In the past decade, a playbook for buying and growing software assets has helped smart investors and management teams make a great deal of money.
This playbook is now widely copied:
- Seek specialised software assets that are market leaders and mission-critical to customers;
- Focus on growing markets below the radar of global software giants
- Carefully but steadily raise prices and upsell
- Manage costs tightly and, where possible, build a portfolio of more than one software asset in the vertical, building links between products to strengthen retention and drive cross-selling
Further value has been created through bolt-on acquisitions that offer both p/e multiple arbitrage and some strategic and operational synergy. An analogy on the public markets is Constellation, which has returned on average over 30 per cent p.a. to shareholders since its IPO in 2006.
But – and there must be a ‘but’ – it is getting harder to make exceptional returns using the old playbook.
Owners of software companies are savvier about their potential value, and many more potential buyers are now chasing the same deals. The future value-adds from the old playbook are already in the price paid on day one.
So, a new owner needs new ‘plays’ to get an exceptional return.
At OC&C, we’ve identified three high level ‘plays’ every software company should be adding to their playbook. All three are harder to achieve than the wins in the old playbook – but if they’re done well, they promise to yield many more years of outstanding value growth ahead.
1) A more sophisticated approach to pricing. It is still common to see simple above-inflation annual rises, or a deal offering lower annual increases in exchange for multi-year contracts. Looking forward, we will see more sophisticated approaches that better align price increases with willingness and ability to pay. We will also increasingly see yield-based approaches and bundles replacing modules on a price list – especially for products where the ‘obvious’ upsell modules are mature. Lastly, the pricing strategy must be designed to support rather than hinder the transition to the cloud – which often requires detailed analysis and long-term strategic thinking.
2) Development of progressive Software as a Service (SaaS) propositions, and a long-term cloud migration strategy. This is inevitable, and not trivial. Use smart segmentation and proposition development to create a plan that repositions you as a SaaS player, while avoiding cannibalising existing profits unnecessarily. We believe the key is to define and develop a proposition explicitly targeting progressive customers, positioning your business as their champion
3) Reposition for the long term: build Services, Data and Networks – each of which contributes to long run growth as well as acting as a moat.
- Default to including services in your proposition, rather than a pure software business model. Most investors instinctively prefer a pure software model without services: high margin, super-scalable, what’s not to like? We believe the burden of proof should be reversed, that services can usually help you win, and that you should ask ‘Can I really win without services?’ We see forward-looking vertical software players using professional services to bring them closer to customers and improve feedback, and to educate customers, ensuring they get the most value from the product (these tend to work better than encouraging customers to customise their implementation, which stores up problems on the software upgrade path). We also see support services bringing the software company into the client’s daily workflow and, when done well, creating a sense of team as well as some high margin revenue and stickiness. A final point on services: we often hear, especially from investors, a point of view that services are low margin – but the reality we see is that high quality services organisations have an effective monopoly with the client and frequently achieve contribution margins of 35-40 per cent.
- Start work on a data strategy. On a 5-10-year view, data will be a source of strategic value in many verticals. The right data strategy now will unlock a future step change in value for software businesses that are able to offer AI-driven productivity gains for customers. In some cases, a wholly new and incremental business model may be available in the years to come. In verticals with data-led potential, we would recommend thinking this through sooner rather than later, as it will feed into proposition design and pricing (e.g. do not price in a way that creates a disincentive to usage and the generation of potentially valuable data).
- Build in network effects. SaaS native software businesses like to focus on using network effects to add value for users while increasing switching costs. Network effects can be designed into the user level (e.g. collaboration tools such as Slack), the client level (e.g. data co-operatives, marketplace models), the channel level (e.g. joining ecosystems such as Salesforce). Cultivating the right network effects will likely be the single biggest driver of value to market leading vertical software businesses in the years ahead.
The new playbook often necessitates a reshaping and upgrade to many aspects of the business. It is fundamental, but very doable.
Businesses need a strong action plan to:
Tackle each of the 3 plays that are necessary for success in the years ahead. Every scaled software company should have:
- A high quality and fact-based strategy for pricing
- A plan to target the most progressive customers in their market
- A smart plan for each of Services, Data, and Network Effects
Add and upgrade organisational capabilities, KPIs and incentives. Capturing value remains key of course – but many incumbent software businesses will have to re-learn how to create more value for customers.
Clean up the brand and product portfolio to make room for innovative SaaS propositions, and rethink the product and tech stack for the long term.
This reshaping may be a one-year journey or a 3-5 year one, and the level of urgency varies greatly from case to case. But the direction of travel is clear.
Justin Walters, Partner, OC&C Strategy Consultants
Image Credit: B-lay