5 Phases Describing How the Recession Could Play Out for B2B SaaS — ATAD Weekend Edition
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I’m not big on trying to predict the future, but I do think we can try to describe the most probable events. Based on my first-hand experiences as an employee and founder, combined with continuous close reading and analysis over the years, this post lays out how I’m thinking through the likely scenarios for the publicly traded companies in this sector. I believe this line of exploration may reveal buying opportunities, or help me avoid buying into over-valued names.
Why I’m Thinking About This
B2B SaaS / PaaS is my largest exposure, both for the ATAD overall portfolio and my overall net worth, so I have been mentally preparing for what the coming economic recession could mean for stock performance. I say *coming* recession because it has not hit yet. People are still being paid PPP and other assistance, unemployment is still rising but has not reached most white collar workers (yet — the layoff at LinkedIn might have been a shot over the bow), and quarterly earnings are still a lagging indicator by 1-4 quarters depending on existing sales cycle length for the biggest deals.
Companies with recurring revenue models, “software margins” (usually considered gross margins of 70% or better), and negative net churn (where expansion revenue growth outstrips any gross account churn) are extremely resilient in general. In difficult market conditions, the companies who can respond to the changing market and take this opportunity to tighten up operations stand to benefit. Due to cycle times from campaign to lead to opportunity to close, there is a bit of a waterfall effect for what we will see play out. The clock started in mid-March, so we are 4 months in and the first effect is starting to be felt already:
Phase 1
Situation: Longer sales cycles, with downward pressure on average sale price
Reduction of sales force headcount
consolidate quotas with top performers
Increased focus on growth from expansion renewals, upsell quotas
Reworking of the sales compensation model
More self-service sales, including higher price point tiers
Phase 2
Situation: Poorer LTV/CAC ratios, driven by slowness to adjust CAC spend
Re-packaging and bundling to address objections that fuel discounting
Reduction of paid lead generation
Pressuring sales people to outbound prospect, previously able to “farm” deals
Strict adherence to sales rep ramp periods, quota attainment up or out model
Finance audit and accurate calculation of “all-in” CAC, magic number, etc.
Phase 3
Situation: Declining ROI on R&D investment to create new products
R&D budgets that were set pre-pandemic start to look overly generous
New annual planning processes contemplate a business that is more focused on harvesting existing value and protecting it, than sowing new seeds
Long awaited systems cleanup projects, which are intended to safe money and reduce dependence on human business processes, get prioritized (e.g. setting up an ERP system, recurring payments software, value chain management, CI/CD)
Phase 4
Situation: Things are getting better, but businesses are still operating from scarcity
This is the most unfortunate thing that often happens to previously high growth companies who have just weathered a storm, and is not unique to SaaS.
Just as companies take a few quarters to adjust expenses downward to optimize for efficiency and survival, it is also difficult to identify when things are actually getting better and begin ramping and building pipeline. If the recession is long enough, it is also possible that many of the people who were hired during the time of growth and prosperity have moved on and the company is now filled with a more risk adverse population who operate well in times of scarcity, but are hesitant to push the gas pedal until it feels very safe.
Hesitant to re-invest in R&D line item expenses for new product lines, key hires, experiment projects, or M&A — despite abundant reasonably priced talent, fewer competitors, and reasonably priced M&A targets
Hesitant to re-invest in Marketing expenses to start building pipeline — despite channels being less crowded, less expensive, and thought leadership from other executives in sincere demand
Either hesitant or too eager to rebuild the sales force before the R&D pipeline and Marketing pipeline are functioning — “we need more revenue” closely followed by “let’s expand the sales team again” suffers from narrative fallacy again and again. Simply adding more sales people, and having them prospect, rarely can build up the pipeline as effectively as new product launches and demand generation will. On the same token, those who realize this might already feel they’ve hesitated too long on building up R&D and Marketing, and are approaching a coffin corner.
Phase 5: Recovery
Situation: We are back in a bull market (this might not be measurable by the stock market) and B2B SaaS companies are once again feeling the wind at their backs when it comes to revenue acceleration.
Consolidation: Companies who struggled to weather the storm and saw their valuations decimated will be gobbled up by peers with stronger multiples.
King Making: Companies who continued to invest in R&D and growth, who might have been punished for not conforming to cost-saving measures during the downturn, will be the first to hit the gas and reap major gains.
New IPOs: Private companies who were quietly building great products, growing in headcount and operational skill, winning customers, and building during a time of fear an uncertainty (see: Twilio in 2008 to 2011) will begin to IPO as the window opens.
Competition: CAC will begin to climb as more players have the capital available to compete in the most popular customer acquisition channels. Those who learned how to grow using scarcity tactics will find diminishing returns on those approaches, and will adjust with new strategies that require bigger spending.
And so the cycle begins again…
How I Can Use This Framework
I’ve spent the last 11 years of my career as an allocator of time and money within recurring revenue businesses (wearing the CEO, CFO, CMO, and CTO hats) and I feel this will be one of the most interesting times to take apart and differentiate SaaS businesses. Today, recurring revenue businesses are rewarded with high multiples across the board, but I believe during a recessionary period there will be a barbell effect that separates the horizontal and vertical players in meaningful ways.
Platform infrastructure software companies like Twilio (where I am heavily invested, was employee #1 and am extremely long) will have the opportunity to re-invest in R&D and pull ahead of the market, while potentially being punished short-term on stock price for not conforming to the behavior of point solution software companies like Wix, Smartsheet, and Slack — which while positioned as platform plays do not reach the level of mission-critical importance when compared to infrastructure. A quick rule of thumb for telling the two apart is whether they are seat-based (Point Solution), rather than consumption-based (Platform Infrastructure), in their pricing.
I also expect to see a strong delineation based on which companies can minimize downward pressures on ASP and keep net revenue expansion rates (e.g. stay in Phase 1 for as long as possible).
Possible Next Step: spreadsheet with the $EMCLOUD companies, assigning phases. Would you be interested in this analysis? Let me know in the comments.
If you’ve made it this far into my Saturday morning coffee ramble - thank you! I am looking forward to applying these phases to my analysis of companies in the Bessemer Emerging Cloud Index as things process in the months and years ahead. If you’re interested in reading future analysis, including access to all my underlying research spreadsheets, I encourage you to subscribe for $10/month or $100/year.
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Great post. Will be interested in the phase analysis for each company.
This is amazing! Really interesting perspective on the different phases. Would definitely be interested in how you would categorize each of the cloud SaaS companies!