Investing in the Cloud — From Gold Rush to Hunger Games and Beyond

Scale Venture Partners (Rory O’Driscoll, Sam Baker) on what happens after cloud investing becomes consensus. The load-bearing line: “Nothing is more destructive to investors over the long term than a shared consensus that something is a sure thing.” Gold rush → hunger games is the arc.

Notes

• Venture investors, entrepreneurs, and Wall Street have all learned to pile on, leading to a shared consensus that cloud investing is “a sure thing”. Nothing is more destructive to investors over the long term than a sure thing, so I began to wonder, “What could cause the wonderful economics of cloud investing to unravel?”
• Three Key Summary Points:
  • (1) Cloud company Valuations are at all-time highs which cannot be justified by improved company operating performance but can explained by 20 years of consistent 30% growth in the cloud software market. This has given investors the comfort to “pay up”.
    • Can software companies actually grow forever?)
  • (2) Within the next two to three years, there will be a “growth crunch” as many cloud markets saturate. At that point the Gold Rush will become the Hunger Games as cloud companies large and small compete against each other for survival.
    • Massive consolidation opportunity? Real potential for largest platform companies to build war chests and grow inorganically through M&A?
  • (3) There will be three winning strategies for a startup when this happens: Fight, or compete head on in an existing cloud market; Focus, or find those parts of the cloud market where there is still low competition and good growth; Fly, which is to build a company based on more than just the move to the cloud.
  • (4) “Beyond the cloud” means “assume the cloud” and build on top of that stack using newer technologies and a design approach where instead of the user working for the software, the software works for (or instead of) the user.
• Are cloud companies performing better than ever? The short answer is no. The four charts below show growth rate, profitability, Sales Efficiency and the Rule of 40 (a combination of growth and profitability) for the entire public SaaS universe from 2004 to today.
• So why are these companies trading so richly? It’s all about the growth. Sometimes the answer is in plain sight. The big picture in all the above numbers is that the public companies in this sector have been growing at 30% plus for 15 years now, since the Salesforce IPO in 2004. Growth has not gone up but – far more importantly – it has not gone down.
• With 30% growth, even if multiples permanently collapse by 30%, cloud stocks regain their entire value on a per share basis after one year and four months.
  • Altimeter
  • Even in times like COVID and multiples expand, they eventually come down as the underlying business continues to grow
• A dollar invested at a 0.6x sales efficiency turns into $0.60 cents of revenue that promptly gets valued at 10x revenues or $6.00. It’s six-to-one money in a 2% world.
• As long as the growth is there, the risk of paying up is low—which is why the valuations can be explained, if not justified, by this 20-year track record of consistent growth.
  • This is why companies that start to see precipitous declines in growth even before IPO are concerning; they’re not demonstrating the Compounding ability of the best companies
• Cloud software is a subset of the $419 billion (2018) enterprise software market, so after 19 years cloud is still only 31% of the total market. Intuitively, you might feel there is a lot of runway left. But that intuition would be horribly wrong. The grim reality of exponential math means that it takes 19 years growing at 30% to go from 0.25% market share to a 31% market share, but it only takes two more years to get to a greater than 50% market share and two more years after that to be at 100% of the software market. With no growth in the overall software market, cloud would reach 100% penetration by 2022. This would be a growth crash.
  • [image: Cloud Market Grim Realities of Exponential Growth — held in the private wiki]
• Marc Andreessen famously stated that “software is eating the world,” but we need to actually quantify this phenomenon because the growth rate of the enterprise software market over the next five years (call this the Andreessen Eating Factor) is the “get out of jail free card” for cloud growth.
• Once the cloud market is 100% of the Software market, then by definition the cloud growth rate of 30% has to converge with the overall Software growth rate of 10%. This is not a growth collapse — but it is a growth crunch — and it will happen over the next five years.
• The largest cloud companies will feel the pressure first as they hit growth limits in their core markets and are forced to diversify into adjacent markets to keep up growth. For startups, the competitive dynamic will shift from “you vs. the company you have competed with for five years” to “you vs. a large behemoth cloud company in an adjacent market that wants to add your product and take your market”.
  • Twilio Flex, Amazon Connect, etc.
  • This would be an interesting exercise; look at all the large cloud players and the adjacent products they’ve launched. How have they performed relative to startups / competitors? Where are these players not launching products? Or potentially unlikely to launch products?
• Because the largest expense for an enterprise software company is Sales & Marketing, an adjacent behemoth that already has the customer relationship can offer a second product to that customer at a dramatically lower price point than a single-product company can.
  • Speaks to the strength and importance of Product Led Growth (PLG)
• The power of the bundle is even stronger if the products are in fact “better together” from the end customer’s perspective. This was Microsoft’s strategy in the 1990’s and, again today, it is AWS’ strategy as they announce 10+ new products every year. We can expect it from Salesforce as they leverage their eight cloud products. **The key question for every startup has to be “who is your adjacent behemoth bundler?” **Bundling
• Strategies in The Cloud Hunger Games
  • Fight
  • Compete head on and win in an existing served cloud market.  The perfect example is Zoom, the next generation video conferencing company that went toe-to-toe with large incumbents and won big in a wildly cash efficient manner. The fact that Zoom created $20Bn of value in a mature cloud market with competitors including Microsoft, Cisco, and LogMeIn, makes it one of the most impressive entrepreneurial achievements of the past decade. Other startups looking to emulate Zoom will have to bring to the table the same market knowledge (the team came from WebEx), clarity of product vision, and raw execution ability.
  • Focus
    • Focus on a newer cloud market within software where cloud penetration is still low. Software is not a single market but a thousand different niche markets. An entrepreneur selling cloud software to small and mid-sized trucking companies does not care a hoot about the market penetration of ERP software in the Fortune 1000, nor should she. **Obvious parts of the software market that are still underpenetrated today include many industry verticals, most SMB’s, and the parts of the cloud that are being carved out of the wider telco industry. **
      • Distribution curve Mark Valdez
    • The one non-negotiable here is a clear-eyed understanding of the likely adjacent behemoth bundler and how to position against them. What big SaaS company will want to steal your lunch money? Remember too, the typical SaaS startup takes eight or more years to get to scale, so it is not enough to have a clear runway now—that runway has to stay clear for a long time.
      • The better companies are going to be those who don’t dismiss the incumbents as “not focused on this space,” and rather can speak very intelligently to the role thattheir behemoth competitors will play
  • Fly
    • Fly beyond the cloud. The last option is to build a company that is based on more than just the move to the cloud, instead building the next generation of applications that we are calling the Intelligent Connected World.
• What does that new world look like? Software in the next 10 years will be:
  • Driven by progress in three technologies: AI, sensors, and ubiquitous connectivity
  • Designed to coach us, assist us, or in some cases actually do the work for us
  • Built to leverage existing cloud applications, not replace them
• We input information into Salesforce, just as we did for Siebel in client server land, **but the next generation of CRM will tell the rep whom to call and what to say. **Gong
• Many new applications will have to exist in an uneasy co-dependence with underlying systems of record, creating a running border war over who captures the most value: the AI-driven systems of engagement/intelligence or the underlying system of record. Systems of Intelligence
• This is going to be the meta trend of the next 10 years. Cloud software has eaten Enterprise Software and is already eroding the vulnerable parts of the Technology market. The next huge lift in growth has to come by reaching deep into the “real world” and earning dollars by automating or, more bluntly, eating, the work that today is outside the scope of current technology spend.
  • Who are the companies “reaching into the real world?”
  • [image: Automation is How Software Eats the World | Scale Venture Partners — held in the private wiki]