Macro-Trends Affecting The Next Wave of B2B Tech
By Esteban Reyes, Founding Partner at Las Olas VC (a.k.a. LOVC)
We’ve spent the last 6 months researching early-stage, investment opportunities in B2B software. This work has become foundational to our investment thesis at Las Olas VC (LOVC), which so far is yielding promising results. We’re sharing our findings in this blog post series, which hopefully is helpful to other founders and investors exploring similar opportunities.
In the prior post I explained the Intelligent Enterprise investment thesis and summarized the macro and micro trends driving the opportunity.
In this second post I’ll unpack the macro-trends.
Please reach out to me directly with any feedback, comments, or ideas to er@lasolasvc.com
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Macro-trend 1: Decline in productivity despite increase in tech spend
Throughout the history of mankind, new technology has been the catalyst for progress and societal transformation (see Appendix table 1), but the technological breakthroughs of the last 50 years haven’t yet had a major impact on productivity rates (see Appendix table 2). Labor-productivity has been on a decline in the U.S. and Western Europe since the 1960’s boom, and it decelerated further after the 2007–2008 great recession to historical lows. The U.S. in particular experienced a strong productivity boom in the mid-1990s and early 2000s followed by the largest productivity growth decline, which began even before the financial crisis.
Productivity growth over time in U.S., 1871–2016, %
Source: A. Bergeaud, G. Cette, and R. Lecat, “Productivity trends in advanced countries between 1890 and 2012,” Review of Income and Wealth, volume 62, number 3, 2016; McKinsey Global Institute analysis
The 1990s boom was enabled by computers and the internet, completely transforming how every business operated. The world went from paper, mail, and filing cabinets to computers, email, and digital files. However Robert Gordon, a professor at Northwestern University, claims that this kind of transformation hasn’t happened again since 2005 and that the marginal recent improvements to multifactor productivity are attributable to tax cuts and not modernization. Jaana Remes, head of McKinsey & Co, strongly believes recent developments in digital technology will lead to another productivity boom akin to the 1990s digitization push. According to her research at the McKinsey Global Institute, digitization has not yet reached scale, with a majority of the economy still not digitized. Her research has found that Europe overall operates at only 12 percent of digital potential, and the United States at 18 percent, with large sectors lagging in both.
Macro-trend 2: Adoption of cloud, machine learning, and faster connectivity
Cloud adoption is compounding.
The adoption of cloud is enabling the aggregation of unique, end-to-end, business process data sets. These new data sets are the kernel for enabling deep workflow automation and solving industry specific problems.
Cloud adoption facts:
- According to Forrester nearly 60% of North American enterprises rely on public cloud platforms, which is 5x what it was 5 years ago.
- An IDG study conducted in 2018 found that 95% of all organizations will be relying on the SaaS model for application delivery in 18 months, with IaaS increasing to 83% and PaaS, 73%.
- Since 2016 Amazon Web Services (AWS) has been the fastest growing and most profitable segment of Amazon (NASDAD: AMZN), growing at more than 47% year-over-year in 2018. AWS contributed $7.3 billion in operating income, over 50% of the aggregate total for Amazon, which now holds a market capitalization of nearly $1 trillion dollars.
Machine learning is accelerating:
- Advances in neural architectures enable people without technical knowledge to build ML algorithms for certain use cases. While the scope of use cases is limited the promise is to empower non-technical users to harness the power of ML in their day-to-day work.
- Alibaba language processing AI outscores top humans at a Stanford University reading and comprehension test, scoring 82.44 against 82.304 on a set of 100,000 questions
- Five areas where artificial neural networks outperform humans:
- Image and object recognition
- Video games
- Voice generation and recognition
- Art and style imitation
- Predictions
Faster and deeper layers of connectivity:
Expanding internet infrastructure combined with growing cloud compute power eliminates constraints, and enables front-line worker populations to modernize business processes.
- Mobile: The world’s average mobile download speed of 22.82 Mbps increased 15.2% over the past year, while mobile upload speed increased 11.6% to reach 9.19 Mbps.
- Fixed broadband: The world’s average download speed on fixed broadband was 46.12 Mbps, 26.4% faster than last year. Upload speed increased 26.5% to 22.44 Mbps.
- Internet improvement in the world’s largest economies:
Source: SpeedTest World’s Internet Report 2018
Macro-trend 3: Entrepreneurship as a widespread phenomenon
The United States is experiencing increasing interest and workforce participation in entrepreneurship. According to the Global Entrepreneurship Monitor, the Total Entrepreneurial Activity rate (defined as the percentage of the population setting up or operating a business less than 42 months old) in the US has well recovered from the Great Recession.
Source: Global Entrepreneurship Monitor
This expansion is buoyed by positive outcomes, public opinion, and media coverage. Approximately 75% of adults think entrepreneurs have high status in US society and 75% think media attention towards entrepreneurs is favorable. A further 63% of adults believe that entrepreneurship is a good career choice, while 54% believe they have the skills to start a business. This level of attention has created unprecedented interest in founding companies.
Turning back to SaaS, the prior decade saw the success and adoption of horizontal SaaS platforms, which are industry-agnostic software platforms designed to tackle a specific business need. These companies, like Salesforce, ServiceNow, Workday, and Dropbox, were built and funded on the coasts of the United States.
Today, companies like Atlassian and Veeva are pioneering the vertical SaaS model, often building on top of these horizontal SaaS platforms. These vertical SaaS companies need deep industry expertise to successfully sell to their target customers, leading to vertical SaaS companies frequently being launched outside of the traditional coastal tech hubs.
Some tailwinds for companies operating outside of New York, San Francisco, or Boston include:
- Venture funds raised and deployed outside of the traditional tech hubs
- Lower cost of living and cost of labor
- Expanding set of cheaper tools to write and deploy software.
In general, the cost of building new software companies has shrunk as tools have become cheaper. One example of this is the decrease in AWS cost per instance between 2008 to 2018, leading to an overall 4x reduction in cost in that period.
Source: Kleiner Perkins 2018 Internet Trends Report
The public cloud market will continue to grow at a rapid pace. Gartner predicts that the public cloud market size will increase to $278bn by 2021 at a CAGR of 13.9%, from a $145bn market size in 2017.SaaS is expected to account for 41% of the total public cloud market, at an estimated $113bn market size in 2021. The public cloud market expansion is coming partially at the expense of on-premise servers, as increasing numbers of SaaS companies choose to use providers like AWS, Microsoft Azure, or Google Cloud to deliver their products.
Source: KeyBanc Capital Markets SaaS Company Surveys
There are multiple opportunities for vertical SaaS companies to disrupt incumbents, which are typically on-premise solutions.
Source: Bessemer Venture Partners, Vertical Software
Vertical SaaS companies are also more capital efficient than horizontal SaaS companies. From a study done by River Cities Capital of 20 public vertical SaaS companies and 72 public horizontal SaaS companies, horizontal SaaS companies spend 15% to 20% more on S&M as a percentage of revenue than vertical SaaS companies do. This is likely because vertical SaaS companies can conduct targeted marketing on their customers, who usually have very similar needs. As a caveat, the efficiency gap begins to narrow as vertical companies pass the $30mm ARR threshold, which is when vertical SaaS companies need to increase spending to expand to an adjacent vertical or to a new geography.
Vertical SaaS companies also show a capacity to generate more revenue per dollar invested than horizontal SaaS companies. By the time they are public, the typical vertical SaaS company generates $2.87 of LTM revenue per dollar of equity or debt raised, while the typical horizontal SaaS company generates $1.68 of LTM revenue per dollar of equity or debt raised. 75% of public vertical SaaS companies generate more than a dollar of LTM revenue per dollar of equity or debt raised, while only 59% of public horizontal SaaS companies generate more than a dollar of LTM revenue per dollar of debt or equity raised.
Regarding location, an analysis done by Bowery Capital found that while nearly 60% of publicly traded horizontal SaaS companies were started in the West Coast, only 25% of publicly traded vertical SaaS companies were started in the West Coast. In the same vein, many notable billion-dollar vertical SaaS companies have been started and headquartered away from the large coastal tech hubs.
Source: Bessemer Venture Partners, Vertical Software
Because vertical SaaS companies are being started away from established tech hubs, these companies can take advantage of the lower cost of living and cost of doing business while also bringing in new talent to these hubs. CBRE conducted a study of where tech talent is flowing in 2018; some of the fastest growth markets for tech jobs in the US include Los Angeles, Madison, Orange County, Pittsburgh, Richmond, Hartford, Cleveland, Seattle, and Ft. Lauderdale.
Source: CBRE, Scoring Tech Talent in North America
On the whole, the top US non-hub cities where the demand for tech workers far exceeds supply include:
- Charlotte (14,800 more jobs than graduates)
- Atlanta (9,000 more jobs than graduates)
- Kansas City (5,500 more jobs than graduates)
- Nashville (5,300 more jobs than graduates)
Macro-trend 4: Venture Capital at record high, yet not evenly distributed
A record-breaking $131bn of venture capital was deployed in 2018, surpassing the $83bn invested in 2017 and breaking the $100bn mark for the first time since 2000. Of the $131bn, $12bn is attributable to the Altria-Juul investment, emphasizing the larger investment rounds that dominated the news cycle and investor attention.
Early-stage investing statistics in 2018 (angel vs seed):
- The number of angel and seed investing rounds fell to 3,760 from 4,521 in 2017
- The median angel pre-money valuation increased to $6.7mm from $5.8mm in 2017
- The median seed pre-money valuation increased to $7mm from $6.3mm in 2017
- The median angel deal size increased to $650K from $500K in 2017
- The median seed deal size increased to $2mm from $1.6mm in 2017
Median Angel/Seed pre-money valuations ($mm)
Source: Pitchbook, 4Q18 Venture Monitor
Median Angel/Seed deal size ($mm)
Source: Pitchbook, 4Q18 Venture Monitor
Early-stage investing statistics in 2018 (amount invested):
- The number of sub-$1mm check size deals decreased to 2,144 from 2,591 in 2017
- The number of $1-$5mm check size deals decreased to 2,699 from 3,042 in 2017
- The total amount invested in sub-$1mm check size deals decreased to $760mm from $880mm in 2017
- The total amount invested in $1-$5mm check size deals decreased to $6.6bn from $7.3bn in 2017
One interesting trend is that corporate venture capital has become more active recently, with large deployable cash reserves accumulated from lower corporate tax rates. Corporate venture capital invested $69bn across 1,443 deals in 2018, up from $37bn across 1,427 deals in 2017. Of these, 211 deals in 2018 were devoted to angel and seed rounds, down from 238 corporate venture capital angel and seed deals in 2017.
On the whole, venture-backed exits had a stronger 2018 than 2017, with $122bn in exits in 2018 over $92bn in exits in 2017.
- The median acquisition size increased to $100mm from $80mm in 2017
- The median buyout size increased to $150mm from $101mm in 2017
- The median IPO size increased to $348mm from $337mm in 2017
Top venture capital firms have taken great interest in vertical SaaS opportunities recently. Sequoia explained its rationale for leading the seed and Series A rounds in Remix, a vertical SaaS company that helps local transit authorities manage fleet routes, micro-mobility (scooter) deployments, and road planning, in a blog post. Some of the reasons cited include the team’s industry expertise through working with local governments in the Code for America program, and an increasing willingness by local governments to spend in upgrading their technology solutions. Other industries that are taking a deeper look into vertical SaaS solutions include construction and transportation.
The Sequoia team also highlighted the difference between systems of engagement and systems of record.
Systems of record (old opportunity)
- Companies: Salesforce, Workday, ServiceNow
- Value: unified source of data and truth for the company within one system
Systems of engagement (new opportunity)
- Companies: Slack, Okta, Segment, Intercom, Clari, Culture Amp, Front
- Value: “consumerized” enterprise apps and integration with existing systems
Integration is a big value driver:
- Okta lets employees log into any of their accounts and IT can exert control over any account
- Segment allows companies to pull together analytics data from all of their sources (i.e. Google Analytics, Salesforce, Amazon S3)
Mary Meeker, in her 2018 Internet Trends Report, reached similar conclusions. She especially highlighted how the healthcare industry may see a sharp drop in consumer costs, as the consumerization of healthcare tech along with increasing amounts of data collected work in tandem to reduce bills. Some companies in this field include One Medical, Oscar Health, and Capsule.
Meeker also discussed how readily available education tools are enabling internet users to engage in “lifelong learning.” Education startups like Coursera or Udacity are partnering with enterprises like AT&T to provide worker reeducation programs in new fields like machine learning or cybersecurity. The workers who make the effort to go through retraining are being rewarded through company promotions.
As more entrepreneurs are starting companies outside of the traditional tech hubs, more investors are investing outside of the traditional tech hubs. PwC reported in late 2018 that, for the first time, US venture capital investment made outside of Silicon Valley exceeded US venture capital investment made inside Silicon Valley. One of the most notable VCs investing outside of traditional tech hubs is Steve Case’s Revolution Ventures, whose $150mm Rise of the Rest seed fund includes LPs like Jeff Bezos and Eric Schmidt.
