We sure do miss simply worrying about a global pandemic instead the trifecta of rising inflation, negative GDP, and global unrest. Market conditions have hit the COSS Index hard as open source stocks have traded down 44% YTD, or more than twice the Nasdaq retracement. From a valuation standpoint, COSS companies and the broader cloud index are trading near the trough of their five-year lookback period. Cloud companies are down 3 multiple turns from their long-term average at levels not seen with persistence since 2017.
The private markets seem less impacted (although they tend to lag the public markets) with over $750mm going to 9 companies in the last two weeks including $230mm to Harness, a self-service CI/CD platform co-founded by AppDynamics founder Jyoti Bansal.
This week, Mark Coleman (GM, Netbox) interviews David Wilson (CFO, NS1) across a spectrum of topics at the intersection of finance and the open source community, including valuation, fundraising, and financial health. As open source continues to proliferate through the enterprise, the financial implications of early decisions will continue to play a critical role in the long-term success of a project.
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Private Markets
Sonar, building tools for clean code, announced their $412M funding round led by Advent International. Link
Harness, building a modern software delivery platform, announced their $230M Series D led by Norwest Venture Partners. Link
ARMO, making the first open-source Kubernetes security platform, announced their $30M Series A led by Tiger Global. Link
Smallstep, building security infrastructure with certificates, announced their $26M Seed/Series A led by StepStone Group. Link
Fleet, building device management security tools, announced their $20M Series A led by CRV. Link
Enso, makers of a self-serve data analytics and visualization platform announced their $16.5M led by SignalFire. Link
Deepset, building NLP-powered search integrations, announced their $14M Series A led by GV. Link
Rocicorp, makers of Replicache, announced $7M in funding led by Elad Gil. Link
Nuclia, a low-code API for multi-language semantic search, announced their €5M Seed led by Crane. Link
Public Markets
To track the performance of COSS companies, we’ve created an equal-weighted index comprised of public names including Gitlab, Kaltura, Couchbase, Confluent, MongoDB, Elastic, Rapid7, Fastly, and Jfrog.
The COSS Index continued its downward trajectory in conjunction with the broader indices who are off to the worst four-month start in decades.
COSS Index -44%
NASDAQ -20%
S&P 500 -13%
The COSS Index fell back into the red this week as April finished with the worst monthly performance since March 2020.
COSS Index -1%
NASDAQ +56%
S&P 500 +42%
The COSS Index traded below its five-year average by 1.5 multiple turns as the appetite for risk has retreated quickly from the market. The NASDAQ also fell below its five-year average nominally while the Emerging Cloud Index fell dramatically to close nearly 3.0 multiple turns below its average.
COSS Index: Current Multiple 11.6x | Five-Year Mean: 13.0x
Emerging Cloud Index: Current Multiple 7.4x | Five-Year Mean: 10.4x
NASDAQ Composite: Current Multiple 3.4x | Five-Year Mean: 3.5x
Interview with Mark Coleman (GM, Netbox) and David Wilson (CFO, NS1)
Mark Coleman: Could you share an overview of your background and how you ended up at NS1?
David Wilson: Of course Mark, I’m a serial CFO who’s built a career that’s essentially focused on Networking at a range of different companies, including home broadband with DirecTV; facilities based wireline and wireless with ACS; online video delivery with Ooyala; encrypted messaging with Symphony Communications; and now foundational network services with NS1.
There were essentially three compelling reasons for me joining NS1: First, the quality of the application logos that NS1 supports- I’m hard-pressed to think of a single customer, whether at work or at play, that NS1 doesn’t support. Second, the amount of customer love NS1 has been able to garner serving these customers. NS1 enjoys an NPS score of +70. That level of customer love is practically unheard of in the B2B SaaS space; and third how extensible the core foundational technology is and the opportunity to leverage it to abstract out complexity for customers as they embark on the digital transformation journey. This is a massive market opportunity.
Mark Coleman: A question for those readers who, like me, don’t have a background in finance. Could you share some of the rules of thumb you use when assessing the financial health of a software business?
David Wilson: If I narrow down the scope of your question to VC-backed SaaS businesses, I certainly can. At the highest level, there are essentially two major areas that matter the most in assessing the health of a business: 1) topline growth; and 2) strong evidence of operating leverage (i.e. at scale the business will throw off a lot of cash).
Starting with growth, early-stage SaaS businesses are essentially valued on a revenue multiple with the size of the multiplier heavily correlated to how fast the company is growing. So simply put, topline growth is king for valuations because it maximizes both the absolute revenue number and the size of the multiplier.
Breaking this down for a subscription business there are essentially two key measures for topline growth, gross bookings, and gross dollar retention (the inverse of $ churn). A helpful analogy is to think about water coming out of a faucet (gross bookings) into a bucket with some leaks (churn). In terms of the underlying health of a business, having fewer leaks in the bucket is the most impactful measure as it’s way more efficient to retain customers than it is to add them.
Looking at the second area, operating efficiency, there are three key measures, stated in order of importance.
Gross Margin is the primary determinant of how much cash the business will throw off at scale. Customer Acquisition Cost Ratio is essentially how many dollars you need to spend in sales and marketing to land a dollar of recurring revenue. As the business scales, Sales and Marketing is typically the largest source of OPEX spend. Efficiency here, therefore, limits the amount of shareholder dilution you will incur as the business grows. Expense to revenue ratio for R&D and G&A means essentially, for every dollar of revenue that I earn, how many cents do I spend in these areas. These ratios typically drop down significantly as the business grows as they benefit from economies of scale.
Mark Coleman: Could you share your opinions on fundraising, and how that’s changed over time?
I think there are two vectors to think through when looking at fundraising. The first is the thing you have the most control over, your underlying business. There’s a huge amount of overlap between what an investor is looking for and the measures for business health that we just discussed.
There are other things that have an impact on an investor’s willingness to fund at favorable valuations which include the size of the overall market opportunity, how compelling & defensible your solution is versus the competition, and fashionable go-to-market and business metrics like product-led growth and high net dollar retention through cross-product upsells.
The second vector is the overall market conditions. These have definitely worsened over the last year. 12 months ago the revenue multiple in public and private markets for SaaS companies were at record high around 20x compared to sub-10x historical norms. These record highs were driven in part by excess capital chasing returns because of low-interest rates and also COVID driving tech demand in general leading to a “growth at any price” approach.
From Q4 last year there’s definitely been a major turn in how accommodating the markets are to fund SaaS businesses. Raising interest rates started this off, but the current geopolitical landscape has been a factor here too. Markets are taking a much more balanced approach and while revenue growth remains the primary valuation gauge, it is tempered by an increased focus on how much cash is being burned to generate that growth, leading to a “growth at a reasonable price” approach.
Mark Coleman: How has open source affected the way that you look at financial health, and valuations?
David Wilson: That’s a great question and while I don’t have a definitive answer I can share some perspectives based on first principles thinking together with an illustrative example.
Successful open source companies have a massive advantage versus closed source businesses when it comes to operating leverage for numerous reasons.
They get to crowdsource, at minimal cost, development and support activities. Crowdsourced marketing through word of mouth is a factor too. Open source projects are often a great fit for product-led go-to-market motions which have the potential to drive an extremely efficient customer acquisition cost and finally, an active community provides a wonderful window to identify and nurture target customers, again driving GTM efficiencies.
While there are major operating leverage advantages, these are, however, tempered by significant drawbacks on the revenue side of things.
By its nature, the protective moat for pure open source revenue is both narrower and shallower than for closed source. Lower barriers to entry limit pricing power and increase the possibility of a competitor entering the market with a similar product at a lower price.
MongoDB is a great worked example of this where its underlying offering was at great risk of being arbitraged away by an AWS managed service offering. In order to protect itself, MongoDB essentially transitioned the work on the underlying product that it was spending hundreds of millions of dollars on to a much more restrictive license, effectively stranding AWS on a legacy version of MongoDB.
Overall though, the risk profile attached to open source revenue likely trumps the operating leverage benefits, meaning OSS companies will trade at a discount to a closed source software company of similar size and growth rate. That said, there are things that an OSS business can do with the underlying license to help protect revenue streams and, by extension, close the valuation gap.
Mark Coleman: Let’s talk about NetBox. What do you think about investing in an open source community? What excites you, and what worries you about it?
Well there’s a huge amount to be excited about with thousands of enterprise users, 10K+ GitHub stars, and a product that’s highly complementary to the core services NS1 is developing. Of those thousands of enterprise users, the vast majority are on-prem which is counter to where the world is headed with a strong preference for key applications to be delivered through the public cloud. As a phase one, there’s a clear need and opening to bring a managed service offering for Netbox to market, an opportunity set that’s currently monopolizing your time Mark and one that also requires NS1 to make significant investments back into the OSS project.
Looking to future phases, megatrends centered on network automation and edge computing creates an opening for NS1 to provide tools and capabilities, which are desperately needed to help tame the complexity of digital transformation, to NetBox users through plugins.
Mark Coleman: Based on the strong start we’ve seen in Q1 for NetBox. How does that affect your thinking? Has your concern or excitement focus changed?
The real joy of Netbox is how tangible and realizable the opportunity set is. While there are no sure things in business, Netbox is pretty damn close with a meaningful subset of the current enterprise users keen to transition over to a managed service. The risk-reward profile here is so compelling that the overriding desire is to move more quickly and aggressively than previously planned or contemplated.