Nov 30, 2023
 in 
Venture Capital

Navigating the Changing Landscape of Venture Capital: Exploring the Impact of Economic Trends on Cloud and SAAS Markets

Author
Michael Sable
A

t a time of rising interest rates and slumping economic growth, the venture capital markets have felt the impact. Global venture capital investment declined from $81.4 billion across 9,563 deals in the second quarter of 2023 to $77.05 billion across 7,434 deals in the third quarter of 2023.

Those investment figures represent the lowest totals since the third quarter of 2016 and the deal volume figures are the lowest since the second quarter of 2019. In recent years, the cloud and software as a service (SAAS) markets have emerged as important investment opportunities for venture capitalists. They are a bright spot in an otherwise moribund investment market. For example, over the last ten years, the total public cloud market has quadrupled by over 450% from $283 billion in March 2013 to $1.3 billion in March 2013.

The three largest public cloud vendors—Amazon, Google and Microsoft—all reported robust third quarter 2023 annual growth of between 28% and 42%. Spending on cloud technology shows no signs of abating and is projected to increase to 17% by 2026 from 12% or $600 billion in 2023:

A DataDog slide of cloud spending

Based upon the current growth trajectory, it is expected that cloud services will eventually account for approximately 25% of global IT spending. This is the kind of huge market that venture capitalists are attracted to. Undoubtedly, these trends are driven by the ongoing imperative to manage and manipulate ever increasing volumes of data as the advent of the Knowledge Economy shapes the way that we live, work and play.

Global Cloud Investment

Another factor driving venture capital interest in the cloud is that it is an inherently global investment opportunity.

The 18% spent by end users in North America on public cloud services in 2022 represents a sizeable market of $265 billion while the 12% spent in Latin America is $19 billion with 10% or $121 billion spent in Europe, the Middle East and Africa and 6% or $82 billion spent in the Asia Pacific. While the absolute figures are important, the trends are even more profound. 

From 2021 to 2022, public cloud spending grew 85% in Latin America, 35% in the Asia Pacific, 14% in Europe, the Middle East and Africa, and 11% in North America. Venture capitalists have taken note of these trends and deployed $53 billion into cloud companies outside of North America in 2022 such that cloud and SAAS deals represented almost 25% of worldwide venture backed startups last year.

China is increasing in importance in the global cloud market. The country is already a leader in the AI and 5G technologies that depend upon the cloud for successful deployment. By 2025, the country is poised to spend $1.6 trillion through a combination of public and private investment to reinforce its strengths in these foundational technologies. As such, it is now also ramping up investment in the cloud.

China is becoming a hotspot for venture capital as 13% of VC dollars—a figure equivalent to $72.5 billion—were deployed in the country in 2022. Of the 5,493 Chinese startups funded in 2022, 585 or 11% were cloud or SAAS businesses. This market is expected to increase by almost 300% from $36 billion in 2022 to $90 billion in 2025.

China also has the highest growth rate of cloud spending of any country as it increased spending on the cloud by 45% in 2021. The country spent $27 billion on the cloud in 2021 and this is projected to increase to $85 billion by 2026.

The SAAS Value Proposition

SAAS is important to venture capitalists not just because of the size and growth of the market but also because it has a robust and strategically important value proposition. Specifically, SAAS refers to a distribution model where applications that are hosted by a service provider—usually in the cloud—are made available to users over the Internet. 

Unlike traditional software that must be installed and maintained on individual devices at greater cost, SAAS allows users to access and use software applications at greater convenience and lower cost through web browsers which eliminates the need for local installations. Not only is this less costly and more convenient but the subscription-based pricing and ease of updates has great appeal because they generate consistent revenue with less hassle. 

Moreover, the software can be iteratively and quickly updated in the cloud which reduces error and speeds maintenance. Both startups and legacy software companies are transitioning to this model. The net result is that the SAAS market has grown by 550% to be worth an estimated $172 billion in 2022 from $31.4 billion in 2015.

US venture capitalists have embraced this trend by pouring $76.5 billion into enterprise SAAS startups in 2021 and $62.4 billion in 2022 before a dramatic decline in 2023.

It should be noted that the enterprise or B2B SAAS startup sector, which constitutes 90% of the VC investment in this sector, is not monolithic as it includes a variety of subsectors including enterprise resource planning followed by customer relationship management that combine for 2/3rd of VC investment. Additional areas of investment include analytic platforms, supply chain management, knowledge management systems, and other application software.

A catalytic factor driving venture capital interest in SAAS is that it is poised to benefit greatly from the ongoing artificial intelligence revolution. Many of the products and applications that are poised to have AI-capabilities embedded within them will be delivered as SAAS through the cloud. Indeed, according to Index Ventures' partner Erin Price-Wright:

"[G]oing forward, it's going to be very difficult to raise any cash as a B2B or enterprise SaaS company if you don't have an A.I. strategy. Within a decade, A.I. will be a core component of every piece of application software that's built and shipped."

The power of the SAAS business model, which is being supercharged by its ability to leverage the AI Revolution, is anchored in the kinds of metrics that venture capitalists love. Simply put, SAAS companies can be highly capital efficient. For every dollar that an SAAS business spends on its sales team, the company can experience a dollar of recurring revenue in less than a year and watch that grow nearly in perpetuity. 

Due to the power of the cloud-based business model, these businesses are often valued at 10 to 20 times their annual revenue which makes for attractive exit opportunities. It also means that it is possible to build a profitable SAAS business with a relatively small investment of less than $10 million if the management is sound enough to use the capital to build a good product. 

In inherently challenging markets, the subscription-based model of SAAS startups offers the recurring revenue that is essential for their survival. Pay-as-you-go is better than attract as many users as possible and try to figure out later how to make money from them. Finally, the ability to adapt and customize the SAAS to customer demands provides the flexibility that is essential to retaining them as features can be updated as needed and the startup is constantly learning what the market requires versus investing a lot of time and money in a software product that may not function as desired when it is ultimately deployed. This helps to mitigate the product-market fit risks that are inherent to the venture capital milieu.

SAAS Metrics

Venture capital have an important commonality with the SAAS companies that they fund: they are both data-driven as the tracking, optimizing, and leveraging of critical metrics is central to their success. There are several metrics that are essential to the success of the SAAS business model:

  • Customer Acquisition Cost

Accurately understanding the total cost of marketing and sales initiatives required to acquire a customer is essential. If these figures are calculated too conservatively, it can lead to a poor understanding of how much one can spend to acquire more customers which can result in missed revenue opportunities from new customers. Conversely, overestimating this cost can lead to overspending and low profitability.

  • Lifetime Value

This is an estimate of the total amount that a customer is likely to spend on the software through the course of their time as your client. It can give a good approximation of how much revenue existing customers will bring in each month, which can be leveraged to estimate the overall value of the business.

  • Churn Rate

This is the rate at which customers stop being your customer over a defined period or the number/percentage of subscribers who renew or cancel a SAAS subscription. Understanding why customers leave is essential to decide which features to incorporate or how to properly price the offering.

  • Retention Rate

This is the opposite of the churn rate as it measures how successful the SAAS company is at retaining customers. The goal is to keep retention high and churn low.

  • Monthly Recurring Revenue and Annual Recurring Revenue

This is essential to understanding the financial health of the enterprise, which in turn is critical to plotting the growth trajectory or where changes need to be made.

Top SAAS Venture Capitalists

Amongst the top venture capital firms that consistently and successfully invest in SAAS are:

  • Sequoia Capital: Successful investments include Hubspot, Zoom, and Okta.
  • Andreessen Horowitz: a16z has invested in Slack, Airbnb, and GitHub.
  • Accel: Dropbox, Atlassian, and Qualtrics are among its successes.
  • IVP: The company focuses on growth-stage SaaS companies. Its successes include Dropbox, Datadog, and Databricks.
  • Bessemer Venture Partners: Successful investments include Twilio, Shopify, and DocuSign.
  • Battery Ventures: The firm has invested in Glassdoor, Marketo, and Sprinklr.
  • Sapphire Ventures: Successes include MuleSoft, SquareSpace, and Box.
  • Founders Fund: Founders Fund invests in early-stage and growth-stage SaaS companies; and has experienced success with Airbnb, Stripe, and Palantir.
  • Khosla Ventures: Khosla Ventures has invested in companies such as DoorDash, Instacart, and Square.

The cloud/SAAS market is an enduring area of strength in an increasingly troubled information technology industry. It is the foundational infrastructure through which the delivery of a number of important technologies—AI, 5G, etc.—will be realized. It is also vast, growing rapidly, and global in scope. The iterative nature through which services are delivered and maintained also means that it provides the opportunity to mitigate the risk of poor product-market fit while earning revenue on the go and constantly learning about the customer. It is likely to remain an enduring safe harbor for venture capital investment during these trying times.

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