21.10.19

Investing in technology businesses (part three)

Cache is king!

Tom Matthews

At Pemba we meet with many technology companies seeking investment. However, only a handful of these get through our rigorous screening criteria of what makes an attractive investment opportunity.

I’m not for one moment claiming that our approach is the only way. Only that it has proved successful for us – all of our technology investments have performed exceptionally well with none crashing or synching (sorry couldn’t help myself).

During this article, I will take you through some of the key criteria we look for in tech investing, as well as some of the learnings from the 15 highly successful tech investments we have made to date.

Start with the mission-critical base

At Pemba, we look for platform businesses that provide mission-critical software or services to their clients. The ideal tech companies for us provide software or services that are deeply embedded in the workflows of their clients’ organisations and essential to the delivery of their on-going operations.

Once the software or services have been adopted by clients and their staff become familiar with the system, there is often strong inertia to change and switching costs can be high.

Market position

At Pemba, we like tech businesses that service the SME segment of the market (i.e. clients with 20-1,000 employees) – but with a scalable technology platform and market-leading functionality to enable them to push up into larger enterprise-sized customers (i.e. those with >1,000 employees).

We like the SME market segment for the following reasons:

  • Lower business failure rates – smaller companies (up to 20 employees) are typically earlier stage (many of which are in start-up phase). It is often said that more than half of new businesses fail during the first year. While this might not be exactly correct, we prefer tech businesses that provide software or services to more established businesses which have been through the start-up and shake-out stages of the business life cycle and are into the maturity stage
  • Shorter sales cycles – larger companies (>1,000 employees) tend to have very long sales lead times, with complex sales cycles (e.g. formal tender processes, independent consultants involved in procurement, etc.), numerous levels of sign-off from multiple decision-makers and a natural bias for choosing large legacy software vendors (even if their technology solution is inferior). As the old saying goes: “no one ever got fired for choosing IBM”. We prefer tech businesses providing modern cloud-based software to more nimble SME clients that can make quicker purchasing decisions and where the key purchasing criteria focus on the benefits to the client (e.g. value, functionality, service, relationships, etc.). Once these modern cloud-based software providers have the backing of an experienced tech investor like Pemba (with significant financial firepower), it often makes it easier for them to compete for larger enterprise-sized clients.
Revenue visibility

At Pemba, we look for tech businesses with high levels of recurring revenue. We like SaaS and software businesses with a focus on continuously growing their recurring revenue ‘asset’, where recurring revenue has very much become part of the DNA of the company.

We spend a lot of time understanding the components of the key revenue streams and analysing the company’s:

  • Contractual arrangements with customers
  • Length of client relationships
  • Revenue retention rate.
Diversification of client base

At Pemba, we look for tech businesses with low customer concentration risk. This way if the business does encounter some abnormal churn and loses a major customer, then it is not going to have a material impact to the bottom line.

Robust financials

We look for businesses with a history of growing their annual recurring revenues, that are profitable and with sustainable margins.

There is always a trade-off for tech companies between growth and profitability and many make the deliberate decision to sacrifice margin for revenue growth. At Pemba we like businesses that take a disciplined approach to cost control and consider key metrics such as lifetime value per client to customer acquisition cost when making significant spending decisions.

Consistent investment in R&D

Best in class tech businesses continuously invest into research and development to maintain strong levels of innovation, stay ahead of competitors and continue to add value to customers.

Highly cash generative 

One of the great thing about SaaS businesses is customers typically pay in advance. In addition, software businesses tend to have minimal capital expenditure requirements. As a result, tech businesses tend to generate lots of free cash flow.

Ambitious and ‘backable’ management team

Many tech investors focus their due diligence on the technology and don’t spend enough time on the people in the business who will be delivering the growth plan. Technology businesses, like all businesses, are reliant on the people that work within them. At Pemba, we spend a lot of time getting to know that key people at the heart of the businesses we back.

We typically incentivise key members of the senior management team of our investee companies. This is often through equity participation to ensure interests are aligned. We find this often leads to a dramatic change in mindset and behaviours. These key individuals change from employees to “owners” and are more focused on delivering the growth initiatives that help create value for all shareholders.

What next?

If you are interested in learning more about technology investing or are an owner of a technology business considering partnering with an experienced technology investor, then please contact us to find out more.

Photo by Alexandre Debiève on Unsplash

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