The Three Stages Of Software Company Life
Over the past 12 to 18 months, we've seen a number of customers increasingly migrating to the larger, more mature, established software vendors under the oft-cited adage "no one ever got fired for buying." However, we'd hardly describe the past 12 to 18 months as a "normal" environment, so let's examine which companies have historically shown the strongest and weakest revenue growth as a group in aggregate. By examining more normalized growth patterns, investors can gain additional insight into the growth of the software industry at large, and by examining the growth of groups of companies rather than individual companies we can normalize for the fact that an incremental $1 million of business is much more significant for a small companies than a large company. Interestingly, although there were obviously variations across companies, the overall pattern of growth has been relatively consistent over the past eight years. Medium-sized software companies (defined as companies with revenue between $100 million and $500 million) have consistently outperformed their larger and smaller peers on a revenue growth basis, with the notable exception of the most recent trailing 12 months. Conversely, smaller software companies (defined as companies with less than $100 million in revenue) have consistently reported the worst or near-worst revenue performance.
The distribution in growth rates is an interesting reflection of the lifecycle of a typical software company. For the companies in the smallest revenue group, there are two possible outcomes-either succeed and push up into the middle tier of companies, or struggle and eventually flame out. The bifurcation between these two outcomes is the driver behind the underperformance of the under $100 million in revenue group at large. The successes are counter-balanced by the failures.
As successful small companies prosper and grow, they move into the middle tier of companies with $100 million to $500 million in annual revenue. At this point, most of the companies with poor products, poor business models, or poor luck have disappeared, and the remaining players have gained a certain level of "corporate credibility" after bypassing many of the hurdles that accompany the start of a new business. After surpassing the $100 million revenue level, these companies typically have referenceable customers, decent balance sheet strength, credible management, and a relatively robust and growing corporate infrastructure. The basics are in place- it is now a matter of executing well, driving new revenue opportunities, and managing the complexities of a growing infrastructure. The company will probably make a few acquisitions at this stage as well, as a means to accelerate growth. If all goes well, these companies continue the push to corporate maturity and break through the $500 million revenue level.
The sales force is executing, demand is good, infrastructure is robust, and management doesn't wear jeans to the office anymore. Our company is now officially mature. After surpassing the $500 million mark, companies face a new set of issues. Bureaucracy starts dragging on the company's ability to move quickly to pursue new opportunities. Increasing headcount begins to reflect the law of diminishing returns. Now companies need to focus not only on top line growth, but profitability as well. Mid-sized companies are like cats-quick, agile, and able to readjust rapidly to pursue new opportunities. The big, mature companies are more like elephants-it may take a while to get pointed in the right strategic direction, but you don't want to get in the way when they charge into a new market. SAP is the classic example of this-by leveraging its mature status in the ERP market, SAP has been able to become a leader in other markets, like supply-chain management and CRM, as well.
The most notable aspect of this discussion is the shift we've seen over the past 12 months. Instead of outperforming, mid-sized companies have been hit the hardest by the economic downturn. The larger companies are able to scrounge up revenue opportunities from their large installed bases, while the smallest companies tend to address niche and emerging needs and issues that are not met by the big players. The ones getting squeezed in the middle are the mid-sized companies that lack the installed bases of the industry giants and the agility and low overhead of the small vendors. However, we believe it is important not to discount these mid-sized players. While they may be struggling today, the group at large has traditionally shown the strongest growth, and it is important to note that some of those that survive the current economic malaise may very well be tomorrow's giants.
(U.S. Bancorp Piper Jaffrey) |
