Platform People Demand
Plenty of products fit a market, but very few products are in high demand by its market. It's not enough to be part of a secular trend, as nearly every software company is. Every business is moving to the cloud, all businesses need enhanced cybersecurity coverage, and so on. In order for a company to be considered in high demand, there must be real people at real companies clamoring to buy the software. Software companies typically fall into two "demand" buckets.
The first demand bucket is product-driven demand, where individuals buy and implement self-service. Best examples are Atlassian (TEAM), Slack (WORK), and Intuit (INTU). Signs that a company may be a "product-driven demand" type of company are short sales cycles that are driven by 1-3 people, usually end users. Product-driven companies typically have lower ACV and a self-serve, freemium or open-source model, and heavier investment into marketing and channel partners than direct sales. These companies are closer to B2C tech companies in that they can go incredibly viral, really quickly, with higher FCF than the second demand bucket. Marketing and product are the two most important functions typically.
The second demand bucket is "distribution-driven demand." These types of companies typically sell to committees within their customer base and have a longer sales cycle with higher average ACV. The best examples here are Veeva (VEEV), VMWare (VMW), Workday (WDAY), and nearly all of the supermajors (IBM, SAP, ORCL, MSFT). These vendors are usually older and their differentiation lies in their sales+marketing teams. They have strong relationships with their clients, huge switching costs if they're an incumbent, and the ability to devote significant resources to winning a deal. Sales and marketing are by far the most important functions in these companies.
You may be thinking to yourself (or yelling at your screen) "aren't you just describing an SMB-focused software company vs an enterprise-focused company?" You're not wrong, but there's more nuance than that.
There are some companies that effectively straddle this line between "product-driven demand" and "distribution-driven demand" type companies, and these are the most valuable in our eyes. The moniker "unicorn" is already taken, so let's call them "zebras" because they're two distinctive colors in one. Companies such as Smartsheet (SMAR), Zoom Communications (ZM), Alteryx (AYX), and Elastic (ESTC) have all created awesome products and have THEN built awesome sales+marketing machines.
It's much easier to go from product-driven to distribution-driven than the reverse. Especially in 2020, when the cloud has made buying and implementing software easier than ever. These companies that straddle the middle line have the best of both worlds. They have the viral, low CAC growth of product-driven companies combined with a high and growing net retention rate usually found in distribution-driven companies.
Our conclusion is this: Product-driven demand is table stakes for software companies in 2020, and growing more important for their initial wave of traction. This is leading many to believe that a great product is enough. The issue with a product orientation is that competitors can copy your product easier than ever before, too. The most valuable companies are ones than have a past history of product superiority, and have built a durable sales and marketing engine.
While product-driven demand is becoming more important, we think that “business driven demand” is a bigger moat and makes a more attractice investment. Products are easy, people are hard. If you have mindshare, relationships, and a decent product, you have better long-term prospects than just with a good product.
Where this is playing out in real-time is maybe the largest and most important battleground in tech, the cloud. AWS (AMZN) has a huge product head-start and have the majority of market share. Over the past 12-18 months, however, Azure (MSFT) has gained traction in the enterprise. Almost ZERO developers would tell you they prefer using Azure over AWS. AWS has better technology, bar none. But Azure is gaining traction and market share – why? It's because of MSFT’s strong relationships with enterprises. It's because they already know what enterprise IT buyers want, their priorities for 2020 and beyond, and yes - "what keeps them up at night." It's because the average enterprise already owns 50 or 100 different Microsoft products, it's because Microsoft sales reps already know how to get a deal done in their accounts, and it's because Microsoft already has a Master Service Agreement with their clients.
I don't use this example because I'm enamored with Microsoft. This is just my example because it illustrates the reasons a sales + marketing machine is an immovable object in enterprise software. Even if the products truly suck, it's hard for enterprises to overcome to sheer inertia of doing something new.
Really Hard to Kick Out
Robert Smith of Vista Equity Partners has a great quote about how valuable "sticky" software is.
“Software contracts are better than first-lien debt. You realize a company will not pay the interest payment on their first lien until after they pay their software maintenance or subscription fee. We get paid our money first. Who has the better credit? He can’t run his business without our software.”
If you own a small business, consider for a minute what would happen if any of your mission critical applications cut off their service to you? If you work a day job, what can you accomplish without email, a CRM, or whatever other software you use every day. Practically nothing.
Many software investment analysts use the term "mission critical" to describe a software that a company cannot function without. I don't think that term goes far enough. "Really hard to kick out," goofy as it is, encompasses more of the ways a software vendor can ensure it gets paid before the customer's first lien lender. Here are the traits I find encompass a product that's hard to kick out:
Mission critical (Will our business function without this software? Can our employees do their job without this software?) Some take this term too literally and think of mission-critical as only important things like a billing system, Internet provider, or supply chain suite. This can also be things that groups of people MUST have to do their job. If a graphic design consultancy can't access Canva or their Adobe suite, there will be hell to pay. You can get around not having a billing system for a few days, at least.
High switching costs (Would switching to a competitor disrupt operations? Are other systems reliant on this one that could be disrupted? Would the cost of switching and risks of downtime outweigh the potential savings?)
Industry insights and relationships (Does my current vendor provide valuable insights that I'd lose by switching from them? Do I attend this vendor's annual user conference and expand my network? Do I just darn like my salesperson?)
Career and Reputational risk (Do I have people who have hitched their career to a specific vendor? E.g. Salesforce admins, Quick Base developers, Oracle DBAs. How will these people react to a potential new vendor? Even scarier, has a certain executive promised certain results from using this vendor, and now they need to see those results through? Even better, has the software delivered the promised BUSINESS results? If so, any other vendor is a huge risk. Notice that these are ways "product-driven" and "business-driven" software companies can entrench themselves in a customer
Incumbent leverage (Do I have 5 other products from this vendor, and if I try to get rid of one of them, will they jack my overall price up? I already have an MSA in place with the incumbent, if I want to bring in a new vendor how much time will negotiating a new MSA take? What will the cost of that time be?)
Network effects (If I leave my current vendor, will I be able to find skilled people who know the other product? If I leave my current vendor, will current or future employees view the use of a specific software as a negative (for example, I know many software salespeople who refuse to use anything but Salesforce. Developers are especially important to consider – some will only choose an employer that has the "latest and greatest" tech. This is so they ensure they're more employable down the line.
In summary, we look at software businesses through this lens. Although it's simple in theory, figuring out if a public software company has these characteristics is really darn hard from the outside. Our aim at Siro Capital is to take you deeper into the businesses of these companies, simplify what they do, and help you figure out if they're a good investment or not.