March Notes From The Trenches

Mar 28, 2023

Welcome friends! Quite the turbulent month we had. A couple of banks down, a few more near misses (hopefully), and a Final Four with UConn and three schools that made it this far in literally no one’s bracket. Very much on-brand for 2023.

We wanted to share some exciting data we stumbled into while doing unrelated research on publicly traded software companies via the SaaS Capital Index of publicly traded software companies (many thanks to the good people at SaaS Capital for putting this together – it’s a great resource).

What Happened to Software?

Over the past few years, we’ve written about our suspicions that the widespread phenomenon of late-stage companies raising 9-figure mega rounds every 6-12 months seemed more like a cry for help than a sign of progress. But without any companies’ financial data, it was hard to know. We also assumed that recently IPO’d companies (whose data is available) would be those who declined the invite to the cash bonfire because how else could they survive the cold light of public financial disclosures.

We were wrong. As it turns out, software is no longer just eating the world; it now seems to be eating quite a bit of the world’s capital as well.

To be clear, we love software. In fact, along with robotics (which is just software delivered in a 3D-printed Dr. Suess machine instead of an app), it's pretty much all we invest in. So while this new information was a bit perplexing at first glance, a deeper dive reveals not a failure of the software thesis but rather a failure of execution.

The Headline Numbers

The SaaS Capital Index is made up of 74 currently active companies ranging in public listing age from July of 1985 (RAM may have been measured in kilobytes back then, but we did have software) and November of 2021 and includes most of the largest software companies in the U.S. (exceptions explained here).

Out of those 74 companies, with an average market cap of $14.5 billion, the number that were profitable in their most recently reported 12-month period (which we’ll abbreviate from here on as “TTM”) was…

15! One in five of the U.S.’s biggest and best software companies is profitable! Not only that, but on average, the 59 unprofitable companies are really unprofitable. In their most recent annual reports, these companies averaged a net margin of -33.9%. On $858 million of annual revenue.

Companies that IPO’d during the recent late-stage venture bubble are even worse. A total of 44 of the index components IPO’d between 2019 and 2021 (27 in 2021 alone):

11% of these companies (5 in total) were profitable TTM, making up only a third of the total profitable companies in the index.
The other 89% comprise two-thirds of the unprofitable index components, with aggregate TTM losses of $6.4 billion.

On the other hand, the profitable 20% are exceptionally profitable, averaging 15.4% net margins and more than 20% EBITDA margins. For context, this puts them roughly 40% ahead of the S&P 500 despite being roughly 1/7th the average size.

So… what does this mean?

Not All Software Companies Are Created Equal

This should go without saying (in fact, we’re pretty sure this is why we VCs exist), but it appears that it hasn’t, and this is clear when looking at the underlying the data.

First, a quick review of the thesis. The financial case for software companies centers on two inherent structural advantages to their primary business model:

1. Excellent unit economics (i.e., a product that’s expensive to build but cheap to deploy means exceptionally high gross margins – generally 75% or more)

2. Highly efficient growth (recurring revenue with high customer retention rates = companies that can scale with sales and marketing costs using a relatively small share of annual revenues)

This is a structure built for capital efficiency and should result in companies that (relative to other types of startups):

Reach self-sustaining operational cashflows much sooner and
Are significantly more profitable at scale.

The first of these is why those non-stop mega-rounds raised red flags for us, and we see a failure of the second in this public data.

So where did this go wrong?

Given the massive 48% difference in net margins, it’s not surprising that the profitable set is better in all areas, but Gross Margin and Sales & Marketing Expense stand out as these are not only the areas where software companies are supposed to have inherent advantages, but also areas where the cash generators are most notably different from the cash burners.

This becomes even more clear looking at the share of companies in each subset that outperform key benchmarks in both areas:

Many of these companies have gross margins scarcely better, and returns on sales and marketing spend that are significantly worse than struggling ecomm companies like Allbirds and Warby Parker (who were abandoned in favor of software for these very reasons).

Furthermore, the idea behind dumping money into these companies and encouraging them to spend it as quickly as possible (i.e., that they just need to get bigger and it will all fix itself) has little to no support in the data. While the average size of the profitable subset is larger:

Only half of the profitable companies in the index are in the top quarter of revenues
The top five most profitable rank 2, 13, 39, 20, and 11 in size
The 3rd and 4th largest companies lost half a billion between them in the past 12 months.
The only company to grow itself into profitability over the past 4 years (Zoom) needed a significant boost from a global pandemic to make it happen

There’s also less than a 25% correlation between Sales & Marketing spend and growth. Meaning even if you’re willing and able to spend, you still need to be good at it (and you need a product that sells).

Even high-flyers like Snowflake and Monday.com (annual growth of 168% and 81% over the past 3 years, respectively) are spending staggering amounts of money to acquire those new customers. We estimate that each dollar of new annual revenue has cost them $1.10 and $2.63, respectively, to acquire over that time. After already quadrupling in the past 3 years, Snowflake looks like it may need to grow another 600% or so just to reach breakeven (burning several billion additional dollars in the process).

On the other hand, we’re seeing software companies in our portfolio running close to cash neutral while growing 40-60% per year as early as the $10mm ARR range. And these aren’t flukes. Just companies with great products and founders who use their resources efficiently.

Bottom line, we can’t say for sure how or why these companies with subpar models are still getting billions thrown at them. It seems too many people are chasing the headline without understanding the rationale behind it, but the thesis is still good if you pay attention to the details.

New Investment

Condoit Releases New Version and Raises Seed Round to Fuel Growth in the Electrical Industry

The round was led by C2 Ventures, a Greenwich, Connecticut-based venture capital ﬁrm specializing in “Dirty, Dull, and Dangerous Vertical Markets.”

Condoit is a SaaS platform for electrical design, analysis, and collaboration that digitizes electrical construction and engineering mechanisms with standardized and validated site audits, on-the-fly design scenarios, in-app engineering calculations, and the complete automation of electrical plan assembly. More importantly, Condoit’s intuitive, mobile-first UI is designed to be used by electrical contractors in the field, in real-time, directly accomplishing in hours what normally requires outsourcing to engineering firms at substantial cost and with multiweek turnaround times.

While Condoit’s software applies to the entirety of the electrical installation and maintenance industry, they’re initially focused on the large and rapidly growing EV charger installation market. In addition to the typical top-of-funnel efficiencies this focus affords Condoit, the company has also built new sector-specific, off-the-shelf automation tools (e.g., EV readiness assessments, complete permit applications, bill of materials, etc.) that significantly improve customer ROI (as well as Condoit’s conversion rates and sales cycles).

From a C2V perspective, in addition to being an obvious fit for our core thesis, we get the added benefit of capturing value from what is likely to be a multi-decade EV charging infrastructure boom without having to try and pick a winner from the increasingly crowded (and homogenous) installer market.

In The Trenches

We have been busy in the socials this month, taking a new approach to delivering information. Chris has been sharing valuable insights in bite-size snippets for those with no attention span. And we enjoyed Matt’s 3-parter on the SVB debacle here. We would really appreciate it if you like and follow us, and we will do the same for you.

C2V Instagram

Chris is excited to announce that he is launching a new podcast, The Honest VC, that cuts through all the bullshit happening in the VC world right now and brings transparency to founders looking for success with fundraising. We want thoughts from our readers if you would be interested in listening to this, so help us out and fill in this quick poll. Sign up here if you want to get on the waitlist for early-release content.

Portfolio Highlights

A message from Otis Founder, Vivian Graves

“I'm excited to share that I've become one of only ~70 Latinas to have EVER raised over $1m in venture funding along the way. Women-founded startups raised just 1.9% of VC dollars last year, but on today’s International Women’s Day, I feel incredibly optimistic about what lies ahead. I look forward to sharing more about how we’re changing the future of pet health and what we’re building in the coming months.”

Calling all pet owners: Otis, the first condition-based online clinic for pets, has launched a medication reminder tool that makes it easy for dog and cat owners to stay on top of their pets' flea and tick prevention schedule. Share this and sign up here for automated reminders from Otis so you never forget a dose.

Read the full post here.

How Truck Fleets Can Survive Inflation

Small and medium-sized trucking fleets are definitely feeling the inflationary crunch. Mike Dorfman, co-founder and chief operating officer of Koffie Financial, describes what they must do to deal with those pressures.

“Using technology is a great way to mitigate some of the inflationary increases,” Dorfman says. “There is lots of technology to find the best fuel rates, find credit facilities, retain drivers, use safety technology to increase fuel efficiency, and reduce idle time. But it’s tough out there right now.”

Read the full article.

Driver Technologies Research Finds Dash Cams Increase Driver Safety

The new research analyzed the driving patterns of 17,000 drivers after using the Driver next-gen dash cam for 20 hours and found that the users were:

11x less likely to speed
4x less likely to run stops signs
3x less likely to tailgate
3x less likely to hard brake