Software Market Cycles: Expansion vs. Consolidation
If I had to simplify software market cycles, I’d say they come in two phases: the expansionary phase and the consolidation phase.
In the expansionary phase, buyers scoop up software almost indiscriminately. There’s little concern for cost or efficiency, what matters is speed. It’s about accelerating product development, capturing market share, or outspending competitors to stay ahead, all under the assumption that growth will take care of everything else. During this phase, public markets shift their focus entirely to growth over profits. Take a look at the multiples chart I post later on breaking out multiples by high, medium, and low-growth companies. You can see the high-growth bucket has seen multiple expansion this year, while the mid-growth bucket has seen steady contraction.
In the consolidation phase, companies start to heavily scrutinize their existing vendor relationships, looking for places to cut costs or consolidate spend into bundled platforms.
2020–2021 and today, I’d argue, were / are expansionary phases. A few years back, the driver was low interest rates. Today, the driver is AI. No one wants to fall behind, and everyone is willing to spend to figure it out. Whether that means experimenting with new tools, building internal capabilities, or buying growth stories tied to AI. The fear of missing the next platform shift has become its own form of FOMO, and it’s fueling a new wave of aggressive software spending.
2022–2023 was the period of consolidation. During that time, how often did we hear phrases like “Microsoft is bundling their way to dominance” or “sales cycles are elongating”? The emphasis shifted, and everyone started worrying about cost. Gone were the days of growth at all costs. Point solutions were axed or absorbed into broader platforms, and in markets with five or more competing vendors, a single player, often the best-of-breed solution, emerged as the long-term winner while the rest tailed off.
I don’t know when we’ll exit the current expansionary phase, but it will happen eventually, and we’ll enter another period of consolidation. The longer this expansion lasts, the longer (and more painful) the next consolidation will be. And this is separate from the debate over whether we’re “in a bubble.” Bubbles relate more to valuations. What I’m describing is the underlying psychology of buying and procuring software. They’re related, of course, but there’s nuance in the difference.
I call this out because now, more than ever, when I’m evaluating earlier-stage businesses, I often find five to ten competitors per category, sometimes more. It’s easier than ever to start a company. And because we’re in such an expansionary period (and so many of the markets being created today are greenfield), it’s common to see all ten companies in a space showing strong growth. They all seem to be working. A lot of it echoes what we saw in 2020–2021: buyers shortening sales cycles, rushing to get new tools in place, and buying quickly. Once the consolidation phase hits, that behavior flips. Suddenly, there’s intense scrutiny on every vendor relationship.
We’ll inevitably hit that point again, and we’ll look back on this moment and wonder, “How did I ever think five companies in the same market could all become successful public companies?” Of course the market, and market share, will consolidate around one or two. It always does.”
This is one of the hardest parts of venture today. The rising tide is so strong that everyone with an AI tailwind looks like they’re working. But separating who’s working now (in the easy expansionary phase) from who will survive and thrive later (in the difficult consolidation phase) is more important than ever. Venture investing is about long time horizons, and success ultimately comes from backing the companies that can endure through consolidation—not just accelerate during expansion.
For founders, it’s worth being intellectually honest. Are you growing because you’ve truly built the best solution in the market? Or because you’re riding a rising tide? Getting that answer wrong, and not addressing it early, can make the next consolidation phase a very painful one. This phase can also be quite frustrating for companies with leading offerings in their category. Subpar competitors raise venture capital with ease, flooding the market with marketing confusion. However, this too shall pass. The focus should always be on building the best product experience for your customers. Eventually the market will coalesce around the best product (of course this undermines the importance of great execution along the way!)
Quarterly Reports Summary
$Palantir Technologies Inc.(PLTR)$ $Shopify(SHOP)$ $8x8(EGHT)$ $Qualys(QLYS)$ $Unity Software Inc.(U)$
Top 10 EV / NTM Revenue Multiples
$Cloudflare, Inc.(NET)$ $CrowdStrike Holdings, Inc.(CRWD)$ $Figma(FIG)$ $Snowflake(SNOW)$ $Datadog(DDOG)$ $Zscaler Inc.(ZS)$ $Guidewire(GWRE)$ $Palo Alto Networks(PANW)$
Top 10 Weekly Share Price Movement
Update on Multiples
SaaS businesses are generally valued on a multiple of their revenue - in most cases the projected revenue for the next 12 months. Revenue multiples are a shorthand valuation framework. Given most software companies are not profitable, or not generating meaningful FCF, it’s the only metric to compare the entire industry against. Even a DCF is riddled with long term assumptions. The promise of SaaS is that growth in the early years leads to profits in the mature years. Multiples shown below are calculated by taking the Enterprise Value (market cap + debt - cash) / NTM revenue.
Overall Stats:
Overall Median: 4.9x
Top 5 Median: 24.6x
10Y: 4.1%
Bucketed by Growth. In the buckets below I consider high growth >22% projected NTM growth, mid growth 15%-22% and low growth <15%. I had to adjusted the cut off for “high growth.” If 22% feels a bit arbitrary, it’s because it is…I just picked a cutoff where there were ~10 companies that fit into the high growth bucket so the sample size was more statistically significant
High Growth Median: 16.3x
Mid Growth Median: 6.3x
Low Growth Median: 3.8x
EV / NTM Rev / NTM Growth
The below chart shows the EV / NTM revenue multiple divided by NTM consensus growth expectations. So a company trading at 20x NTM revenue that is projected to grow 100% would be trading at 0.2x. The goal of this graph is to show how relatively cheap / expensive each stock is relative to its growth expectations.
EV / NTM FCF
The line chart shows the median of all companies with a FCF multiple >0x and <100x. I created this subset to show companies where FCF is a relevant valuation metric.
Companies with negative NTM FCF are not listed on the chart
Scatter Plot of EV / NTM Rev Multiple vs NTM Rev Growth
How correlated is growth to valuation multiple?
Operating Metrics
Median NTM growth rate: 11%
Median LTM growth rate: 14%
Median Gross Margin: 76%
Median Operating Margin (2%)
Median FCF Margin: 19%
Median Net Retention: 108%
Median CAC Payback: 30 months
Median S&M % Revenue: 37%
Median R&D % Revenue: 24%
Median G&A % Revenue: 15%
Comps Output
Rule of 40 shows rev growth + FCF margin (both LTM and NTM for growth + margins). FCF calculated as Cash Flow from Operations - Capital Expenditures
GM Adjusted Payback is calculated as: (Previous Q S&M) / (Net New ARR in Q x Gross Margin) x 12. It shows the number of months it takes for a SaaS business to pay back its fully burdened CAC on a gross profit basis. Most public companies don’t report net new ARR, so I’m taking an implied ARR metric (quarterly subscription revenue x 4). Net new ARR is simply the ARR of the current quarter, minus the ARR of the previous quarter. Companies that do not disclose subscription rev have been left out of the analysis and are listed as NA.
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