways from the episode include (1) don’t waste time forecasting, focus on optionality, (2) how to make sure customers get the most value out of your product, and (3) mental health is a marathon, not a sprint.

PPP Update
The day before the PPP safe harbor deadline the Treasury released updated FAQs, including an updated Question 46. As it relates to the necessity criteria borrowers of less than $2M will have been deemed to make the necessity certification in good faith. For those without this new safe harbor, if they are found by the SBA to have not have had an adequate basis for necessity certification, the SBA will seek repayment of the loan (and bar forgiveness of it) but the SBA will “not pursue administrative enforcement or referrals to other agencies based on [the necessity issue]” so long as repayment is received.
This should not be considered a comprehensive analysis and all companies should continue to consult their counsel and Board on this topic. While a positive development it is too little too late for many borrowers who would have benefitted but didn’t pursue loans due to opaque eligibility criteria.

Capital Markets Resources

Market Updates

We enjoyed this April Tech M&A report from AGC – total disclosed tech M&A value declined 76% YoY in April. We typically focus on equities but the credit markets for corporate debt provide significant insight into investor sentiment. When investors are bullish they move funds into equities and riskier corporate debt (riskier than the “risk free” US Treasuries). As the price of these bonds goes up the implied yield to maturity goes down thus “spreads tighten.” As Europe began to reopen in April spreads tightened and their credit market returns led the world – we hope to see a similar recovery in US corporate debt markets as states continue to reopen. All but the SaaS Index closed the week down as worries about the economy and reopening timing increased (SaaS +3.44%, Dow -2.65%, NASDAQ -0.73%, S&P 500 -2.26%).

Economic Data
Fed Chair Jerome Powell’s speech on Wednesday was less than optimistic. He noted that while the expectation has been for a quick recovery his belief is that the markets are increasingly divorced from the economy and a downturn will persist for an extended period. Powell urged the government to act more aggressively in their efforts to curb recession, but Congress remains divided over passing additional relief. As we‘ve written previously the market has priced in a V-shape recovery and continued government stimulus (the “irresistible force”). As of Friday, neither seems like a certainty anymore.

What Else We’re Reading)

SaaS valuation multiples moved up nearly 15% from 8.8x to 10.1x 2020E revenues at the median to open the week. Principles for Navigating Big Debt Crises by Ray Dalio (will download full PDF of book from Bridgewater Partners). To bootstrap or to fundraise? A second week of optimistic trends from Hubspot.