We’ve explored the state of the SaaS and early stage tech startups, comparing performance from the second half of 2021 with the summer of 2022 and found that contrary to the media narrative that has focussed on the drop in valuations, this sector has been surprisingly resilient. Most companies continue to exhibit strong year-on-year growth, continue to invest in growth and customer acquisitions and, while the unit economics may have declined due to macro-economic pressures, the long term secular trend towards automation and use of software continues to benefit the sector. The pace of Venture Capital deal-making may have slowed down, but given the dry powder in the VC market, a rebound in investments is bound to happen sooner or later. We also observe that companies are turning to Capchase to support their capital needs and act as a trusted advisor to navigate this environment.
The last few months have brought significant change in the technology sector and the startup world. With the increase in inflation driven in part by government stimulus and supply chain issues during the pandemic, the Fed (US Federal Reserve System) had to step in early this year to tighten the money supply by increasing interest rates. An increase in interest rates increases the hurdle rate (minimum return expectation) for any investment and has a significant impact on long-term investments like venture capital. Due to this, there has been a decline in valuations - it started with the stock market selloff   in the public tech markets in January 2022, spread to late-stage VC startups in the subsequent months, and more recently has impacted early-stage startups. While the media has focused on the significant decline in valuations since the start of this year, what hasn’t been studied enough is the core health of technology startups. The only data that has been studied is from public tech companies, but they are not a representative sample for understanding early- to late-stage startups.
To answer the question, Capchase is starting the Pulse of SaaS series (in addition to our recently released SaaS Benchmark Report). We have created this new series by compiling insights from our dataset of thousands of SaaS and B2B recurring revenue companies and beyond to understand the performance of early-stage companies during this current economic and investment climate. This first episode will be focused on overall trends; subsequent installments will further analyze different dimensions of interest for the SaaS ecosystem such as geography, size or funding source. So… stay tuned.
To perform this analysis we took data from August - December 2021 (what we describe as pre-downturn) and compared it with data from April - August 2022 (what we refer to as post-downturn in our discussions). While the results reflect a slowdown in the market, with a focus away from growth and towards profitability - they also show that the tech startups, especially SaaS, are resilient, and continue to do well relative to the broader economy.
These companies continue to benefit from the trend toward automation and use of software in various sectors, and contrary to the media narrative, these companies also continue to invest in R&D and growth. We believe that the companies that capitalize on the current market environment will have an opportunity to consolidate and capture market share from their competitors.
Throughout our analysis, we analyze metrics at different percentile thresholds. We make use of the 25th, 50th (median) and 75th percentile levels to give us a sense for the % of companies above a certain threshold for every metric, giving us insight into company behavior over a period of time at a more granular level.
Insight 1: Growth - Can’t Stop Won’t Stop
In this exercise, a dataset of 200 companies was analyzed, 64% VC-backed, 36% Bootstrapped, 75% in North America and 25% in Europe with ARR ranging between 100k and 50MM. The first finding that gets our attention is that while growth has slowed in April - August 2022 compared to August - December 2021, companies continue to grow at a year-over-year rate of greater than 50% in 2022. Top quartile companies continue to grow at greater than 100% year on year. Likewise, while the median R40 company experienced a drop from 65% to 27%, the top quartile still landed close to 80%. The growth rate is much higher than public tech companies, which is somewhat expected since these companies are smaller, and therefore, comparisons are to a smaller base. However, in times of turbulence, it’s often thought that B2B clients tend to gravitate towards larger and more established players - so this growth story is bucking that trend.
Although the changes in growth and R40 reflect the market narrative around the slowdown, both are surprisingly resilient when compared to industry benchmarks. While the long-term effects of the slowdown may still not be fully reflected in the market, we are optimistic about the SaaS ecosystem. If history is to serve as a guide here, some of the world’s largest and most resilient businesses have come out of previous recessions - Microsoft from the 1975 oil embargo recession, Electronic Arts from the 1982 recession, and Slack, AirbnB and Square (among countless others) in the 2009 recession. Only time will tell which future unicorns are born through this time period, but rest assured that those companies exist and are busy consolidating their market position and spending on growth right now.
Insight 2: Increase in expenses due to continued spend on growth coupled with inflationary pressures
We observe a 34% increase in median dollar expenses and 42% net margin deterioration, which contradicts the cost-control focus that has been emphasized within a number of publications since the beginning of the slowdown. We have two hypotheses around the increasing expenses: 1) companies continue to spend on growth, since the expenditures on sales and marketing have continued to increase, and 2) the macroeconomic environment may have had an overpowering effect even relative to the shift toward conservatism that startup founders have been guided toward during this period. With inflationary pressures, labor shortages, and post-pandemic challenges, it seems that the downturn has had an undeniable impact on early-stage startup expenses and profitability.
A slowdown is an opportune environment to cut excess fat, and develop the muscle for running a lean organization. However, it’s also an opportunity to capture market share when some of your competitors may be going out of business. We believe that the best companies are reducing their expenditure on G&A and improving operational efficiencies, while continuing to spend on customer acquisition and making investments in R&D so that they are positioned for long-term success.
Expense Shifts Across Periods: Dollar Values & As a Percentages of MRR
We analyze the change in both the actual dollar values of expenses for the same group of companies as well as the percentage of MRR that the expense amounts represented across the two periods (where, both MRR and expenses are usually produced from a trailing three month window, occasionally adjusted for representativeness). We observe an increase in spend as a % of MRR, which reaffirms both our hypotheses - companies continue to spend on growth, and there are likely also inflationary pressures which make it difficult to reduce certain expenditures.
We will explore a more detailed analysis around expense categories and associated trends in another installment of the Pulse of SaaS. For now, we shift our focus toward overall trends around unit economics.
Insight 3: Unit Economics - Reducing LTV and increasing Acquisition Costs
LTV / CAC (Lifetime Value / Customer Acquisition Cost) is an important metric since it tells the efficiency of the marketing spend of a company. We see a reduction in the LTV/CAC metrics of companies when comparing post-downturn to pre-downturn data. Overall, the downturn seems to have reduced the multiple of value generated for each dollar of customer acquisition cost, implying that either customer lifetime value is reducing (potentially due to increasing churn) or acquisition costs are not scaling efficiently or are increasing at a quicker than anticipated pace. It seems like both the effects are coming into play - given the pressures on budgets, every company is looking at their spend and determining what expenditures can be done away with. Due to this, churn is increasing, leading to a reduction in lifetime value. At the same time, sales cycles are becoming longer as there are more negotiations and higher scrutiny around budgets - leading to an increase in CAC. Both effects combined are leading to a reduction in LTV/CAC post the downturn.
While the headline news here doesn’t seem as positive - churn has increased and at the same time the customer acquisition costs have gone up - a counter view here is that the customers acquired during a slowdown are likely to be sticky with a higher long-term LTV, which is not showing up in the data just yet. In addition, we have observed companies intentionally doubling down on their most profitable customers and upselling, and letting go of their less profitable or unprofitable customers that are difficult to service - leading to a reduction in logo retention, but higher net $ retention, and therefore a net positive for the company. While this may seem unintuitive, it's a phenomenon observed and studied in the past (HBR articles on this topic - example 1 and example 2). We will dive deeper into this topic in one of our follow-up posts.
Insight 4: Runway - Run-away Burn and its Limitations
Runway is the number of months that a startup can survive given the cash on hand and the monthly cash burn. There are a lot of moving pieces in the runway calculation, and it is ultimately a dynamic concept: companies can increase their runway by reducing their monthly burn (by increasing revenues, reducing expenses, or both), and companies can also increase their runway through an equity or debt cash infusion.
In our data, we observed a reduction in runway across the two periods. Interestingly, the 75th percentile saw a notably larger decrease in runway than the other percentiles. It seems that the companies that had longer runway have been opportunistic during this period by spending on growth and customer acquisition. The lack of movement toward the lower end of the distributions seems to reflect a ‘staying alive’ effect, where these companies are looking to hold onto their position, conserve rather than expand, even if it means losing competitive advantages in the short-term. However, this lack of reduction of runway on the lower end also shows the resilience of these companies - even with a historic pullback of VC funding and challenging market conditions, they have been able to maintain their runway and survive. That is, a company with <6 months of runway in 2021 should theoretically not have survived to see the middle of 2022, but we are observing that while such companies may not have thrived, they are able to pull back expenses and go into cockroach mode to survive.
Relative to other sectors of the economy, we believe that SaaS companies are resilient and are able to extend their runway in multiple ways. Higher gross margins and stronger unit economics on average enable them to cut costs while continuing to service their customers. However, in a macro-environment where volatility in the markets is expected to continue, and there is uncertainty around the business outlook, it is imperative for companies to bolster their balance-sheets with cash while continuing to spend on growth in order to have an advantage while some of their competitors struggle for survival. This will allow them to exit the slowdown in a position of strength.
From this analysis of our dataset, we have discovered that the market environment has presented both unique opportunities and challenges in various forms. We have found that growth has been resilient, and though ideas of conservatism seem to be top of mind, there hasn’t been a decline in spending. This supports our view that the secular trend towards automation and use of software will continue to drive disruption and innovation in every part of the economy over the coming years. While there has been a reduction in LTV/CAC and runways, we believe that this data actually shows how resilient this part of the economy really is - even in the face of a historic pullback in the VC market and reduction in business confidence, companies that entered the slowdown with short runways continue to survive, and companies that started the year with long runways continue to thrive. Our hypothesis is that companies that navigate this market environment well will be positioned uniquely, and will reap the rewards on the other end by being leaner (stronger muscle for expense control), by having better unit economics (through higher LTV due to stickier customers acquired during a slowdown), and a stronger market positioning (fewer competitors since the slowdown would lead to some competition to disappear and dissuade new entrants to the market).
Our goal is to partner with you during this timeframe by bringing to the table three valuable elements that every founder needs: strategic capital (imperative for growth and extending runway), data-driven insights (our clients will continue to get real-time insights like the ones presented above), and a supportive community of founders who are solving similar problems. Learn more here, and start your journey with Capchase here.