SaaS Companies & Capital Markets


Many of the companies I work with are self-funded when I start working with their CEO. There is a time and place to raise outside capital (which I will cover in a separate article in a few weeks).

Regardless of whether you have or intend to raise outside capital, you need to understand the dynamics of capital markets and the implications this has on your company and competitors.

At the moment, the capital markets are a bit ridiculous. Even with COVID-19 slowing capital and deal flow (especially a year ago), overall levels of capital raised and deployed are very high.

Valuations in public markets are at bubble levels, which of course influences valuations at private levels.

For most of my career, I’ve felt that venture capital and private equity money have been massively overused (and often wasted) by many founder CEOs. So, my bias is to self-finance or finance through operations unless there’s a compelling reason to raise outside capital.

However, even if you don’t plan to access outside capital markets, you’d be foolish to not monitor them and recognize the implications they have for your business.

Before I dive into this, it’s useful to recognize one important feature of SaaS businesses that’s not nearly as prevalent for businesses in other industries.

For decades, the software market has always had a “winner take most” trait to it.

Microsoft Word was effectively the only word processor for a long time. Today, it’s Microsoft Word and Google Docs.

In ERP, it has been SAP and Oracle.

In operating systems for consumers, it was Microsoft Windows. Recently, Chrome OS became the #2 OS with a 10% market share.

In virtualized consumer cloud storage, it’s really just Dropbox.

In sales automation, it’s Salesforce.

What these market segments and companies all have in common are compatibility and interoperability. I first started using Microsoft Word at McKinsey in my first job after college. I used Word because my clients used Word. It made no sense to use anything else, as I needed to send files back and forth between myself, my co-workers, and my clients.

Today, most of my clients use Salesforce because it’s the industry standard with more integrations than any other platform.

In software markets, customers want a market leader. The market leader is more financially stable. If you build your business by using someone’s SaaS product, you don’t want that application going away.

When you want multiple SaaS products that you use to be integrated, you don’t want to pay to do the custom coding yourself. You want the vendors to do it. The industry can only support so many integrations profitably.

Let’s look at this in comparison to, say, the fashion industry.

If you’re someone who is “fashion-forward” (a.k.a. you’re wearing the latest fashion trends a few months or years before the mainstream population), you do not want market standardization.

You don’t want a dominant player that everyone buys from. You want to wear clothing from a designer that nobody else is paying attention to.

In the legal profession, you don’t want a single behemoth law firm that everyone uses… too many conflicts of interest. You want multiple good law firms so they can compete against each other for your business.

For SaaS customers, there’s is an interdependence amongst customers that’s not nearly as prevalent in other industries.

This interdependence amongst customers is what creates the “winner takes most” effect in many SaaS markets.

This has several implications for the SaaS CEO.

Everyone wants to scale their business.

However, not every business is at a “ready to scale” stage.

When you try to scale something that’s not working (e.g., poor product/market fit, or poor sales-message/market fit), you simply broadcast your market irrelevance at scale and great cost.

If your product sucks, you don’t want the whole market to know.

If you’re promising customers something they don’t care about, you also don’t want to incur the cost of letting the whole market know.

However, if you do have product/market fit, sales-message/market fit, and have an operational approach that is ready to scale, it is time to scale.

If your competitors have also achieved these three prerequisites to scaling, then you have to be mindful of the role of capital (and capital markets).

If two companies are equally ready to scale, then the one that wins is often the first to achieve both scale and quality at scale. This is one period when relying on outside capital has many major advantages.

[Product/market fit, sales-message/market fit, and developing operations compatible with scaling are not capital intensive. You can often do it off of operating cash flow.]

Once it is time to scale, you have a highly strategic decision to make. Do you take outside capital to accelerate what is essentially a winning formula? Or do you not?

This depends on two important decision-making criteria.

The first is personal. What is your goal in all of this?

The second is external.

Do you have a competitor in a similar scale-ready position? If you do, you must consider what will happen if they raise the capital and you don’t.

If you’re the only game in town, that’s a different story.

If you’ve been strategic in segmenting the market to focus on a particular niche (which is often a shield from competition), that’s a different story.

But if you’re head-to-head against a competitor that is scale-ready and raising capital but you’re neither, you have a headache to deal with.

Even if you’re scale-ready but opt not to scale, you have the same headache.

Strategically adding and then using capital on the balance sheet is a key skill in the founder CEO’s toolbox.

This is why you must pay attention to the capital markets.

If there is no capital available, then having strong operating cash flow is an enormous advantage.

If capital is limited where some companies can raise it but others can’t, the advantage goes to those that can.

You also must consider where the capital is flowing toward.

If the public IPO markets are closed, then you need to design your exit strategy around a private exit.

If your financial buyers aren’t active, then you need to build your company to be compatible with a strategic buyer.

If strategic buyers are on the sidelines, then you need to build your company (and your P&L) to appeal to a financial buyer.

To quote Stephen Covey, “Begin with the End in Mind.”

Capital markets are dynamic. They change and evolve. As they evolve, so must you.

From a CEO perspective, tracking capital markets on a monthly or quarterly basis is sufficient. You don’t need to look at market valuations daily. Use that time to pay attention to your customers instead.

However, you can never afford to completely ignore the capital markets. They will influence your competitors’ behaviors, as well as the behaviors of prospective acquirers.

P.S. Let me know what you think of this article by commenting below. I’d love to hear your thoughts.

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