Software companies are lucrative targets for investors.
The business model lends itself well to the buy-and-build strategy: low overhead, strong margins. That said, one of the most painstaking parts of investing in software companies is finding the companies that are private and bootstrapped before your competitors.
It’s easy to Google the Top 100 software companies, but those companies are publicly traded (or well on their way). Here’s what’s hard: how do you find software companies before they’re software companies?
To understand this, let’s consider how software companies are born:
- Self funded: Founder spends their own money or time to get their software business off the ground. These are “bootstrapped” companies and often hard to find without a company search engine.
- VC backed: Founder takes investor money to start their business. These are often in the news and much easier to find.
- Company funded: Founder uses company’s profits to invest in technology, build a software product, and either pivots their business model or spins off a new company. These are very hard to find but rising in prevalence and creating huge opportunities for investors-- we call them the “software-enabled” company. Companies that have software as a part, but not the entirety of their business model.
Middle market dealmakers are not looking at the unicorns. They’re looking at the often overlooked hippogriffs–companies that are half horse, half eagle– that could potentially reach unicorn status.
The obstacle to taking advantage of these opportunities? They're even harder to identify at scale than pure software platforms.
What is a software-enabled company?
To understand this new kind of company type, it’s important to think about software as a business model rather than an industry.
We can draw a clear distinction between a plastics manufacturer and a VR software developer. But what about the companies in between that are manufacturing the VR headsets and building the VR software? How do we define that kind of company?
At Grata, we call those kinds of companies “Software-Enabled.” And we did a lot more than just give them a new name; we gave investors a faster way to find those kinds of companies.
The challenges dealmakers face when identifying software companies
There are 2 major reasons why finding a list of software and software-enabled companies is such a challenging task for dealmakers:
- NAICS doesn’t cleanly classify software.
The existing NAICS ontology has one category for all software publishers and it doesn't get any more granular than that. One level higher than “software publishers” is simply labeled "information technology.” Often, the lines between all of these services are blurred when searching within NAICS.
These are not helpful categories for dealmakers.
To craft more successful searches, dealmakers need the ability to differentiate between “pure-play software” or SaaS and companies like consulting, custom software developers, and IT services.
- Companies often present themselves as “software” in their descriptions.
The way companies self-describe can make it difficult to tell whether they are a software or services-based company. Services companies often use the same self-description terms as software companies. It likely will require a deep dive to learn exactly what certain technology companies do – frequently it’s a mixture of software and services.
All dealmakers know the difference in how much software and how much services a company is will have a huge impact on EBITDA. It's extremely important to be able to distinguish between them early on in the sourcing process.
ML models can help identify software-enabled companies at scale.
The “software-enabled” classification in Grata gives dealmakers a much more accurate view of a company’s business model. The category can help filter down to the right opportunities in a fraction of the time.
What does “software-enabled” mean for investors?
The benefits of investing in a software-enabled business are numerous, but it starts with multiples. You can often enter a software-enabled business at a lower revenue or EBITDA multiple that reflects the old (services, hardware, etc.) business model but sell the company at a much higher, software multiple.
Other benefits over a services or hardware business model include: scalability, margins, and customer acquisition costs– and the benefit over a VC or self-funded software company, entry valuation aside, is risk. In the worst case, you have a profitable services or hardware company that you will get good returns.
One famous software-enabled company was Tiny Speck– game developers working on a game called “Glitch.” You’d recognize this company now by the name Slack. What started as a solution to game development became a billion dollar company.
With data like “software-enabled,” investors can find the next big deal, before it’s the next big deal.
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