Invest Like the Best with Patrick O'Shaughnessy - Eric Vishria – The Past, Present, and Future of SaaS and Software - [Invest Like the Best, EP.183]

Episode Date: July 21, 2020

My guest this week is Eric Vishria, a general partner at Benchmark Capital. Eric joined Benchmark after spending the first part of his career as an operator and CEO. The topic of our conversation is the past, present, and future of software businesses. We begin by explaining why public software companies trade at such incredibly high multiples today. We then explore the several different generations of these businesses and why the future remains so bright for companies building software as their primary product. I’d go one step further and suggest that the information in this episode is even more valuable for non-software businesses and investors, because its crucial to understand the impact that these products will have on the overall business landscape. COVID has accelerated the long-running transition to digital across the corporate world, and Eric serves as the perfect guide. Let’s dive in.    This week’s episode is sponsored by Bottomless. Bottomless is a smart coffee subscription which automatically re-orders coffee for you based on your consumption habits.  Bottomless is offering one month and your second bag of coffee for free at bottomless.com/patrick.   For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club and new email newsletter called “Inside the Episode” at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag   Show Notes (2:29) – (First question) – His take on public markets, and specifically as it relates to SaaS businesses (4:04) – Why these companies trade so high             (7:53) – Peter Zeihan Podcast Episode (11:19) – The competitive frontier in the digital markets (14:02) – The API competitive frontier             (14:22) – Chetan Puttagunta Podcast Episode             (18:36) – Every Company is Becoming a Software Company             (20:10) – John Collison Podcast Episode (22:54) – Charging in an API business model (24:09) – Describing the different generations of SaaS, starting with Gen 1 (28:15) – Gen 2 SaaS businesses (31:52) – Being an investor in SaaS (36:55) – Gen 3 and importance of traditional SaaS companies to get into API (38:06) – Other problems software can solve (44:19) – Why more money isn’t going into SaaS (46:48) – Lessons from the investment universe and how it could apply to SaaS             (47:26) – The Hierarchy of Marketplaces — Introduction and Level 1 - Sarah Taval (51:49) – Lessons about scaling (57:51) – Cross customer strategy             (1:00:01) – Energy and Civilization: A History (1:01:28) – Qualities of an interesting investor (1:03:52) – Kindest thing anyone has done for him   Learn More For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club and new email newsletter called “Inside the Episode” at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag  

This week's episode is brought to you by Bottomless. Bottomless is a smart coffee subscription which automatically reorders coffee for you based on your consumption habits. You may remember Bottomless from Episode 124 when we had co-founder and CEO Michael Mayer on the show. I'm also a Bottomless customer and like the service and idea so much I became an investor. Here's how Bottomless works. They send you a complimentary Wi-Fi scale with your first coffee order. Just set up the scale with your Wi-Fi, store your coffee on top, and then from that point forward, Bottomless sends you coffee at the perfect time with your coffee. no additional effort. The coffee itself is always roasted to order and shipped straight to you from a

network of roasters across the country. My favorite part about Bottomless is how the technology could be used for almost anything I buy regularly. It feels like magic and how everything will work in the future. Bottomless is offering one month and your second bag of coffee free at bottomless.com forward slash Patrick. That's Bottomless.com forward slash Patrick. Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com. Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management. All opinions

expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaunsi asset management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaunice the asset management may maintain positions and the securities discussed in this podcast. My guest this week is Eric Vishria, a general partner at Benchmark Capital. Eric joined Benchmark after spending the first part of his career as an operator and CEO. The topic of our conversation is the past, present, and future of software businesses. We begin by explaining why public software companies trade at such incredibly high multiples today.

We then explore the several different generations of these businesses and why the future remains so bright for companies building software as their primary product. I'd go one step further and suggest that the information in this episode is even more valuable for non-software businesses and investors, because it's crucial to understand the impact that these products will have on the overall business landscape. COVID has accelerated the long-running transition to digital across the corporate world, and Eric serves as the perfect guide. Let's dive in. So, Eric, I thought an interesting place to begin would actually be away from what you do in your day job in the private markets and talk a bit more about public market software companies. I know you follow them. I'm sort of obsessed with them, in part because they are so expensive. By any measure that I can drum up, they look sort of absurdly priced and they've performed

incredibly well in 2020 when so many stocks have had such huge trouble. Maybe we could just begin there. I'd love to get your take on what's going on in public markets around SaaS businesses. It's so fascinating. It's incredible. I was actually looking at it yesterday just in terms of performance year to date. So get this, the Dow and S&P are down five to 10 percent. The NASDAQ, as we all know, is up about 10 percent. And if you look at the Bessemer emerging cloud index, which is a good proxy because it's the basket of whatever, 100 or so public SaaS companies ranging from Salesforce and Adobe and Shopify all the way down, it's up 50 percent on the year. In the middle of a global pandemic. And it's this really fascinating thing because there have been all of

these companies where you could literally, over the last six or seven years, you could get venture returns in the public market. So you'd have all liquidity that you'd want. You'd have the ability to trade in and out. And you'd have literally venture returns. So it is really astounding. And it's very interesting. I always try to look for the reasons behind these sorts of moves. One of the things I've learned in my career is when something seems ridiculous, it usually isn't. Markets are quite smart in aggregate and highly efficient. And so it's easy to dismiss these things as an aberration and as silly valuations and everyone says dot com valuations. But usually markets are pretty good. So I'm curious what you think is going on under the hood here.

Obviously these are, the business model is incredibly impressive, very highly profitable. But what do you think is going on? Why do these continue to trade at 10 times revenue in multiples, which is like a startup valuation. Interestingly, actually, a lot of them aren't profitable P&L sense of the word, but it is a really good question. So at benchmark, we did this thing where we were just trying to look at these public companies in an effort to help our kind of growth stage private companies and even mid-stage private companies, we were trying to understand what happened in the public markets to forecasts.

Because one explanation possibly would be in the middle of the pandemic, digital became more important and everybody's forecast jumped. And we looked at it, so we looked at kind of guidance in January versus the latest guidance that these companies had. And you have Zoom and a couple of outliers where forecasts jumped. But for the most part, the forecasts are the same or withdrawn, actually, in a lot of cases. A lot of public companies have pulled forecasts. So what's really happening is multiples have expanded.

And I think I looked at it recently. And to your point, they're trading at about 10 to 11 times forward. revenue. And if you kind of look at the underlying characteristics, they, on average, again, looking at the Vesimer Emerging Cloud Index, they're at a 35% growth rate and like a 7 or 8% free cash flow margin, which is the kind of typical rule in software was the rule of 40, which is you add operating margin plus growth rate and you aspire to be above 40. And what's really interesting here is you have this index of 100 plus SaaS companies and the entire index is above the rule of 40 using free cash flow margins instead operating margin. And that is really,

really impressive. And oddly, the multiples are the highest for the SaaS companies. And so I think it is really interesting. And to your business model point, I actually think it is what I call a unicorn business model. And what I mean by that? It's actually, it's win-win. It's win for the vendor and it's win for the customer. And a lot of people talk about how, hey, it's recurring revenue and it's great cash flow and all this stuff. People talk about the vendor perspective, which I would summarize as almost software margins plus compounding, which is really powerful. But I actually say one of the things with SaaS is it's actually better for the customer. The customer gets good software, thoughtfully delivered, a relatively good experience.

they have none of the operational overhead, they don't have the maintenance and upgrade headaches. Literally, they, by using a lot of these SaaS software packages, they have the ability to focus on their customer and their core competency. And so that's been true. So has the market just woken up to that fact and realized, wow, with compounding, these things can get really, really big or what we once thought were narrow is actually much, much larger? I don't know. I think that's interesting.

And then I guess the other side of it is just what's happening macro, which is a bunch of external things. Alex Wojham at TechCrunch had a couple of good pieces on this. But there's obviously the zero interest rate policies. So you have investors seeking return. I think Peter Zahon, who you had on your podcast, is a very interesting thinker. And every book or every podcast I listen to his makes me really reflect on what I believe. and know, he'd probably make the investors are seeking haven in the U.S. dollar argument.

And so there are all of these interesting external macro things that are happening behind the scenes, which I know very little about, I'll put them out there, then leave and be. But I do think that there is a paradigm shift, which shelter in place and COVID have really shined a very bright light on, which is digital has gone from, kind of nice to have or sidecar to, holy shit, if we don't get this right, we're done. And it's become existential, which then drives companies to look hard at their digital strategies and their IT stacks. And that ends up being really important.

And that will drive a lot of revenue for these cloud and SaaS companies for many years to come. One way to think about this is what's the competitive frontier? And I think if you think about any company, think about retail, think about a bank, think about entertainment. In every case, the competitive frontier has shifted to digital. It's amazing to look at the chart. There's this famous chart circling around now about e-commerce penetration in the U.S. And pre-COVID, I think it was 15% or something like that. And it's jumped at decades worth in three months. But even after this crazy, inflection point, it's still not a third penetrated. Maybe the answer is as simple as, oh, my God,

not only are these good businesses and they're good products, so they're the win-win that you mentioned, but actually their, let's call it market share, a sort of market share is still really, really low and it's a superior solution. Interest rates are down, so markets are just valuing growth more than they did, all things equal three months ago. But even with all those things in mind, it's been a wild ride. Oh, it's been a totally wild ride. I mean, I think it's really hard to understand it in some case justify some of the stuff. But to your point, I don't know if you've heard the Nike's latest earnings call from last week. But it was just astounding. So Nike said in the last quarter, 30% of their revenue was direct, direct to consumer digital.

And that was their 2023 goal. So literally the future got accelerated by three years. And now they they've actually increased their goal to 50% to be digital or direct to consumer, which are kind of the same thing because scores are shut. And so you really do have this notion of where is the competition is so interesting to me because if I think about a bank 10 years ago, I might have chosen a bank where I open an account based on which branch is close to me, who has the most ATMs, whatever, whatever. Now if I'm choosing a bank, I'm choosing who has the best digital experience, leaving it.

all the economic side of it, controlling for the economic side of things. So the digital, and I think companies are realizing, wait a minute, we have to get this right and we've kind of treated it as a sidecar and this is existential for us. It really, really matters if these businesses want to be around long term. I think I understand now what you mean by competitive frontier as sort of the appropriate battleground where similar companies are vying for consumer or enterprise attention. Has that shifted over time, do you think? How long do you think that's been digital? Is that really just coming into people's minds in the last COVID period?

Say a bit more about that idea of competitive frontier. That's an interesting concept. I think of competitive frontier as for a business, where are they going to fight or what is the battlefield or where they're going to fight for the next customer and to keep the existing customer? And so it's just kind of like, what are the criteria and where is that battle happening? And what I realized is digital has been part of it for a really long time. Take digital entertainment.

Entertainment is really interesting. So if you think about HBO, if I'm HBO, it used to be that I'm producing great content. And then I'm using that content through satellite and through cable, through bundling. And I'm using my differentiation on that and the subscriptions that I sell through those middlemen, quote unquote middlemen, to drive up the share of revenue that I get from those cable and stuff. satellite companies. Now you live in a world where HBO is actually competing on the digital front with HBO Max and HBO Plus. They're going direct to consumer on that digital experience. They're capturing that and that really matters. And now there's kind of an elimination of a middleman

in a way or maybe people would prefer there's a new middleman in terms of who that is, who they're selling through. But now they actually have to have a great digital experience. And Disney is another and very prominent current example of this where they had all of the content assets forever and they were distributing through traditional channels. But the competitive frontier shifted and they needed to actually go direct. And they couldn't go direct through some shitty experience. They actually had to build Disney Plus as a really great experience on its own merit in order to compete and drive subscriptions there. And I think that's obviously been a runaway success. And so I think those are examples of companies,

kind of traditional, legendary companies who have had to realize, wait a minute, the new battles over here, and we have to put all of our energy against it. And they have both done it very creatively and well in the sense that they have leveraged their strength, which is the content and to some extent the back catalog, but competed on the new battlefield. How is that same concept morphed or evolved in SaaS companies specifically?

So obviously those are very digital companies, purely digital companies in many ways. They're building software. How is that battlefield shifted over time? I'll give you a little tiny example. I'm really interested in open source businesses involved in one. Did a conversation with Chathen recently on this topic. And one of the things we talked about is the power of community. that all things equal if two companies are trying to solve the same problem, one place there's

sort of a battleground is the quality of the community amongst developers and how they nurture that. Would that qualify in your mind as a competitive frontier within software and what other ones would come to mind? Yeah, I think that is definitely a competitive frontier within software, which is what's the community, what's the community contribution? Is there a network effect that's kind of created across the customer base, which has really been lacking actually in software and SaaS, even in modern SaaS. to a large extent. I'll give you another one where the competitive frontier is shifting for

SaaS companies, and that's to this API economy, or the APIs, as you want to call it, API economy sounds highfalutin. I think there's this really interesting idea, but if you think about Twilio, you think about Stripe, you think about contentful, we're investors in Commerce Layer and Modern Treasury and Duffel, a bunch of these API companies, API first, quote unquote, companies, What you're seeing is with a lot of the SaaS companies that were maybe founded 10 years ago, the primary interface and the primary experience that the customer had was through a UI. It was through a GUI of some kind. And it was a person who was interacting with that software.

Think about how people use Salesforce, for example. It's human beings looking at software, entering data into software and running reports and everything else. And a lot of the middle generation of SaaS, we can go through these, but the middle generation of SaaS, the Zendes, the new relics, asanas, the wixes of the world, they competed on a really great user interface and experience that way, the user experience. But what you're seeing here now is a shift to where this up-and-coming generation of SaaS companies is actually competing in large part on APIs and big part of Stripe. success has been the design of the APIs and the thoughtfulness of the APIs and the ease of consumability of the APIs. And that is one of these competitive frontier shifts that's happening. I mean, it's worth spending some time on if you want because I think it's a really interesting, why now? Why is this happening now? APIs have been around forever and what's actually happening

and why is it all coming together now. Yeah, let's get into that because I think just to clear up the terminology, I've started using that term API a lot. I have to remind myself to kind of explain what it means every time because it's sometimes not intuitive until it becomes intuitive and then it's very clear. So maybe you could, in your own words, describe exactly how you think of what an API does, the job that it does. And then I'd like to get into this why now question because it does seem to be the big idea in software right now. I'll answer it backwards because I think it'll be a little easier to understand. And I have to admit, it's quite tricky and maybe unobvious, but I'll give you the best articulation I have of it.

So the last couple generations of SaaS have really been, or software broadly, have really been about business users using software to get their job done. So you have a person in an organization, say a salesperson, who is using Salesforce to get their job done. That has been the last generation of SaaS and software. And that has been very, very effective, and it's helped people, individuals, become more productive. And in that case, the user of the software is a human being.

And therefore, the interaction with the software is through an interface, called a graphical user interface or GUI for short, which is often in the SaaS world or mostly in the SaaS world, webbase. through the browser. So that's what the interaction was. What's happened is Jay Kreps, the founder of Confluent and one of the authors of Kafka, he had this blog post last year reading it made it this come to life for me. What he described is like, hey, businesses have historically used software, but what's happening now is businesses are actually becoming encoded in software. That's a mega shift. And when businesses become encoded in software, now,

what you need is not a person necessarily using software, but you have software using other software. And when software is using other software, it's obviously not interacting through a user interface. It's interacting with the other software through an API. An API stands for application programming interface. And so the software is talking to other software through this interface. So I think a really nice way to think about APIs is without. getting into the technical mumbo-jumbo is if a human's interacting with software, they're doing it through a GUI. And if software's interacting with software, it's going to happen through an API.

And that's kind of the analogy. It's a really interesting way to think about things. And you can go through kind of example of example inside of businesses where this is really happening, where the business used to use software and now is increasingly actually encoded in software. And I suppose also that alongside encoded in software is many businesses are building software themselves. More and more even small companies have a, say, a developer on staff. And that the, we'll call it like a library of APIs is basically just a bunch of Lego bricks to build an application. I had John Collison on recently. And Stripes API is this unbelievably complicated and beautiful thing.

But all it's really doing is say, dump this code in and you'll be able to accept payments from anyone in the world. The job is very simple, but the complexity is large. Yeah, totally. Call the software. I mean, I think that's exactly right. The Lego analogy is a really good analogy where you have these building blocks and you can put things together. This is a little bit of what we mean by encoding. The business gets encoded in software.

So think of maybe a loan application process. Old days, whatever, four years ago, a person goes and talks to a loan officer. The loan officer asks for a bunch of documents. Those documents come in. the loan officer assembles those and makes sure the packets goes back and forth with the customer, blah, blah, blah, it takes it to kind of the credit committee or whatever to approve it and presents the case manually and there's a discussion and the decision comes down, et cetera. Okay, then people started using software for that.

So now we have PDFs things. We use DocuSign for things. We start to assemble documents electronically. Maybe there's some workflow that helps facilitate. Okay, finally, we have a complete packet. it now hit submit and that packet gets submitted digitally and everything else. Where we're working towards and what we'll get to is actually this entire thing being encoded in software.

So literally you're clicking a button, the customer supplying some basic information, and then software is going out and talking to your bank and talking to your existing mortgage company and pulling all of this information together automatically and assembling that, maybe doing some analysis and then another piece of software or another service is actually looking through that quantified data and actually surfacing automatically a decision based on historicals and everything else and surfacing a score or a decision based on that and surfacing that back to the customer immediately and you can imagine a world where all of that you see this with kind of credit cards and things today, all of that happens very, very quickly.

And so what used to be a multiple weeks manual process that was labor intensive for the customer, labor intensive for the loan officer and the credit committee, all of a sudden starts to become very fast, very real time, and very automated. And APIs are a big part of that. And so I think that's one of the big drivers here of the kind of next generation of SaaS companies. and further facilitated why now the world just has a lot more Legos to start assembling, whereas 10 years ago there were just a handful of them. I've got a lot more questions on this, but I don't want to lose track of a question around

business model. So traditionally, I love you to describe how SaaS per seat SaaS has charged its customers. If the people are being sort of abstracted away and now software is talking to software, How does one charge in an API business when so much more is automated and now we're relying less on humans sitting in front of a screen entering data or pressing buttons? What important shifts are you seeing in the business model itself of software as APIs become more popular? It's a really interesting point that actually I hadn't thought of until you just asked the question, which is if you think about Salesforce or ServiceNow, what I'll call kind of Gen 1 SaaS, they were. were seat-based pricing. And if you think about a Twilio or a Stripe or most of the API companies, they are actually charging based on transactions, some volume of transactions. And so that's kind of the

primary driver of the price you pay is it used to be the number of people and now it's the volume of transactions, which is exactly consistent with who the user of the software is. That is a big pricing change. What do you think about the business strategy? Obviously, you've invested in tons of companies that were traditional. I think what you would call gen 2. We keep using these generations. Maybe we should pause and describe what, Gen 1, 2, and 3 are. Actually, you know what? Let's do that. So maybe just briefly describe Gen 1, 2, and 3, and then I'll ask my follow-up question. Let's go back kind of the past presence and future, so to speak, of SaaS and go through it. So in the late 90s, my first exposure to this idea of SaaS was at LoudCloud, and they were actually at the time called

Application Service Providers, ASPs, ASPs was the big analogy. And really, the original generation of SaaS companies did was capitalized on a better delivery model and a better economic model. And so let's kind of break that down. So the delivery model, what I mean by that is it used to be you would ship CDs to a customer site and the customer would install it. So it was customer hosted software. And the new delivery model is, it's a vendor hosted. And so the vendor themselves is actually hosting the software, running the software, operating it, operating it, et cetera, on behalf of the customer.

So that's the better delivery model. The better economic model was in the old world of software, you would sell software and you would get one-time revenue. And then you would charge typically 18% of ongoing maintenance on an annual basis for upgrades and things like that. And the new economic model in Gen 1 SaaS was actually recurring. So you may pay an implementation fee, and then you pay an annual fee on an ongoing basis that's the same or grows year to year. Those were the kind of the two big developments of the original generation of SaaS. What's interesting is actually what stayed the same in the original generation of SaaS.

So it was still big ticket enterprise sales. It's still a relatively large implementation. For the most part, those were all still single instance. So they weren't multi-tenant SaaS. So what would happen behind the scenes is the vendor would then stack servers, install software, configure an instance for that customer on their behalf. And because they were doing it across thousands of customers, they were able to do that more efficiently or invest in automation.

if you were Coca-Cola and you had traditional software, it wouldn't make sense for you to invest in automation for your ERP, but if you're doing it across a thousand customers, it does make sense. There were benefits there, but it was still single instance, not multi-tenant SaaS. And that first generation of SaaS companies, the other kind of interesting notion,

if you think about what was Siebel, became Salesforce, was PeopleSoft, became Workday, Paragon, became Service Now, It was actually the same founders. Literally. It's like the same people. They just realized, wait a minute, there's a better delivery model. We know what to build. We know the features.

There's a better delivery model. There's a better economic model. Let's go build it. And Dave Duffield, you have the Peregrin founders founded Service Now. Tom Siebel and Beniof worked together at Oracle, I believe, before Beniof went off to do Salesforce. So you have a lot of the same ideas. And honestly, not that great software experience, but a better delivery and economic model. So that was what I would call Gen 1 SaaS. All those companies were founded, I don't know,

1999 to 2005. So really that generation. And by the way, those three examples, Salesforce Workday Service now, relative to Sebel people soft in Peregrine, 10 times the size or something. Just the delivery and economic model is a much more valuable company. I mean, I think even more than 10. I think Siebel was a little around $3 billion, ultimately acquisition. And I think Salesforce, whatever, is like 170. Two orders of magnitude. Yeah, two orders of magnitude. I mean, I think PeopleSoft was a big outcome and workday. So PeopleSoft and Workday are probably 5x or so.

But I think Peregrine and Service Now be like 150x. I mean, these things are just some of that's market expansion, but definitely better delivering economic model too. Okay, great. So that brings us to Generation 2. So Gen 2 took the ideas of a better delivery and economic model and then added a better adoption model. I think the realization was, hey, now we have this software, the customer doesn't have to do anything.

Why don't we make it really nice user experience, make it very easy to consume, make it go from this kind of big implementation, high cost of failure to very cheap, low cost of failure for the customer, low cost of failure. So you can kind of get to a what I'd call a try and toss mentality. an organization can try a new piece of SaaS, and if they like it, great, and if they don't, whatever, no big deal, which definitely isn't true with a Salesforce or a Service Now or a Workday. Those are huge implementations, big decisions, executive decisions, et cetera. And so the adoption model shifted from what I would call a macro adoption, where the whole enterprise is buying into this adoption, to a micro adoption model, where an individual or a small group inside of an organization can make a decision to try a SaaS application and adopt it.

And that is just a massive elimination of friction in terms of the adoption. And so think about a Zendesk or a New Relic or Wix or a sauna or a Twilio or Docsson, like all those types of companies. They really added this adoption model that was much streamlined. And it's really interesting what happened with that because that generation of companies has turned out to be giant. They turned out to be really big companies. But they took a little time.

You're adopting. They have much larger customer bases. The initial land price is much lower. They took time to compound. And so you actually got in the earlier days of these companies evolution, you got slower revenue growth. And then it kind of exponentially compounded in recent years they've grown like wildfire. And so it's very interesting. It's actually in some ways it's consumer-like adoption where if you think about the evolution of Facebook or Snapchat, those types of companies. Remember for a long

time, everyone would in the media and otherwise be like, well, when are they ever going to generate revenue and how are you going to make money on these things? And they were just amassing these massive, massive user bases and relative to the revenue they were producing was much lower. Even Google, frankly, didn't figure out the revenue model, but was getting a bigger and bigger user base in the early 2000, 2001, 2000. And then all of a sudden it's like, okay, we later a revenue model on this monster user base and it just goes through the moon. The best business ever. Yeah, the best business ever. And so in a way, this kind of second generation of SaaS companies, the economics actually look much more like that. They're actually in some ways also more capital efficient. But again,

you have to have patience where before we got on, we were talking about workday and how these companies were built. And you actually built a big, expensive enterprise sales force. And so that takes a lot of capital and it's capital consumptive. But then you get kind of quick revenue, but you're kind of continuing to add sales force. So there's a decent amount of burn. Whereas some of these other companies that we're talking about, they're relatively capital efficient, but you don't get the time to $100 million in revenue might be a little bit longer. from the time that the first line of codes written. I'm assuming that this has also changed in Gen 2 the sort of failure rate, or maybe it hasn't,

but since it's cheaper than ever to start a business, the Gen 2 adoption model means that you can address sort of any kind of problem with software and have, start to get picked up by small groups or small firms or big firms, doesn't really matter. It would stand to reason that that would lead to, I don't know, thousands of software experiments being tried versus a fewer number of the big enterprise plays. Have you seen that lead to a higher failure rate then? So kind of looking at this through an investor lens, is it harder to be an investor in that environment, even though it leads to great companies? I don't have enough history. I've been an investor for six years. I don't have enough history. Like I kind of landed in the

middle of a gold mine without quite appreciating that I got dropped into a gold mine. But to your point, I do think it's led to Cambrian explosion of SaaS, where there's basically any little function in an organization, anything that is repeated can be quote unquote sassified. So lots of small stuff got sassified in that process. And I think that's been interesting. Like I think if you look at a typical company now, there are hundreds of SaaS applications inside that company, which I think is quite different than it looked 15 years ago. So I think that's definitely been there. There's actually one other important point which just relates to this unicorn business model that I want to just go back and say, which is just true of SaaS broadly, Gen 1 and Gen 2, which I think is actually really underappreciated and may have been unintended, frankly. And that's that in a traditional software company, if I think back to Opsware in our days there, a good 30% maybe more of the engineering and product development resources were back.

backward looking. And what I mean by that is they were supporting old versions. They were fixing bugs on old versions or backporting bug fixes. They were supporting customers who were on old versions. It was just you kind of always had to think about backward compatibility. And you had these windows in our contracts. We'd say, okay, we'll support version six for two years after version seven comes out. So you lost. There was this huge tax that you paid in the the traditional software world of product development resources being backward looking. And what happened in the SaaS world is actually now, because customers are getting, whether they know it or not, they get upgrades continuously. They're getting upgrades because the vendor is just upgrading

behind the scenes and they're pushing fixes. The product development resources actually all go towards forward looking and helping the customer solve the next problem, getting back. better. And that, if you think about that, you get 30% or so of your engineering back to actually look forward and accelerate. That's huge deal. And I think, like I said, may have be unintended, but I think it's a really big deal that's allowed those SaaS companies to continue to stay at the front. And I'm definitely not saying that that first generation of SaaS companies, those products are fantastic because they're definitely not fantastic. But they are definitely better. and have stayed at pace better than their kind of legacy software counterparts.

It makes me think of John Collison's point, again, that modern income statements for a lot of those public companies you mentioned, the engineering core at some of these companies is so critical. And the operating expense that pays their salary is really expense to build something. And if you're focused on just your core value proposition and sort of outsourcing all the ancillary functions that are also compounding because they're run by these great SaaS businesses, you start to maybe understand a little bit of the public market valuations for these things because the efficiency sort of sharing the load across all these companies all compounding at the same time sure is a compelling business proposition.

No question. I think that's totally right. I think there's actually a lot. You mentioned the e-commerce penetration. Another way to look at it, kind of a similar metric would be what's the quote unquote cloud and SaaS penetration of total IT spend. So I think cloud and SaaS penetration is probably 15-ish percent of total IT spend, which means 85 percent is spent on companies doing this stuff themselves and legacy software and racking, stacking boxes and everything else and, of course, the labor behind. And so, I mean, okay, it's not going to get to 100 percent, but is the cloud and SaaS spend going to go from 15 to 20 percent to 60 percent?

Yeah, I think it is. And it could go further. And by the way, I should say, I think Tomaz Tongs over at Red Point was the one who articulated that part to me that way. And I was like, oh, wow, that's really good. That's a very macro view of things that really resonated and landed with me. Now that we've laid the first two generations, I'm able to come full circle back to the question that I was going to ask around API. So I'm thinking about API as part of whatever the next generation three of software. And we're going to go into some other subcategories of what you anticipate.

there as well. But first on the API side, do you think then it stands to reason that all of those software companies that had traditionally lived in graphic user interfaces and GUIs need to have an API strategy to stay relevant and compete? The companies that you invested in, are you advising them to start thinking about that now? Yeah, I think it really matters. And that isn't to say that the goos goos go away. If you think of Stripe, there's plenty of GUIs and Stripe. It's just that the primary consumption vehicle of Stripe isn't a GUI. It's the API. And so I think that's probably broadly true, which is all of these companies, there's still going to be software for users and for individuals to do stuff. But I think they all probably end up needing APIs because

they live in a part of an ecosystem. They live in an ecosystem of other software that they need to talk to, exchange data with call functions of. And so I think that definitely ends up being really important part of the competitive frontier. I love this idea in Gen 2 that the adoption model is so different. It creates this sort of different revenue growth curve and opportunity set. What do you think is still left untapped? What other challenges can software go solve for people trying to accomplish some outcome that you're excited about? I think it's massive. Now we have, we've gone to a micro adoption model. We have a better delivery model. We have a better delivery model. We have a better economic model.

And I think that TAMs are exploding in just really unanticipated ways. And let's look at them. So Gen 1 SaaS really served the Fortune 2000. And traditional venture capital advice was there's no money to be made in the midmarket. If you're a service provider providing to the mid market, there's no money to be made in that. And obviously, Shopify and Wix and the list goes on and on, just totally. totally proved that wrong. We've made some of those mistakes. Benchmark historically has made some of those mistakes too and got some things right like Zendesk and Urelic and others

in the sauna. So Gen 2, the kind of micro adoption model, opened up the mid-market and SMBs as a really viable customer base for this kind of software because all of a sudden you didn't need expensive salespeople to go to the SMB. It was easy for the SMB to try themselves. So you switch from kind of expensive sales led to low-cost. marketing led. And I think that was really revolutionary. But that now opens up all sorts of kind of new quote-unquote customers. So that's one area that opens up. I think you have new specialists. I think one of the interesting things is you look at all of these different functions inside of an organization and now all of a sudden you can build a software package to serve

FP&A and a plan which serves planning inside of an organization is like a $7 billion company. I think 12 years ago if you said, hey, there's going to be a SaaS company that serves FP&A and it's going to be a $7 billion company. We'd have been like, get the hell out of here. No way. Zwara is subscription billing. It's a multi-billion dollar company. So there's just all of these kind of seemingly narrow functions that actually end up being very, very, very deep.

So I think that's new specialists emerge. I think there's another area where what I'll call Mad Men to Moneyball. So what do I mean by that? Let's take marketing as an example. Marketing, everybody's seen Mad Men, right? So marketing used to be very madmen style. What I mean by that? It's smart people, creative people sitting around thinking, apparently drinking a lot.

A lot of scotch. Yeah, scotch and midday scotch and doing other inappropriate things. but it wasn't quantitative. It was very qualitative. And that was the crux to marketing. In the early 2000s, when I was in marketing, if you looked at your traditional CMOs, they kind of were brand oriented or comms oriented.

And what happened was, as all of this money shifted from kind of print and TV to digital marketing, people started to realize, wait a minute, one of the benefits of digital is we can actually quantify it and we can look at performance and we can look at click-through rates and we can actually measure the ROI of these various initiatives. And marketing went from very Mad Men style to very Moneyball style. And people hopefully are familiar with the Michael Lewis book Moneyball where Billy Bean at the Oakland A's

kind of took scouting and team building of baseball from this kind of scouts, which was very qualitative to looking at very deep and esoteric statistics and constructing a team that way. So he kind of quantified this area. And so it became money balled. So money ball is this notion of kind of quantifying and making very quantitative or analytical decisions as opposed to subjective decisions. And so you went from Madman style marketing to Moneyball style marketing. And if I look at the CMOs that are enterprise companies today, they in large part aren't from brand. and they aren't from comms. They are actually from the demand genp.

Performance. They're very analytical and they just don't feel like traditional marketers. And so that area, that kind of notion of Mad Men and the Moneyball is happening in all sorts of areas. So it happened in marketing. It's actually happening in product management right now in product development where product managers also used to be very, it's a smart person doing some surveys. talking to a few people coming up with something, build software, ship it, and you get no

feedback outside of focus groups or whatever. To now it's like, okay, it's all SaaSified. We can actually have metrics. We can understand what users are actually doing in our software, what causes someone to retain, what causes someone to churn. It can all be quantified. And so we're an investor in Amplitude, which is a company that does that. You have another company that we're forcing to work with is called Chainalysis. And chain analysis is also interesting to me this way because so chain analysis serves financial services and government that are basically trying to understand what's happening in cryptocurrencies. And if you kind of take as a given that criminals or people with ill intent are going to use cryptocurrencies for transactions,

old way to do forensic analysis and everything else is very qualitative and investigative. Chain analysis has basically said, hey, with blockchains, there's all of this data. There's all of this data exhaust. We're going to collect all that data exhaust and we're going to analyze it. And we will be able to surface to fencer in government and law enforcement. We'll be able to surface what's actually happening and help them understand where there might be money laundering or quote unquote tumbling going on. And that's what they do. So it's another area that's gotten kind of quantified. So I think there'll be a lot more of those. With all this green field, there's so many interesting new areas that software could go into. He talked about the relatively low penetration of

cloud and e-commerce and everything else. It feels ubiquitous, but the market share is still low. It just seems to me like there should be more dollars going into early stage companies in this area than there are. You add up all of the commitments, let's say, to venture capital funds, even though you hear about them a lot, the dollar amount is kind of shockingly low. There are mutual funds that manage more money than the entire venture capital industry. It seems hard for me to square the size of the opportunity, the ability to build businesses now with the supply of entrepreneurs. It seems like we don't have enough. Do you agree with that? And if so, why is that the case? I think one of the things that's happening, which I'm really bullish on and optimistic on,

is the cost to get started is actually lower than it has been because of cloud, because of all of the other services and apps that are available APIs, you can actually get started at a very low cost. It doesn't take that much. It takes a person with an insight or a couple of people with an insight, an idea, and a notion to get started and build a lot of these SaaS applications. There are still things that require multi-year engineering efforts, but a lot of these applications we're talking about are really, it's kind of low cost to get started. Once you start scaling and they start to work, it actually is pretty expensive to fuel them. And so I think that has been a lot of the drivers of the growth, venture growth, or the public market investors coming down or whatever,

where there's quite a bit of money at that growth stage pouring in. But one of the other interesting things that's happened is because of the cloud and these services, it's actually become really possible for entrepreneurs all over the world to get started and serve a global market. And so we've seen kind of more companies that we've backed as benchmark in Europe, for example, started in Europe. It's a European entrepreneur who has an idea and serves an initial market and then kind of wants to expand and get to a global market or scale up. And so we've seen more of that. There've obviously been a few New York successes in recent years. And so more and more stuff is actually possible outside of Silicon Valley. There's actually plenty of stuff happening inside

of Silicon Valley too. To your point, I think they'll continue to be lots more on both sides. I'd love to think about how you as a deep expert in SaaS and software specifically, both as an operator and now as an investor for the last six years of benchmark, how you take lessons from other technology investors, most notably your partners. I know you guys spend every Monday in deep dive conversation. What are some of the interesting crossover lessons that you've learned from other parts of the investment universe at the early stage that you are starting to think about how it might apply to SaaS. There are a couple things that we've been talking a lot about. A few weeks ago, my partner Sarah Taville released kind of her hierarchy of marketplaces. And as I was reading it and

kind of digesting it and understanding these marketplaces, I was like, holy shit. So much of this applies to SaaS companies. And there's so many opportunities for SaaS companies. And there's so many opportunities for SaaS companies to take characteristics in marketplaces and marketplace companies to take characteristics of SaaS companies. Let's unpack that a little bit. If you think about the old moats of the Gen 1 SaaS companies or whatever, there were kind of two big ones. One was, hey, there was a system of record. So it was like your data goes in, it's Hotel California. Data goes in and it doesn't come out. It was a system of record. It was constantly referred to and going from one to another was a huge lift. So that was one thing. The other big,

was frankly the enterprise sales team. It was like they had account control. So we talked about Gen 2 and you go to this better adoption model and you go to a try and toss mentality. And it's like, well, wait a minute. All of a sudden, some of the defensibility is lower with that kind of Gen 2 SaaS companies. It is frankly easier to switch. It's not easy necessarily, but it is easier to switch. And so you have kind of those notions there. What does Shopify doing? now or what is Salesforce done? They're actually trying to think about some marketplace elements where they actually get cross-customer network effects. So I buy from one Shopify vendor, and now they're trying to make it really easy for me to then buy from another Shopify vendor.

Shopify is able to understand what vendors I might be interested in based on who I've purchased from in the past. That's really different than where Shopify started, which is just, hey, we're enabling the vendor to do something really easily. Now they're really thinking about how do they help the end customers of those vendors have a better experience. So that's kind of Shopify's way of approaching it. Salesforce built something, took a different approach, which is, hey, we have the system of record.

We have all this great data. And there's a whole ecosystem of other applications that we're not going to do or maybe we will do and compete with. And we want to enable those vendors to actually work on. on our quote-unquote platform. And so Salesforce has done that. And that's a big part of Salesforce's moat. It's not that, hey, such-and-such company uses Salesforce,

but such-and-such-and-such company uses Salesforce and 27 other companies that are in the Salesforce ecosystem. That has reinforced their moat in marketplaces. So I think there's a lot of really interesting marketplace in SaaS crossover where you can start to take elements of both business models and use them to reinforce each other, to build new moats, to kind of get to a winner take all, winner take most economic theory. So I think there's a lot of cool stuff there. One company that we're involved with, and many of our companies are doing this, but Hacker

One is a bug bounty company. So it's a company where basically you have hackers, that's the supply and the marketplace mentality and companies. and companies have software exposure or software bugs, security holes that they want to uncover. White hat hackers, so good hackers, want to basically get paid for helping surface some of these vulnerabilities. And Hacker 1 acts as a matchmaker. So it's a marketplace for these types of things.

And they're very marketplace dynamics. But the way they've gone to market is actually largely kind of SaaS. So they charge and bill in a SaaS way. and then they facilitate money going from their customers to the hackers. And so there's a lot of cool crossovers like these. And I actually think that every SaaS entrepreneur should spend time on Sarah's hierarchy of marketplaces and really understand how these marketplaces work. And I think every marketplace entrepreneur should really understand SaaS businesses and think

about how they work because there will be tons of little things that, you'll pick up and will make you better. I love that idea. I mean, I love the cross-pollination of different business models, especially around defensibility. Marketplaces are so defensible. And to sprinkle some of that thinking into a SaaS business, sounds like a very smart idea. I'm curious when you've been involved in companies for a while now, I'll use Confluent as an example, which I believe is one of your earliest investments at Benchmark. So well done on that one. Watching a company like that evolve in size, what lessons have the entrepreneurs taught you about scaling that you think are valuable for other companies out there to think about?

Gosh, there's so many lessons at each of these stages. If I were to summarize it, as you're going, and I'm going to use revenue numbers, it's a proxy for this stuff. But as a company goes from zero to a million in ARR revenue or whatever, that's really, do we have something here? At those points, you want to do a bunch of stuff that's unscailable. You're just trying to figure it out. You're trying to figure out, do we have product market fit? Is there something here is it interesting?

Do our theories pan out? As a company goes from 1 to 25, a lot of maintaining that momentum and that growth is really, does the CEO build a leadership team? Do they build an executive team? Do they start to get functional expertise? If they do those things, then they start to introduce an ability to scale. scale the organization, scale the business. And now you're starting to do things. They need to be quite repeatable. You need to kind of constantly be thinking, okay, we're at one, what does it look like at 10? We're at 10. What does it look like at 25? We're at 25. What does it look like at 100? And you start to find all of these points of friction. There's a candidate I was talking to recently. And he was describing a company that he worked out that was one of these rocket ships. And he was like, one of the things that was really good as a management team, we were always looking forward

and saying, okay, we're doing this now. How will this work and does this scale when we're an order of magnitude bigger? And they were finding systematically any point of friction and eliminating it. And I think that's a really good mental model for scaling, which is just finding points of friction and eliminating them. And so as you go from one to 25, I think building that management team helps you get management bandwidth and leverage to actually be able to scale, eliminate more friction, and kind of rinse and repeat. As you go from 25 to, say, I don't know, 150 million in revenue, then it's really, do those managers and those executives build their management teams

and do the same thing. And so you kind of get this, what are the Russian nested doll effect? Yeah, yeah, yeah. It's either that or a fractal or whatever analogy you want to. use, but it's basically a recursion. You get this notion of, okay, now do those executives build their management teams? One of the things that we find oftentimes in these companies is you hear this a lot, like the executives who get you from one A to B and do a great job aren't necessarily the ones who get you from B to C. And that's where it is, where a lot of the people will do an amazing job,

kind of getting you going, introducing that initial level process, et cetera, but then they don't do a great job building their management teams and empowering those people. and kind of parceling out the work and responsibilities and missions to the next level in the organization. And so if you kind of keep doing those things and you're kind of continuing to build management and leadership bandwidth, and simultaneously you're continuing to look at points of friction of how your business operates in eliminating, systematically finding and eliminating those points of friction, then I think what you end up doing is actually getting to much, much higher levels of scale and frankly, much less painfully.

You can brute force a lot of things and get pretty far, especially in a white-hot market, as many of these markets are. But it's painful. It's painful for the organization. It's painful for the entrepreneur and the CEO and the leadership. If you do some of these things, I think it actually allows you. you to grow faster, but more painlessly. It's so interesting how the arc is sort of more art early on, more structure and science

later on. And I have to imagine, never done it, I hope to, but how hard it is for founders to do all of those things well. I mean, to more from someone doing stuff that doesn't scale to get to a million bucks of revenue to building a team of teams of teams, very different skill sets and it makes it pretty remarkable that there are founders that can do that. whole thing. It's astounding. And actually, what's crazy is the best founders in this kind of notion of your greatest strength becomes your greatest weakness. What will happen to a lot of these companies is

they get really good at execution and they get very systematic. In getting very systematic in eliminating these points of friction, they also eliminate all of these inefficiencies. But some of those inefficiencies are the next product. They're the next idea. They're the kind of handful of engineers who are sitting around at lunch bullshitting and coming up with the next innovation. And some of that stuff gets eliminated or doesn't get fueled or funded. And so what's amazing to me is the best entrepreneurs are like able to in the morning have these incredibly operational, systematic, vigilant meetings and drive and look at things quantitatively and systematically. And then in the afternoon, turn around and dream and think about the second

horizon or the third horizon fuel innovative efforts and pick those things out. And I think it's just, it's remarkable to be able to do that because it's such different thinking. What do you not understand well right now that you wish you did? I mean, dude, we could be here for the next six months with me rattling off stuff that I don't understand. Any notion of understanding is a mere illusion, a femoral illusion at that. Actually, there's one. thing I meant to say earlier that I just want to go back to if we could on we talked about the marketplace SaaS crossover, but I think there's something else that is a huge opportunity for SaaS companies that I've seen very few doing. And that is a cross-customer perspective.

So if you think about version 1 SaaS, they did this better delivery and economic model, but it was kind of very isolated per customer or whatever. And then version 2 SaaS did multi-tenant and they put everything together and they kind of introduced this better adoption model and made it very low cost for them to stand up a new customer for the vendor and also very low cost for the customer to try something. I think that generation of SaaS hasn't fully taken advantage of the multi-tenancy and what's possible there. All of the data across customers is now in one place, one virtual place,

but it's still isolated customer by customer. So it's still like a very customer by customer experience. And what's interesting is the customer 1,000, besides the features they get and the kind of robustness of the product, they don't get benefit from the vendor having 999 other customer data. And so what's interesting is why can't this be abstracted and anonymized so every company can kind of see how they compare, see how they're doing relevant? to their peers, see what the benchmarks are. Why can't there be some network effect value in a cross-customer perspective? You see little bits of bits of this. Stripe radar, for example, for fraud. They can understand, hey, there's fraud coming from this IP address on our API, and therefore it's probably fraud when we see that same IP address from another customer.

So you see at the beginnings of that, but it's very little. And I think that there's a lot of potential benefit of these SaaS companies to actually anonymize, look across customer data, and make each customer's experience better as a result. I love this, and it makes me think of, this is kind of an obscure reference, but bear with me. I love the writing of Vacloff-Smil, the guy who writes about the history of energy, and how obviously the things that matter are the source of the energy and the efficiency with which you can extract usable energy from it. And so we find cheap coal or something or deposits of oil and that's great.

But even cooler is how efficient we've gotten at spinning a turbine or something. We used to get 10% efficiency. Now we're approaching 100 of the energy in the underlying substrate. And just making me realize like everything you're talking about, it's almost like we are through software going that 10 to 100% efficiency. So much of this is making what people actually do trend more towards creative, positive green field work and away from maintenance turning the crank Dunder Mifflin style work. I mean, I just find it incredibly exciting. We've talked about it's kind of a wonky discussion,

which is my favorite kind. But when you step back, what all of this means is, I think, a more interesting world and existence for most people. I totally agree. I'm very bullish and optimistic. I think that there's lots of cool stuff happening. And when you think about the Lego blocks that are possible and what can be offloaded so that more energy can go towards the creative or advancing the ball stuff and less energy can be expended on the rope stuff. It's really positive for humanity. And I think there's just a lot of possibilities here. I love obviously talking to investors that sort of started to collect them as my primary hobby and an evocation. You, I think, get to speak with a lot of investors of all different stripes. I'd just be curious.

You go through companies with a lot of reps, but also through investors. What in your mind makes for a very interesting investor? As you think about the next generation of investors that you would want to personally work with, what qualities stand out to you as most important? Really interesting question because there's so many different ways to be successful in investing. We think about the different successful venture capitalists and the legendary ones. Take John Dorr and Michael Moritz. And I've spent very little time with both of them,

But you can tell in the first 10 minutes that their personalities and their approaches are so different. John is very salesy and very relationship oriented. And Maritz is introverted and an incredible thinker. And if you go back through the benchmark founders and the kind of current generation, you'll see a lot of those contrasting approaches in our shop today. The way Peter Fenton thinks about things and approaches businesses very different than the way Bill Gurley thinks about things and approaches things. And that surfaces.

So I think there's a lot of different approaches that are successful. Having said that, one consistent theme is that they are hyper curious. All of these people are hyper curious. There's something that they don't understand or they hear about and they don't understand why it works or they made a mistake on like they are going to delve into it and think about it and talk to people about it and ask questions and pull information and try to form a point of view about what they miss. or what they didn't understand or what's happening. So they're super, super curious. And they're hyper competitive. These people are very competitive. They want to win. They want to be the best. I think both of those end up being really defining characteristics of the great ones. Some are quantitative, some are qualitative, some are people oriented, some are market oriented.

There's lots and lots of differences, but I find those two characteristics to be. be quite consistent. I've found this conversation to be so edifying for me as I think about this space of business and investing in the markets. I've learned a tonne as I always do whenever I talk to you and your team. I think you know my closing question for everybody, which is to ask for the kindest thing that anyone's ever done for you. There have been so many people who have given me a shot when I probably didn't deserve it. I mean, going back to, I think about my 11th grade AP physics teacher, Mr. Mullins, or my calculus teacher, Mrs. Gates,

to Ben Horowitz and Mark who hired me as their assistant, as Ben's assistant in the very early days of Lab Cloud, and gave me shots many times over the eight years I worked there to the benchmark crew for giving me a shot, someone who's never invested to be able to join benchmark. So I think those are all incredibly kind things. And I wake up every day trying to repay that favor to all of them and pass it on, frankly, to the next gender. Yeah, I love it. It's emerging as the major category of the answers to this, which is taking a chance on somebody, being the recipient of someone else's

risk, which is really, really cool. And this conversation will, I think, stand the test of time. And I look forward to doing it again with you a year or two from now when this landscape Keep continues to grow and evolve. Such an interesting part of the market. And I really appreciate you taking the time to explain it to us today. Thank you so much. It was awesome. If you enjoyed this episode, you can sign up for a new email newsletter sent out each week called Inside the episode.

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