The Billionaire vs. the Billion Dollar Fund Manager
“Software contracts are better than first-lien debt. You realize a company will not pay the interest payment on their first lien until after they pay their software maintenance or subscription fee. We get paid our money first. Who has the better credit? He can’t run his business without our software.” — Robert F. Smith
Lots of people found out about Robert F. Smith last year when he paid off all the student loans of roughly 400 Morehouse graduates, but the billionaire founder of Vista Equity Partners has been a legend in software investing for a long time.
It might sound hard to believe now, but when Smith started his firm in 2000, most investors thought that software was way past its prime. The title of a 2003 Harvard Business Review article summed up the prevailing mood at the time: “IT Doesn’t Matter.” Nicholas Carr, the author of the piece, basically called the entire sector a bunch of humdrum utilities:
“By now, the core functions of IT — data storage, data processing, and data transport — have become available and affordable to all. Their very power and presence have begun to transform them from potentially strategic resources into commodity factors of production. They are becoming costs of doing business that must be paid by all but provide distinction to none.” (emphasis mine)
Smith, on the other hand, recognized that software companies were wildly undervalued. Why? Because a revolution was about to happen: software was about to turn into a service, and that service would run on recurring revenue, the gift that keeps giving. Most investors used to treat all cash equally: a dollar was a dollar. But Smith recognized that some cash is more equal than others. And as a result, four hundred seniors graduated without any student loans last year.
But lately, some people are starting to question Smith’s early insight into the power of recurring revenue. With the advent of the COVID-19 crisis, people are starting to wonder whether the software industry is really all that special.
Case in point: the investor Gavin Baker, who previously built a Fidelity fund into a $15 billion behemoth, widely recognized as one of the most successful investors of all time. In a widely read Medium post, Baker challenges Smith’s famous quote:
“We are about to find out if Robert Smith’s insight holds true. My instinct is that…software payment terms will change significantly as a result of this recession. I suspect that fewer customers will pay cash upfront and that we will see payment terms lengthen significantly.”
And then he goes for the knockout punch: “At the end of the day, there is no such thing as truly recurring revenue.”
So who’s right? The billionaire who helped fuel the SaaS industry, or the billion dollar fund manager?
Personally, I think that Baker’s points all make sense. Baker notes that software companies that work with small businesses in high-risk industries are going to take a hit. He notes that contracts based on utilization or seats will likely suffer. He suggests that enterprise sales motions are going to struggle. He says value propositions are going to be called into question; companies that aren’t truly mission-critical might find themselves on the chopping block.
To which my response is: So what? I’ve talked to dozens of subscription business leaders since the crisis started, and they’ve all said essentially the same thing: thank God for recurring revenue! The stability and predictability of the subscription business model is absolutely essential to overcoming the issues that Gavin is talking about. Judging from my conversations over the last six weeks, it all comes down to three basic advantages:
You start each quarter near the finish line, not the starting line. If every quarter is a 100-yard race, then standard transactional businesses begin back at the starting blocks with everyone else. Subscription businesses, on the other hand, start 20 yards from the finish line! Sure, maybe during a recession you have some more distance to make up, but having MRR in the bank every month is a huge competitive advantage. That’s why so many companies with mixed revenue models are shifting more subscriptions — just look at online news, where the current crisis might be the last nail in the coffin for ad-based business models.
Your business is based on relationships, not transactions. When it comes to revenue, most businesses are essentially binary: you either make a sale, or you don’t. But subscription businesses aren’t based on one-off payments, they’re based on long-term relationships. So instead of losing a customer today, you might give them a discount or a credit, but that’s okay because the golden goose egg of recurring revenue will be waiting for you tomorrow. Because time is on their side, companies with these business models have much more operational flexibility.
Because they know who their customers are, subscription businesses can adapt faster. If you’re focused on selling a product through a particular distribution channel and that channel fails (ie. no one is going to the store), then you’re stuck. Subscription businesses aren’t focused on products and channels, they’re focused on customers. And that means they can adapt in smart and empathetic ways, like some Zuora clients have recently done. Fender can give away a million new music tutorial subscriptions. Headspace can give free meditation classes to health professionals and the unemployed. Resy can give credits to their restaurant customers, then pivot towards take-out and delivery. How do they do this? Well, their maniacal focus on retention means they’ve already developed this muscle, and these days, their customer data has become a huge advantage.
Yes, there will be short-term pain, but the whole point of healthy subscription businesses is that they are oriented towards long-term value, which is helping them weather this storm. Just look at the headlines. In retail, Neiman Marcus and J. Crew just declared bankruptcy, while Forbes is calling subscription-based retailers like Nurture Life and Nordstrom’s Trunk Club “the surprise winners of the coronavirus shutdown.” In transportation, J.D Powers expects vehicle retail sales to decline a staggering 80% compared to last spring, but Volvo is still planning on selling half their cars by subscription by 2025. In the media, the crisis has only accelerated the shift towards streaming services; today almost one-third of American households don’t have a traditional TV package.
The list goes on. This is a model that’s spreading across every sector of our economy. We’re all technology companies these days, which means we’re all capable of generating software-like levels of return (my company is finding that most subscription companies are dealing with slowing growth, as opposed to negative revenue). We’re not out of the woods yet, but I still think that Robert F. Smith was right when he said that subscription fees were more valuable than first-lien debt. And you can take that to the bank.
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Disclosure: These opinions expressed are mine, not those of the company. The companies mentioned in this newsletter are not necessarily Zuora customers.