The five forces driving software’s accelerating growth
Key trends in 2018, including setting records in three areas: (1) public company revenue multiples, (2) IPO volume (by over 2x), and (3) M&A volume (by over 2x).
Key trends from their 2017 report that are still alive, well, and driving software businesses.
But, most of all, it has some great charts on the Rule of 40  that I want to present and discuss here. Before doing that, I must note that I drank today’s morning coffee reading Alex Clayton’s CloudStrike IPO breakdown, a great post about a cloud security company with absolutely stunning growth at scale — 121% growth to $312M in Ending ARR in FY19. And, despite my headline, well in compliance with the Rule of 40. 110% revenue growth + -26% free cashflow margin = 84%, one of the highest Rule of 40 scores that I’ve ever seen . Keep an eye on this company, I expect it should have a strong IPO .
However, finding one superstar neither proves nor disproves the rule. Let’s turn to the Battery data to do that.
When discussing the Rule of 40, most financial analysts make one of two plots.
They do a scatter plot with revenue growth on the X-axis and FCF margin on the Y-axis. The Rule of 40 then becomes a line that separates the chart into two zones (compliant and non-compliant). Note that a minority of public companies actually comply suggesting the rule of 40 is a pretty high bar .
Or, more interestingly, they do a linear regression of Rule of 40 score vs. enterprise-value/revenue (EV) multiple. This puts focus on the question: what’s the relationship between Rule of 40 score and company value? 
But that thing has always bugged me is that nobody does the linear regression against both the Rule of 40 score and revenue growth. Nobody, until Battery. Here’s what it shows.
First, let’s look at the classic Rule of 40 regression. Recall that R-squared is a statistical measure that explains the dependence of the dependent variable (in this case, EV multiple) on the independent variable (Rule of 40 score). Here you can see that about 58% of the variation in enterprise value multiple is explained by Rule of 40 score. You can intuit that by looking at the dots relative to the line — while there is clearly some linear correlation between the data, it’s a long way from perfect (i.e., lots of dots are pretty far from the line). 
Now, the fun part. Let’s see the same regression against revenue growth alone. R-squared here is 51%. So the explanatory power of the Rule of 40 is only 7% higher than revenue growth alone. Probably still worth looking at, but it sure gets a lot of PR for explaining only an incremental 7%. It could be worse, I suppose. Rule of 40 could have a lower R-squared than revenue growth alone — in fact, it did back in 2008 and in 2012.
In the vein, for some real fun let’s look at how this relationship has changed over time. The first thing you’ll notice is that pre-2012 both last twelve month (LTM) revenue growth and the Rule of 40 had far weaker explanatory power, I suspect because profitability played a more important role in the equation. In 2012, the explanatory power of both metrics doubled. In 2015 and 2016 the Rule of 40 explained nearly 20% more than revenue growth alone. In 2017 and 2018, however, that’s dropped to 7 to 8%.
I still think the Rule of 40 is a nice way to think about balancing growth vs. profit and Rule of 40 compliant companies still command a disproportionate share of market value. But remember, its explanatory power has dropped in recent years and, if you’re running an early or mid-stage startup, there is very little comparative data available on the Rule of 40 scores of today’s giants when they were at early- or mid-stage scale. That’s why I think early- and mid-stage startups need to think about the Rule of 40 in terms of glideslope planning.
Thanks to the folks at Battery for producing and sharing this great report. 
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 Rule of 40 score = typically calculated as revenue growth + free cashflow (FCF) margin. When FCF margin is not available, I typically use operating margin. Using GAAP operating margin here would result in 110% + -55% = 55%, much lower, but still in rule of 40 compliance.
 If calculated using subscription revenue growth, it’s 137% + -26% = 111%, even more amazing. One thing I don’t like about the fluidity of Rule of 40 calculations, as you can see here, is that depending what might seem small nuances in calculations, you can produce a very broad range of scores. Here, from 55% to 137%.
 To me, this means ending day 1 with a strong valuation. The degree to which that is up or down from the opening price is really about how the bankers priced the offer. I am not a financial analyst and do not make buy or sell recommendations. See my disclaimers, here.
 In fact, it’s actually a double bar — first you need to have been successful enough to go public, and second you need to clear the Rule of 40. Despite a minority of public companies actually clearing this bar, financial analysts are quick to point out the minority who do command a disproportionate share of market cap.
 And via the resultant R-squared score, to what extent does the Rule of 40 score explain (or drive) the EV/R multiple?
 If R-squared were 1.0 all the dots would fall on the least-squares fit line.
 Which continues with further analysis, breaking the Rule of 40 into 4 zones.
Because I’ve been quite busy of late with the sale of my company, I’m doing a somewhat quicker and lighter (if not later) version of my annual predictions post. Here goes, starting with a review of last year’s predictions.
2018 Kellblog Predictions Review
1. We will again continue to see a level of divisiveness and social discord not seen since the 1960s. HIT. Hard to argue I need to justify this one. Want to argue about it?
2. The war on facts and expertise will continue to escalate. HIT. Unfortunately, the President is leading the charge on this front, with the Washington Post fact checker tallying 7,645 false claims since taking office.
3. Leading technology and social media companies finally step up to face ethical challenges. MAJORMISS. Well, I nailed that the issue would be critical, but boy did I overestimate the maturity of the management of these companies.
4. AI will move from hype to action, meaning bigger budgets, more projects, and some high visibility failures. HIT, I think. See this McKinsey report for some interesting survey data on AI adoption and barriers to it.
8. The freelance / gig economy continues to gain momentum with freelance workers poised to pass traditional employees by 2027. HIT. Per this Forbes article, 57M people now participate in the gig economy in some way.
9. M&A heats up due to repatriation of overseas cash. HIT. Per Berkery Noyes, software M&A deal value was up nearly $100B over 2017. To the extent this was due to overseas cash repatriation I don’t know, but it certainly was a factor.
10. 2018 will be a good year for cloud EPM vendors. MAJOR HIT. Anaplan went public, Adaptive Insights was acquired by Workday, and Host Analytics was acquired by Vector Capital.
With 9 hits, two of them major – and with only one offsetting major miss — I should probably just drop the mike and get out of the predictions business. But no guts, no glory.
Kellblog’s 2019 Predictions
Reminder to see the disclaimers in my FAQ and remember that these predictions are not financial or business advice – they are made in the spirit of fun. To the extent they’re concrete, that’s to make the game more interesting so we can better assess them next year. Here we go.
1. Fred Wilson is right, Trump will not be president at the end of 2019. I think Fred’s also right on virtually all of the other predictions made in his epic post, which I won’t attempt to summarize here. Read Fred’s post – and just make sure you read to the end, because it’s not all doom and gloom. So, as a Kellblog first, prediction #1 is a pointer.
2. The Democratic Party will continue to bungle the playing of its relatively simple hand. Party leaders will continue to fail to realize that the way to beat Trump is not through a hard-left platform with 70% tax rates that caters to the most liberal Democrats – but a centrist, pragmatic, people- and business-friendly platform that certainly won’t be enough for the far left, but will be far better than the Republican alternative for all Democrats, and most importantly, give centrist Republicans a realistic alternative to what their party is offering them. The Democratic Party will continue to be more concerned with making statements than winning elections. This may cost it, and the Nation, dearly.
Remember the famous Will Rodgers quote: “I am not a member of any organized political party. I am a Democrat.”
3. 2019 will be a rough year for the financial markets. Political problems in the USA, Europe, and increasingly Latin American. Trade wars. Record deficits as we re-discover that trickle-down, tax-cut economics don’t work. Threat of rising interest rates. Brexit. Many folks see a bear market coming.
Years ago, I accepted the fact that – like many – I am a hypocrite when it comes to the stock market. Yes, I absolutely believe that it’s theoretically impossible to time the market. But yes, I’m entering 2019 with a high allocation to cash and intend to keep it that way. Hum. Try to reconcile that.
For fun, let’s makes this concrete and predict that the BVP Emerging Cloud Index will end 2019 at 750. I do this mostly to provide some PR for Bessemer’s Index, officially launched via the NASDAQ in October, 2018, but which was built on the back of five years of Bessemer maintaining it themselves.
4. VC tightens. Venture capital funding has been booming the past several years and – for the above reasons and others (e.g., the fact that most VCs don’t product enough returns to justify the risk and illiquidity) – I believe there will be tightening of VC in 2019. If you agree, that means you should raise money now, while the sun’s still shining, and try to raise two years of capital required in your business plan (with some cushion).
If things follow the recent trends, this will be hardest on average and/or struggling companies as VCs increasingly try to pick winners and make bets conservative in the sense that they are on known winners, even if they have to overpay to do so. In this scenario, capital on reasonable terms could all but dry up for companies who have gone off-rails on their business plans. So, if you’re still on rails, you might raise some extra capital now. Getting greedy by trying to put up two more good quarters to take less dilution on your next round could backfire – you might miss one of those quarters in this increasingly volatile environment, but even if you don’t, VC market tightening could offset any potential valuation increase.
5. Social media companies get regulated. Having failed for years to self-regulate in areas of data privacy and usage, these companies will likely to face regulations in 2019 in the face of strong consumer backlash. The first real clue I personally had in this area was during the 2016 election when Facebook didn’t just feed me, but actually promoted, a fake Denver Guardian story about a supposedly dead FBI agent linked to “her emails.” I then read the now-famous “bullshit is highly engaging” quote from this story which helped reveal the depth of the problem:
Or, as former Facebook designer Bobby Goodlatte wrote on his own Facebook wall on November 8, “Sadly, News Feed optimizes for engagement. As we’ve learned in this election, bullshit is highly engaging. A bias towards truth isn’t an impossible goal. Wikipedia, for instance, still bends towards the truth despite a massive audience. But it’s now clear that democracy suffers if our news environment incentivizes bullshit.”
I won’t dive into detail here. I do think Sheryl Sandberg may end up leaving Facebook; she was supposed to be the adult supervision, after all. While I think he’s often a bit too much, I nevertheless recommend reading Chaos Monkeys for an interesting and, at times, hilarious insider look at Facebook and/or following its author Antonio Garcia Martinez.
6. Ethics make a comeback, for two reasons. The first will be as a backlash to the blatant corruption of the current administration. To wit: the House recently passed a measure requiring annual ethics training for its members. The second will have to do with AI and automation. The Trolley Problem, once a theoretical exercise in ethics, is now all too real with self-driving cars. Consider this data, based on MIT research in this article which shows preferences for sparing various characters in the event of a crash.
Someone will probably end up programming such preferences into a self-driving car. Or, worse yet, as per the Trolley Problem, maybe they won’t. While we may want to avoid these issues because they are uncomfortable, in 2019 I think they will be thrust onto center stage.
7. Blockchain, as an enterprise technology, fades away. Blockchain is a technology in search of a killer application. Well, it actually has one killer application, cryptocurrency, which is why it was built. And while I am a fan of cybercurrencies, blockchain is arguably inefficient at what it was built to do. While Bitcoin will not take down the world electric grid as some have feared, it is still tremendously energy consumptive –in coming years, Bitcoin is tracking to consume 7.7 GW per year, comparable to the entire country of Austria at 8.2 GW.
While I’m not an expert in this field, I see three things that given me huge pause when it comes to blockchain in the enterprise: (1) it’s hard to understand, (2) it consumes a huge amount of energy, and (3) people have been saying for too long that the second blockchain killer app (and first enterprise blockchain killer app) is just around the corner. Think: technology in search of a business problem. What’s more, even for its core use-case, cryptocurrency, blockchain is vulnerable to being cracked by quantum computing by 2027.
8. Oracle enters decline phase and is increasingly seen as a legacy vendor. For decades I have personally seen Oracle as a leader. First, in building the RDBMS market. Second, in consolidating a big piece of the enterprise applications market. Third, more generally, in consolidating enterprise software. But, in my mind, Oracle is no longer a leader. Perhaps you felt this way long ago. I’d given them a lot of credit for their efforts (if not their progress) in the cloud – certainly better than SAP’s or IBM’s. But SAP and IBM are not the competitors to beat in the future: Amazon, Google, and a rejuvenated Microsoft are. The reality is that Oracle misses quarters, cloud-washes sales, and is basically stagnant in revenue growth. They have no vision. They have become a legacy vendor.
9. ServiceNow and/or Splunk get acquired. A friend of mine planted this seed in my mind and it’s more about corporate evolution than anything else. They’re both great businesses that mega-vendors would love to own – especially if they end up “on sale” if we hit a bear market.
10. Workday succeeds with its Adaptive Insights agenda, meaning that Adaptive’s mid-market and SMB presence will be greatly lessened. Most people I know think Workday’s acquisition of Adaptive was a head-scratcher. Yes, Workday struggles in financial apps. Yes, EPM is an easier entry point than core financials (which, as Zach Nelson used to say, were like a heart transplant). But why in the world would a high-end vendor (with average revenue/customer of $1M+) acquire a low-end EPM vendor (with average revenue/customer of $27K)? That’s hard to figure out.
But just because the acquisition was, to be kind, non-obvious, it doesn’t mean Workday won’t be successful with it. Workday’s goals are clear: (1) to unite Adaptive with Workday in The Power of One – including re-platforming the backend and re-writing the user-interface, (2) to provide EPM to Workday’s high-end customer base, and (3) to provide an alternate financial entry point for sales when prospects say they’re not up for a heart transplant for at least 5 years. I’m not saying Workday can’t be successful with their objectives. I am saying Adaptive won’t be Adaptive when they’re done — you can’t be the high-end, low-end, cheap, expensive, simple, complex, agnostic, integrated EPM system. Or, as SNL put it, you can’t be Shimmer — a dessert topping and a floor wax. The net result: like Platfora before them or Outlooksoft within SAP, Adaptive disappears within Workday and its presence in the mid-market and SMB is greatly reduced.
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I’m Dave Kellogg, advisor, director, consultant, angel investor, and blogger focused on enterprise software startups. I am an executive-in-residence (EIR) at Balderton Capital and principal of my own eponymous consulting business.
I bring an uncommon perspective to startup challenges having 10 years’ experience at each of the CEO, CMO, and independent director levels across 10+ companies ranging in size from zero to over $1B in revenues.
From 2012 to 2018, I was CEO of cloud EPM vendor Host Analytics, where we quintupled ARR while halving customer acquisition costs in a competitive market, ultimately selling the company in a private equity transaction.
Previously, I was SVP/GM of the $500M Service Cloud business at Salesforce; CEO of NoSQL database provider MarkLogic, which we grew from zero to $80M over 6 years; and CMO at Business Objects for nearly a decade as we grew from $30M to over $1B in revenues. I started my career in technical and product marketing positions at Ingres and Versant.
I love disruption, startups, and Silicon Valley and have had the pleasure of working in varied capacities with companies including Bluecore, Cyral, FloQast, GainSight, MongoDB, Recorded Future, and Tableau.
I previously sat on the boards of Granular (agtech, acquired by DuPont), Aster Data (big data, acquired by Teradata), and Nuxeo (content services, acquired by Hyland), and Profisee (MDM, exited to Pamlico).
I periodically speak to strategy and entrepreneurship classes at the Haas School of Business (UC Berkeley) and Hautes Études Commerciales de Paris (HEC).