Due to rising valuations, combined with the niche focus of most new SaaS companies, VCs will find it harder to earn their target returns in the future. Why we think this below
In a recent article, TechCrunch provided an intelligent thesis on how the enormous returns that VCs have seen in their SaaS investments are unlikely to be repeated in the future.
In this blog post, we discuss a few of those ideas—and some of our own—as we ponder the future of SaaS investing.
1. The Maturation of SaaS
Just a decade ago, the “Software as a Service” business model was still unconventional. At the time, most of the investor interest was in consumer-focused technology companies due to the hype around initial public offerings (IPOs) for the likes of Facebook and Twitter.
For VCs willing to invest in the B2B space, prices were relatively cheap, providing investors with great opportunities in companies that would become some of the world’s biggest unicorns (think Slack, Qualtrics, and Datadog).
2. Demand for Enterprise SaaS
There is no longer a supply-side constraint on VC investments for enterprise SaaS. In fact, the tables have turned—enterprise SaaS is now more popular among VCs today than consumer SaaS. B2B SaaS has proven more stable and dependable in its growth than consumer technology companies.
3. SaaS Finds Its Niche
The “Oklahoma Land Rush” of SaaS started in the early 2000’s as innovative SaaS companies took on critical business processes and converted them to SaaS. On top of the conversion of existing business processes, SaaS growth was further supported as companies invented new business processes and brought them to market, utilizing the SaaS model.
However, the penetration of SaaS business processes into core business processes will eventually approach an asymptote. Further growth will occur as a result of the creation of new business processes, which are generally more niche and ever more competitive. In essence, the SaaS market is becoming balkanized as it develops. New companies are seeking niche models, focusing on one or two market verticals rather than being a platform technology across multiple verticals.
For SaaS companies that start today this means that the likelihood of an IPO is decreasing. The more likely outcome for SaaS companies today are to sell for a modest price (e.g. $50M to $100M). While a $100M exit can be lucrative for the founders and their angel investors, it does not make economic sense for a venture capitalist who needs the triple, triple, double, double, double (T2D3) from a proportion of its portfolio in order to deliver the returns their investors are looking for.
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4. Price of Investing has Increased
The biggest threat to the VC status quo are company valuations. According to the TechCrunch article, what might have been a $4 million Series A round at $16 million pre-money a decade ago, is now a $20 million Series A round at $80 million. These insane valuations are driven, in part, by the unusual valuations on Wall Street, where companies like Slack and Datadog have a revenue multiple of 25x and 64x, respectively.
The bottom line is that higher prices make it harder for VCs to secure great investment returns for their investors. The lucrative SaaS bets made a decade ago, at much lower valuations, are not a good indicator of the investment returns to be expected going forward.
The VC Model No Longer Fits SaaS
Due to rising valuations, combined with the niche focus of most new SaaS companies, VCs will find it harder to earn their target returns in the future. And since banks are reluctant to lend to asset-light SaaS companies, where does that leave future growth capital for enterprise SaaS?
Revenue-based financing is stepping in to fill the void. Finance companies like TIMIA have created revenue-based financing models that are specifically tailored to the opportunity that niche SaaS companies present.
These non-dilutive financing options can meet the changing needs of today’s SaaS companies that VCs are ill-suited to. Further, they are more founder-friendly than venture capital as the entrepreneur retains equity in their business.
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