First rule of software investing: it’s all about the product
Nothing scales quite like software. Programs and applications that find a willing base of users can ride an exponential growth vector with margins that simply aren’t possible in other industries. Software also has a stickiness and loyalty factor that few other industries, let alone those with such margins, can match.
For that reason, companies who don’t build software often aspire to, and investors—private equity and others—who don’t have exposure to it often look for ways to work it into their portfolios.
As a technologist, I love software. Along with many of my colleagues, I’ve built software, raised money to do it and sold software companies to strategic buyers. So we’re not only familiar with what’s required to build a successful software product company, having done it, but we also understand the satisfaction that comes from launching a piece of software—something that, at its core, exists to automate what was once tedious.
Couple that affinity for software projects with their obvious allure to investors and it’s a sector in which I often find myself working on behalf of clients. So in addition to the software platforms I’ve helped build, I’ve also spent time with several dozen software companies helping them find product market fit, preparing for diligence work and putting together roadmaps.
I’ve taken observations from these engagements, plus those from my own experience as a software creator and investor, and compiled a guide of best practices for growing software companies. These are factors that should be weighed by all software investors. This can also be considered a constructive read for those who are building a software product within a company whose main focus and revenue driver is something else: services, hardware, healthcare, etc.
There is a wealth of data to consider when evaluating a software company. The lynchpins, however, are typically: Product, Technical Talent, Sales, Marketing. This piece will cover the top and most important factor: Product.
A great product can cover up ills in leadership, team, and even marketing, but it’s the hardest item to get right.
When I was part of the 2011 class at Y Combinator, Paul Graham had a few refrains he would trot out again and again. One of them, the mantra that everybody now identifies with YC the world over: “Make Something People Want.” At its core, product market fit is that simple.
But there’s lots of pieces inside of that, starting with those most simple of measures: appearance.
A software product should look good, obviously, and be intuitive to use, have good online support and all of the other qualities most people expect from modern applications. A software company who is serious about being a leader in its space will also be highly aware of two things as it pushes its product forward:
- What its customers are saying about its product relative to their market and how they use it.
- What its competitors’ products are up to and how they’re thinking about evolving for the future.
Both of these measures are encapsulated in something that the software world refers to as product-market fit.
The phrase product-market fit echoes through Silicon Valley and other technology hubs, but it’s not always something that companies who are years into the throes of building and selling a product stop and take time to think about. This is especially the case at companies that weren’t reared on traditional software-making ethos.
Many software companies that show up on the radars of private equity firms weren’t spawned from the traditional venture-capital treadmill. VC-funded companies, while they often make great software, are more likely to see exits to a strategic buyer, as their earnings profiles aren’t as attractive to PE buyers. More often, PE shops are looking at companies that bootstrapped to some degree, which often lends them a leaner backbone and the kinds of recurring earnings that can pay down leverage required in PE deals.
So what is product-market fit? Going beyond the four-word YC mission statement, Mark Andreessen writes that it means being in a good market with a product that can satisfy the market. Further, he explains that, “You can always feel when product/market fit isn’t happening. The customers aren’t quite getting value out of the product, word of mouth isn’t spreading, usage isn’t growing that fast, press reviews are kind of ‘blah’, the sales cycle takes too long, and lots of deals never close.”
That’s a simple enough description. Nearly all software companies being considered by private equity companies satisfy or did satisfy product-market fit requirements at some point. If they hadn’t, they likely wouldn’t possess the growth and earnings required to interest PE investors.
The thing about product-market fit, however, is that it’s an ever-evolving relationship. Customers’ expectations around software change, and the threat of disruption, often from products that may be considered simpler and which have been pioneered by smaller, nimbler companies, is always a threat—and one that should be continuously sized up.
It’s Cuesta’s opinion that bootstrapped companies tend to be more susceptible to disruption from up and coming software companies, especially those who have seized on better tech, delivery mechanisms (mobile vs. desktop, automation and AI vs. user-entered values) and user experiences. Venture funded companies can move more quickly because they often have cash to throw at problems.
For that reason, we often recommend that our PE clients who are weighing an investment in a software company complete not only a standard technical diligence, but also a moderate commercial/product diligence that delivers good intelligence on competitive players in the target’s market. During our process, we use data gathered during the technology diligence with the target to inform our with and around competitors.
Things we take stock of during a commercial diligence, which is really an in-depth comparative analysis of software products:
- Features: This goes straight to the heart of product-market fit, as the software that has found the best approach will roll out features ahead of the rest of the market, but generally in-line with what their customers want and need. Software companies typically trumpet their feature superiority in online landing pages with comparison charts and other graphics because they know how important this piece is to those who are shopping. Investigation is usually required a level deeper than what is available online, however, as marketing bluster tends to be just that.
- Application architectures and how they differ: Better constructs here can enable scaling more easily and at lower costs, plus they offer better speed to end users, something that will be noticeable to anybody comparing products. Inflexible architecture choices might not look like a big problem on the surface, but when we know that much of the market has pivoted to more modern frameworks (something gleaned in commercial diligence), we can infer that the target will be much slower to adapt to changes in the space and the ability to offer new integrations.
- Built-in integrations: As companies push toward more digital synchronization within their operations in all sectors, software purchases will continue to be scrutinized for their ability to share data and ingest data from other packaged and SaaS applications. Having an internal-facing API that drives much of the backend, now considered simply good practice in application architecture, can help a company quickly integrate with other software and apps.
- Pricing: This is obvious, but it’s important to have a good feel for how the rest of the market is couching their value to potential customers and the kinds of contract terms they’re making available.
- Marketing: Sizing up privately-owned competitors can be difficult, but Cuesta has several methods to get a bead on how much business a software company may have. One data point we like to reference is digital marketing. Using a slew of tools, we get a picture of how advanced a marketing operation a company is running by looking at what kinds of tracking cookies, site development tools and other things running in the background of its website. We couple that information with data around the kinds and volume of search ads a company is paying for, plus estimated traffic numbers for an application/website. Taking all of this together, we can get a feel for how big a marketing operation is, a solid input for determining a company’s size. The sophistication of marketing is also instructive when it comes to determining how easily a potential target may be able to win share.
There’s a lot that goes into a product-market fit analysis, but it’s the heart of determining the quality of target’s product compared with competitors and the demands of the market.
The other big rocks when weighing investments in software companies: technical talent, sales and marketing. Those items will be covered in a subsequent piece, to be linked here.
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