Sales Efficiency and Other Takeaways From Software in 2021

Key Points

Disclosures and Disclaimers

Sales efficiency is a key metric that we track when analyzing software companies’ growth. Beyond gross margins, net retention rates, and total addressable market (TAM), it’s a key measure of a company’s path to profitability.

Most companies experienced a decline in sales efficiency last year as a result of COVID-related headwinds and longer sales cycles.

To learn more about how this trend may impact this sector’s future profitability, we examined sales and marketing and execution efforts among 72 software names. Our findings uncovered some important trends regarding future growth patterns and valuations.

Here are the key takeaways from our report:

Higher sales efficiency correlates with higher valuations

Sales efficiency is a key driver of a company’s path to profitability, and a strong indicator of its sales and marketing effectiveness. It’s regarded as the inverse of customer acquisition cost (CAC). We estimate that median sales efficiency is around 0.8x (i.e., for every $1 of sales and marketing spend, a company generates $0.80 of additional organic revenue). This translates to a CAC of 1.3x, which we believe is the midpoint of typical CAC ratios of 1.2x-1.4x.

We found meaningful correlation between sales efficiency and valuation multiples, where companies with higher sales efficiency trade at above-average EV/revenue multiples, while those with lower ratios trade at lower multiples.

Here are our other major findings:

1. Companies with a meaningful self-service motion tend to see higher sales efficiency because they make significantly lower investments in sales reps.
2. Most companies experienced a drop-off in sales efficiency during the pandemic. We expect sales efficiency to return to pre-COVID levels in CY21 due to CY20 COVID-related cost savings (2Q earnings could show a “COVID sales efficiency bump”).
3. Declining sales efficiency may reveal execution challenges. Declining sales efficiency may signal sales execution issues or potential TAM constraints. On the other hand, improving sales efficiency may indicate more effective sales execution or channel use.

“We found meaningful correlation between sales efficiency and valuation multiples, where companies with higher sales efficiency trade at above-average EV/revenue multiples, while those with lower ratios trade at lower multiples.” –Rishi Jaluria, Software Equity Research Analyst

M&A activity higher than any recent year

Merger and acquisition activity declined over the last two years, but remained far higher than the previous two years. Year to date, M&A activity has surpassed recent years with 120 deals totaling $188B so far, versus $139B in 2018.

We don’t believe that COVID-related limitations on in-person negotiations, diligence, or integration work will interfere with continued M&A activity. In fact, we expect to see a rapid pace of acquisitions driven by greater dispersion in valuations; rollups of sub-scale providers offering distribution systems and shared backend costs; and incumbent software providers’ continued search for potential disruptors.

High revenue companies have outperformed over the past few years

Although this year has represented a slight reversal from the trend, high revenue growth software companies have strongly outperformed low growth ones over the past few years. Companies experienced 20%+ revenue growth in 2020, delivering returns of 381% over the 2019-present period, a CAGR of 69%. This compares favorably with companies that experienced 10-20% growth delivering returns of 212% (a 34% CAGR), and companies that grew <10% that delivered returns of 163% (a 21% CAGR).

Similarly, stocks that achieved a top 25% percentile EV/Revenue on December 31st, 2020 have returned less than the bottom 25% percentile of stocks (-2% vs. +17% YTD). In prior years, the trend was reversed. At the end of 2019, the top 25% percentile of multiple stocks returned 133% in 2020, compared to the bottom multiple of stocks which returned 37%. At the end of 2018, the top 25% percentile multiple stocks returned 58% in 2019, compared to bottom multiple stocks returning 36%.

Software companies expect strong year and robust spending

Here are other key findings from our research:

1. Post-COVID, growth won’t fully return to normal. The outlook for the rest of 2021 seems strong and companies expect software spending to remain robust. But a number of companies, especially those that faced COVID headwinds, are cautious about pipeline and growth returning to pre-COVID levels.
2. Small-midsized businesses (SMB) may not fully recover until 2022. Although SMB companies are recovering quickly, they are not yet back to pre-COVID levels. We predict it may take until 4Q or 2022 for these companies to fully return to those levels.
3. Digital transformation and remote work tailwinds seem sustainable. Companies reported that many of the pandemic tailwinds, including remote/hybrid work and accelerated digital transformation, will linger long term.
4. Federal opportunities appear strong. As governments accelerate digital transformation, Federal opportunities will be strong for software companies. Given that the government’s fiscal year ends September 30, the impact of this trend may show up in next year’s numbers.
5. A tough hiring environment. Due to macro factors, many companies expect a tougher post-COVID hiring environment and more competition for employees. The companies that hired more aggressively during the pandemic are less likely to experience a wide skills gap than those that were cautious about hiring during the pandemic.
6. Disrupting the disruptor. Although investors rightfully focus on SaaS disrupting legacy solutions, they often overlook the potential for disruptors to be disrupted themselves. Many private companies told us they were focused on disrupting public companies that investors view as disruptors.
7. Developer appeal matters. As developers become more empowered about IT buying decisions, software companies will have to appeal to developers through easy-to-use APIs or through simpler software solutions.

Rishi Jaluria
Information Technology Equity Research Analyst, RBC Capital Markets LLC

Rishi Jaluria joined RBC Capital Markets in 2021 and is covering the software sector. Previously, he worked at D.A. Davidson and JMP Securities in similar roles and prior work experience includes Pacific Crest Securities, J.P. Morgan Securities, and UBS. Rishi has an MBA from the Stephen M. Ross School of Business at the University of Michigan and a BA from the University of California, Berkeley. He is based in RBC’s San Francisco office.

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Matt Hedberg
Information Technology Equity Research Analyst, RBC Capital Markets LLC

Matt Hedberg joined RBC Capital Markets in 2006. In addition to his 15+ years of software equity experience at RBC, he spent eight years in the software industry working with companies including GMAC and Accenture. While at RBC, Matt has published multiple white papers on the software industry and has deep knowledge of both public and private software companies. His software coverage universe focuses on security, DevOps and infrastructure names. RBC’s software team was ranked as the #1 SMID Cap Software Team and Matt was individually ranked #2 SMID Cap Software Analyst by Institutional Investor in 2020. Matt holds an MBA in finance from the University of St. Thomas.