In a previous post I explained how I personally believe that in the traditional B2B software categories (productivity, sales and marketing software, developer tools, analytics etc…) we now see many more “incremental SaaS” than “radical/category defining SaaS”. And how it changed my perspective when it comes to pre-seed/seed SaaS financing.
In this post I will continue to develop this point of view by covering some of the consequences for the VC side. I’ll post the founders’ perspective next week.
As I previously explained, this series is part of my “summer introspection” and intends to open discussions rather than just being a “one way opinion”.
1. Looking for the new software categories where “radical change” will happen.
A first obvious consequence is that if the traditional B2B software categories are saturated, then VCs should look for the next categories where software will bring “radical change”. And you have a few of them that check the boxes such as ClimateTech, BioTech, markets related to the demographic transition, SpaceTech etc.
I know that I’m not being particularly original here. Plenty of VCs are starting to refocus their effort on these topics. But I think that this transition is very hard because the playbooks to assess, invest and exit companies in these spaces are different from the playbooks we used the past ten years during the golden age of “pure software” SaaS.
For example, most B2B software investors tend to stay away from startups that have a hardware component with their software product . But the challenges that climate change poses might require more companies that mix hardware and software (and maybe not).
Same with business models that might not be purely subscription based with “80% gross margin”. Many companies in the ClimaTech, BioTech or SpaceTech industries rely on a mix of different BM such as licensing, services or leverage revenue streams such as carbon taxes. Through the scope of the past 10 years these are not the best BMs (the 80% margin subscription model was), but maybe they’ll become in the next ten years. Who knows.
However it’s not the first time that the VC industry goes through this kind of transition. The first VC partnerships emerged in the late 50s/early 60s to finance silicon based companies (Intel, Apple etc…). A first transition happened in the 80s when on-premise software emerged (like Oracle). Then another cycle started with the internet in 90s. Then another one with SaaS in the 2010s. And the best VC firms managed to adapt to the new cycles (Sequoia, Kleiner…).
2. Investing in the incremental SaaS startups that break through at Series A/B.
Another potential change is that we might see an increasing number of SaaS companies raise a big Series A/B round after skipping the traditional pre-seed/seed rounds. Series A/B investment firms could make some great investments by following this pattern and become the first institutional VC of the incremental SaaS that manage to break this ceiling.
As I mentioned in the previous post, while I believe that “incremental SaaS” startups are not VC compatible at pre-seed/seed, I believe that some of them can become VC compatible once they reach a couple of millions of ARR (the Series A level). Why? Because if these companies manage to build certain assets (such as an outstanding brand or a very efficient internal organization) or because they are successful at building a portfolio of “incremental SaaS” (the playbook of Intercom, Swile or Rippling for example), which enable them to escape velocity and potentially provide returns compatible with a VC investment.
I do not have data points to support this increase, but anecdotally I do see more SaaS companies that have raised an angel round then spent a couple of years growing their business in a very capital efficient way until they reach the point where they can directly raise a healthy Series A.
3. Investing in B2B software at pre-Seed / seed is not dead.
The past couple of weeks I had several discussions with fellow investors about whether SaaS pre-seed/seed investing was dead. My view on the topic is that pre-seed/seed investing is an equation/a math problem. So I don’t think that it’s dead, it just depends on your approach to solve this equation.
How you return an early stage fund depends on your fund size (returning a $15M seed fund is not the same as returning a $200M seed fund), on your strategy (do you invest in many or few companies, what ownership you target etc…), on what you agree with your LPs, and on plenty of other factors. If you are extremely good at investing in the best incremental SaaS companies and the economics of your fund are aligned with it, I don’t see why you couldn’t be successful as a VC.
This is also why I think that VC firms that have invested in incremental SaaS the past two years when the market was at its peak, will probably face some issues with these companies now that the bubble has burst. Many incremental SaaS are great companies. But they probably don’t justify the super high valuations that they might have raised at. However with the current reset and more reasonable valuations, it can make sense to invest in incremental SaaS if fits your model.