I have given this talk to a variety of large tech companies and investors. The goal is to educate others around qualitative aspects of enterprise software investing and how you can use these insights to determine the quality of the company.
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A Framework for Evaluating Enterprise Software Companies
1. A Framework For Evaluating
Enterprise Software Companies
Shomik Ghosh
August 2019
2. My Investing Principles
Incorporate multi-disciplinary learning into investing - Munger
Be mindful of behavioral biases (overconfidence, loss aversion, availability)
Buy and hold exceptional businesses for the long term
Invest as an owner, not as a trader
Understand qualitative factors first and then approach valuation
Mauboussin: “Value is the present value of future free cash flow”
Determine the inputs and outputs of these factors that drive long term FCF
and form a view as to sustainability and duration of “competitively
advantaged period”
Culture is a function of business performance, mission, and learning
environment
Tom Russo: “Capacity to Suffer”
3. Illustrative Holdings
High barriers to entry (regulatory, upfront capex)
Excellent marginal unit economics
Strong management investing for long-term
“Capacity to Suffer” - India
High barriers to entry (regulatory, trust – see 2008)
Multiple strong businesses with pricing power
Plenty of areas to reinvest in business while still
returning capital to shareholders
Outstanding capital allocation
Owner mentality pervades culture
Flexible decentralized organizational structure
Strong FCF generation from vertical software in niche markets
4. How Do I Evaluate Enterprise Software
Companies
1. Qualitative understanding of the product, industry, and company culture
2. Business Model/Strategy
3. Alignment of Cost Structure
4. Switching Costs
5. Distribution
6. Valuation – Factor of all the above and then overlaying what you believe is
a reasonable multiple to pay
Strongest mental model is evaluate everything with the lens of what will produce
the strongest steady-state FCF
5. Qualitative Understanding
Need to take scuttlebutt approach to investing here picking up datapoints from
podcasts, engineers, PMs, salespeople, and customers
Hiring velocity, nature of hires, tenure of employees (LinkedIn, Google Trends)
Product velocity, company blog posts
Glassdoor reviews; medium posts on leaving/joining company
Centralized vs decentralized decision making in management team
G2Crowd, Stackshare, Hacker News, Reddit, Youtube
S-1s and transcripts of other companies
No substitute for talking to employees directly
6. There are certain misconceptions in
enterprise software that need to be
addressed in order to properly provide a
framework for evaluating companies in
this sector.
7. Misconception #1: Business models
matter more than strategy
Reality: Business models help guide strategy but need to be combined
together to have strong execution
8. Business Models
Bottoms Up
Higher sales velocity, many cases direct sales learns based on engagement within
product by same customer
Typically lower upfront CAC at steady state
Product marketing, community engagement
Low friction to purchase/use: website optimization, freemium, documentation
Top Down
Slower sales velocity, inside sales & marketing generating leads for direct sales
Typically higher upfront CAC at steady state
C-suite strategy discussions, budget optimization
Channel partners and professional services help to lower friction to purchase/use
Typically a higher friction to use product; many times requires
certification/training
10. Business Models Help Guide Strategy
Top Down Sales Model
Delving deeper into vertical
offering
Customers generate more
predictable FCF at steady state
Vertical approach: Security,
Syncing, Integrations,
Permissioning, Automation,
Authentication
Extract more revenue from
existing customers
Bottoms Up Sales Model
Moving horizontally into
adjacent verticals
Business model generates more
FCF quicker to reinvest
Horizontal approach:
Collaborative productivity
software (Paper), Design
(Showcase), E-sig (HelloSign)
Broaden product base to address
more new customers
11. Case Study: Elastic Acquisition of
Endgame
Bottoms up, product-led distribution model with strong open-source brand
Strong steady-state FCF from core product
Why buy an endpoint security company in a competitive environment?
Potential upsell opportunities
Already ingesting log data so threat hunting should be relatively easier
No endpoint security companies have tried bottoms up model; asymmetric risk/reward
Already have distribution
What if it doesn’t work?
Product offering still augments core search, APM, and infrastructure product
Increases gross retention as a nice-to-have add-on
Business model allows for experimentation because can view demand from open-
source or free tier of product before staffing sales team
12. Misconception #2: Top down business
models are better than bottoms-up or
vice versa
Reality: Need to align cost structure to business model
13. Alignment of Cost Structure
Not all enterprise software companies are the same
Go-To-Market approaches need to be tailored to:
Average ACV/ARR including potential upsell
Gross margin (at steady state) – thinking about long-term steady state is important
(storage infrastructure is example)
Churn
Sales cycles, contract length
Customer Lifetime Value (LTV) / Customer Acquisition Costs (CAC) is
shorthand for this
Shorthands only work though if you have innate understanding of industry/product
Read Michael Mauboussin paper on P/E ratios or EV/EBITDA multiples
Read Bill Gurley’s paper on the “Dangerous Seduction of the LTV Formula”
14. Alignment of Cost Structure…ServiceNow
G2K ACV of $1.7M
Gross margin: 83%
Churn: 1-3%
Avg contract term: ~ 3 years
CAC Payback: ~20 months
15. Alignment of Cost Structure…Twilio
Average ACV of $10k
Gross Margin: 55%
Churn: 3-5%
Avg contract term: 12 months +
CAC Payback: ~10 months
17. Case Study: Endpoint Security Space
Endpoint security may be one of the most brutal areas of competition
Marketing technology exhibits similar dynamics
Very hard to estimate true alignment of cost structures
Threats from bad actors are constantly evolving (higher steady state R&D
expenses)
Customers consistently conducting Request for Proposals (RFPs) to evaluate
new entrants (higher churn, lower LTV, less capital efficiency, more CAC)
Large market opportunity attracts lots of competition
Companies like Elastic and Microsoft offer endpoint security as non-core add-
ons to essential business to increase stickiness
Hard to align a cost structure properly here
18. Misconception #3: Switching costs apply
to hard to rip out software only
Reality: Switching costs can take multiple forms and need to be analyzed
from the viewpoint of a customer
19. Traditional Switching Costs
Classic Switching Costs
Salesforce CRM
Gmail
Workday
These are all systems of records, storing your data, files, identity, etc
Switching is a huge burden on enterprises or users in terms of cost, time, and
maintenance of critical data stored in systems
Large CAC upfront is warranted
20. Other Switching Costs
Survey Time!!! – Productivity Software Questions
Non-traditional switching costs
DocuSign
Smartsheet, Airtable, Asana
Zoom
Slack
Products that users opt into out of love, network effects, branding… or laziness
Example: switching from Dropbox to Google Drive
New product must come in either meaningfully cheaper or with much better
functionality to replace
Habit and ingrained workflows are a powerful deterrent
21. Misconception #4: Distribution only
matters in consumer goods, not
software
Reality: Distribution can create large moats in enterprise software
22. Distribution is King/Queen
What do you think of when you hear distribution?
Guns, Germs, Steel: QWERTY keyboard example (also ties into switching costs)
Distribution in many cases can overcome a bad product
Ability to rapidly expand surface area of interaction with customers
Leads to more customers and more cash flow
Leads to more capital to reinvest in product and distribution
Virtuous cycle
“Consumerization of IT” trend changes some of this in certain verticals
Developer software
Productivity software
Design software
23. Distribution is King/Queen…examples
Initial CRM product, not necessarily considered by experts to be best product
Business model innovation in subscription payment and then hosted product
Many Salesforce products still have quarterly release cycles, so how do they
succeed?
Sales Cloud -> Marketing Cloud (ExactTarget) -> Commerce Cloud
(Demandware) -> API Cloud (Mulesoft) -> Analytics Cloud? (Tableau)
Leveraging inherent distribution channel to upsell customers in new verticals
Benefits to customers of bundling, lower friction
Benefits to Salesforce of expanding TAM, generating more FCF
24. Distribution is King/Queen…examples
Started with Jira, essentially creating new market in developer product
management and collaboration tools
Business model innovation in freemium (30-day free trial) product
Jira and Confluence provided steady stream of users to website and
community support
Acquired Hipchat (work chat) -> Bitbucket (VCS) -> Trello (task management)
-> OpsGenie (IT Alerting)
Same benefits as Salesforce….different approach
26. Takeaways
Enterprise software contains huge advantages as a quality focused investor
Pricing power
Barriers to entry
Asset light and capital efficient
Network effects
Reinvestment moats
Focus on differentiating the quality from the generic
Patience is a virtue
Most enterprise software trades in highly correlated manner
Leverage your technical skillsets and environment at Google to conduct
scuttlebutt research that provides you an edge