Valuations are falling and take-privates are on the rise—how management teams can set themselves up for short-term wins and long-term profitability
Faced with tumbling stock prices, constricted debt markets, and tighter revenue streams, public software companies are struggling to right their lopsided balance sheets—and for the first time in a decade are looking beyond growth for growth’s sake and instead toward long-term financial stability.
The pivot comes after several years of historic growth, with software companies benefitting from favorable credit, significant PE and venture capital funding, and generous R&D budgets to drive top-line numbers. These factors fueled a rush to acquire market share and new customers, with shareholders placing a heavy emphasis on growth over profitability. In today’s economic climate, that’s been changing quickly over the past few quarters.
Private equity (PE) firms with abundant dry powder on hand have taken notice. Seeing an opportunity to realize long-term gains, these dealmakers are snapping up software companies at reduced valuations. Many CEOs and management teams see an easier path to profitability as a private company—particularly through right-sizing cost of goods sold (COGS) and operating expense budgets, and making future-proof investments in areas like automation and cloud infrastructure that will help drive more cost-efficient growth.
We’ll dive into why tech take-privates are on the rise, and how management teams can leverage this crucial moment to position themselves for both long-term growth and profitability.
Through November of last year, private equity firms announced or completed $223.4 billion worth of take-private deals—and that number is poised to increase in 2023. Two factors are spurring this trend.
First, today’s firms are sitting on a significant amount of dry powder and continue to attract funding for investment in the tech industry. Firms like Hg Capital, Vista Equity, and Thoma Bravo have been able to raise billions in new capital to finance a steady march of software company acquisitions that include Coupa, Duck Creek, ForgeRock, UserTesting, and Ping Identity.
This also comes at a time when software companies encounter greater shareholder scrutiny in the public sector amid macroeconomic headwinds and ongoing recession concerns. Looking to quickly right-size their operations as public investment dwindles, software executives see an opportunity to be more nimble and to leverage private equity partners to help drive improvement and evade mounting pressure for near-term returns by going private.
While some deals may seem like the perfect marriage, private equity firms have their work cut out for them. Overinvestment for the sake of growth has left some software companies bloated and inefficient.
Here are three opportunities for private equity investors and software management teams can take to tamp down spending and generate healthier margins.
One result of the decade-long push for growth is that many software companies have sales, marketing, and R&D teams that are over-staffed and focused solely on expanding their customer base.
To trim excess costs, private equity firms should begin by reviewing revenue and growth trends across product segments and regions, pulling their focus away from those that are stagnating and redirecting resources to those that are growing at a high rate.
If the company has acquired other product/service lines, management should also leverage data-driven insights to quantify the success of cross-sell and upsell initiatives and identify whitespace within the existing install base. If cross-sell and upsell hasn’t been a core focus—as is often the case—management should steer the sales team to focus on KPIs related to those opportunities.
Next, leadership should evaluate sales team structure and individual productivity (i.e. quota attainment) and make appropriate readjustments. Pay specific attention to quota capacity—the planned usage of capacity allocated for the best and most optimistic economic scenario. Ideally, at least half of sales headcount should be quota-carrying. They should also focus on attainment (the time it takes for a given team to hit a specific target) and find the root cause for unproductive team members.
R&D teams are often caught up in unnecessary and low value investments—especially if the sales and marketing teams are over-aggressively pursuing growth. Operating teams and management teams can re-focus R&D by working backwards from product-level margins to identify where R&D is failing to drive a high return on investment (i.e., R&D spend that is greater than 20-25% of product revenue without high growth rates).
Additionally, many R&D teams can seek to expand their nearshore or offshore presence by leveraging growing global talent pools—oftentimes, R&D leaders are identifying strong nearshore partners to efficiently scale their R&D teams with productive teams in the same time zone as the domestic/onshore team. Lastly, automation (both within QA and DevOps functions) is critical to drive efficient growth, and while many companies tout their automation capabilities, few have truly made enough investment in automation to truly drive out costs.
In parallel with trying to expand their customer base, software companies need to double down on existing customers to drive revenue growth. That means reducing churn and keeping net retention above 110%. To do that, they’ll need to pull on a wide range of value levers, which include:
While one might expect software companies to have limited overhead, COGS are increasing (and therefore gross margins are tightening) as companies shift more aggressively to SaaS delivery models, and G&A expenses, especially for public companies, are often bloated due to legal & reporting requirements and lack of synergy capture from prior M&A. Across 73 SaaS companies that have gone public since October 2017, COGS and G&A spend averaged around 29% and 25% of revenue respectively—a substantially higher average than in other industries.
Some tactics PE firms and software companies can employ to reduce these expenses include:
Private equity firms should feel confident knowing they can leverage this crisis point to steer software companies toward leaner, healthier balance sheets. Take Elon Musk’s recent layoff of 80% of Twitter’s workforce. Operations are still running and new features have been implemented at a rapid pace. It’s quite possible that many software companies are just as bloated as Twitter—and that means long-term profitability is readily achievable with the right firm—and digital consultant—at the helm.