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The seventh week of the year kicks off the earnings season for the messaging space. On Valentine’s Day, within twenty-four hours of each other, Twilio, Sinch, and LinkMobility will announce their results. From February 22 to 27, Bandwidth, Upland, and Klaviyo will announce their Q4 results. There shouldn’t be any surprises, but what will be instructive is how these companies are looking to the future. The question comes down to growth and its effect on valuation.
Can We Grow Responsibly?
If 2023 was the year to demonstrate efficiency, the mandate in 2024 is to show if you can grow responsibly. There are two pressures on growth: the pressure from your borrowing costs and the pressure on product strategy.
The Pressure from Your Borrowing Costs
If you bought a car in 2020, your borrowing costs were 0.9–2.9%. Now it is around 5%. It may not change your buying ability, but the doubling monthly payment will affect your buying appetite; you may question your need for the car. The same applies to investing in growth. If you were borrowing at 3%, 30% growth felt like a steal. At 11% you may still find it acceptable, but you’re concerned about risk. The money may still be in productive use, but as an investor you’re asking more questions.
Profitability proves efficiency and affirms growth decisions. The pressures of inflation, risk premiums, and discount rates on investors transform into the manager’s pressure to show efficient growth. The question then is not so much about short-term profitability but how soon they will know whether the long-term bets are working out. In fact, it’s a mistake to sacrifice long-term growth for short-term profitability (more on this later). Regardless, high interest rates will continue to drive greater scrutiny on investment decisions.
The Pressure on the Product
A tough economic environment silences wholesome product differentiation and nullifies high switching costs. When times are tough, it doesn’t matter if Target has everything you want; Walmart is good enough, even if it’s a longer drive away and doesn’t have your favorite brands. Similarly, you will cancel your Slack subscription because, as much as you love the product, the clunky Microsoft Teams software that comes with your Office 365 bundle is free.
2023 saw enterprise businesses commoditize text and voice and shop for better deals. This showed up as revenue softness in the CPaaS industry.
If you were providing voice and text over an API, suddenly it didn’t matter how well the client liked your account executive (AE), your client development offsites, or your technical support; if your pricing wasn’t acceptable, the pain of building new integration was worth the cost savings. This played out across industries (crypto) and use cases (2FA). For the API players, thankfully, most of this has already happened.
In contrast, Klaviyo has demonstrated that the SMB is strong and growing. This is a reflection of both Klaviyo’s product suite and the market segment.
During tough times, the small business doubled down on what worked, took the long view, and used that to continue their outreach—proof that the buyer and user personas being the same person is a good thing.
The B2B user only cares that the product works. No amount of steak dinners or conference tchotchkes will make up for a poorly performing product. On the other hand a good product makes the software critical to the user’s success. A flywheel then appears where the more successful the user, the more the B2B software company makes.
By its focus on key e-commerce use cases, Klaviyo has successfully yes, and-ed its way to mission-critical status. More importantly, thanks to its Shopify partnership, product distribution is built into its onboarding.
Klaviyo’s success shows the lift that every product team will have to undertake: find a way via cross-selling to improve retention and acquisition—and most importantly, make distribution part of the product instead of relying on customer success teams to do the work.
How Will Growth Affect Valuation?
Growth drives valuations. This is clear just from the last four years, even from the “heady” days of CPaaS valuations—the ones with the biggest growth got the largest valuations. Even in today’s tamer times, the one with the highest growth (Klaviyo) commands the biggest valuations (eleven times revenue), while the one that is highly profitable (Upland) but has no growth is trading at a 50% discount on revenue. When introducing the Rule of X (and announcing the death of the Rule of 40), Byron Deeter and Sam Bondy said it best: “While a margin increase has a linear impact on value, a growth rate increase can have a compounding impact on value.”
So valuations will continue to be a function of growth; however, the source of growth will be important. Consistent, high-quality growth, like a nutritious meal, will be prized, and fast-food-like quick fixes will be penalized.
And How Will This Affect M&A?
The focus on efficiency provides a clearer picture of asset value, and this will be good for dealmaking. However, target companies that either raised money during the days of free money or during the pandemic valuation boom need to have expectations reset. Most of these companies have cap tables that are burdened by assumptions made in different times. The investors and management of these companies will have to undertake some deep soul-searching if they want a good exit.
The market is helping with catalyzing such soul-searching. WSJ is already reporting that earnouts have become a way for both parties to “close the gap” between asset pricing mismatch. In some cases, as much as a third of the deal value is contingent on a future goal being met. One can expect this to percolate into the CPaaS space as well.
Finally
In a nutshell, 2024 will be the year to rebuild and grow responsibly. The macro pressures of high borrowing costs will continue, but so will the pressure to differentiate through product and GTM. And all this will reflect in a better deal-making cadence than 2023.
Karma and schadenfreude await anyone who dares make predictions. And yet predicting and allocating capital for the future is every leader’s job. In that light, then, it is best to look at predictions as pathways to discuss what ought to happen and what to do to make it happen. It is necessary to treat every prediction as an ever-evolving thesis responsive to critique and feedback.