Software — the “OG” as-a-Service model

If there are two phrases I come across most in my day job as an investor it’s “tech-enabled [blah]” and “[blah]-as-a-Service”…

It makes sense, since investors have a justifiable fetish for business models that benefit from digital transformation and those that are characterized by highly recurring revenue with close to zero marginal cost.

It’s 2022, which means we’re officially in a new era of “Everything-as-a-Service”. A friend of mine who lives in a luxury building on the Upper West Side has a Dale Chihuly chandelier in his lobby. If you’re not familiar, Chihuly is a famous artist known for his glass blown works that fetch millions. What I recently learned from my friend is not only did the building pay a [million] bucks for the chandelier — they have a dedicated team that comes back every 6 months to clean the dang thing, for a fee of course!

And who else are you going to trust to handle the cleaning of your million dollar piece than a team assembled by the artist himself? Worst case they’ll crank out a new one in no time if they ever break it. Call it…Chihuly-as-a-Service.

The “OG” as-a-Service business is software, which despite now entering its third decade of existence, arguably remains in its very early innings. Let’s walk through an abbreviated history on the rise of SaaS (Software-as-a-Service):

“On-prem” software — literally meaning software installed on site — emerged in the 2nd half of the 20th century, with the rise of personal computing. Think old school Microsoft Office on floppy discs. I’m a 90s baby so even I remember those.

Enter the cloud computing age in the early 2000s, with the mind boggling growth of the big three “hyperscalers” — Amazon AWS, Microsoft Azure and Google Cloud. Cloud computing enabled a massive transition from “on-prem” software to SaaS, which is delivered via the internet and accessible by users from anywhere in the world, thanks to massive server farms and data centers hosted by the big three as well as others.

SaaS models can generally be characterized in two buckets — vertical and horizontal.

Vertical: Software designed to addresses the needs of a specific industry, such as Athena Health — an electronic medical record business

Horizontal: Software designed for use across industries and businesses, such as CRM tools like Salesforce and HubSpot

The beauty of both horizontal and vertical SaaS, as a product and business model is several fold. The growth of SaaS reflects a massive tailwind as nearly every industry becomes increasingly digitized. The benefit of software is that it doesn’t set out to fundamentally change industries but rather improve upon existing workflows. You’d be surprised by the number of businesses that still use pen and paper, clunky “on-prem” software or cobbled together, disparate tools that SaaS can easily and efficiently replace. Even still, SaaS remains categorically underpenetrated across major industries such as restaurants (6%), home services (1%) and automotive repair (2%). As a product category SaaS demonstrates a number of attractive and investable characteristics, a few of which are below:

• Recurring revenue, hence the “as-a-Service”
• High customer lifetime value (LTVs), driven by modest churn and high renewal rates, though this is obviously dependent on the specific company
• High gross margins, typically 70 to 80%, with COGS primarily network and delivery costs
• “Version-less”, resulting in highly efficient R&D spend focused on the next iteration vs. supporting prior versions

Bessemer Ventures recently put out a report that highlights their top lessons investing in vertical software over the last decade. A few highlights:

• Vertical software are smaller markets but often have winner take all dynamics; Companies buy what their peers are using
• The best companies build a “layer cake” of new products that drive growth e.g., integrating new services that are easy to cross-sell into existing customers (such as payment processing for Shopify or Toast)
• Monetizing customer data remains an under-exploited opportunity
• Use M&A to scale cautiously. Start small, integrate well and go bigger slowly.
• Continuously work on deepening your competitive moat; increase switching costs by capturing data, encouraging third-party integrations, extending offerings across multiple client departments for organizational buy-in (e.g., sell into marketing AND finance departments)

Sound fundamentals are critical across all business models — and software is no different. Some of the relevant KPIs investors track in the space include:

• Annual recurring revenue (ARR), monthly recurring revenue (MRR) multiplied by 12, to get to an annualized revenue figure
• Rule of 40, ARR growth + FCF margin should be 40%+ (more relevant for businesses at scale)
• Gross margins of 80%+, 25 — 30% operating margins at maturity
• Gross retention of 90%+ (Existing revenue less churn)
• Net retention of 100%+ (Existing revenue less churn plus new adds)
• LTV / Customer Acquisition Cost (CAC) payback between 1—3 years
• Capital efficiency, free cash flow burn of 1x ARR or less

I’m increasingly intrigued by a number of (primarily vertical) SaaS themes and ideas, a few highlighted below:

• Online ordering and loyalty tools such as Olo, Punchh and ChowNow which help restaurants rekindle a direct relationship with customers currently being disintermediated by aggregators such as Uber Eats, DoorDash, GrubHub, etc.
• Spend management software such as Jaggaer which helps companies identify key risks in their supply chain
• Compliance tech such as ComplySci which helps address challenges in highly regulated industries such as financial services
• Condition-specific, vertically integrated telehealth tools tackling the 84% of healthcare spend on chronic conditions, such as Oshi Health which is creating a “full-stack” solution for GI patients
• Specialty electronic medical record (EMR) and practice management platforms such as Therapy Brands (behavioral health) or Hippo (vet clinics)
• Patient engagement tools that enable the growth of the consumerization of healthcare such as Relatient and WELL, which offer new-age patient communication
• Video engagement platforms such as SundaySky and Fireworks, which power personalized video creation tools for brands to better engage with customers
• Software catered to the small & medium business (SMB) market such as Rinsed, a CRM for the car wash industry or Heard, a back office accounting platform for independent therapists

As I’m writing this (June 2022), Bessemer’s cloud index, which tracks the performance of emerging public cloud software companies is down 50% year-to-date given the growth shakeout triggered by rising interest rates. While painful — the correction is probably a healthy one, as revenue multiples which approached or exceeded double digits are coming back to reality.

Bessemer Cloud Index EV / Forward Revenue

We’re still in the early innings of digital transformation — which I think will be one of the greatest secular tailwinds of our generation. The future looks bright for SaaS companies that solve differentiated pain points, have an attractive underlying economic profile and can find an efficient path to market leadership. I look forward to following as the space continues to grow and evolve!

Thanks for reading — have feedback? I’d love to hear from you. Feel free to slide into my DMs and speak your mind!