Tutorial: analyse a software company
In software, the question is not whether customers buy. It is whether they stay, and whether they spend more each year.
Judge a software business on the things that actually predict its future.
How analyse a software company works, in one picture
The same argument as the text, as a chain. Each step is what makes the next one possible.
The only five moats there are
If you cannot name which of these a company has, it probably does not have one. It is merely doing well, which is a different and far more temporary condition.
- 1
Start with retention, because it dominates everything
Net revenue retention asks: of the money existing customers spent last year, how much are they spending this year, after cancellations and upgrades? Above 100% means the existing base grows on its own, without a single new customer. That is the closest thing to magic in business.
Below 100% means the company is filling a leaking bucket, and every new sale is partly replacing one it lost.
A company with 90% retention can grow fast and still be worthless, because the growth stops the moment the marketing budget does.
- 2
Then ask what a customer costs to acquire
Sales and marketing spend, divided by the new customers it produced. Compare that to what a customer is worth over their life. If it costs more to win a customer than they will ever pay you, scale makes the problem bigger, not smaller.
- 3
Check gross margin, and be suspicious if it is low
FinancialsReal software runs at 75 to 85%. If a company calls itself software and posts a 45% gross margin, it is probably a services business with a login screen, and it should not be valued like software.
- 4
Look for the switching cost
OverviewSoftware's moat is rarely the software. It is that the customer has built their workflow, their data and their integrations around it, and ripping it out would take a year. That is why boring, deeply embedded, unglamorous products are often far better businesses than exciting ones.
- 5
Then find the stock-based compensation
Software companies pay staff in shares. It is a real cost, it dilutes you every year, and it is the first thing excluded from 'adjusted' profit. Check the share count over five years. If it keeps rising, the company's growth is partly being paid for out of your slice.
Ordinary. The market expects steady, unremarkable growth.
You can name the company's net revenue retention and its five-year change in share count.
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In software, the question is not whether customers buy. It is whether they stay, and whether they spend more each year.
Every one shows its exact method, and the circumstances in which it is wrong. Free, and no account to look.