framework fo revaluating enterprises oftware companies-190826155044.pdf

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
This is similar to consumer SAAS.. low price ticket....
Here one needs to meet with CFO and CTO to drive sales.... high ticket size so SG&A cost is very high....
LOW SG&A
Big lever for both is
understanding of
Life Time Value
To get LTV right you need to
understand switching cost...
High friction in sales...due to
high ticket size...
Low friction in sales
Larger the sales team higher the switching costs as you need to train
lots of people....
U need to be reasonably certain of high LTV,
else SG&A costs would not recover...

9. Business Models…Discussion
Vs.

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

16. Is Any Model Better?

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
User Interface is a switching costs too....

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
Your implementation partners become your sales force...
If implementation partners chooses your product over
competitors you will get edge...

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

25. Tying It All Together

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