It’s far from breaking news that 2022 has been a difficult year for technology stocks. The Big Tech stocks that have been the engine driving stock market gains over the previous several years have seen their valuations hit hard as inflation levels hit 10% and higher in major economies and interest rates quickly rise.

Even Apple has seen its valuation drop by around 25% despite continuing to post largely positive quarterly trading updates. At the other end of the scale, Meta Platforms, which owns Facebook and Instagram, has been punished by markets for a combination of its ad revenue growth slowing and the perception CEO Mark Zuckerberg has taken his eye off the ball in a stubborn and expensive pursuit of dominance in the still hazy and unsure future metaverse. Its valuation has been crushed and is down 70% to date.

However, away from the headlines of mass layoffs at the biggest tech firms, Meta has just announced 11,000 redundancies and new Twitter owner Elon Musk has brutally axed half the microblogging platform’s staff, another sub-category of tech is suffering almost as badly – software as a service (SaaS).

Mainly mid and small-cap companies, the unbridled market exuberance of 2020-21, which especially favoured high growth tech stocks, saw a significant number of SaaS companies go public at giddy valuations. While not all have suffered equally this year, many have seen their valuations slump by as much as Meta Platforms, and some even more.

Twilio, a SaaS company that that sells cloud-based digital communications tools, has seen its valuation plunge by over 83% this year.

Yesterday, David Heinemeier Hansson, co-founder of 37Signals, the SaaS company behind the popular project management tool and Hey email service, published a blog bemoaning what he sees as the sector’s self-harming dash for cash over recent years. Founded in 1999, originally as a web design design company before moving into app development, 37Signals has staunchly refused to chase high growth rates in a way the co-founders see as unsustainable. Or take on VC or public markets investment. As of 2021, the company famously only had 34 full-time employees.

Hansson’s critique of rivals, many of whom achieved valuations in the billions as either still-private VC-backed unicorns or newly listed companies, may not be entirely objective. He is a “stay private, say no to VC cash and the strings attached, grow organically” evangelist. But he also raises key points and lays bare the extent of the funding pumped into SaaS companies, which has funded massive losses in the pursuit of high velocity user and revenue growth.

For investors, the smoking wreckage of public and VC-backed SaaS valuations offers a lesson on what to look out for the next time markets move into meltup, as they inevitably will when the economic and financial markets wheel has again turned full circle.

What are SaaS stocks?

SaaS is an acronym for software-as-a-service, which essentially means software sold via subscription model. The traditional software business model was based on users purchasing a software license upfront which then allowed them to use it for as long as it was useful to them. Software companies would typically launch a new or updated version of the software every few years, which usually meant users who wanted to upgrade had to purchase a new license.

Cloud computing opened the way for a new software sales model – SaaS. SaaS products can be either web-based, which means they work via an internet browser, or application based – the packaged code is downloaded onto a computer or mobile device and run on the hardware. It is not uncommon for a SaaS product to offer both, like Microsoft Office 365 which users can either use online or locally via apps installed on their devices.

Cloud computing means both web and app-based SaaS products can be continuously updated and improved without users needing to wait for a new version to be released. We’re all now familiar with our apps giving us a notification an update is ready to be downloaded and installed. And for web-based software, even that’s not necessary. Updates can be rolled out in real time and be part of the product the next time a user opens it up in a browser tab and signs in.

Of course, in theory, software updates could be added more regularly to traditionally licensed software too. But because the business model is based on users buying one-off licenses, companies have to release a significantly and obviously updated and improved product.

New releases also can’t be more regular than once a year at most if the company wants to avoid alienating customers who have just paid for the license of the inferior previous product. The update also has to be significant enough and seen to add enough value to convince current users of previous versions to fork out for a new license.

SaaS avoids those limitations by selling access to continuously updated software products via a usually monthly fee, with discounts usually offered to users who pay for a year in advance. The SaaS model has strong commercial advantages as well as meaning software can be constantly improved, keeping it competitive in comparison to rival products.

There are a huge variety of SaaS products that target both retail and business users. Any app you have on your phone or computer for personal use you pay for monthly or annually is a SaaS product. But the most valuable SaaS companies usually sell business products. Well-known examples include Microsoft’s Office 365 suite of productivity tools, the FreshBooks accountancy software, the sales, marketing & CRM platform Hubspot and Slack, the communications and collaboration app.

When a company integrates a SaaS product into its business processes, it usually stays loyal to that product for at least a few years. Changing such tools is disruptive and often costly because it takes employees time to get used to an alternative and they are often integrated with other systems and SaaS products.

Selling software products via a monthly subscription massively increases the average revenue per user companies generate. The monthly fee is usually small enough to tempt new users into a SaaS product and not be seen as a significant expense. But over months and years usually adds up to much more than the upfront one-off cost of a traditional license.

Investors also love predictable recurring revenue streams, especially if they are growing quickly. That is one of the main reasons why so many SaaS companies, especially those selling into businesses, have successfully attracted big valuations as still private start-ups. And then even bigger valuations as publically listed companies.

Unfortunately, investor enthusiasm for the SaaS model also led to what was now obviously a valuations bubble.

The SaaS stock rout – what and why

In his blog, Hanssen spins off a list of SaaS companies that have seen their valuations plunge this year including Asana, Monday.com, and Smartsheet, all productivity tools which have seen their share prices shed 88%, 78% and 62% respectively over the past year.

He points out with a hint of smugness:

“Asana lost an incredible $285m in 2021, $210m in 2020, and $118m in 2019. They’re on track to losing even more with over $370m in losses booked for the trailing twelve months. That’s closing in on a billion dollars in losses over the last four years. Madness. To use the glib insult that we’ve also enjoyed receiving over the years: They make f*****g todo lists!!”

He goes on to predict worse is yet to come for Asana, which has only $238 million cash on hand, which won’t last another year at the company’s current loss rate, concluding:

“And where is relief going to come from? 17% of the stock is held by shorts. Will Asana raise more capital with new issues at these levels, and essentially wipe out the investors who went in just a little while ago? Interest rates aren’t about to let up any time soon either, and everyone is predicting the economy will get worse in 2023. It’s ugly.”

Even more mature SaaS companies with less competition like Atlassian, which makes project management tools popular with software engineering teams, are suffering more than expected. Investors hoped these software products would be so deeply embedded into company processes that customers would not jettison them during an economic downturn.

But it turns out that as public companies they are more tied into to the macroeconomic environment than it was hoped they would prove because heady valuations were so tightly coupled with growth rates. Motley Fool writes:

“Atlassian reported that it continued to see fewer users of its free software subsequently convert to paid plans, with adverse trends from the previous quarter worsening over the past three months. In addition, the workplace software company started to see its rate of growth among existing customers slow this quarter.”

What went wrong for SaaS stocks?

Hanssen blames the VC backers his own company has made a point of turning down over the years:

“The logic of venture capital is to rush every business it touches through a steroid program that accepts a mortality rate of up to 90%. All it needs is one moon shot out of ten to hit escape velocity, and the fund will be golden.”

“But golden for whom? For how long? The venture capitalists who invested in Asana, Monday.com, and Smartsheet surely all made out like bandits when these unprofitable software companies went public. Now every single one of these stocks is getting destroyed in the public market, as investors sour on the idea of them losing hundreds of millions of dollars every year chasing growth with no prospect of profits in sight.”

VC companies invested in still private SaaS are, however, also taking a hit now. They invested at sky-high private valuations and now own chunks of companies that are racking up hundreds of millions in losses and are a million miles from profitability because the condition of their funding was to pursue huge growth at almost any cost.

Most of the VCs will, however, likely survive and recover if just a tiny number of their bets come off. But many of the founders of the SaaS companies that relinquished control and saw shareholdings watered down for the promise of a shot at billionaire status may be left with very little to show for it. Their companies will either fold or early shareholders be all but wiped out by the need to raise new capital at knockdown valuations.

The lesson for investors

It would be too simple, and almost certainly a wrong decision, to say investors should avoid growth companies. Or even SaaS companies in future. The SaaS bubble blew up precisely because the business model is so attractive and profitable. Good SaaS software products come with high margins, low fixed costs and minus the logistics and supply chain issues that physical product companies have to deal with.

But investors would be wise to remember the lesson of how quickly it can go wrong when huge valuations are attached to loss-making companies, regardless of their growth rate if a route to profitability is not clear on the horizon. Especially in high-competition markets like that for productivity tools, professional software solutions and consumer-facing apps that have relatively low barriers to market entry for new competitors.