January 2023 | Point of View

Strategies for tech companies and PE firms to optimize cost of growth and improve margins

Valuations are falling and take-privates are on the rise—how management teams can set themselves up for short-term wins and long-term profitability

Strategies for tech companies and PE firms to optimize cost of growth and improve margins

Faced with tumbling stock prices, constricted debt markets, and tighter revenue streams, public software companies are struggling to right their lopsided balance sheets—and for the first time in a decade are looking beyond growth for growth’s sake and instead toward long-term financial stability.    

The pivot comes after several years of historic growth, with software companies benefitting from favorable credit, significant PE and venture capital funding, and generous R&D budgets to drive top-line numbers. These factors fueled a rush to acquire market share and new customers, with shareholders placing a heavy emphasis on growth over profitability. In today’s economic climate, that’s been changing quickly over the past few quarters.  

Private equity (PE) firms with abundant dry powder on hand have taken notice. Seeing an opportunity to realize long-term gains, these dealmakers are snapping up software companies at reduced valuations. Many CEOs and management teams see an easier path to profitability as a private company—particularly through right-sizing cost of goods sold (COGS) and operating expense budgets, and making future-proof investments in areas like automation and cloud infrastructure that will help drive more cost-efficient growth. 

We’ll dive into why tech take-privates are on the rise, and how management teams can leverage this crucial moment to position themselves for both long-term growth and profitability.  

The growing momentum of public-to-private transactions 

Through November of last year, private equity firms announced or completed $223.4 billion worth of take-private deals—and that number is poised to increase in 2023. Two factors are spurring this trend.  

First, today’s firms are sitting on a significant amount of dry powder and continue to attract funding for investment in the tech industry. Firms like Hg Capital, Vista Equity, and Thoma Bravo have been able to raise billions in new capital to finance a steady march of software company acquisitions that include Coupa, Duck Creek, ForgeRock, UserTesting, and Ping Identity. 

This also comes at a time when software companies encounter greater shareholder scrutiny in the public sector amid macroeconomic headwinds and ongoing recession concerns. Looking to quickly right-size their operations as public investment dwindles, software executives see an opportunity to be more nimble and to leverage private equity partners to help drive improvement and evade mounting pressure for near-term returns by going private. 

While some deals may seem like the perfect marriage, private equity firms have their work cut out for them. Overinvestment for the sake of growth has left some software companies bloated and inefficient. 
Here are three opportunities for private equity investors and software management teams can take to tamp down spending and generate healthier margins. 

1. Refocus R&D, sales, and marketing teams 

One result of the decade-long push for growth is that many software companies have sales, marketing, and R&D teams that are over-staffed and focused solely on expanding their customer base.  

To trim excess costs, private equity firms should begin by reviewing revenue and growth trends across product segments and regions, pulling their focus away from those that are stagnating and redirecting resources to those that are growing at a high rate. 

If the company has acquired other product/service lines, management should also leverage data-driven insights to quantify the success of cross-sell and upsell initiatives and identify whitespace within the existing install base. If cross-sell and upsell hasn’t been a core focus—as is often the case—management should steer the sales team to focus on KPIs related to those opportunities. 

Next, leadership should evaluate sales team structure and individual productivity (i.e. quota attainment) and make appropriate readjustments. Pay specific attention to quota capacity—the planned usage of capacity allocated for the best and most optimistic economic scenario. Ideally, at least half of sales headcount should be quota-carrying. They should also focus on attainment (the time it takes for a given team to hit a specific target) and find the root cause for unproductive team members.  

R&D teams are often caught up in unnecessary and low value investments—especially if the sales and marketing teams are over-aggressively pursuing growth. Operating teams and management teams can re-focus R&D by working backwards from product-level margins to identify where R&D is failing to drive a high return on investment (i.e., R&D spend that is greater than 20-25% of product revenue without high growth rates). 

Additionally, many R&D teams can seek to expand their nearshore or offshore presence by leveraging growing global talent pools—oftentimes, R&D leaders are identifying strong nearshore partners to efficiently scale their R&D teams with productive teams in the same time zone as the domestic/onshore team. Lastly, automation (both within QA and DevOps functions) is critical to drive efficient growth, and while many companies tout their automation capabilities, few have truly made enough investment in automation to truly drive out costs.   

2. Maximize revenue growth through the existing customer base 

In parallel with trying to expand their customer base, software companies need to double down on existing customers to drive revenue growth. That means reducing churn and keeping net retention above 110%. To do that, they’ll need to pull on a wide range of value levers, which include:  

  • Pricing: Software companies should revisit their pricing tactics to make sure they’re getting the most from their user base. Our clients have found value by increasing  annual escalator clauses, reducing discounts (or shifting to bundle discounts), and changing their terms and conditions (e.g., grace period before billing starts, frequency of payments, early termination penalties, etc.). 
  • Usage analysis: By knowing which features and capabilities are most commonly used, leadership can rally product and sales teams around them. This approach will allow them to develop a smarter investment roadmap tied to user demand, leading directly to revenue growth. Better telemetry can enable product-led growth motions, pushing customer to adopt or buy additional functionality based on actual usage. 
  • Customer and transactional data: Data should be leadership teams’ North Star for analyzing growth trends, identifying customer up- and cross-sell opportunities, and predicting potential drivers of customer churn. Most organizations can’t go it alone; they’ll need the help of industry-leading data-science driven tools to triangulate these drivers of revenue growth. 
  • Account-level execution: To reduce churn and both upsell and cross-sell high-priority accounts, sales teams will have to first identify them using their customer data.  Segmenting customers based on opportunity and churn risk will allow teams to take targeted approaches by segment.  For example, companies have successfully leveraged top account programs (e.g., dedicated CSM, executive sponsor, onsite QBR, favored pricing) to secure high value accounts.   

3. Seek out cost savings opportunities within COGS and G&A 

While one might expect software companies to have limited overhead, COGS are increasing (and therefore gross margins are tightening) as companies shift more aggressively to SaaS delivery models, and G&A expenses, especially for public companies, are often bloated due to legal & reporting requirements and lack of synergy capture from prior M&A.  Across 73 SaaS companies that have gone public since October 2017, COGS and G&A spend averaged around 29% and 25% of revenue respectively—a substantially higher average than in other industries.  

Some tactics PE firms and software companies can employ to reduce these expenses include:  

  • Optimizing cloud and infrastructure usage: The benchmark for cloud spend for a leading cloud-based SaaS company is 5% to 8% of revenue—and while newer companies may not be able to quickly get down to that level, most can reduce spend by a couple of percentage points within a year. 

    Start by examining cloud infrastructure footprint and reducing underutilized instances, redundant backups, and reserved instance purchasing (which can lead to unused credits). Take advantage of variable cloud cost models—like pay-as-you-go contracts priced by the number of users and transaction volume—to prevent unnecessary spending. Finally, adopt the principles of best-in-class SaaS companies, which means creating a centralized FinOps team to ensure cross-functional ownership for cloud usage, provide accessible and timely reporting, and a scalable ongoing approach to managing usage and spend.  
  • Review span of control (SOC): Management teams will want to evaluate the organization’s SOC: the number of people reporting to one individual. An inflated company or specific function will have a median SOC of 2:1 or 3:1—as opposed to 5:1 or 8:1. To get that number in line with best-in-class operations, identify which teams are filled with unnecessary middle management, tune up operational inefficiencies, and restructure accordingly. 
  • Streamline compliance and reporting: HR, legal and finance departments offer a range of cost-saving opportunities. Management can take advantage by making a one-time investment in accounts payable automation, software tools, and scalable, automated HR processes. These investments will enable all three departments to meet the growing demands of the business with fewer employees, in addition to right-sizing G&A processes in a private setting. 
  • Find and leverage acquisition synergies: For software companies with several recent acquisitions, unrealized cost synergies are unfortunately common. While many organizations integrate high-level structures, core systems and communications quickly, incremental synergies are often overlooked – often tied to taking a hard look at product-specific investment levels (see section #1 above).  

Transformational opportunities await for the software industry 

Private equity firms should feel confident knowing they can leverage this crisis point to steer software companies toward leaner, healthier balance sheets. Take Elon Musk’s recent layoff of 80% of Twitter’s workforce. Operations are still running and new features have been implemented at a rapid pace. It’s quite possible that many software companies are just as bloated as Twitter—and that means long-term profitability is readily achievable with the right firm—and digital consultant—at the helm. 

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