Software Contracts, First-Lien Debt and the Reality That No Revenue Is Truly Recurring (Gavin Baker)

Gavin Baker (March 2020) on why ‘recurring’ software revenue is less durable than it looks, through the lens of how lenders treat software contracts.

Why it was kept

The passages Kyle kept, at the start of COVID, on churn risk, customer surveys and private-equity-backed software.

As Kyle captured it

• Read Software contracts, first-lien debt and the reality that no revenue is truly recurring on Medium
  • Robert Smith, CEO and founder of Vista Equity Partners famously said: “Software contracts are better than first-lien debt. You realize a company will not pay the interest payment on their first lien until after they pay their software maintenance or subscription fee. We get paid our money first. Who has the better credit? He can’t run his business without our software.” He used this insight — which has been absolutely correct to date — to build one of the most successful private equity firms in the world and generate exceptional investment returns.
  • I suspect that fewer customers will pay cash up front and that we will see payment terms lengthen significantly. A slowdown in revenue growth accompanied by a potential paradigm shift in working capital will have a substantial impact on software companies that are burning a significant amount of cash.
  • A survey of 500 businesses published by AvidXchange on March 18th found that only 54% of businesses had the technology necessary to even pay a bill remotely.
  • It is my understanding that some Private Equity firms are asking their portfolio companies to stop paying all bills. No cash out the door.
  • Any software company that has a true enterprise sales motion is going to be challenged in this environment, while those that have freemium or E-Commerce-like distribution models are going to be advantaged.
  • For me, Net Revenue Retention has always been one of the important software metrics — but it will be even more critical over the next 6 months. If gross churn spikes on a large revenue base, recovery will not come easily. Conversely, if a majority of a software company’s incremental growth comes from the installed base with continued low churn, it will be much easier to manage through this.
    • Similar to our Tencent teach-in; software companies with stable customers / limited churn will be able to weather this storm significantly better than consumer businesses or heavily-impacted technology companies that could see their revenue go to zero
  • Cyber Security, infrastructure, DevOps, service desk, Collaboration, communication, CRM, Marketing and HCM will all be impacted differently across industries and customer types. We will find out which software companies actually are “Systems of Record” without which companies cannot function.
  • Seat based, transactional and workload based Pricing models will obviously immediately feel the changes in the economy and naturally be more cyclical — one way or another. Some seat based, transactional and workload based companies will benefit, others will be hurt by the current economic situation. It is hard to frame the impact by pricing model but it will ultimately come down to utilization. Utilization will matter even for seat based models if the customer can cut seats, and utilization will matter in the context of minimum threshold deals.
    • It’s not just that utilization pricing models are better, its a question of whether or not utilization is increasing in the current environment (e.g. Snowflake ($SNOW) does better because there is more data and more compute, TripActions does worse because there is less travel spend)
  • ==Longer term, software contracts were already moving away from multi-year subscription models billed upfront towards usage based models billed in arrears which is consistent with hyperscale IaaS.==
  • As Nachkari pointed out on Twitter, “contracts are only as good as the counterparties credit.” At the end of the day, there is no such thing as truly recurring revenue. Some revenue is just more recurring than other revenue.