Software stocks had a strong 2023, while fundamentals seem to have found a floor with some calling an end to the “software recession” after Q3 earnings. However, deal activity remained sluggish, as market participants continued to adjust to the profitable growth paradigm. We witnessed strengthening confidence towards year-end, with the first software IPO in ~2 years, the return of scale strategic M&A, and improving credit markets. Heading into 2024, for the first time in several years, we are in an environment where well-positioned software companies can create differentiation and outsized returns through calculated strategic M&A and capital raising. We remain highly active across all sectors of technology, particularly software.
Software Market Perspectives
Strong Stock Price Appreciation. After a tough 2022, software stocks staged a strong recovery in 2023, with average stock price appreciation of 73%, more than 3x the broader market. Mega-cap software companies led the charge, as investor optimism stemmed from rebounding growth trajectories, a stabilizing macro, and the promise of generative Al.
“New Normal” Valuations at 6x Revenue. Median revenue multiples for publicly traded software companies have settled at ~6x forward revenue, reverting close to the pre-pandemic median of ~7x. Many investors and founders we speak to have accepted this as the “new normal” after the unsustainable heights of 20-25x seen briefly in 2021.
Stabilization, Spawning Deal Activity. With the stabilization of public software revenue multiples in the 5-7x range throughout 2023, the tone of our conversations has shifted to renewed optimism. Diminished volatility and uncertainty provide a strong footing for companies and investors to transact with greater confidence. And while private market valuations remain inflated, we expect them to eventually follow the path of public peers. In the meantime, we anticipate a continued focus on investments that structure around valuation.
Emergence of the Profitable Growth Paradigm. The growth versus profitability debate is over. Nearly 90% of public software vendors we track achieved breakeven profitability in 2023 compared to just over 60% in 2021. With the viability question answered, the market has turned its attention to “profitable growth”. As a result, the Rule of 40 which measures growth OR profitability is waning in relevance, as the “Rule of X” gains in favor for its emphasis on growth AND profitability.
Investor Leverage Spurring Creativity. Diminished exits and access to capital has shifted leverage in the ecosystem back towards investors. Companies raising growth equity or pursuing M&A have experienced more onerous terms around seniority, stepped up liquidation preferences, pay-to-play and earn-outs. Many companies have turned to structured equity and ARR loans to replace venture capital altogether. Fewer Exits, Driving Pent Up Liquidity Demand. While exits were down dramatically in 2023, we witnessed pockets of strength in secondary transactions, continuation funds and PE take privates. Strategic M&A revolved around spinoffs and carve-outs to streamline focus, while GenAl and remote work began driving transformational M&A. Looking forward, the logjam in sponsor-to-sponsor M&A appears to be thawing based on our private equity dialogue around deal pipelines. The IPO bar remains high. There was just one software IPO in 2023 and the median software company nowadays has over $400 million of revenue at IPO. Many are predicting that exit activity will be back-half weighted in 2024 as the thaw broadens.
Private Equity vs. Strategics M&A Tug-of-War Reaches New Heights. 2023 saw continued competition between strategics and private equity. Private equity was involved in 9 of the 10 largest software transactions as either buyer or seller in 2023. Transaction multiples paid by private equity were almost on par with strategics, despite popular perception of more price discipline, with a ~6x median multiple paid by private equity vs. ~7.5x paid by strategics. We believe this gap is narrowing as industry specialization over the past decade has transformed many PE firms, enabling them to act like strategics to compete head-to-head for scale assets with modern technology platforms and attractive growth profiles. We expect private equity will be extremely aggressive in pursuing software M&A 2024 given the capital overhang resulting from record high fundraising in 2020-2021, followed by record low dealmaking in 2022-2023.
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