The 2020 Software Report has been published. It can be downloaded here.
Below are some of the key takeaways.
The software market grew by 11% in 2019, which is 2-3 times global GDP. The average growth rate of a software company is 22.5% (the difference between the 11% and the 22.5% is because large companies grew slowly and smaller companies grew faster).
The average software company has gross margins of 69.4%, invests 35.0% of revenue in sales and marketing, 20.8% in research and development, 14.8% in general and administrative expenses, and generates a 16.2% adjusted EBITDA margin.
The software market continues to be very dynamic and is still relatively young. Because of this, software companies employ a wide range of operating models, with widely-different investments in sales and marketing, research and development, and general and administrative. That said, a reasonable general long-term operating model would follow a 30:20:10 rule with 30% investment in sales and marketing, 20% investment in research and development, and 10% investment in general and administrative (all percentages of revenue). The degree to which companies vary from this general model depends on many factors including lifecycle stage, product and market, and competition.
Software companies are very well capitalized, with an average cash position of 77.1% of revenue on their balance sheets.
As is well known, software companies are asset-light businesses, with a physical asset base (PP&E, net) of 11.1% of revenue.
Software companies generate an average of $278,689 of revenue per employee.
Acquisitions are a key ingredient to software company growth. A proxy for this is goodwill. Balance sheet goodwill has grown in lockstep with revenue for the past decade, and stands at 51.7% of revenue for the average software company.
Historical analysis of the ten years from 2010 to 2019 shows remarkable consistency in the average value of operational variables from year-to-year. Averages for YOY growth, gross margins, sales and marketing investment, R&D investment, G&A, and operating margin are all consistent across the ten years, with the following exception:
In 2010 and 2011 (and to a lesser extent in 2012 and 2013) software companies ran significantly higher operating margins (10-13 percentage points) by investing less in sales and marketing, R&D, and G&A. This is consistent with companies emerging from the great recession of 2008-2010. It may also be a harbinger of things to come as companies start the 2020s with a significant shock caused by the coronavirus pandemic.
Historical analysis of IPO companies shows significant changes to their operating models towards higher levels of operating profit and cash flow as they evolve in the years after IPO. This validates the thesis that young software companies will evolve towards profitability.
Growth rate and cash position are the only reliable statistical predictors of market cap multiple. All other variables have weak to no statistical correlation, indicating current market valuation analysis must include consideration of a complex set of intangibles, including problem set, product, industry, brand, ecosystem, lifecycle stage, and many others.
Software market cap leaders are growing 2 times faster than laggards, generate gross margins 10 percentage points higher, have cash positions 3 times higher, employ twice as much stock-based compensation, and enjoy market cap multiples 8 times higher.
There are 63 companies out of the 132 in this report that satisfy the “Rule of 40,” defined here as 1-year growth% plus adjusted EBITDA% greater than or equal to 40%. These companies have an average market cap multiple that is 32% higher than the average for all software companies.
Very few software companies run a balance of high growth and high EBITDA. Only 22 of the 132 companies in this report had a growth rate of 20% or higher and adjusted EBITDA of 20% or higher. These companies have an average market cap multiple that is 55% higher than the average for all software companies.