While commercial due diligence (CDD) is as established and professionalized as private equity investing, investors’ recent run in the tech sector warrants a closer look at the particularities of CDD on software companies and software enabled businesses. In addition to the traditional CDD work streams, there are additional dynamics unique to the software sector that are not as apparent in other sectors. Before identifying these unique dynamics, we will quickly review the work streams and objectives of a typical CDD engagement.
Regardless of the sector the investment target competes in, the overall objective of CDD is to provide a well-informed opinion of the commercial outlook of the target company. To build a relevant, up-to-date fact base, CDD advisers evaluate the current adoption, penetration and spending trends in the market, size the market and forecast its growth, evaluate customers’ purchasing processes and selection criteria, and assess the strengths, weaknesses and positioning of providers that compete in the market.
We examine many different software markets and targets for tech-focused investors and have identified several key factors that drive the commercial outlook for companies today. While all of these factors are not completely unique to software, their role in software is often more significant than in other spaces. These factors include: 1) proliferation of offerings, 2) complexity of pricing, 3) cloud evolution and migration, and 4) professional services and channel partners.
1. Proliferation of Software Offerings
When conducting CDD on a company in a hard goods space, say furniture manufacturing, it is relatively easy to understand the product and how customers use it. While there are different ways to design, manufacture, market, and price a chair, the fundamental use case has been the same for thousands of years: to sit on it. If manufacturers decide tomorrow that they want to manufacture chairs that serve additional purposes, they face significant barriers – capital outlay, manufacturing and design constraints, customer resistance to innovation of established products, and others.
Now consider conducting a CDD on enterprise resource planning (ERP) applications. ERP applications were originally used to automate inventory management and manufacturing resources planning. Shortly after, accounting, financial management, and human resources management were introduced into ERP suites. Since then, ERP suites have also incorporated product lifecycle management, supply chain management, and even CRM. Chances are that, if you were to look at the ERP space five years from now, you might see a set of ERP offerings that’s noticeably different from the one we see today. The fact that software providers can bolt additional use cases onto a particular software offering without altering or limiting the functionality of the original offering, and without having to incur major capital outlay, constitutes a major difference from other industries.
Needless to say, the constant proliferation of software offerings has created multiple complexities for investors. For example, it has become increasingly difficult to define the boundaries of competitive landscapes and assess providers’ positioning within them. As offerings continue to evolve, competitive alignment with geographies, verticals, customer segments, and different functional budgets, changes, too. As a result, providers’ go-to-market strategies have also proliferated as they can choose to compete with end-to-end ERP suites or point solutions, cater to horizontal or verticalized use cases, and serve enterprise customers or SMBs; the effectiveness of each strategy depending, in large part, on each provider’s offering and cost structure.
2. Complexity of Pricing
In addition to carefully defining the competitive boundaries and relevant offerings within a software space, CDD advisers also must sift through complex pricing schemes. In hard and soft goods industries, products are usually priced on a per-unit basis. In service industries, pricing tends to be a little more complex, featuring a combination of time-based, flat rate, and value-based pricing models. When looking at software companies, we usually find term license fees, token license fees, maintenance fees, subscription fees, usage-based pricing, server-based pricing, various tiered pricing models, and multiple hybrid models. Worse yet, even within an industry, multiple vendors are likely to price on very different dimensions.
The coexistence of multiple pricing models adds complexity across CDD work streams, including market sizing, forecasting adoption and overall growth, as well as evaluating competitors’ alignment with different customer segments. It also warrants a more granular assessment of customers’ decision making processes, how they think about using Capex or Opex, which functional budget to draw from (especially for software that is used in multiple corporate functions), and how they approach renewal and switching decisions.
In addition to the variety of pricing models, many software providers also have convoluted price lists or worse no price lists at all. During our CDD work, we frequently hear from customers that figuring out pricing without providers’ sales personnel is nearly impossible. Even once the final pricing is shared with the customer, it is often difficult to trace or understand how prices were calculated. These dynamics often translate into distinct competitive advantages for certain providers, depending on their pricing strategy relative to that of competitors.
3. Cloud Evolution and Migration
While many industries are disrupted by technology, the extent and consequences of technological change vary significantly. For example, with the introduction of email, the speed, format, and cost (for both vendors and customers) of personal and, more importantly, corporate communication changed abruptly and dramatically. While similar with regards to the magnitude of change, the introduction and adoption of electric cars is happening at a much slower pace, and improvements to cost and other key dimensions are less immediate and less obvious to some players in the value chain.
When it comes to the shift from on-premises software to various types of cloud-based deployments, software vendors, depending on the space and competition, find themselves somewhere between physical mail providers and car manufacturers on the disruption spectrum. While most software vendors can re-platform their on-premises software into a cloud-based offering in a reasonable timeframe and don’t face complete obsolescence or displacement, many have seen more nimble, pure cloud competitors enter their spaces and capture significant market share before being able to adapt themselves. In addition, re-platforming an on-premises offering into a cloud-based one can come with significant cost and customer migration challenges, similar to the challenges car manufacturers and car buyers are facing in the advent of widespread demand for electric cars.
In order to assess the significance and impact of the shift to the cloud in a particular software space, it is inadequate to merely evaluate the progress and pace of customer migration-to-date. For example, it seems appropriate to dismiss on-premises offerings in a market where 50% of users have migrated within three years of competitive cloud offerings becoming available. However, segmenting the user base by incumbent systems, use cases, size, vertical, and other dimensions can often reveal that the remaining 50% of the market is unlikely to migrate to the cloud any time soon and might in fact be the most profitable segment of the market.
We have seen a multitude of spaces in various stages of cloud migration and have found each market’s and each vendor’s exposure to cloud migration dynamics to depend on multiple factors. While this list is not exhaustive, we have observed the introduction and adoption of cloud-based offerings impact any or all of the following: providers’ products and roadmaps, pricing models and price changes, customers’ purchasing criteria and evaluation or replacement cycles, the roles of channel partners, and vendors’ overall competitive positioning and alignment with various customer segments. Needless to say that each time we are evaluating the impact of cloud migration on a software category or a particular vendor, we remind ourselves to leverage both pattern recognition and a fresh pair of eyes.
4. Professional Services and Channel Partners
The involvement of service personnel and partners in selling and delivering products is not unique to software. However, professional services groups and channel partners do have distinct roles in the software value chain that warrant special attention when evaluating software targets for investors. For instance, professional service groups in software have a somewhat analogous overall purpose when compared to support services in other spaces – that is, to install / configure products for customers – but their impact on top and bottom line success is arguably more significant.
When Best Buy dispatches the Geek Squad to install consumer electronics products for its customers, that’s exactly what they’ll do. They will show up at your door step, mount your new flat screen TV and hook it up to your new surround sound system. After 30 minutes the job is done and they move on to the next job. For Best Buy, this is pretty lucrative, because service fees are charged on top of product sales, installations usually do not cause problems that can’t be solved on the spot, and many Geek Squad employees work part-time or as contractors, which reduces costs.
On the contrary, when Oracle sends out a professional services team to help an enterprise customer with a new ERP implementation, that team is likely going to be onsite with the customers’ employees for 6 – 18 months, depending on the complexity of the ecosystem and level of product customization. This not only amplifies the vendor’s exposure to the impact of individual personnel’s performance, but also translates into an expensive undertaking to hire, train, and retain qualified personnel. In any case, how well vendors’ professional service groups execute both their technical expertise (i.e., how well do they handle implementation projects?) and broader service efforts (i.e., identification of cross-sell opportunities) warrants special attention during our research efforts.
Given the importance of efficient implementations and cost structure of professional services groups, many software vendors also leverage channel partners. Depending on the coverage of a vendor’s sales organization, the complexity of implementation projects and degree of customization needed, as well as pricing and service fee models, channel partners can be involved in generating leads, negotiating and closing deals, executing implementations and / or providing after-sale customer support. We have seen multiple combinations of these services being provided by channel partners along with varying incentive structures and coverage and assignment rules.
In order to understand the impact of professional services groups and channel partners on top line growth and bottom line profitability, we go beyond qualifying the extent to which a software company uses both of them. Among other questions, we validate what the impact on alignment with different customer segments is, how it influences a vendor’s competitive positioning, and whether there are levers that the vendors can pull to make their professional services teams and channel partners more efficient.
Compared to performing CDD on targets in other spaces, software targets demand a more detailed examination of the pace of proliferation of offerings, complexity and evolution of pricing models, the stage, drivers and implications of the shift to cloud-based offerings, as well as the role and performance of professional services and channel partners. While it is common for investors to leverage CDD to assess the commercial outlook of a software target due to the implications of these four key factors, they are well advised to also undertake an assessment of the target’s organizational performance against them. In one of our upcoming articles, we will discuss the specific benefits of conducting an integrated commercial and product / technology diligence on software targets.
by Carlo Franke, Manager in the Strategy Consulting practice