What are Market Trends for Software Companies

Published: Sep 14, 2022
By: Richard A. Cleaveland; Lee Tomasso
Topics: Technology
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Charting a course for software companies over the next several quarters may have its challenges. The lasting effects of COVID-19, including labor supply constraints, have caused significant inflation and have led to uncertainties surrounding rising interest rates. The rate of inflation has climbed significantly, nearly doubling from Q2 2021 to Q2 2022. This has prompted the Federal Reserve to raise the benchmark interest rate four times in 2022, including an increase of 0.75% in both June and July.

The uncertainties have contributed to recent volatility in the public markets, causing a decline in broader market valuations and especially hitting hard the technology and software sectors. This in turn has limited public exit opportunities and dampened corporate acquisitions. According to Nasdaq’s IPO Calendar, in July 2022 there were only seven IPOs, whereas there were more than 100 in the same month in 2021, and the average deal size of $40 million in July 2022 was down considerably from $234 million in the same month in 2021.

These public market conditions are also impacting private company valuations. Late-stage venture-backed software companies have been impacted most by the macroeconomic uncertainties. Given their proximity to a desired exit transaction, the drop off in IPOs and acquisition activity has delayed planned liquidity events, and for those requiring capital to bridge this delay, there has been an adverse impact to the pricing of rounds.

According to PitchBook, in the first half of 2022 the median deal size was $14 million, a 7.1% decrease from the median deal size in all of 2021. The decline suggests that investors are more hesitant to deploy capital to late-stage rounds if they don’t see favorable prospects of an exit in the near-term.

PitchBook also pointed out some trends on valuations. Earlier stage venture round valuations in 2022 saw contradictory results, with growth in deal sizes but a decline in pre-money valuations. The decline in valuations was likely due to companies possibly having to extend their cash runway since the timeline for exit might take longer. Meanwhile, seed round valuations have been the least impacted as they are far enough from their eventual exit. And finally, pre-money valuations have continued to grow through Q2 2022.

There has also been a noticeable shift in the way private companies are being valued. We are seeing less of an emphasis from investors on top line revenue growth and a renewed interest in profitability and cash burn rates.

Recently several public software companies, in their second quarter earning calls, have also cautioned investors that they expect longer sales cycles going forward and have lowered revenue and profit targets. The uncertainty across the entire economy has no doubt caused a refocus on cost containment, cost-cutting and careful consideration of new significant contracts.

We believe that in light of these headwinds facing the software industry, companies should make several adjustments to their business plans. They include the following:

Revisions to Operating Forecasts

Given longer sales cycles and cost-cutting exercises by customers, projections of annual recurring revenue (ARR) need to be adjusted downward in forecasts and estimated churn may increase as customers look for cost savings. Companies that have been focused on growth may also now find that the losses and cash burn resulting from these investments are less sustainable. Especially with uncertainties in available financing, companies should work toward becoming profitable to extend their runway and wait out this economic storm.

Accelerating Financing Plans

Companies should start working on financing sooner than planned. Just as sales cycles may become longer, companies should expect the time to raise capital to take longer as well. Raising money before you need it becomes critical in an environment like this. So, when reevaluating financing plans for the next year-to-18 months, companies should move up the timing of targeted raises.

No one can fully predict the future. However, taking stock of current trends and being prepared for future uncertainty will enable companies to more successfully navigate challenges.